Five year summary of PDCO stock price. From 2012 to 2018

Written by:

Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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Anticipating NAFTA

NAFTA And Core Molding Technologies

October 20, 2018

That things are not always what they seem and that first appearance may deceive many was already understood by Plato over two millenniums ago. In this meditation I will describe what at a first glance appeared to be a bargain stock, was an ill-advised purchase upon a careful review. My purpose in writing this meditation is to demonstrate that financial numbers and the prices of stocks are the starting point, but not the final word in stock investing.  

Core Molding Technologies Inc., which trades on the New York stock exchange, appeared to be a bargain stock. Management had increased the number of outstanding shares by one percent compounded over the past decade. In 2008 there were 6.8 million common shares outstanding and today there are 7.7 million common shares outstanding. The average 10-year earnings per share was 93 cents - the stock traded at roughly 9 times the decade-long average earnings per share. The book value per share increased by three-fold during this time. And Benjamin Graham would be proud of my discovery, I thought.      

Its rags to riches story is remarkable. CMT sells a particular niche product called reinforced plastics. The top industries that use the product are transportation, construction and industrial. The company’s major customers include Navistar, Volvo, Paccar, Yamaha and Bombrader Recreation Production. As of the end of last year, these customers were responsible for over 90% of CMT's sales.  

What drove the stock price down

So here is a company with a reasonable product that traded hands at a cheap price. The company's common stock started at $20 in 2018 and had halved recently. The culprit was Mr Market's fear of how changes in the North American Agreement on Environment Cooperation (NAFTA) will affect the company.

NAFTA targets the relationship between America, Mexico and Canada, the same countries in which CMT predominately operates. In 2017 CMT revenue from Uncle Sam’s land was $103.5 million in the United States, $52.5 million from the land governed by Enrique Pena Nieto and $5.6 million in the land of Maple syrup. It also owns and leases manufacturing plants in all three countries.

As many of you know NAFTA is now being renegotiated. And while final details have yet to be published, it will be of little surprise to see red tape and additional costs in the auto industry (in which the majority of CMT’s customers operate.) And business logic dictates that if the customer of a company is suffering, then the company’s business will be hurt too. In short, the expected macroeconomic changes in policy penalized the stock price of CMT.    

But while the looming NAFTA uncertainty is not helping companies like CMT, the is more to the the decline in the stock price. I argue that CMT’s stock price to decline its purchase of Horizon Plastics International, which was announced in January of this year.

Using a combination of cash and debt, CMT paid $63 million for Horizon. "The purpose of the acquisition was to increase the company's process capabilities," explained management. "They will now include structural foam and structural web molding, expand the geographical footprint and diversify the company's customer base."

All nice and well, I thought. But at what premium? Instead of waiting to see whether the future value of companies that operate in Canada and Mexico will deteriorate given the new NAFTA agreement, CMT's management was eager to move forward and paid a premium for Horizon Plastics.

On an increase in goodwill and debt

In CMT’s10-Q filing as of year end 2017, the company recorded $2.9 million in goodwill and intangible accounts. Compare that to the second quarter of this year where it recorded a whopping $40.1 million in intangible assets. Yet what should truly scare current shareholders (yours truly is not included in that group) is the debt level.

Long term debt as of last year was only $3.75 million. Yet as of the second quarter of this year, long term debt was $39.4 million, a little over nine times as much. Evidently, management's appetite for debt affected the income statement. The interest expense this year was 8 times higher compared to the same period last year. In numbers: In June the interest expense was $1.07 million compared to $129 thousand a year ago. So operating income to interest expense deteriorated to 2.37 times, compared to 44.38 times a year ago.

In our rising interest rate environment, it is puzzling why management had added fuel to the fire by taking a variable debt obligation and not a fixed debt obligation. Since management had not addressed the matter in its recent earnings call, I will offer a few explanations for the variable versus fixed debt conundrum.

First, the bankers would not finance the acquisition of Horizon Plastic with fixed debt. Second, management does not consider this to be a rising interest rate environment. Third, the cost of variable debt payments was much cheaper than fixed debt payments. Fourth, management was just careless and does not see the variable-versus-fixed debt as a material issue. Fifth, and most likely in my opinion, management did not have other options.

All roads lead to Rome. And no matter the justification, current shareholders should be appalled by CMT’s management's past business decisions. To pay a premium for a company that operates in Canada and Mexico was wrong. To finance the acquisition using variable debt was wrong. And to reduce the cash balance to practically nil was wrong too.