Monday, May 21, 2012

National Presto Continues To Fall

National Presto Industries (NPK) now trades with a P/E under 10, having dropped 50% of its share price in just the last year and a bit! Instead of discussing the company further, I'll point you to someone who has already done so at GuruFocus, but come back here when you're done because there are a couple of issues with that article that I want to dissect.

Done reading it? Okay good!

In my opinion, the author does an excellent job describing some of the salient points regarding a potential investment in Presto. Management has shareholder-friendly capital allocation policies (and is of a family tree that Buffett admires!), the company leads in a number of its product categories, and there is unlikely to be any secular decline in the company's products.

But while the author discusses the major risk facing this company, he kind of ignores it when he draws his conclusion that Presto should be purchased at current prices. The risk is one of customer concentration.

If these major customers continue to buy in the future at a similar rate to what they have in the past, I agree with the author that Presto appears undervalued. But when a single customer makes up 47% of sales, there is significant downside risk.

This is not a company trading at a discount to book value that can just shrink if sales decline and still make shareholders whole through monetizing its assets. At 1.5x book value, one has to be sure of the company's earnings power in order to protect the downside, and this is very tough to do when one customer holds so much sway.

Carnage can result from such a situation, as seen in this example; contrast this with Staples, a company with a moat that trades at a similar P/E to Presto but that is not reliant on a single customer. Staples recently walked away from two major contract customers because of price competition, but this did not register a blip on the company's results.

Already, this major customer of Presto's has reduced purchases of late, but the company has blamed the reductions on simply the timing of shipments. Unfortunately, as pointed out by Frank Voisin, the company has blamed the timing of shipments for three quarters in a row, calling into question management's credibility!

Current earnings are good! (They're better than negative earnings!) But even better are sustainable earnings. When customer concentration is high, the sustainability of earnings is harder to predict, reducing the investor's odds of success!

Disclosure: No position


Jacob Dove said...

I completely disagree with your assessment that “while the author discusses the major risk facing this company, he kind of ignores it when he draws his conclusion that Presto should be purchased at current prices.”

On the contrary, the author actually presents evidence that directly addresses the customer concentration issues, and then goes on to quantify the likely impacts going forward.

If you go through that exercise for this company (i.e. quantify different scenarios for segment revenues, and apply realistic probabilities to each), it quickly becomes apparent that the company is either already at, or is extremely close to, an attractive entry point to buy the stock.

Instead, your assessment just summarily dismisses this company on the basis of customer concentration. By the way, this is the same error made by Frank Voisin in his series of articles on NPK to which you link in your post. As a commenter on that site aptly points out, if you actually perform the exercise of quantifying possible reductions in each segment and then assess what is already priced in, then this stock is already cheap at these levels.

Lucas said...

Harmless question, but how would one quantify realistic probabilities? Is it easy enough to say something like this is 18% probable instead of 17%? And what methodology is one using to get these probabilities? Has Presto been the same situation enough times to create a decent sample size? Or are there Pseudo-Presto's out there one is using as a proxy?

From what I understand, the essence of being a value investor is the margin of safety. This is the level that one feels comfortable buying because it takes care of much uncertainty inherent in the analysis. If I were having to assign probabilities, I may have to just admit that I don't know what I don't know.