In my previous article on Park Aerospace (PKE), I indicated that PKE is both a growth company and a dividend giant. Because of the valuation at the time of the writing of the previous article, I only entered a small position. This article updates the progress of the company and provides another look at the valuation.
Management has updated its mid-term plan and has taken a more conservative view of revenue and profitability. PKE shares continue to trade at a valuation that does not provide very attractive future returns nor a wide enough margin of safety. I will continue to hold and wait for a more attractive price before adding to my position.
PKE continues to return cash to shareholders
PKE has $144M of cash and no long-term debt. At about 20.5M shares outstanding, this represents about $7 per share out of a recent share price of $16.5. Out of the $144M, $17.7M is earmarked for payment of remaining transition tax installment. Another $15.1M is earmarked for capital expenditure for the expansion of the manufacturing facility in Wichita, Kansas.
Mr. Brain Shore, CEO and a son of one of the founders, runs the company with the mindset of an owner rather than that of a hired manager. PKE’s capital deployment plan has the following priorities: growing the existing business, growing through M&A, and return capital to shareholders through dividend. The facility expansion positions PKE to grow within its existing business. PKE is active in seeking M&A candidates. The intention is to acquire unique or niche technologies that add to its technical capability to address the aerospace market. PKE indicated that it is interested to expand in Asia, but believes that it does not have the knowhow to enter that market by itself. Hence, it is looking for a JV partner to invest in or invest with. The M&A process has not yet yielded any results, but management indicated that PKE will be patient and disciplined.
In terms of capital return through dividend, PKE has a regular quarterly dividend of $0.1 per share. At a current price of $16.5 per share, the shares yield 2.4%. This quarterly dividend has not changed since 2010. However, in addition to the regular quarterly dividend, PKE has been returning capital through a special dividend. The latest special dividend is $1 per share, payable on February 20, 2020 (ex-dividend date was January 17, 2020). PKE’s special dividend history is shown in Table 1.
Table 1: PKE special dividend history. Source: dividendinvestor.com
Assuming the regular quarterly dividend stays at $0.1 per share, the dividend payment in 2020 will be $1.4 per share. This translates to a dividend yield of 8.5%. Some investors may be less enthusiastic with a special dividend as it is not a regular payout that they can count on. However, there may be a place for a special dividend payer in a portfolio, but just do not count on the special dividend to pay the bills.
Mid-term plan update showed a reduced sales/profitability expectation
PKE management provided its annual update of its mid-term plan (through FY2024, ending on February 2024). The most notable items of this update are that management has dialed back its expectation for both revenue and profitability. Selected items of the plan are shown in Table 2 below.
There are several notable items in Table 2. FY2020 results will fall short of PKE’s plan from a year ago (more on that later). PKE has slightly dialed back its revenue expectation for the midterm. More importantly, PKE has significantly reduced the expectation of its EBIT margin. The reduced expectation comes about as a result of the lessons learned from the challenges experienced during FY2020.
FY2020 operational challenges reduced profit
The challenges are caused by order pushed out by customers, significant additional cost in testing and qualifying its products, additional cost of manufacturing to correct quality issues of suppliers, constraint of supply of key materials from its suppliers. PKE management realized that it costs more to develop and qualify its products and manufacturing processes. There are also additional costs to improve the quality of its supplier and of its own manufacturing processes. The realization of these costs came about during the challenges to ship products in FY2020. The net result of these challenges is that revenue in FY2020 will fall short of PKE’s plan and that its profit margin will be much lower than planned.
Of the items that impacted results, there are some that are beyond PKE’s control: order push-out by customers, and constraint of supply of key materials from its suppliers. However, the rest of the items are well within the control of PKE. PKE did not anticipate the additional cost in testing and qualifying its products. This is an indication of PKE’s relative inexperience in the aerospace industry, which is rather conservative in the qualification of its products and in the data required for qualification. I hope management has learned its lessons and will be better able to anticipate the time and cost for product and process qualification. I am disappointed by the supplier quality issue that impacted FY2020 results. I will not recount the issues as management provided details in the 2Q and 3Q earnings CC. Suffice it to say that supplier quality management processes should have been a standard process for Nelco (the electronic materials division that PKE spun off). Apparently, PKE has not transferred this knowhow across divisions. As a result, the aerospace group has to re-learn this knowhow from scratch. I consider this a major blemish on PKE’s management. Going forward, I hope that management will review the weaknesses within its business capabilities and processes and make pro-active improvements.
Current valuation does not provide a large enough margin of safety
With the mid-term update, and especially with the more conservative forecast of profitability, I updated my valuation model for PKE. The results are shown in Table 3.
Table 3: Valuation model based on updated mid-term plan. Source: Author’s model. Note: The model assumed a tax rate of 27%. The FWD multiple is calculated based on the current share price ($16.5) and PKE’s plan for FY2021, and the same multiple is carried forward for subsequent years.
The model shows that the RoR is respectable without accounting for the dividend yield. Note that the ex-dividend date for the $1 special dividend has already passed. Hence, a new investor today should only count on the 2.4% yield based on the regular quarterly dividend. After release of the updated mid-term plan and the moderation in profitability expectation, the share price did not adjust correspondingly. Given the risks described below, I will be more comfortable if there is a wider margin of safety. Hence, I will continue to hold the small position that I have established. Should there be a correction, I may add to my position.
FY2020 results to date clearly showed the growing pain of PKE in the new aerospace market vertical, where it is learning that developing products and manufacturing processes usually take longer and cost more. The results also showed the limited capability of the company in terms of supplier quality management processes and ramping manufacturing capacity. As the company continues to grow, other weaknesses may surface that may impact financial results.
While management has reduced the profitability expectation, further ramping of production may uncover other costs that are not currently planned for. Being a small company, PKE has little leverage with its supply chain. Hence, it may continue to suffer from supply shortages that may limit its ability to ramp with its customers, impacting revenue.
Customer programs may push out. PKE’s revenue visibility is only as good as the revenue visibility of its customers. Revenue visibility may be adjusted either way. Even though PKE is not designed in the 737 Max program, which is a black swan event, a black swan event in one of the programs that PKE is designed in will impact its revenue outlook. Being a small company, its revenue mix is such that it will be difficult for PKE to make up lost revenue from one program by accelerating other programs.
PKE is a company with a combination of growth and good capital return to shareholders in the form of dividend. It is cash-rich and management shows the characteristics of a good steward of owners’ capital. PKE’s dividend policy is for a regular quarterly dividend, and pays a special dividend with excess cash. This policy may turn off some dividend investors. PKE recently updated its mid-term plan, which shows a more conservative expectation for profitability. The challenges the company faced in FY2020 in lower-than-planned revenue and profitability are results of higher cost in development and qualification of products and processes, quality issues in supplier materials and weaknesses in PKE’s supplier quality management and manufacturing quality management processes. Hopefully, the challenges will result in continuous improvement. Given the risks, the share price values PKE fairly and does not give me a wide enough margin of safety to enter new positions. I will hold my current position and wait for a correction to add to my position.
Disclosure: I am/we are long PKE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All investments have many risks and can lose principal in the short and long term. The information provided is for information purposes only and can be wrong. By reading this you agree, understand and accept that you take upon yourself all responsibility for all of your investment decisions and to do your own work and hold the author harmless.