Why Ceco's Dividend Increase Translates Into A Higher Price Target

| About: CECO Environmental (CECE)

Over the past few days, the GeoTeam's interest in Ceco Environmental (NASDAQ:CECE) has been heightened. The company offers a special situation play similar to one that we had just recently highlighted in Orchids Paper (NYSEMKT:TIS), which has already experienced a gain of over 37% to a high of $19 since our mention. If history repeats itself, we may be at least looking at a successful trade and at most a very lucrative near-term investment opportunity.

Why we are so interested in CECE

On Friday, March 9, 2012, CECE announced that it was increasing its quarterly dividend per share by 40%, from 2.5 cents to 3.5 cents. We consider dividend increases greater than 25 % to be game changing scenarios. Since the announcement, the stock's price has gained 15%, but we feel that there is still room for the value of CECE to quickly appreciate up to $12.75 per share.

Our target price can be justified by reviewing the TIS play.

Similarities to the Orchids Paper Situation

Our assumptions regarding TIS proved to be spot on. At the time that we brought our interpretation of Orchid Paper's dividend increase to light, the company's shares were trading at around $14.50 per share. Commensurate with the dividend yield eventually settling closer to the value that it was prior to Orchid's dividend increase, TIS shares quickly increased in price and surpassed our target of $17 per share. Excerpts from our research:

[...]Prior to this dividend boost and based on the prior day's closing price of $12.67, the market had assigned to TIS a dividend yield of about 3%. The stock's price responded to the dividend news by rising sharply to $14.61. Even at the higher price, the dividend yield now stands at near 6%. Boosting the quarterly dividend could lead to a vote of confidence by investors who may now view TIS as less risky investment.

As the Orchids Paper story may now embody less "perceived" risk, we will be watching to see if the market will fill the dividend yield gap by lifting shares. Said differently, dividend yields can be a way that the market assigns risk premiums to companies. The higher the yield demanded by investors, the lower the price [...]

[...] If the market was willing to price TIS with a yield of around 3% the day before the dividend increase and believes that the company's risk profile has at least remained the same, it should reduce the new and current dividend yield of around 6% should once again approach 3%. Per the formula this would occur through an increase in the price of TIS shares. [...]

[...]In the end, we think that market could assign TIS a P/E of 25 on 2011 analyst estimates of $0.68. This would translate into a price of $17.00 and a dividend yield of 4.7% (~midpoint between new yield and old yield). Again, the increase in the dividend should also create a new higher floor for TIS shares. [...]

Applying the same logic to CECE, especially when considering that the company has an active stock buy back program in place, we can say to a degree of certainty that the company's risk profile has not changed substantively and possibly improved. There is really no reason for there to be a higher risk premium assigned to the company, especially being that the magnitude of the dividend increase could lead the market to assume that CECE is more confident about its near term outlook.

Before the announcement of the dividend increase, when CECE was trading around $7.50 per share, the annual dividend yield was:

[($0.025 per share) x 4 quarters / $7.50 per share] x 100, or 1.33%

The annual dividend yield based on the current price, a few days after the announcement, is:

[($0.035 per share) x 4 quarters / $8.47] x 100, or 1.65%

It is our belief that the current annual dividend yield will once again gravitate towards 1.33%, leading to the higher price:

($0.035 per share) x 4 quarters x 100 / 1.33%, or $10.52 per share

Of course, one could just adjust the share price by the amount of the dividend increase:

40% * $7.5 = $10.50

P/E Expansion - An Added Bonus of a Lower Risk Profile

There is also likelihood that CECE will enjoy the benefit of P/E expansion. 2012 analyst EPS estimates reveal that a year over year growth rate of about 25% is in the cards for the next three quarters. Considering our assumption that the market will assume that the risk profile of the company has improved, we feel that the attainment of a P/E of equal to CECE's near-term growth rate is realistic. Couple this with the fact that the company made its dividend move one month before the end of the first quarter, and it could be argued that analyst estimates are on the conservative side since they may have not yet taken the company's vote of confidence into consideration. A P/E of 25 on trailing EPS of $0.51 would equate to an immediate short-term price target of $12.75.

Disclosure: I am long CECE, TIS.