Mestek (OTCPK:MCCK) manufactures and distributes heating, ventilation and air conditioning (HVAC) equipment. According to Q1 2014 report the company now also produces automated duct making machinery in its new factory in China. Mestek has a long history as it was started by John Reed, now Chairman of the company. The Reed family still owns a majority of the business. Mestek has over the years acquired numerous smaller, usually family-run, businesses to integrate under its "Mestek family". It is difficult to say how well these acquisitions have been done (company doesn't disclose revenues or profits from the acquired businesses separately) but in general purchasing small family-owned businesses in a mature industry should give decent odds of adding value to shareholders. Goodwill amounts currently to $25 million. Without any numbers it's impossible to say for sure whether the company has gotten revenue and cost synergies worth +$25 million from the acquisitions.
For management Mestek gets a big plus sign. If the annual reports' messages represent reality, CEO Stewart B. Reed seems to know what his role in the company is. In the 2013 annual report he writes: "My primary role is capital allocation, compensation, asking the right questions, and helping the people who do the heavy lifting." And later, regarding capital allocation: "If no favorable risk versus reward opportunity is apparent, we don't try to force one." In 2012 the company paid a special dividend of $3 per share. Because of taxes, the company doesn't currently have intentions of paying a regular dividend. Instead they believe that it is best to be patient and look for opportunities to put the cash to work and create more value (referring mostly to acquisitions and capex).
How do the company's operating results look like then? From 2007 to 2013 operating cash flow has grown from $16.5 to $36.9 million last year (12% growth per year). Net income has grown from $1.6 million in 2007 to $16.6 million in 2013, or 39% per year. Revenue hasn't grown during the same period as it was $378 million in 2007 and $331 million in 2013. Though it's worth noting that from 2012 revenue grew 10% to 2013. In Q1 2014 revenue growth was 3.6% year-over-year. With today's $135 million market cap (and $122 million EV) Mestek trades at 0.41 times sales, 8.1 times net earnings, 0.97 times book value, 4.6 times free cash flow and at an EV/EBITDA multiple of 3.8. Even though the numbers look good, they're gotten by using 2013 results which were all time high. Still, taking for example the average FCF of the past 7 years you get a P/FCF multiple of 7.5 and EV/EBITDA of 5.3.
Why is the stock undervalued?
To date, Mestek has had about 400 asbestos-related cases dismissed without any payment and settled 26 cases for a "de minimus" value. Currently the company is a party to approximately 140 asbestos-related lawsuits with total requested damages of over $3 billion. It is extremely difficult to say how these will turn out eventually. Buyers of the stock should bear in mind taking this risk could blow up. However, if the past 400 cases are any indication of the next 140 cases, the company should be alright (from 2012 100 cases have been dismissed). The cases most likely take up management's time and resources, although that seems to have been the case in the past as well. Besides the asbestos-cases, the company has reserved $8.5 million for an environmental case against its one Illinois factory. Whether that amount covers all the costs is unknown. According to management, to date the expenses have been lower than expected.
The HVAC industry in general isn't the sexiest or most profitable one in the world. If the industry faces headwinds, the company doesn't have a whole lot of room for margins to suppress without going negative. Although in the past 7 years the company has been steadily profitable, this could of course change.
Mestek trades in the OTC market and the shares aren't especially liquid. Past 30 days average daily volume www.otcmarkets.com/stock/MCCK/quote is 182 shares or about $3000. This certainly limits the amount of investors who would be able to take a position in the company. However, this shouldn't be that big of an issue for smaller investors with patience to use limit orders and no real need for huge liquidity in the stock.
A decent scenario for shareholders would be one where Mestek grows revenues at least 5% per year and at least maintains its 5% FCF margin. Because the company isn't the most liquid one it's worth giving it a couple years to find it's way up. Assuming at the end of FY2015 Mestek has revenues of $365 million and FCF of $18 million (5% of revenues, below 7 year average of 5.6%), a conservative investor would put a price tag of $180 to $200 million on the company. An upside of 35% to 50% in 2 years with such conservative assumptions is certainly intriguing.
But what could happen if things go better than just OK? Let's take a 5 year case. Revenues growing at 5% per year leaves the company with $420 million in sales. Thinking they'll be able to continue the good performance and generate 7-8% in FCF (in 2013 they did almost 9%) would give $29-$34 million in FCF. Putting a multiple of 12-13 we get to a range of $348 to $442 million, an upside of 150% to 225% (20% to 26% annualized). Whether the company is able to grow at 5% for the next 5 years remains to be seen and could prove to be difficult but certainly the assumptions are still achievable. Though, to err on the conservative side, these valuations don't give any merit for possible returns of cash to shareholders or other means.
In a bear case the company finds itself struggling with sales plunging and profitability taking a hit, but doesn't run into issues with the litigation. Instead of trying to figure at what earnings or FCF multiple the stock might be trading in such a situation, we'll look at book value. Currently Mestek's book value stands at $139 million with goodwill of $25 million. If the company had to impair all of the goodwill and then traded at 0.85 times book value, we'd get a valuation of $97 million (downside of 28%).
If litigation cases go very bad, there's perhaps the possibility of the company going to zero. How big is this possibility? Hard to say, but if past is any indicator of future, not very big. Having had about 400 cases dismissed without any payments and 26 cases settled for small payments, dealing with the rest of the cases without bigger damages should be more likely and unlikely.
Multiple expansion to more appropriate valuation levels can happen via many roads in Mestek. If the company shows it can grow the topline, share price will most likely follow. If the legal cases are settled without large payments, shares could easily rocket up as potential litigation payments are likely holding some investors back for the moment. Additional special dividends down the road would most likely give a nice boost as well. Getting more liquidity in the stock would certainly help the valuation, although it's not the most likely thing to happen as it'd probably require the Reed family to sell some of their shares or the company to issue new equity.
Roadmap for investors, what to do next
There's a lot to like in Mestek. A business run by family-owner who appreciates minority shareholders, understands capital allocation and tries to do the best value-driving decisions. Combine this to a valuation that is on the bargain side no matter which way you look at it and you have Mestek.
So for whom is this stock? Investors who are able to buy the illiquid stock and don't see the need to trade the stock all the time. Some patience might be required as the company's lack of liquidity could make value realization slower than what it'd be with more liquid stocks. And finally one must be willing to bear the risk that is posed by litigation. For these investors, Mestek offers a very interesting buying opportunity at the current prices.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in MCCK over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Please, do your own due diligence, there’s always a risk of losing one’s principal. The company’s stock is illiquid, using limit orders is encouraged.