Simple, boring, and cheap; ROE Plastics at 55% of BV and EV/EBIT 2

Nobody loves a boring investment writeup, yet the bread and butter of my investment philosophy are average companies selling at below average prices.  Today's company is a great example of a quality unlisted company selling at an irrationally low price.

REO Plastics is a injection molding plastics manufacturer.  Injection molding is a fairly simple concept, a mold is developed for an item, the company then injects liquid plastic into the mold, cools it and packages it, or ships it to the next step in the manufacture process.  Anyone with an injection molding machine can injection mold, so to compensate for this companies offer valued added services, REO Plastics is no different in this regard.

The company was founded in 1960 by Robert E. O'Connor, hence REO.  The company was run by Earl A. Patch from 1975-2008, and is now run by his daughter Carrie Sample.

What's so great about REO Plastics?

  • Trades at $15, although it hung around $12 for the past year.
  • Earned $3.07 p/s last year, and $.79 p/s the prior year.
  • NCAV is $15.39
  • Book value $27.66, grew 12% from the previous year.
  • EV/EBIT 2.12
  • P/E 4.88
  • ROE ex-excess cash 12.86%
I should just end my post here, but I feel like it's worth explaining a few things about the company, first a summary of their financials provided by http://www.unlistedstocks.net


The first item of discussion is the company's sales and earnings this past year, they were the highest in the company's history.  This could mean two things, the first is that they'll never be repeated and will become a high water mark.  Astute readers will notice they recorded a loss in 2011, although they do have a large retained earnings account.  The second possibility is that something has changed and the company is building sales momentum.  This is clear if you look at the last three years, sales rose from $17m to $25m bringing increased profits along with it.

Injection molding is not a high margin business, but the results show that as the company's operating leverage increases their margin becomes respectable topping out at 5.37% this past year.

The company's profits and growth are interesting, but what attracted me to the company is their balance sheet.  They have $2.4m worth of cash on their balance sheet with no debt and essentially no liabilities except for accounts payable and accrued compensation.

It is easy to argue that book value is a worthless metric for an industrial company, a lot of digital ink has been spilled over this issue.  I have no interest in starting an argument, but want to point out a few items that I find interesting.  The first, the company is investing heavily in their plant, in the last three years they have spent $4m in capex.  The company is proud of their machinery, they have a list of every machine make and model available on their website.  The type of company that lists their equipment models and posts pictures of them on their website is also the type of company that problem keeps them well maintained.  A negative against the company is that injection molding is a commodity business, a positive for book value is there are plenty of other companies that could purchase old equipment that is in great shape at a good price.

The last point I want to make with regards to book value is that the CEO considers this a valuable metric.  A CEO is the person who knows the business the best, and the metric they use to value it themselves (if rational and conservative) is one investors should consider as well.  Investors value Berkshire Hathaway on book value because this is what Buffett uses.  The CEO of REO Plastics considers book value to be important enough to highlight in the annual letter to shareholders.  This is significant because the letter is three sentences long, and one of those sentences is asking for questions and comments.  The CEO highlighted book value in last year's annual letter (also three sentences) too.

The investment case for REO Plastics is very simple, the company is selling for slightly less than NCAV, and for 55% of book value.  The CEO considers book value a fairly important metric, so it could be reasonably presumed that the company is possibly worth something close to book, maybe 80% or more.  Throw in growing sales and growing earnings as an investment sweetener.

The downside is the stock is extremely illiquid, it will go months without trading.  I purchased shares with a GTC order at the price I wanted to pay, I believe I had a fill in less than a week.  The second downside for many investors is they won't be flooded with information.  You will receive a nine page annual report once a year.  It's not a stretch to say it takes 10 minutes a year to follow this investment.  

Disclosure: Long REO Plastics

16 comments:

  1. Nate,

    Thanks for another idea. How many companies do you own , not counting the Japanese basket. How do you size positions . Sorry if this was discussed in another post.

    Thanks
    A

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    Replies
    1. Excluding the Japanese stocks I have about 50 positions.

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  2. why could this company make profits while DSWL based in China is losing money? The products are about the same.

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    Replies
    1. Sure, but it's not just about the products, if you bought a plastic injection molding machine you suddenly wouldn't be making money, it's the client and industry contacts that are important. Maybe clients would rather work with an American company verses a Chinese company so REO gets their business, there are a multitude of potential reasons.

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  3. Could ROE's business be threatened by the rise of 3D printers?

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    1. From my understanding 3D printing is more for small batch sizes, whereas injection molding is for larger batch sizes. I'm sure at some point 3D printers will be able to print as fast as injection molding and at that point the company could be threatened. But it's also possible that REO might switch to 3D printing themselves by then.

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  4. Looking at this company, only one major issue jumps out at me--the negative average free cash flow for the past three years. It looks like this company was almost certainly FCF positive at some point in the past to accumulate its large cash reserve; thus, do you have information for before 2010?

    Thank you for the post!

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    Replies
    1. I don't have anything before their 2011 fiscal year. You're welcome to call the company for more info, that's how I got my reports.

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  5. Nate,

    Thanks for the great post. Would you please tell us when Fiscal Year 2013 ended and when the annual report was written and/or likely mailed? It would be nice to correlate with historical changes in stock price.

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  6. The company is spending all it's free cash flows in new equipment just to remain competitive... reminds me of Buffet's textile company.

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  7. well, it's certainly worth more than REO Speedwagon.

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    1. I don't know. I heard it from a friend who heard it from a friend who.. said they both have dated products. While REO Speedwagon hit it big in the 1980's they are focused more on milking the past rather than investing in current technology. REO Plastics hit it big in the 1990's but is trying to keep up with technology. I think REO Speedwagon is taking the wiser course of action.

      REO Plastics is listed in past Walker's Manuals (1996, 2000, 2003) so I can look at brief financials from 1992 to 2004. Book value was $13 million in 2000, a nice increase from $4.8 million in 1992. Doesn't look like they have achieved much since then unless there was a dividend in the missing years.

      Of course it could just be a very cyclical industry that does well for a number of years in the peak years.

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  8. The following data is from Capital IQ and the only historical data available on capiq - hope this helps people

    FY07 revenue = $19.5M GP = $1.5 Net Income = $0.2M

    FY06 revs = 20.8 GP = 1.6 NI = 0.3

    FY05 revs = 16.2 GP = 0.9 NI = (0.3)


    B/S - FY07 - FY06 - FY05
    Cash = 1.2M - 0.3 - 0.5
    A/R = 3.7 - 4.0 - 3.8
    Inv = 3.9 - 3.9 - 3.5
    OCA = 1.2 - 1.4 - 1.5
    PPE = 4.1 - 4.8 - 4.9
    Total Assets = 14.1 - 14.3 - 14.2
    Total Liab = 2.3 - 2.6 - 2.8
    Equity = 11.9 - 11.8 - 11.5

    So unless the sharecount has declined it appears that book value really hasn't grown much over the past eight years. Maybe they had large losses in the recession. Still decent value though as long as they don't start bleeding cash.

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  9. Nate,

    I think you're so used to thinking about the metric ROE - Return On Equity - that you misspelled the name of the company in your title to this post. You called it "ROE Plastics" instead of "REO Plastics".

    - aagold

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  10. Nice call, Nate. This thing's up over 50% in the meantime. And it still looks attractive - numerically, at least.

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