The word quirky probably doesn't do justice to Raven Industries (NASDAQ:RAVN), as this small conglomerate is a leader in such disparate markets as reinforced plastic sheeting, GPS-based controls for agricultural equipment, and high-altitude balloons. While Raven has consistently generated strong returns on capital, the free cash flow hasn't been as consistent or impressive. With meaningful exposure to markets like energy and government and what looks to be a premium valuation, I think investors may do better to wait before making a major commitment to Raven with their own capital.
Three Very Different Plays Under One Roof
As the intro indicated, Raven operates in three non-overlapping businesses - engineered films, "applied technology" (precision-guided controls), and Aerostar. While this a fairly strange mix, Raven has a significant market presence in these markets and relatively few competitors with similar resources.
Films - Will Construction Pick Up Where Energy Leaves Off?
Raven's engineered films business provides a variety of reinforced plastic sheeting products that are designed to either protect property from the elements or protect the environment from contaminants/pollutants. To that end, while "reinforced plastic sheeting" may sound like a simple product that anybody could produce, Raven serves markets with low tolerances for failure/leakage (and often potentially high costs for remediation) and there is considerably more engineering and certification/qualification involved than may seem obvious at first glance.
There are numerous applications for heavy-duty plastic barriers, including environmental protection (lining landfills and water systems), packaging films, vapor barriers, and silage covers, but Raven gets close to 50% of its revenue in this division (roughly 15% of total company revenue) from the energy industry. Raven's films are used as liners for the pits that drilling companies use to store fluids necessary for drilling and fracking. That effectively exposes the company to U.S. onshore drilling activity, and service companies like Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL) have amply demonstrated lately that that's not a great place to be.
This could be a somewhat vulnerable business for Raven in the years to come. While there are a lot of environmental objections to fracking, at least some of those objections center around the use of pits to store the fluids - faulty liners can allow seepage into the ground, while inclement weather can lead them to overflow. There is a risk, then, that Raven could see service companies choose to (or be forced to) switch to alternatives like tank farms or above-ground reservoirs like those sold by Poseidon Concepts (OTCPK:POOSF).
On the other hand, the downswing in construction activity could be about to reverse. Raven's films/sheeting are used as under-slab vapor barriers and to protect construction projects from the elements. If and when construction activity picks up, I would think Raven should see more demand in this industry.
As will be a common theme for Raven, there aren't many direct competitors of note for Raven in this business. GSE Holding (NYSE:GSE) is a credible rival in geoliners, but packaging film companies like Illinois Tool Works (NYSE:ITW) really aren't peers or rivals, and products like DuPont's (DD) Tyvek are a very different thing altogether.
Aerostar Can't Float On Its Own
While Raven's Aerostar division is best known for its high-altitude balloons, that's only part of what this division does. Raven also sells inflatable military decoys - basically, special balloons that look like planes or tanks and have similar radar signatures. Raven also sells protective clothing, parachutes, surveillance technologies, and offers EMS services in the aerospace sector (largely to United Technologies' (NYSE:UTX) Goodrich business).
Here, too, there isn't exactly a who's-who list of competitors to Raven in its primary markets. Japan's Totex sells meteorological balloons and parachutes, but it's not as though there's an easy to find list of companies who manufacture inflatable fake F-16s. Companies like 3M (NYSE:MMM) and DuPont are competitors on the protective clothing side, but again that's a small part of what Raven does.
The bigger risk to the high-altitude balloon business is from government budgets. Under sequestration and likely lower federal spending, it is probable that NASA and NOAA are going to see their budgets cut, and that could filter down to Raven. Likewise, I wonder if high-altitude unmanned vehicles, like descendants of Boeing's (NYSE:BA) Condor, can eventually grab a bit more of this market.
Applied Tech - Smarter Agriculture Holds A Lot Of Promise
Raven's largest business, and the one that I believe holds the most long-term organic growth potential, is its precision agricultural controls. From field computers to GPS-guided steering to application controls, Raven sells a wide array of products designed to make farming easier, more precise, and more productive. Given that every extra bit of yield goes into a farmer's pocket, that's no trivial opportunity.
What is most interesting about Raven's approach is that the company has chosen to collaborate with rather than compete with major ag machinery OEMs like Deere (NYSE:DE), AGCO (NYSE:AGCO), and Case (CNH Global (NYSE:CNH)). Raven's products integrate with systems like Deere's StarFire and allow farmers to perform tasks like crop spraying with exceptional accuracy. Raven is also working closely with Monsanto (NYSE:MON) on its IFS (Integrated Farming System) project - a service that is designed to help farmers determine optimal seeding and could boost yields by 5% or more.
Can Raven Hit Lofty Goals?
Raven management has talked in the past of targeting 10% to 15% growth rates for revenue and earnings. I believe that could be a challenging goal to meet. More than one-quarter of the company's business is tied to government spending, and while the long-term potential in both energy and construction look solid, they are volatile markets (and energy could see regulator-mandated changes in how companies operate).
As it stands now, I see Raven growing its revenue at a long-term rate of about 7% - below the historical trailing rate of 12%, but still fairly solid relative to most companies. Raven has a mixed history of converting revenue to free cash flow and though I expect that to improve, I don't see large-scale fundamental changes. I believe Raven has room to improve its operating margin by a few percentage points, and I believe that free cash flow production can become more consistent, but I think the company will be hard-pressed to produce free cash flow margins above the low teens on a consistent basis (it has done so just once in the past ten years). To that end, then, I see free cash flow growing at a long-term rate of around 10% - ordinarily a very good growth rate for most companies.
The Bottom Line
Although Raven is barely covered by the Street, it's no secret to institutional investors and the stock does not look significantly undervalued today. Based on a 10% free cash flow growth rate (which is actually higher than the trailing rate over the past decade), I see fair value for Raven at around $25. Even if management hits that 10% revenue growth target, the fair value only jumps to $30 - neither of which suggest significant undervaluation.
A growth rate of 10% suggests that Raven's stock can still perform quite respectably over the coming years, though I caution investors not to underestimate the challenges that could make the results in Aerostar and films more volatile. I'm not inclined to own these shares at today's valuation, but the company's strong history of returns on capital and owner earnings growth indicates that this would be a name worth revisiting at a lower valuation.
Disclosure: I am long MON, MMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.