In my last article in this space, I highlighted Utah Medical Products (Nasdaq: UTMD), a maker of high-quality medical devices that has been a beautiful case study in how a management team that makes smart capital allocation decisions can reward shareholders. I found Utah Medical by looking for stocks that fit a pattern -- good companies with management teams that have shunned growth for growth's sake and opted to grow value for its shareholders in the most efficient way possible, usually by repurchasing its own cheap stock. Two similar companies that have followed a similar path to shareholder bliss are Lone Star Steakhouse (Nasdaq: STAR) and Raven Industries (Nasdaq: RAVN), both profiled in recent issues of The Motley Fool Select.
Of course, it's most often that I discover these companies after they've been rewarded handsomely by the market, not before. I didn't discover Raven at $7 in early 2000; it wasn't until the stock was in the low-$20 range earlier this year that I caught on to the story (the stock is now at $35, so I'm not complaining.) While I think that there is still plenty of money to be made on all three of the above-mentioned stocks, I also have been keeping my eyes open for stocks that are candidates to be the next Utah Medical before the big move is made.
The pattern is pretty simple: Look for a company with a good core business that is re-focusing on value creation instead of growth. Often, these companies are either divesting underperforming operations or at least cutting back on unproductive growth. Further, such companies must have leaders that are willing to buy back shares when the stock is undervalued. A dividend is also not unwelcome. The last activity in the pattern is a new focus on growing the business profitably, either by investing sensibly in the core business or by making smart acquisitions that really add value.
Can Knape & Vogt come back?
One company that I think is a pretty good candidate is Knape & Vogt Manufacturing (Nasdaq: KNAP). Founded in 1898, Knape & Vogt is the world's leading designer, manufacturer, and distributor of shelving systems, drawer slides, and other storage-related products. The company also produces the Feeny line of kitchen and home storage solutions and the Idea@Work line of ergonomic office products. It sells its products to original equipment manufacturers (OEMs) specialty distributors, hardware chains and home centers, and directly to the consumer.
KV has long been a profitable operator, but may have been guilty in the early 1990s of overpaying for acquisitions that made the company bigger but not better. While the stock paid consistent dividends, much of the value of the free cash flow generated by the business was being destroyed through these suboptimal acquisitions. In fiscal 1993, for example, the company took on $6.75 million in debt to buy a powder-coat facility and the next year, it took on over $29 million in debt to purchase Hirsh, a maker of free-standing wood shelving and workshop accessories.
In 1998, William Dutmers, a former management consultant who had been on the board since 1996, became chairman. He was named CEO in May 1999. One of Dutmers' first acts was to engage management consultants Stern Stewart and implement the well-known EVA (Economic Value Added) system at the company at the beginning of the 1998 fiscal year.
EVA leads the way
In his 1998 annual report to shareholders, Dutmers explained the EVA approach and how it would be applied at KV.
EVA is a measurement tool designed to better align management's priorities with those of shareholders, including linking operational and financial targets to management compensation. EVA is founded on the principle that the only way for managers to increase the value of a business is to produce profits over and above the minimum required rate of return on the capital entrusted to them by lenders and shareholders. To increase EVA, Knape & Vogt must accomplish the following: increase operating profits without using additional capital; invest capital in projects that earn more than the cost of capital; and divert or liquidate capital from business activities that do not provide adequate returns.
Though I have my quibbles with the EVA method, it's been my experience that companies that apply EVA generally get good results. This is because EVA charges managers for the cost of the capital they employ in their business, and forces them to find intelligent uses for that capital. Returns on capital therefore tend to go up.
Such was the case at KV, where Dutmers found plenty of businesses not providing adequate returns. In early 1998, it announced it would sell its Roll-it store-fixture business, along with its Canadian manufacturing facility. In September, it sold Hirsh, the company for which it had paid $29.2 million just four years earlier, for $18.1 million. Hirsh had added some $15 million in sales per year to the top line, but wasn't contributing at all to operating profits. Selling it was the right thing to do.
Using the cash generated by the business and the $20 million in proceeds from the sale of Hirsh and Roll-it, the company reduced its debt from $29 million to $9 million during the course of the year. In addition, in 1998 and 1999, it bought back more than 25% of the outstanding shares. The stock hit an all-time high in June 1998 of more than $17 (split-adjusted.) KV reported an 18% improvement in EVA in fiscal 1998.
KV continued to identify and fix problems in its business during fiscal 1999. By fiscal 2000, things were humming. Sales were down to $152 million from 1998's $184 million, but profit margins were up, cash flow was up, and returns on equity hit 25%. Committing to investing in new product development, it also acquired ergonomic office product maker Idea Industries in September 1999 in a $5.8 million deal.
Unfortunately for Knape & Vogt, the Idea acquisition was the right deal at the wrong time. In the last couple of years, KV has really been hurt by the impact of the economic downturn, particularly in its office-furniture sales. The office-furniture market is the worst it has been in some 20 years, with new office shipments showing double-digit percentage declines in both 2001 and 2002. KV's total sales in fiscal 2002 (ending in June) were down about 8% to $131.9 million, and reported net income was $3.8 million, or $0.83 per share, down from $1.22 per share in fiscal 2001. Both figures are well off the record $1.80 per share in fiscal 2000.
Things don't look so good right now for KV. The stock recently dropped under $10, where the company's market cap is around $45 million. So why do I like it? There are several reasons.
The first is that while revenues and earnings per share are declining, cash flow has remained fairly consistent. KV produced $13.7 million in operating cash flow in fiscal 2002, well above the $8.8 million in 2001 and not far from the $17.3 million in the banner 2000 fiscal year. Even better, $9 million or so of that is free cash flow. That's plenty of cash to cover the dividend and still leave some left over, and the dividend payout is a hefty 6.6% at the recent price.
With a little help from the economy, Knape & Vogt could be a nice turnaround play.
Zeke Ashton has been a long-time contributor to The Motley Fool and is also the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. His analysis appears every month in The Motley Fool Select. He also picks two asset management firms as great investments for the years ahead in our just-published Stocks 2003. At time of publication, Zeke held a long position in Knape & Vogt stock. Please send your feedback to [email protected].
