When it comes to finding a possibly undervalued stock to examine in depth, my students always have a much easier time identifying an investment Ben Graham would like than one that would interest Warren Buffett.
These investing legends have two distinctive approaches to value. Graham stocks are normally lower quality stocks that have low price-to-earnings and price-to-book ratios. Buffett stocks are good quality stocks with a high degree of competitive advantage and sustainability; they can still be found to be undervalued, even with a higher P/E, but they can be trickier to find.
This was the case with my recently completed undergraduate value investing class at the Ivey Business School. Students chose to study and value Preformed Line Products Co. . And not only did the stock look possibly undervalued, students found it truly undervalued.
PLPC passed all Ben Graham screening criteria. At time of valuation (end of April), its market cap was US$336-million, its P/E was 11.3 times and its P/B was 1.2 times. PLPC has no active analysts covering the stock and does not offer earnings guidance or host quarterly earnings calls. It operates in a stable, unexciting and niche industry, providing critical “nuts and bolts” components primarily to utilities and telecommunication infrastructure. Management own about 38 per cent of PLPC’s shares.
The company, which makes cable anchoring, fibre-optic and copper-splice closures and high-speed cross-connect devices – the sort of critical infrastructure used in the energy, telecom, cable and other industries – operates in three core segments.
First is the energy products segment, which accounted for 66 per cent of revenue in fiscal year 2020. This segment serves three key customer bases: transmission electric utilities, distribution electric utilities and renewable energy. When compared with other costs facing utilities, PLPC’s products are seen as representing a low portion of the utilities’ total spending, yet bringing high benefits.
Second is the communications products segment, accounting for 24 per cent of 2020 revenue. This segment’s revenues are primarily from the production of protective closures and splice cases, which protect underlying communication cables from damage. Competition in the telecom and internet service providers industries is fierce. Companies rely on these critical components because damage to underlying systems results in outages, harming the end customer experience.
The third segment is special industries, which accounts for 10 per cent of revenue. This segment offers diverse products that serve a range of industries including renewables, communications, tower/antenna, agriculture and marine.
A history that stretches back more than 70 years has enabled the company to develop a strong brand name and build lasting customer relations. Moreover, gross margin analysis suggests that PLPC may have some form of pricing power, as gross margins have remained stable over the past 15 years, falling below 30 per cent only once in the period. Operating margins have also been relatively stable oscillating around 7.5 per cent over the same period. This is particularly impressive considering the wave of consolidation in electric utilities and the commodity inputs required in products.
The company is a major player in most markets in which it operates. Within the energy segment, PLPC appears to be the leader. PLPC is vertically integrated, capturing sales from manufacturing to distribution and service, which improves margins. Moreover, the company’s scale allows it to invest in more R&D relative to peers. Within the past five years, about 17 per cent of revenue has come from newly developed products. In terms of cost structure, about 70 per cent of costs are variable, which has enabled PLPC to remain resilient through times of economic uncertainty and reduced spending from customers. Lastly, the company has a diversified customer base, geographic reach and product portfolio. No customer represents more than 10 per cent of sales and about 57 per cent of sales come from outside the United States. The company holds numerous product patents, and no single patent represents a material portion of sales. This diversification decreases risk.
One possible risk is that PLPC’s key end market is utility companies, which are mature companies looking to cut costs, and have shown an ability to delay refurbishment of electricity grids. There is also some degree of consolidation within the industry, which has had an adverse impact on PLPC. These risks are mitigated by the expected uplift in spending associated with the shift away from fossil fuels and new renewables being connected to the grid. Moreover, PLPC has consistently maintained margins despite much consolidation and deferment in the industry over the past five to 10 years.
Given the reasons mentioned above and particularly the stability of the company’s gross and operating margins, and considering the industry in which it belongs, students concluded that PLPC has a medium business risk. With the company targeting 23 per cent debt-to-capital ratio, students reckoned that PLPC has low financial risk. This led to a cost of capital of 5.4 per cent, which students determined using an algorithm taught in the value investing course, which is based on business and financial risk.
(Financial risk refers to a company’s ability to manage its debt and financial leverage, and pay interest to debtors, while business risk refers to its ability to generate enough revenue to cover its operational expenses, also known as operating risk.)
The company’s adjusted return on invested capital was estimated at 4.7 per cent. Intrinsic value was estimated to be US$103.52 and, accounting for the margin of safety, the entry price was estimated to be US$69. With the stock trading at the time of valuation at about US$67, students felt PLPC was a strong buy.
In the weeks following the student valuation, the stock rose above the entry price and in early June, it reached US$82, way above the desirable buy price. Since then, however, the stock had been treading water and trading in the US$75 to US$76 price range and last week, while the company reported solid sales growth, its profits declined year-to-year – prompting a price correction back to around US$69, making the stock a buy again.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, University of Western Ontario.
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