Price: 90p (9/11/2011)
First off I want to thank Andrew over at Frogs Kiss for sending me a list of Peter Cundill magic six stocks. A stock that qualifies for the magic six designation is trading with a P/E of 6, a dividend yield of 6% or greater and a P/B of 60% or less. Peter Cundill loved to invest in magic six stocks as discussed in the excellent book There's Always Something to Do: The Peter Cundill Investment Approach.
Of the 53 stocks that qualify world-wide as a magic six none of them are in the US which I find fascinating. The first magic six stock I want to dig into is a British stock, Molins Ltd. Molins is a machinery supply company that builds equipment for three different customer types; Scientific Services, Tobacco Machinery, and Packaging Machinery.
While at first glance it might seem like the product lines are diversified they are not; all deal with the tobacco industry. The Scientific Services group deals with machines and instruments for tobacco labs. The Packaging Machinery division creates machines that handle tubular product packaging. And finally the Tobacco Machinery division builds machines which are used in the manufacture, distribution, and processing of tobacco products such as cigarettes.
The company has a long history in dealing with the tobacco industry, Molins was founded in the late 1800s and incorporated in 1912. The company started with the founder hand rolling cigars and cigarettes in Cuba which led him to design a machine to roll smokes automatically, a breakthrough at the time.
I want to break down this post into three sections, I'm going to look at the earnings, the book value, and the dividend, all three main elements in the magic six formula. But before I dive into each I want to present my quick back of the napkin thesis:
-63p per share is cash
-£18m market cap
-Investor return of 36% (ROE * B/P), this is the return an investor gets by buying at such a discount to book, if the company continues to earn a 13% ROE compounded on the low price paid for the company.
-Sustainable 6% dividend yield
The stock is cheap, and I mean absolutely cheap, after backing out the cash it's barely trading above 1x FCF.
A dividend yield of 6% or above is unusual, it often means the company is in some sort of financial distress or the company is a REIT.
The company seems to target a 20% payout ratio which is conservative. During the financial crisis the payout ratio hit the low 60s but still not high enough to cause any concern. I have a detail of the dividends and payouts for the past five years.
As you can see above the company appears to adjust the dividend policy based on profitability although it appears they might have been a bit hesitant to cut the dividend in 2009. Molins has been able to pay a consistent dividend throughout the financial crisis, I don't think a dividend cut is really much of a worry.
In taking a look at a magic six stock I tend to put a lot of emphasis on the composition of book value. In most stocks I analyst I look at the net current asset value which is much more liquid than book value and usually the values are a bit more accurate as well. General book value could include intangibles such as goodwill or the values of a property and plant account that might not be realistic.
In the case of Molins book value is £50m against a market cap of £18m. Here is the breakdown of the book value:
The first item that sticks out as a potential item of concern is £14.7m of intangibles, this is likely a value that won't be realized in a sort of liquidation scenario. I looked at the annual report and there is a note (note 13) which discusses the intangibles, and found the item intangibles is goodwill amount carried on the books as a result of a few acquisitions in the Scientific Services group.
The second item of note is the surplus for the pension account. It's a bit unusual to see a surplus for a company sponsored pension plan, especially in the last few years. The gross pension assets are £327m with a benefit obligation of £314. I like seeing the surplus but in reading the statements it appears to be a more recent development, as of June 30 2010 the company pension plan was operating with a £34m deficit. The surplus is a result from rising asset values. With the falling European markets I'm wondering if the surplus has disappeared since the interim statement came out.
As mentioned earlier in the post Molins has £12m of cash on the balance sheet in addition to a sizable amount of inventory and receivables. As a whole the NCAV is 61p per share which is a liquidation value 32% lower than the current price. I think liquidation value is the absolute worst case scenario for book value. If we add in the £10m property plant and equipment amount in figuring out a base book value it rises from 61p to 114p or 26% higher than the current price.
Book value and net current asset value are nice but I've been burned on "cheap" stocks without earnings in the past so evaluating the earnings and cash flow record is important to me.
I grabbed the 10 year data from MSN money and put together a spreadsheet and a graph of sales, EBIT and net income for the past 10 full years.
Sales have been pretty steady for the past six years following a drop earlier in the decade. Although sales have been steady EBIT and net income are all over the place. Even though earnings are lumpy they are all positive except for a major loss in 2004. The company website only has reports back to 2005 available so I wasn't able to determine what made 2004 so significant. My gut feel is that they took some sort of write down in 2004 that resulted in the loss.
Earnings and EBIT seem pretty decent, to double check the quality of earnings I also put together a little worksheet showing cash from operations, capital expenditures and then free cash flow.
Looking at cash flow is always interesting. In 2008 there was a profit if an investor only focused on earnings yet the company went cash flow negative due to working capital changes. My guess is the company continued to build up inventory and then had a tough time working off the increase. Evidence of this is in the increased receivables and increased inventory for 2008.
Overall for such a cheap company the earnings are decent and while not steady and predictable it does seem likely that they will continue to be profitable into the future. And considering the long history of the company and the ability to mostly be continually be profitably I think a P/E higher than 6 is probably deserved. Molins isn't going out of business anytime soon, a P/E of 10 is probably more appropriate.
Why is it cheap?
This is a question that has been nagging me since I first started looking at Molins, why would a decent company be selling so cheap? The first answer is that the size of the company is tiny and there are a lot of inefficiencies with small companies. While that's true it's not a very satisfying answer. I went digging through the messages at ADVFN.uk to see if there was anything value related to Molons. It seems that the elephant in the room is the enormous pension account. Currently the pension is in the black, but with markets volatile it could easily swing negative and be a large liability on the balance sheet as well. A lot of posters on ADVFN seem concerned about the size and gains/losses with the pension. I'm not sure if this is some sort of conservative British concern or something legitimate. In the US companies run a negative pension balance for years without a problem, there is a day of reckoning eventually but usually it's a LONG way off.
Molins occupies a middleman position in the cigarette supply chain, they make the tools that are necessary for cigarette production. The company is cheap on both an earnings and book value basis and pays a generous dividend. I'm not sure how much upside is realistic on an earnings basis but even if there is a little getting paid 6% to wait seems worth it. I'm not entirely comfortable with the company yet so I'm passing on an investment at this time. I'd love to hear anyone's opinion on Molins.
Talk to Nate about Molins
Disclosure: No position in Molins.
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