National Presto Industries Inc.: Is Performance About To Go Poof? ($NPK)

National Presto Industries Inc (NYSE: NPK) markets and distributes truly vast array of appliances, including such niche products as Bacon Cookers, Deep Fryers, Pizza Ovens, and Waffle Makers (among many more – see the full list here). The company also operates in the defense industry (selling ammunition and mechanical assemblies) thanks to a well-timed acquisition just seven months prior to 9/11. Finally, the company also operates in the diaper industry via its Absorbent Product segment, focusing on adult diapers and training pads for dogs. This is quite a motley collection of businesses but unlike other conglomerates which struggle to operate in diverse industries, NPK appears to have found its stride with these acquisitions, as the following chart shows.

National Presto Industries Inc - Historical Returns, 1993 - 2010

National Presto Industries Inc - Historical Returns, 1993 - 2010

The company expanded into both the defense and absorbent products industries in 2001, after which returns began an inexorable march upward. The recent recession has not registered in the company’s returns, which is quite an impressive feat for a company that derives a large portion of its revenues from the sale of highly discretionary kitchen appliances.

National Presto Industries Inc - Revenues and Margins, 1993 - 2010

National Presto Industries Inc - Revenues and Margins, 1993 - 2010

Here we see the rapid increase in revenues that the company has managed to achieve in recent years. Margins are somewhat unstable (especially gross margins) over the period, but the company has managed to make up for this with strong reductions in operating expenses. Note the fact that the company’s net margin is above its operating margin for a large portion of its history. This is the result of the company’s large balance of cash and securities and zero debt, as the following chart illustrates.

National Presto Industries Inc - Capital Structure, 1993 - 2010

National Presto Industries Inc - Capital Structure, 1993 - 2010

Cash and securities now total $112 million, or roughly 17% of its market cap. This is a significant amount, providing a level of flexibility that value investors can take comfort in. Given that the company has held a large balance over such a long period, it is less likely that the company will waste it on an ill-conceived acquisition (and, as we’ve seen, the company has done quite well with its past acquisitions).

National Presto Industries Inc - Cash Flows, 1993 - 2010

National Presto Industries Inc - Cash Flows, 1993 - 2010

Here we see NPK’s strong cash flows over the last four years, roughly corresponding to the company’s dramatic revenue and margin growth. This provides comfort that the company’s revenue growth is “real” rather than accounting gimmickry (the relative stability of the company’s cash conversion cycle and components further lends support to this).

So with NPK, we’ve got a company that has strong (and growing) returns, combined with a rock solid balance sheet, good (though not great) free cash flows, and improving margins. Sounds great, right?

Well, not so fast.

Remember when I mentioned that the company entered two unrelated businesses (Defense and Absorbent Products) back in 2001? When a company enters new industries and breaks out segment details, it is always worth tracking the segments over time to see how they have performed. Let’s look at the company’s revenues by segment.

National Presto Industries Inc - Segment Revenues, 2000 - 2010

National Presto Industries Inc - Segment Revenues, 2000 - 2010

Here we see that NPK’s core (kitchen appliances) business has experienced only marginal growth over the last decade. Likewise, its Absorbent Products segment has enjoyed only moderate growth after the first four years as part of NPK. Instead, the dramatic growth in revenues shown above is due almost solely to the company’s Defense Products segment.

Let’s look at the contribution by segment to gross and operating profit.

National Presto Industries Inc - Gross Profit by Segment, 2000 - 2010

National Presto Industries Inc - Gross Profit by Segment, 2000 - 2010

National Presto Industries Inc - Operating Profit by Segment, 2000 - 2010

National Presto Industries Inc - Operating Profit by Segment, 2000 - 2010

These charts illustrate the growing importance of the company’s Defense Products segment to its overall revenues and margins. While Absorbent Products have only recently begun contributing positively to the company’s margins, the dramatic improvement in margins shown in the second chart from the top is due almost solely to the expansion of margins in its Defense Products segment.

One more quick chart. Using the company’s segment information, I used a proxy for free cash flow as EBIT*(1-tax)+Depreciation – Capital Expenditures. This is ultimately only a proxy as EBIT is from the accruals-based income statement, but you dance with the data that brung you (is that a phrase yet?). I calculated this for each segment. Here is the result:

National Presto Industries Inc - Free Cash Flow by Segment, 2000 - 2010

National Presto Industries Inc - Free Cash Flow by Segment, 2000 - 2010

Here we see further evidence that the Absorbent Products segment is really hit and miss in terms of contributing or detracting from the company. Also, the Defense Products segment is now by far the largest contributor to free cash flow.

The reason I am showing you all of these segment specific charts is that I think they illustrate an extremely important point: NPK is not a appliance company. Rather, it is a defense supplier with an appliance business on the side.

This fact reveals the surprising amount of hidden risk that exists in an investment in NPK. Just like we would be wary of any company with high levels of customer concentration, an investor in NPK must recognize the company’s reliance on the Department of Defense. Though NPK was awarded a five-year contract by the DoD for 40mm ammunition (expiring in 2015), the DoD contracts include options (in the DoD’s favour) that dramatically alter the value of this contract.

Additionally, the United States recently announced that it would be withdrawing all of its troops from Iraq by the end of 2011:

“Today, I can report that, as promised, the rest of our troops in Iraq will come home by the end of the year,” Obama said at the White House yesterday.

Obama made the announcement after the Iraqi government didn’t agree to provide immunity from prosecution for U.S. troops staying into next year. About 39,000 troops were in Iraq as of yesterday, following a drawdown of about 2,000 this week, according to the Defense Department.

“Across America, our servicemen and women will be reunited with their families,” Obama said. “Today, I can say that our troops in Iraq will definitely be home for the holidays.”

As shown in this report by the Congressional Research Service (PDF, page 9), the United States had an average of 157,800 troops in Iraq in 2008 and 135,600 in 2009 when the report was published. I don’t accurate recent figures, but these levels are approximately 2-2.5x the number of troops in Afghanistan and represent the bulk of troops abroad. Unless there is going to be a massive uptick in target practice, this will likely result in a decline in demand for munitions and thus a decline in revenues for NPK’s all-important Defense Products segment.

So now where does this leave us? By looking at the company’s performance by segment, we see a very different company, fraught with risks and reliance on a single division that has contributed almost all of its recent success. Moreover, this division is almost certain to perform worse in the future than it has in the last four years. Given this, the company is simply not cheap enough to justify a purchase anywhere near the current price.

What do you think of NPK?

 

Author Disclosure: No position.

Talk to Frank about National Presto Industries Inc

  • Pacioli

    This is one of your better analyses in a long time, IMO.

    I would highlight a couple of gaps in the analysis.

    First, I would argue that the market has a pretty good handle on NPK’s segments, and the notion that the munitions business has likely seen its best days. Thus, I disagree with your assessment that the related risks with this company are “hidden”.

    Second, your DoD evidence is a good starting point for discussion, but more is needed if you want to demonstration causation and correlation of Iraq draw-downs with the performance of NPK’s munitions business. For instance, the report you quote shows a 14% draw-down in Iraq from 2008 to 2009. Yet NPK’s munitions revenue and FCF proxy both appear to increase considerably from 2008 to 2009 (based on the graphs you provided).

    Although it is certainly justifiable to project some level of deterioration at NPK due to the Iraq draw-downs, you do not attempt to make any quantification. Do you expect that revenue stream to go to zero? To be cut by half? Some sort of estimate is necessary in order to make an educated assessment as to NPK’s current valuation.

    So I’ll take a stab at it. Let’s assume a severe drop in the munitions business for 2012, and no growth in the other two segments. Using your FCF proxy (which I think is a pretty fair measure), if we assume NPK’s munitions business FCF proxy gets cut by 50% from 2010 levels, I am calculating a $20M FCF for the segment and $34M FCF for the total company. Given the current EV of $523M, that is an EV/FCF yield of 6.4%. Now, this is not spectacular, but it is the result of severe downside assumptions, IMO. It is also the same yield as Emerson Electric, arguably a highly diversified well-run manufacturing conglomerate. Given that NPK has already lost a third of its value from the January highs (around $136), one must assess how much of that downside has already been priced in.

    Again, it would have been nice to see a more nuanced analysis along these lines, examining what assumptions may already be priced into the stock at current levels.

  • Ryan

    This is the best blog on the internet! It’s like christmas every time I see a new post.