2023-07-17 18:04:29 ET
Summary
- Sales continue to recover after the coronavirus pandemic in 2020, and are expected to increase in 2023 and 2024.
- Profit margins are also improving boosted by price raises and easing supply chain headwinds.
- Currently, interest expenses represent the most significant risk, so it will be necessary for the company to make use of its high inventories to reduce its current level of debt.
- The dividend is at risk as cash from operations remains negative.
- This represents a good opportunity for long-term investors with enough risk appetite.
Investment thesis
Park-Ohio Holdings ( PKOH ) is in a very delicate situation, and that is why the share price has fallen by 71% from all-time highs. Revenues have still not recovered from the debacle caused by the restrictions stemming from the coronavirus pandemic crisis in 2020 and the subsequent supply chain issues, and now inflationary pressures and increased wages are taking a toll on profit margins. To this must be added that recent interest rate hikes are increasing the risk of recession, and the perceived risk of investing in the company's shares is exacerbating as a consequence, especially considering that the company has a highly cyclical nature and that the acquisitions carried out in recent years have produced an increase in debt at a time in which increased interest rates are increasing interest expenses.
Despite this, I am going to detail in this article the reasons why I believe this is a good opportunity for long-term dividend investors with enough patience and some risk tolerance despite short and medium term risks of a potential dividend cut. First, sales continue to recover, boosted by a post-coronavirus return to normality, price raises, and supply chain improvements, while increased volumes and profitability initiatives are also being reflected in recent improvements in profit margins. In addition, the weak demand of the last 2 years, as well as recent product price increases, have caused an increase in inventories that if the management manages to empty, at least partially, will provide enough cash for the company to be able to start a deleveraging process that should allow it to digest the acquisitions of recent years and reduce annual interest expenses.
A brief overview of the company
Park-Ohio Holdings is a global provider of supply chain management services, capital equipment, and manufactured components with 130 manufacturing sites and supply chain logistics facilities worldwide. The company was founded in 1907 and its market cap currently stands at $218 million, employing over 7,000 workers worldwide. Insiders own 36.58% of the company's shares outstanding, which means they also benefit from the total returns of the company's shares.
Park-Ohio logo (Fourth Quarter 2022 Earnings Call Presentation)
The company operates under three main business segments: Supply Technologies, Assembly Components, and Engineered Products. Under the Supply Technologies segment, which generated 48% of the company's total net sales in 2022, the company offers its Total Supply Management service, which is a supply chain management solution that includes a wide range of solutions for efficiency optimization. Under the Assembly Components segment, which provided 26% of the company's net sales in 2022, the company manufactures products for fuel efficiency, vehicle electrification, and meeting emission standards. Also, the company recently discontinued its aluminum business and plans to sell it. And under the Engineered Products segment, which provided 26% of the company's net sales in 2022, the company designs and manufactures a wide range of highly-engineered products.
Currently, shares are trading at $18.84, which represents a 71.12% decline from all-time highs of $65.24 on December 30, 2014. This is certainly a very steep decline as investors' pessimism has recently grown due to margin contraction caused by supply chain issues, decreased volumes, inflationary pressures, and increased wages, as well as increased debt due to recent acquisitions.
Recent acquisitions
The company has grown over the years thanks to an active acquisition policy, which has allowed revenues to slowly increase in recent years (putting aside the recent negative impact caused by the coronavirus crisis and the subsequent supply chain issues).
In 2017, the company acquired Aero-Missile Components, Heads & All Threads, and an injection molding business for a total price of $39.7 million. Later, in 2018, the company acquired Canton Drop Forge, a manufacturer of forgings for high-performance applications in the global aerospace, oil and gas, and other markets, for $35.6 million. And during the same year, the company also acquired Hydrapower Dynamics Limited, a manufacturer of fluid handling systems incorporating hoses, manipulated tubes, and fabricated assemblies for the bus and truck, automotive, agricultural, and construction end markets, for $7.8 million. In addition, the company also acquired two distributors of aerospace and defense products for $3.5 million.
In 2019, the company acquired EFCO, Inc., an industry-recognized leader in the manufacturing of advanced forging presses, hydraulic and mechanical presses, and metal stretch-forming and carbon extrusion machines for a wide range of end markets, including aerospace and defense, primary metals, and high-speed rail, for $8.1 million.
After some deleverage, in 2021, the company acquired NYK Component Solutions, a leading distributor of circular connectors and accessories for use in aerospace, defense, and other industrial applications with annual revenues of over $10 million, for $5.4 million. And lastly, in 2022, the company acquired Southern Fasteners & Supply, Inc., a provider of commercial fasteners and industrial supplies to a diverse base of MRO and OEM customers throughout the United States that also specializes in the design of customized inventory programs for its customers. The acquired company has annual revenues of ~$25 million, and Park-Ohio paid $18.7 million for the acquisition. During the same year, the company also acquired Charter Automotive (Changzhou) Co. Ltd., a manufacturer of motor vehicle parts based in Changzhou, China, with annual revenues of around $15 million, for $9.3 million. Taking into account that the company currently plans to divest its aluminum business, it seems that the objective of these acquisitions was, in addition to expanding the market reach of the company, an improvement in profit margins by introducing products with higher added value and later divest a less profitable business.
Revenues are expected to continue recovering
The company has achieved acceptable growth rates over the years boosted by acquisitions, but the coronavirus pandemic crisis and the disruptions derived from it caused a 28.81% decline in revenues in 2020 compared to 2019. Nevertheless, they partially recovered in the subsequent years as they increased by 10.84% in 2021 and by a further 16.91% in 2022.
Park-Ohio Holdings revenues (Seeking Alpha)
As for the first quarter of 2023, net sales increased by 18.40% year over year to $423.5 million boosted by stronger customer demand and price raises, and trailing twelve months' revenues currently stand at $1.57 billion. Furthermore, revenues are expected to increase by 10.74% in 2023 (compared to 2022), and by a further 5.45% in 2024 as the company plans to keep increasing the price of its products to offset inflationary pressures while demand remains relatively strong.
But the recent decline in the share price coupled with increasing revenues has caused a sharp drop in the P/S ratio to 0.154, which means the company currently generates $6.49 in revenues for each dollar held in shares by investors, annually.
This ratio is 49.34% lower than the average of the past 10 years and represents a 74.67% decline from decade-highs of 0.608, which reflects increasing pessimism among investors as the company's capacity to convert these revenues into actual cash is still weaker than in the past due to the current squeeze in profit margins. In addition, as I will explain later, the balance sheet has a fairly high debt load (in terms of interest expenses generated) at a time when recent interest rate hikes are causing growing concerns about a potential recession, which is keeping shareholders on the sidelines as the company has a strong cyclical nature and a potential recession would certainly have a negative impact on the results of the company.
Profit margins are showing strong signs of stabilization
Profit margins are beginning to recover after a major contraction that began in 2020 due to declining volumes derived from the coronavirus pandemic and the subsequent supply chain issues that took place when the world's economies began to reopen. In this regard, the trailing twelve months' gross profit margin currently stands at 14.95%, and the EBITDA margin is at 5.66%.
Furthermore, the gross profit margin was 15.87% during the first quarter of 2023, which represents an improvement of 250 basis points compared to the same quarter of 2022, and the EBITDA margin was 6.75% as the company recently raised the price of its products, improved operating efficiencies and restructured some business activities. Also, supply chain issues have eased in the past few months, product prices are expected to keep increasing, and the company inaugurated a new rubber mixing facility that is expected to increase production capacity while reducing raw material costs, so profit margins should remain at relatively healthy levels in the foreseeable future. Nevertheless, these profit margins are still below what the company was used to, in part because supply chain issues, inflationary pressures, and labor shortages are still impacting its operations, and the company needs to generate positive cash from operations in order to cover interest expenses and begin to reduce the debt load on the balance sheet.
The company's debt is reaching a critical point
This is currently the most worrying aspect for the company and, in my opinion, the main reason (although not the only one) to explain the recent fall in the share price. After the acquisitions that have taken place in recent years and high capital expenditures, as well as ever-increasing inventories, the company's long-term debt reached a critical point at $674 million. Also, cash and equivalents is currently low at $50 million.
This increased debt, along with rising interest rates, has caused a recent increase in interest expenses to $36.70 million (trailing twelve months), but interest expenses increased to $10.70 million during the first quarter of 2023, which means the company is expected to pay over $40 million in annual interest expenses at current debt levels. This is the main reason why investors are currently very concerned as covering these interest expenses will not be an easy task considering the company's historical ability to generate cash from operations.
The most plausible solution is, at the moment, in inventories, since the company currently holds $410 million in inventories. This increase has been possible thanks to the low demand of 2020, 2021, and 2022, as well as recent product price raises, and opens the opportunity to convert said inventories into actual cash. But to achieve this, the company must reduce its production capacity without this causing an increase in unabsorbed labor, since it is the only way in which said inventories could be emptied in a sufficiently profitable manner in order to be able to comfortably cover interest expenses and begin to reduce its debt load. Even so, it can be said that the company has the capacity, by itself, to cover a significant part (but not all) of its current interest expenses, capital expenditures, and dividends through operations thanks to the recent margin improvement.
Even so, the very delicate situation in which the company finds itself, the current risk of recession, and the urgency to reduce debt, suggest that a cut or even cancellation of the dividend is currently a high risk that should be considered. In fact, in my opinion, temporarily cutting the dividend to facilitate debt reduction would be the wisest decision for the long term.
The dividend is at risk
The management decided to initiate a quarterly dividend of $0.125 per share in 2014, which was the first dividend paid in 21 years, and the dividend has remained static ever since.
Considering the current share price of $18.84, the dividend yield currently stands at 2.65%, which should be considered as a potential dividend yield on cost with significant upside potential in the long term (as it actually represents a low portion of the company's cash from operations), but at risk of being cut or even canceled in the short and medium term due to its low sustainability in the current macroeconomic context (marked by recessionary concerns) and, especially, taking into account the currently high interest expenses. Also, dividend investors should be prepared to change their strategy to one based on capital returns by selling the company's shares once current pessimism eases as no one can guarantee a dividend restoration if it finally gets cancelled.
In the following table, I have calculated the percentage of cash from operations that the company has allocated each year to cover the dividend and interest expenses. In this way, it is possible to calculate the sustainability of the dividend through actual operations, both in the short and long term.
Year | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
Cash from operations (in millions) | $53.6 | $44.7 | $72.9 | $46.7 | $54.8 | $63.7 | $69.3 | -$43.3 | -$27.6 |
Dividends paid (in millions) | $4.7 | $6.3 | $6.2 | $6.3 | $6.4 | $6.3 | $3.2 | $6.3 | $6.4 |
Interest expenses (in millions) | $26.1 | $27.9 | $28.2 | $31.5 | $34.3 | $33.8 | $27.6 | $27.1 | $33.8 |
Cash payout ratio | 31% | 77% | 47% | 81% | 74% | 63% | 44% | - | - |
As one can see, the company has historically covered its dividend and interest expenses with relative ease, and very high interest expenses compared to the dividends paid have historically suggested that the upside potential of the dividend in the long term was high since a reduction in debt would give the dividend enough space to grow significantly. But the coronavirus pandemic crisis and the subsequent supply chain issues and inflationary pressures have changed the panorama in the short and medium term as cash from operations was negative both in 2021 and 2022 while interest expenses increased to $33.8 million in 2022 (and are expected to surpass the $40 million mark in 2023). This is why the dividend is currently at risk.
Currently, trailing twelve months' cash from operations stands at -$23.7 million, accounts receivable declined by $29 million compared to the past year, and accounts payable increased by $6.4 million, but inventories increased by $8.5 million. This explains the recent increase in debt as the company is essentially losing cash. As for the first quarter of 2023, cash from operations was -$6.2 million, but inventories increased by $3.5 million quarter over quarter, accounts receivable also increased by $14.1 million, and accounts payable declined by $0.5 million, which reflects the recent improvement in profit and EBITDA margins as the company reported a positive net income of $5.8 million.
But in addition to an annual dividend of over $6 million and interest expenses of around $40 million, the company must also cover its annual capital expenditures of $27.40 million, which won't be easy to cover despite a major cut in 2020 due to the coronavirus pandemic crisis as the company is currently performing growth initiatives in the Assembly Components and Engineered Products segments by investing in onshoring, infrastructure, defense spending, green energy, and battery technology opportunities by designing new products.
In short, the company must cover each year interest expenses of around $40 million, capital expenditures of $27.40 million, and a dividend of over $6 million, and cash from operations danced between $45 million and $69 million before the supply chain issues derived from the reopening of the world's economies after the coronavirus pandemic crisis, so making use of inventories is currently the main solution to the current debt burden. It should be said that inventories have steadily increased in the past 10 years, so the potential cash from operations has been, actually, historically higher.
Debt reduction, if successfully achieved, will determine the company's upside potential
To sum up, it is the reduction of debt and, consequently, the reduction of interest expenses that should unlock value for the company as interest expenses are the most significant expense at this moment. In this regard, a reduction in interest expenses would leave enough room for the company to raise the dividend or, failing that, invest in further growth initiatives or perform further acquisitions, which should put the company back on the growth path in the long run.
Risks worth mentioning
It is important to note, before investing in Park-Ohio, that this is undoubtedly a high/risk, high/reward investment that requires a certain appetite for risk, and below I would like to highlight the risks that I consider most significant for the short and medium term.
- If inflationary pressures continue to be part of the macroeconomic landscape for longer than expected, profit margins could remain low, and recent and ongoing pricing efforts may not be sufficiently reflected in the company's results in the coming quarters, which could increase the difficulties of generating positive cash from operations.
- Recent interest rate hikes to combat high inflation rates around the world could cause a global recession, which could have a significant impact on demand for the company's products. This would cause not only a drop in revenues but also an even more aggravated contraction of profit margins as a result of more unabsorbed labor.
- The company might have difficulty depleting its inventories as demand still remains relatively weak. This risk would be even more likely if a recession finally materializes.
- At this point, the risk of a cut or cancellation of the dividend is very high as the company urgently needs cash to reduce its current debt load as high interest expenses are making its operations less and less sustainable. In such a scenario, no one can guarantee that the dividend will be restored in the foreseeable future, so it is possible that dividend investors will eventually have to change their strategy to one based on capital gains once current prospects improve (the dividend cut should, in fact, help to improve the company's prospects in the long term).
Conclusion
First of all, I would like to remind you again that Park-Ohio represents a high-risk, high-reward investment, so it is important to have sufficient risk tolerance before investing.
Certainly, the situation for Park-Ohio Holdings is not easy at the moment, and the management is currently navigating through very serious headwinds. Rising interest rates have caused a worrying increase in interest expenses, and the company needs to use its inventories to reduce its debt load to make it more manageable in the long run. Luckily, profit margins, as well as revenues, are beginning to recover thanks to recent price increases and the easing of supply chain issues, and this has been largely reflected in the cash from operations of the last quarter which, despite still being negative, was accompanied by a significant increase in inventories and accounts receivable while accounts payable fell slightly.
Park-Ohio's situation would improve dramatically if the company manages to successfully reduce its debt levels as high interest expenses are currently the main reason for such pessimism among investors, and the reason why I believe that the recent share price decline represents a good opportunity for the long term is that the company has many bullets in the chamber to make such debt reduction possible. Further product price increases are still expected in the foreseeable future, which should keep profit margins improving and revenues growing (and would eventually dilute long-term debt), and revenues are expected to increase in 2023 and 2024. Also, the management has the opportunity to reduce production capacity in order to empty inventories, which would provide strong cash from operations in the medium term as inventories are very high at $410 million. In addition, the company could save over $6 million per year by canceling the dividend, which, while painful for shareholders in the short term, represents an opportunity to help reduce debt and thus make the dividend, once re-established, more sustainable in the long term or, failing that (because no one can guarantee that the dividend would be resumed), improve the prospects of the company so that investors can obtain capital returns from the investment.
For further details see:
Park-Ohio Holdings: The Potential Upside Outweighs The Risks