William H. Frazier, ASA, W.H. Frazier & Co., Inc. Nationally Recognized Business Valuation Expert, Speaker, Author
At midyear 2020, compared to the beginning of the year, the S&P 500 Index was down by a slight 4.8%. The Russell 2000 Index, which includes small cap companies, was down by 13.5%. The Invesco S&P SmallCap Industrial ETF was 18.2% lower but the Invesco S&P SmallCap Info-Tech ETF was 4.2% higher.
The implication of these national indices is that, in the midst of the COVID-19 pandemic, larger companies are faring better than smaller ones and technology stocks are actually improving whereas industrial ones are fading.
A look at 12 smaller publicly-traded manufacturing companies in North Texas shows that, on average, these stocks were down 16.6% at June 30, 2020 compared to prices at December 31, 2019. (See table below.) While not a valuation tool per se, local manufacturers may find this barometer at least provides a measure of the current market sentiment.
There are over 5,000 manufacturers in the Dallas-Fort Worth-Arlington Metropolitan Statistical Area. According to Bureau of Labor Statistics, there were 278,000 persons in the DFW area employed in manufacturing. Perhaps one-third of the employment comes from large, international companies such as Lockheed, Texas Instruments or Raytheon but the majority comes from small, privately-held and family-owned businesses.
Normal valuation measures are not currently very useful. The M&A market is virtually shut down and multiples from prior periods cannot be used in today’s market environment. Prior valuations performed through the use of discounted cash flow (DCF) are no longer accurate. Attempting to revise predictions about future financial performance is not likely a fruitful exercise at the moment.
The information in the following tables about North Texas Small Cap Manufacturers (NTSM)provide some key statistics on the financial and market performance of 12 smaller manufacturing companies headquartered in North Texas. The commentary is designed to help the reader decipher some of the market implications of the included statistics.
A quick description of the companies in the NTSM study is as follows:
A Note about the NTSM Study
The table is intended to be a useful guide for local manufacturers not a rigorous academic exercise. As such, some classification rules have been relaxed. In the first place, small cap companies are generally said to have market capitalizations of $2 billion to $300 million. Four of the companies are below the minimum threshold and one is just above the max. One company, Micropac, might be better thought of as an information technology company but since it does engage in manufacturing products for industrial clients, it was included.
None of the 12 companies analyzed are alike. They differ in products produced, industry sectors served and, of course, in financial characteristics. Further, some sell products only in the region and some sell internationally. Thus, one size definitely does not fit all.
Market Values
The next table describes market values and how these have changed between June 30, 2019 and June 30, 2020. Dollars are in thousands, except for per share data.
On average market values for the group were down, 16.6% since the beginning of the year and 14.3% from a year earlier. One company’s value, Micropac, was actually higher for both time periods. The Companies with only single digit price declines included Frontera, CompX, Arcosa and U.S. Lime and Minerals. Two companies had price declines of more than 20%-U.S. Concrete and AZZ.
EBITDA and its Multiple
EBITDA (earnings before interest, taxes, depreciation and amortization) is the most commonly used valuation metric for privately-held businesses. Despite employing MBAs with deep financial acumen, strategic and private equity buyers still prefer the simple EBITDA multiple over seemingly more sophisticated methods such as discounted cash flow.
The EBITDA table does not seem to explain the decline in market value. The median change in EBITDA was actually positive (2.8%). (Here, the median is used instead of the average because the extreme amount of variation in a few of the results would produce a skewed average.) The median EBITDA multiple was down only about 7% for the first half of 2020.
The Data Lag
The data utilized in the NTSM study is as of the trailing twelve months (TTM) reported by each company at the three valuation dates. There is usually a one quarter lag in the data. For example, data for June 30, 2020 (except market price) is for the TTM reported as of March 31, 2020. For this reason, only a couple of months of the four quarters of results has been negatively impacted by COVID-19. For the other two valuation dates, there is no COVID-19 impact at all.
To complicate matters a bit further, AZZ, Micropac and Ennis have fiscal years ending as of the end of February. Thus, their reported data is one month out of sync with the others in the group. For the calendar year end 2019, we use a twelve month period ending November 30, 2019. Since we are trying to align with a calendar perspective, we classify their first fiscal quarter reported at May 31, 2020 as second quarter (calendar) data.
The following table provides a better measure of the impact of COVID-19. It compares EBITDA from just the first quarter of 2020 with the last quarter of 2019. U.S. Concrete, for example, whose value had declined about 40% from the beginning of the year but its TTM EBITDA was down only 1.3%. However, it recorded a 1Q EBITDA decline of 37% from Q4. The market appears to have extrapolated that for the remainder of the year. Historically, this has rarely proven to be an accurate prediction method.
On the other extreme, Friedman Industries’ Q1 EBITDA, falling deeply negative, was almost 300% lower than Q4. Its stock price decline was only 15%-lower then the average for the group. The answer appears to be that Friedman’s stock price is currently measured in relation to book value. Since its cash flow is negative, investors are thinking defensively and in relation to potential break-up value. (In response to this, the company is initiating a stock buy-back program.) At June 30, FRD sold at a price of 50% of book value. The median market/book ratio for the group was 120%.
Market to Book Value Relationship
The table below describes the relationship between market value and book value-an asset-measuring statistic. Half of the stocks are trading close to or below book value.
While U.S. Concrete did suffer a significant decline in EBITDA in the first quarter of 2020, unlike Friedman, it was still positive. The same can be said for AZZ, Micropac, and Ennis.
So why would Fronterra, with a June 30th TTM EBITDA multiple of 10.5X be trading at a price which was 700% of book value? Fronterra is an example of a company whose reported book value is not a meaningful statistic. This is because the company is heavily leveraged and also has a large amount of goodwill and intangible assets on its balance sheet. The interest expense and amortization charges (associated with goodwill) help cause the company to report negative earnings each year. However, Fronterra produces a solid free cash flow and that is the most important number from a valuation standpoint.
The table above describes the relationship between market value and book value-an asset-measuring statistic. Half of the stocks are trading close to or below book value.
While U.S. Concrete did suffer a significant decline in EBITDA in the first quarter of 2020, unlike Friedman, it was still positive. The same can be said for AZZ, Micropac, and Ennis.
So why would Frontera, with a June 30th TTM EBITDA multiple of 10.5X be trading at a price which was 700% of book value? Fortera is an example of a company whose reported book value is not a meaningful statistic. This is because the company is heavily leveraged and also has a large amount of goodwill and intangible assets on its balance sheet. The interest expense and amortization charges (associated with goodwill) help cause the company to report negative earnings each year. However, Fortera produces a solid free cash flow and that is the most important number from a valuation standpoint.
What the NTSM Study Indicates
First, if you are a manufacturer and still profitable, your value has come down but perhaps not as much as you might think from the news. The average year-to-date price decline for the group was less than 20%. For the 11 companies with a positive EBITDA, all traded at or above book value.
What the NTSM Study Does not Say
We know from other sources that companies tied to the oil and gas industry are suffering much greater price declines than others. On the other hand, companies whose products are more technologically advanced and more proprietary have a lower than average decline-even market growth, in some cases.
The study makes no predictions about the future. It should be noted that many published estimates for Q2 and the rest of the year were made at a time when COVID-19 appeared to be waning. The duration and magnitude of the current world-wide spike in COVID-19 infections will greatly affect the prospects for a recovery. No one has the answers. The collective assessment of the millions of stock market participants is one of cautious optimism. But, as we have seen, this can change abruptly.
The results reported for the 2nd quarter of 2020 will be very important for all of the companies of the NTSM study and for the entire marketplace.
