National Presto: Deep Fryers And Grenades

Summary

• National Presto, at first glance, looks like a stereotypical low-end kitchen appliance manufacturer.
• The vast majority of cash flow and EBITDA is generated from its Defense segment, particularly the sole supplier contract on 40mm rounds.
• The Defense sector is red hot right now; National Presto is not. Sum-of-the-parts suggests significant upside.

Potential investors visiting the website of National Presto (NYSE:NPK) would be forgiven if they came to the conclusion that they would primarily be investing in pressure cookers and air fryers, but the reality is that the company generates much of its earnings from selling ammo for grenade launchers. Like most structurally odd conglomerates ruled by founding families, the company is not a bastion of shareholder friendliness. Just $6mm worth of shares change hands every day; Maryjo Cohen, CEO since 1994, controls nearly 30% of shares outstanding. Quarterly conference calls or investor presentations? Not happening here. However, the company does throw off gobs of free cash flow and has a history of paying out large special dividends. Is the relative lack of shareholder interest worth the risk?

Business Overview

Normally not a starting point, but it makes sense to start here given the framework. National Presto carries absolutely zero debt. While the firm has a $648mm market cap, $155mm, or nearly 25%, of the market cap is in cash and cash equivalents. Some of this will leave the firm in the form of the regular and special dividends paid out in March ($42mm) after the last quarterly earnings release, but that will all be replaced by year end in the form of free cash flow generation. All in all, this is an extremely low risk small cap.

While grenades and pizzamakers seem like an odd combination in the manufacturing space, the situation was even more wonky: investors in 2016 had to throw adult incontinence products into the mix as well. Thankfully, after the sale of Presto Absorbents early last year for $68mm to Drylock Technologies, National Presto currently breaks down results under two operating segments:

• Houseware/Small Appliance. Sales are made up of a variety of household electronic products ranging from heat control skillets, pressure cookers, slow cookers, deep fryers, pizza ovens, etc. Produced in China, these products are sold in stores like Walmart (WMT) and independent distributors in the United States and Canada. Like most similar firms, the business is seasonal, with sales peaking in Q4 before the holidays. The business is highly competitive and National Presto does not materially invest in research and development.
• Defense. In 2001, National Presto acquired AMTEC, a manufacturer of 40mm ammunition and precision mechanical products for the US Department of Defense ("DOD") and DOD contractors. National Presto built off this acquisition via the acquisition of Spectra Technologies (ordnance manufacture), Amron (cartridge cases), Less Lethal Systems (smoke and tear gas grenades, impact munition), Chemring (detonators, pellets, cartridges). In many cases, such as the 40mm agreement, National Presto is the sole prime supplier.

Today, I'm not particularly interested in the Houseware/Small Appliance segment. It's a business line that has undergone rampant consolidation in recent years as larger firms are better able to absorb increases in cost (raw materials, freight) and negotiate better deals with Asian suppliers (tougher terms). At the same time as the company describes new product development and introduction as "very important to long-term success" it is at the same time spending very little money to pursue that. It doesn't appear to be a focus area for management - a fact which is reflected in the company's results. From 2015 to 2017, net sales have declined from $126mm to $97mm; gross margin is down from 21.8% to 17.3%, so operating margin has been cut in half. These languishing results do not mean the assets have no value. Investors should consider this quote from CEO Maryjo Cohen released concurrently with the sale of Presto Absorbents:

We are very proud of the strides our absorbent product business has made in the last several years, but recognized that to move to the next level for full success, we needed to combine the operation with that of a major player in the industry

The next stage in the evolution of the firm is the sale of these assets. National Presto reminds me very much of where NACCO (NC) was two years ago: a conglomerate that owned both coal assets and the Hamilton Beach kitchen equipment brand until it spun off those assets late in 2017. The value of Hamilton Beach Brands (HBB) has sold off since then (Amazon (AMZN) fears, declining growth), with that firm now trading at 7.5x forward EBITDA, but I think that's a good bottom end measuring stick for what value National Presto would get in a liquidation for the Houseware/Small Appliance segment. Given the operating leverage gained in an acquisition via lowering of selling, general, and administrative ("SG&A") costs, a competitive bid would be viewed as 9-10x EBITDA. It's a shame, because valuations for these commoditized kitchen products were quite high just a few years ago. Starting with the Jarden assets being sold to Newell Rubbermaid (NWL) for 17x EBITDA, as well as NACCO buying Weston Brands for 12x EBITDA; double digit EBITDA multiple acquisitions were the norm, not the exception. These assets are likely worth $60-80mm ($8mm in EBITDA likely in 2018), a similar level to the capital raised from Presto Absorbents sale earlier last year.

Pivot To Defense

National Presto had absolutely no exposure to the defense markets for more than fifty years before it took that step to acquire AMTEC in 2001. That strength has carried forward for years now, and those cash flows now form the core of the company's earnings. That won't change anytime soon, as in August of 2017, the Army awarded National Presto, via its AMTEC subsidiary, once again announced that the company would be the sole prime contractor of the 40mm round. Running through the end of fiscal year 2021 (Army fiscal year ends in October), this was the fourth five-year contract negotiated with the US government. Deliveries expected to run $79mm in fiscal year 2017, down incrementally from fiscal year 2016 deliveries ($85mm). The actual annual and cumulative dollar volume of the contract over the life of these contracts varies upon military requirements and funding. Speaking with military members, while demanded volumes are down, the 40mm round remains an integral part of the military arsenal. The M203, a single shot under-barrel grenade launcher, remains a common attachment for the M16 rifle (standard issue since the Vietnam War) and the M4 carbine (standard issue replacement since 2014). The MK19 grenade launcher remains a common support asset, and the 40mm rounds also has military use on certain aircraft and military helicopters. Switching costs to something else would be extremely high for the US Military.

The 40mm contract, and others like it, carry risks. Pretty much all of these contracts are done on fixed pricing; National Presto has limited flexibility in regards to passing along costs. In other words, the DoD says they are willing to pay $50/round through the next five years; it's up to National Presto to maintain its margins, but that also it gives it opportunity grow its margins if it can cut costs… or if the market goes its way. Aluminum - the primary raw material component - is down 12% this year. Zinc is down incrementally. Given that National Presto has seen its gross profit increase $9mm from 2015 to 2017 in this segment during a period of commodity inflation over the past three years (aluminum up 13%, zinc up 54% inclusive of recent price increases) could point towards higher margins.

In 2017, Defense generated $64mm in EBITDA. Assuming that National Presto could in fact sell its kitchen appliance assets for $70mm, the implied value of this business is $428mm. That implies a multiple of less than 7x EBITDA for these assets; relatively non-capital intensive assets at that. This is a stark valuation at a time when large cap diversified defense stocks like General Dynamics (GD) and Lockheed Martin (LMT) trade at 15x EBITDA, large prime contractors like Huntington-Ingalls (HII) at 11x EBITDA, and even other small cap defense stocks like Oshkosh at 9.8x EBITDA. It is incredibly easily to make a case for 2-3 turns of the multiple in valuation expansion at National Presto; a 10% multiple point to 33% upside for the firm.

Takeaway

There is clear value here, but the problem, like always with these firms, is how is that value unlocked. The company needs a catalyst; NACCO drove that by the spin-off of Hamilton Brands, and I think a similar spin or sale unlocks that value. If that does not come about naturally, there is little chance of shareholder activism driving that change. Company direction is tightly controlled by Maryjo Cohen (CEO, owns more than one quarter of shares), so shareholders are at the whims of the controlling shareholder. On the bright side, for those looking for income, National Presto has a long and clear history of paying out dividends to shareholders in a healthy manner. The massive cash balance and high free cash flow nature of the Defense business likely means $6.00/share or more dividends are likely over the next several years at minimum: that's 6% yield at current prices. Investors looking for high yield exposure to the defense sector have next to no other operations other than National Presto. It is an interesting small cap option with quite a bit of potential.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.