Value Play: Lydall (NYSE: LDL)

Conglomerates get no respect. Analysts often apply a “conglomerate discount” to their stock valuations of such diversified companies because of fears voiced by legendary Fidelity mutual fund manager Peter Lynch that diversification can cause “diworsification.” Similarly, hedge-fund manager Joel Greenblatt, author of You Can Be a Stock Market Genius, has argued that spinning off an unrelated business can increase the public market value of both the spinoff and the parent. The theory is that focused companies are better able to devote the management time and financial resources to become market leaders in their niche and consequently generate higher returns for shareholders.

But theory and fact on conglomerates are conflicted. In a 2006 study by Boston Consulting Group (BCG), the authors conclude:

Despite the high-profile criticisms of diversified companies over the years, there is evidence that the tide is turning and that investors and analysts are gaining confidence in these types of companies.

On average, most diversified companies outperform both the market and a high proportion of the world’s top focused firms.

It is not the degree of diversification that determines a company’s shareholder returns; it is how a firm manages its business diversity that matters.

One of the benefits of business diversification is that corporate revenues become more stable year-over-year because different businesses perform best at different points in the business cycle. When one business segment is slowing down, another business segment may be speeding up. Consequently, the benefits from a corporation diversifying among different business segments can be similar to the benefits an investor receives from diversifying his portfolio among different asset classes.

The key for conglomerates, though, is that management must view business segments similar to stock investments that can be bought or sold opportunistically, and not simply as a means to increase the company’s size and management’s ego and desire for empire. BCG lists five “value-creation levers” that separate the successful conglomerates from the unsuccessful:

• Efficient capital allocation
• Clear and consistent portfolio strategy
• Lean organization structure with clear responsibilities
• CEO-driven management initiatives
• Management development and skills transfer through rotating assignments

A 2012 report by McKinsey reaches a similar conclusion: conglomerates can be successful if run by intelligently by managers with a private-equity mindset focused on high-return capital allocation and the sharing of cash flow among business segments so that it is optimally deployed where currently growth opportunities exist.

My choice for a small-cap conglomerate with business smarts is Lydall, a Connecticut-based company with manufacturing facilities in North Carolina, New York, New Hampshire and Western Europe. The company operates in four business segments:

Source: Company  website, SEC filings

The takeaway from the above table is that the company is currently concentrated in the automotive sector, which accounts for 65.5% of total sales. The two largest customers are Ford and Chrysler, which combined make up 28.8% of total sales. A strengthening auto market (especially in Europe) is a plus, as is the planned opening of a manufacturing plant in Shanghai China during the first half of 2014 (one of the world’s largest automotive markets). The company’s long-term goal for 2020 (slide no. 4), however, is to become less auto-dependent and grow its performance materials business into its largest segment.

Looking at Lydall’s management team, I am confident that both the CEO and Chairman of the Board view the company’s conglomerate status as an investment portfolio that should be optimized for peak investment returns. CEO Dale Barnhart has been at Lydall’s helm for more than six years. Prior to joining Lydall, he worked as a consultant for two private equity firms which must have ingrained in the importance of portfolios and maximizing return on investment. Board Chairman W. Leslie Duffy is a corporate lawyer specializing in M&A transactions who worked for 47 years at one of New York City’s pre-eminent law firms (Cahill Gordon). Lastly, CFO Robert Julian joined the company in October 2012 and has extensive experience in business strategy, as well as acquisitions and operational integrations. Insider ownership is decent at 5.4% of shares outstanding (page 40), so management also has a personal financial incentive to do right by the average shareholder.

A June 2013 investor presentation makes it clear that management’s priorities are in the right place. Slide no. 6 states that the company has adopted “lean” manufacturing based on “six sigma” principles, which means that financial efficiency and quality control are paramount. Slide no. 12 reveals the amazing increase in profitability since 2010:

 Lydall’s Profit Resurgence

Slide no. 7 persuasively alleges that this improved financial performance is sustainable with consistently improving gross profit margins since 2009. 

Perhaps the most important indication that Lydall will continue to grow is management’s commitment to productive use of its financial resources. The company is virtually debt-free (less than 1% of total capital) with more than $58 million net cash on the balance sheet. Slide 21 states that the company will “continue to assess and optimize our existing portfolio of businesses and execute upon select acquisitions.” Slide no. 8 states that the company has a “clear capital allocation strategy” based on the following four prongs:

1) Support organic growth programs

2) Fund capital investments

3) Pursue attractive M&A

4) Execute against Share Repurchase

Furthermore, non-core businesses such as transport, electrical papers, and chillers have been jettisoned (slide no. 9), freeing up precious capital that is then either re-invested in its higher-growth core business segments or used for complementary acquisitions (e.g., the 2008 acquisition of the Netherlands-based filtration company Solutech).

Although the company does not pay a dividend, it initiated a 1-million share repurchase program in 2012 that still has about 350,000 shares available for future purchase.  The recently-completed third quarter saw earnings per share rise a robust 17.4%, but on modest revenue growth of 4.1%. The operating margin was 7.5%, which means that if the company can achieve its long-term goal of a 15% operating margin by 2020, earnings will at least double. In fact, earnings will more than double because the 15% operating margin will most likely be on a much-larger revenue base in 2020. In the post-earnings conference call, CEO Barnhart concluded:

Overall, I am pleased with the consolidated results for the third quarter of 2013, as the business continued to improve operating performance. The softness that we experienced earlier in the year in Europe has subsided, and we expect that the global demand for products to remain stable in the final quarter of 2013. We remain focused on increasing margins in all of our businesses through our Lydall’s Lean Six Sigma continuous improvement program, and remain committed to funding organic growth programs, capital investments and pursuing strategic growth opportunities.

Over the past five years, earnings have grown at a robust annualized rate of 12.5%, but revenue growth has only averaged 2.3% annualized growth. Why the disparity between earnings and revenue growth? The answer is that Lydall’s management has done a great job cutting costs and improving productivity since the 2008 financial crisis, but the global economy has never really recovered fully. Lydall is an economically-sensitive cyclical, after all! Well, the economy (and Lydall) have no more excuses because Nomura recently announced that the era of global financial crises is finally coming to an end and industrials are one of its favorite industry sectors to outperform going forward.

Just think how powerful Lydall’s earnings growth will be if the global economy actually picks up steam, and I’m confident just such a global pickup is on the horizon for 2014. Bank of America Merrill Lynch agrees, stating: “We think 2014 is the year when the economy finally exits rehab and starts growing at a healthy 3%.”

Lydall’s stock has performed well year-to-date in 2013 – up 23.6% — but it has nonetheless underperformed the S&P 500’s YTD return of 29.2%. Lydall’s valuation remains very low at an EV-to-EBITDA ratio of only 5.4, but with increasing investor confidence in a real economic recovery, the valuation should rise closer to the company’s long-term average ratio of 7. This suggests potential upside of at least 30% [(7.0/5.4)-1]. 

Lydall is a buy up to $20; I’m also adding the stock to my Value Portfolio.

Momentum Play: International Speedway Class A (Nasdaq: ISCA)

International Speedway (ISCA) owns 13 racetracks, 12 of which host a majority (19 of 36) of the stock-car races involved in NASCAR’s premier racing series known as the Sprint Cup. Since almost all of ISCA’s revenues and profits come from NASCAR events, it’s critically important for ISCA to maintain a good and sustainable relationship with NASCAR. Fortunately, this will never be a problem because both ISCA and NASCAR are controlled by the France family (page 1).

Bill France Sr. founded the National Association for Stock Car Auto Racing (NASCAR) in 1947 and founded ISCA (originally known as Bill France Racing) in 1953 in conjunction with the construction of the Daytona International Speedway. He led NASCAR for 25 years (1947 to 1972) and then handed the reins to his son Bill France Jr., who led NASCAR for an even-longer 31 years (1972-2003). The current NASCAR CEO is Brian France, Bill France Jr.’s son. Brian’s sister, Lesa France Kennedy, is the current CEO of ISCA. So, with brother and sister in charge of NASCAR and ISCA, I’m not worried about ISCA losing the rights to NASCAR racing events.

ISCA and NASCAR’s close relationship could be considered an antitrust violation, but the courts have consistently ruled in NASCAR’s favor. It helps that NASCAR only gives ISCA a majority of races and not all of them!

ISCA makes its money through four business segments (page 29):

Television rights are by far the most important component of ISCA’s corporate revenues (50%) and it gets this money through a revenue-share agreement with NASCAR –- NASCAR shares 65% of television revenue with the racetracks. Fortunately, these rights have just been extended for an additional ten years. This past summer, NASCAR signed ten-year contracts (2015-24) with both NBC and FOX for a combined value of $8.2 billion, which represents a 42% increase over the previous contract’s value despite the fact that NASCAR’s television ratings are down 25% from their 2005 peak. Amazing!

In announcing third-quarter financial results, CEO Lesa France Kennedy stated:

NASCAR signed the largest broadcast rights deals in the sport’s 65-year history. Having this visibility through 2024 places us in an enviable position compared to other industries and will provide us unparalleled long-term cash flow.

Although attendance at NASCAR races continues to decline, France Kennedy said that the declines have slowed and attendance appears to be “stabilizing.” Since 2005, attendance has fallen from 4.7 million to 3.5 million per year.  ISCA’s earnings and revenues have followed suit, both declining over the past five years on an annualized basis by 6%. Returns on equity were routinely double-digit until the 2008 financial crisis, but have been mired in the low single-digit range since. The problem is the weak economy and the persistently high unemployment rate which makes it difficult for NASCAR’s predominantly lower-income clientele to afford tickets.

CEO France Kennedy is trying to jumpstart growth by attracting younger and higher-income customers with hundreds of millions of dollars in new capital investments aimed at refurbishing racetracks (e.g., Daytona Rising) and expanding entertainment and leisure offerings (e.g., One Daytona). The One Daytona project is aimed squarely at mimicking the success of Patriot Place, the shopping and entertainment complex next to the football stadium of the New England Patriots. It also reminds me of the brief attempt in the 1990s by Las Vegas casinos to transform the strip from its gambling focus into a family vacation spot. The Las Vegas initiative didn’t work, but I think the family-friendly theme has a much better chance at sporting events like NASCAR and football, which have always been family activities. According to forecasts, the Daytona projects should generate incremental annual revenue of $20 million starting in 2016 with single-digit growth thereafter and become earnings accretive by 2019.

ISCA’s new initiatives at Daytona, combined with an improving economy, should help ISCA return to its glory years. It may take some time, but I’m willing to invest now based on the strong and stable cash flow ensured by the new television contract – combined with ISCA’s “special” familial relationship with NASCAR. I was glad to see the company raise its tiny annual dividend in April by a hefty 10% ($0.22 from $0.20). Debt is low at only 18% of total capital and has fallen in half since 2008. ISCA’s stock has performed well so far this year – up 26.2% — but its valuation remains low at an EV-to-EBITDA ratio of 8.9.

Given the France family’s voting control over ISCA, the stock’s cheap valuation will never translate into a takeover situation. Furthermore, the $8.2 billion television contract – as good as it is – is fixed and now mostly baked into earnings estimates. That leaves future growth focused squarely on ticket sales, concessions, and the new family entertainment offerings of places like One Daytona. But with the U.S. employment situation finally primed to improve in 2014, the ticket-sale “stabilization” that France Kennedy sees today will turn into actual growth next year.

Insiders appear to agree with me. On October 7^th, several insiders purchased thousands of shares of ISCA stock at an average price of $33.39.

International Speedway is a buy up to $39; I’m also adding the stock to my Momentum Portfolio.