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The Eastern Company (NASDAQ:EML) is a micro cap Industrial Goods company specializing in the sales of small tools, a rare industry to begin with. Eastern Company specifically sells industrial hardware products, security products, and metal casting products. Some examples of the products they sell are various latches such as dead bolt latches and compression latches and also a number of passenger restraint locks commonly used in motor vehicles. Keep in mind; Eastern Company is only worth 107.3mm so its market share is miniscule compared to its larger cap competitors.

Along with that, Eastern Company has a very small and highly specific market, which they are slowly losing market share in. Since they only offer a highly unique number of products, it is difficult for it to increase its revenues Q/Q and Y/Y.

The industrial hardware products Eastern Company sells are used in a small number of moving vans, school buses, some military vehicles, and recreational boats. It has trouble diversifying this group of consumers, and expansion has only put them in debt, 7.50mm in debt giving Eastern Company a debt to equity ratio of 0.58. To put it in perspective, it has 7.50mm in debt and the company is only worth 107.3mm to begin with making it extremely difficult for it to pay off its debt. The security products it sells are used in various timers, coin chutes, and drop meters. Again, these are very specific products with an even smaller market making it difficult for Eastern Company to maintain its market share given its financials and debt. Its metal products are used in railroad braking systems, support anchors, and adjustable clamps commonly used in construction. This is a small segment of its revenue though.

The Eastern Company is currently trading at $17.24 as of November 29th, 2013. With its current financials, specifically its debt, I have given it an intrinsic valuation of $13.19: A 23.5% downside from its current price per share. This valuation is driven by decreases in revenue growth Y/Y and also an emphasis on its lack of ability to pay off existing debt, which has been steadily increasing Q/Q. Typically companies will build up debt due to expansion or research and development for new products, but we as investors have not seen many new products or expansion through its 7.50mm in debt.

In 2012, Eastern Company broke $24.00 per share and rapidly plummeted below $14.00 before the end of Q4 of 2012. This fiscal year to date it has recovered to its current price per share of about $17.00, but so have the majority of companies within the industrials sector regardless of market capitalization. Even though its price per share has recovered, I stand by my valuation that Eastern Company is overvalued and will be trading closer to its book value in the near future. Granted the time frame on this investment may be longer due to the current recovering macroeconomic state, but shorting at these levels is difficult to pass up.

Fundamentally, Eastern Company's gross and net margins have had trouble Q/Q so far in 2013, despite the increase between Q1 and Q2 of 2013: due to the success of the capital markets and industry as a whole. It will not be able to maintain these mildly successful margins in the future with 7.50mm in debt.

2012 Q3

2012 Q4

2013 Q1

2013 Q2

2013 Q3

Gross Margin (%)

7.50

8.33

5.89

10.26

7.68

Net Margin (%)

5.00

5.56

2.86

5.13

5.88

Seemingly, it may appear that Eastern Company should have the ability to pay off its large sum of debt accumulated over the past few years. However, its current and quick ratios have been decreasing from its highs ever since the price per share briefly broke above $24.00 back in Q2 of 2012.

Liquidity Ratio

2013 Q3

Current Ratio

5.62

Quick Ratio

3.31

Working Capital Turnover Ratio

0.57

Operating Cash Flow

0.25

Along with its liquidity ratios, Eastern Company's fundamental ratios have been decreasing since its all time highs as well. A few things to note are that its P/B ratio was significantly higher back in Q2 and also P/S has remained at its current level below 1.00. Given its debt situation, we should not expect to see a P/S ratio above 1.00 for quite some time now.

Fundamental Ratio

EML

Industry Average

P/E

15.6

18.7

P/B

1.4

2.5

P/S

0.7

1.4

It is true that there are many benefits of owning a micro cap stock such as The Eastern Company. However, as an investor I do not see any of these benefits currently, or in the future. In the past it has demonstrated some of these benefits, but as of now I stand by my valuation and investment thesis that The Eastern Company will retract to its book value (P/B 1.00) and continue to decline at least until it is able to begin to pay off its large sum of debt.

Source: The Eastern Co. Weighed Down By $7.5M In Debt