While I'm not a believer in timing the stock market, I do believe that good timing counts for a lot in investing and in life. A case in point was Matt Richey's Boring is Beautiful, which sang the praises of Ennis (NYSE:EBF), one of my favorite stocks. Matt explained that while Ennis offers little in the way of tantalizing press releases or bleeding-edge technology, it offers plenty for investors who prefer their portfolio companies to pound out cash and pay dividends. In the case of Ennis, investors have also been treated to the occasional accretive acquisition every couple years.
Just hours after Matt's article was posted online, Ennis issued a press release announcing the biggest transaction in the company's history. Ennis will be acquiring not one but two companies, virtually doubling the size of the company overnight. This is obviously a mammoth deal for a company that has up to now been content with making modest but carefully selected acquisitions to grow and diversify its business. Still, Ennis CEO Keith Walters maintains that this is not a strategic departure from the previous acquisition strategy, but rather a simple result of a larger opportunity becoming available.
The stock has jumped about 15% in the aftermath of the news; all of a sudden, the Ennis story isn't quite so boring after all. I have some thoughts on the merger for those who are interested, but more important, I sense that there might just be some bit of investing wisdom to be gained from this story, and I want to hit on that first.
A stock without a buyer
Just prior to the announcement, Ennis was recently valued at about $260 million, a very modest price for a company with a fine track record of shareholder wealth creation and reasonable prospects for continued free cash flow generation. Ennis produced right at $259 million in sales and generated $22.8 million in free cash flow in fiscal 2003, and therefore, it was valued right at 1 times annual sales and more than 11 times annual free cash flow. The stock also had a dividend yield of about 4%.
It's important to ask why well-managed and profitable companies like Ennis lack willing investors when their stocks are at modest prices. The answer is fairly simple: The stocks lack a natural buying constituency. Of course, the S&P 500 will generally be low on bargains. That index represents a massive buying constituency, with all the index funds that have to own the S&P 500 component stocks and the large institutional funds that likewise are required to purchase the stocks. (This is either so they don't suffer the dreaded index underperformance or simply because they have to buy stocks with significant liquidity.)
But index participation, market cap size, and liquidity can't be the only explanations for the valuation discrepancy. Consider the context of the market in which investors are quick to assign lofty valuations to small companies with some technology sizzle, such as nanotech player Nanophase Technologies (NASDAQ:NANX), or that represent plays on a hot theme such as homeland security darling Taser International (NASDAQ:TASR). Nanophase, which has about $5 million in trailing revenues, was recently valued at about $120 million, while Taser, thanks to recent explosive growth and impressive profit margins, enjoys a market valuation of more than $1.25 billion. The most recent 12-month financials for Taser show annual sales of approximately $34 million and about $4.3 million in free cash flow.
While I have no opinion as to the investment merits of either Taser or Nanophase, I bring them up to point out that there is obviously a buying constituency of growth and technology-oriented investors. These shareholders are willing to pay much higher prices for small-company stocks with significant potential, while they ignore stocks of stable companies that provide consistent but not spectacular growth at more reasonable prices.
There are other ways that stocks gain a buying constituency, and Ennis didn't fit any of them. Ennis doesn't have a consumer brand that would be familiar to investors. There's no hot technology theme that can be hyped -- printed bank forms and cotton tags hardly get the message boards buzzing. Ennis' Yahoo! board lists 589 messages covering the last eight years. The Motley Fool board has all of 17 messages. Indeed, if it weren't for the Taser and Nanophase references, you might not even be reading this article now.
Also, Ennis generally does not appeal to value investors, as it is not cheap enough on traditional metrics for the hard-core value investors. It doesn't trade at a discount to book value, the P/E isn't extraordinarily low, and its price to free cash flow ratio (my favorite valuation tool) is usually between 11 and 13. The stock lacks the volatility to interest day traders. The 4% yield isn't quite high enough to pull in the REIT and other income-oriented investors. There isn't even a brand-name or consumer product that most investors would be familiar with. I mean, who exactly is going to buy this thing?
Along comes a catalyst
One of my favorite mutual fund managers, Robert Olstein of the Olstein Funds, says that "waiting for a catalyst to appear before buying an undervalued stock will result in the purchase of a fully valued stock." Such is the case with a stock like Ennis, although I believe that sometimes it takes awhile for the market to truly comprehend the catalyst.
In this case, Ennis will issue stock worth between $144 million and $149 million. Also, it will take on debt worth $104 million to $108 million to acquire Alstyle Apparel, a T-shirt and fleece goods manufacturer, and Crabar/GBF, a traditional business forms printer. The combined company will have about $525 million in annual sales, combined EBITDA of $65 million to $70 million, and combined free cash flow of $45 million to $50 million. Note that these figures are based upon fiscal 2003 numbers, not forward projections. Ennis shareholders will own 65% of the combined company, while Alstyle shareholders will own 35%. Ennis will maintain its dividend at $0.62 per share. Matt and I think that the new Ennis could generate $55 million to $60 million in free cash flow by 2006, and that the new, larger company will be better appreciated by the market. If it can achieve only a 13 times multiple to that free cash flow, Ennis shares will trade somewhere between $27.50 and $30. For this reason, we don't intend to sell our stock, and if the price drops back to where it was pre-announcement, we'll consider buying more.
There are many reasons why the stock's multiple might expand. The first is that the company's much larger size provides some additional liquidity for larger, institutional buyers. The new Ennis is now further diversified away from traditional business forms and may, therefore, be put into a new "comparison box" and in the company of stocks that the market has assigned higher multiples. Finally, investors might conclude that a solid company that produces cash flow and uses smart capital allocation to grow per-share value for investors should be assigned a slightly higher multiple. Of course, Ennis has to go out and execute in order for any expanded multiple granted by the stock market to stick.
What's the lesson here? Look for companies that are well-managed, are profitable, and have solid track records of good capital allocation, but that don't have a natural buying constituency. These are the true hidden gems of the stock market. It helps if the company issues a nice dividend - there's no telling how long you might have to hold out for a catalyst, so it helps to get paid while you wait. Ultimately, perhaps when you least expect it, a catalyst will emerge that simply prompts the market to recognize the value that's already there.
Longtime Fool contributor Zeke Ashton is the managing partner of Centaur Capital Partners LP, a Dallas, Texas-based money management firm. At the time of publication, Centaur Capital Partners owned shares of Ennis, but had positions in none of the other companies mentioned. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. The Motley Fool has adisclosure policy.
