Overfunded Pensions Are Hidden Investment Gems

by Will Ashworth | August 22, 2013 7:15 am

Overfunded Pensions Are Hidden Investment Gems

Here’s something for the math geeks.

Recently I’ve come across a series of articles[1] by David Trainer, CEO of New Constructs, an independent investment research firm in Brentwood, Tenn. Trainer’s writings focus on “economic earnings”[2] rather than the more traditional accounting earnings.

Trainer uncovered 50 public companies in 2012 with overfunded pensions totaling $5.5 billion — a rarity these days. His argument was these assets shouldn’t be included in one’s return on invested capital calculation, thus producing a higher ROIC.

Trainer’s findings produce several companies that would make excellent investments. The least-known — Park-Ohio Holdings (PKOH[3]) — is a hidden microcap gem that investors should get to know. Read on and I’ll explain why.

Overfunded Pensions Overfunded Pensions Are Hidden Investment Gems[4]
Sources:
New Constructs, LLC and company filings

Background

Park-Ohio’s history dates back to 1907 when Park Drop Forge, a maker of closed-die forgings for crankshafts in trucks, was established in Cleveland. In 1920, Ohio Crankshaft got its start manufacturing crankshafts and camshafts for diesel engines. The two companies operated separately until merging in 1967.

Despite a volatile history, it prospered from the time of the merger until 1983 when the United Automobile Workers went out on strike for a record nine years. Today, the company is riding high, although it has undergone several difficult economic cycles in the interim.

But investing in a thinly traded microcap stock is a very risky decision, so it’s best to have all the details before you consider jumping in.

What’s To Like

As Trainer points out, PKOH’s pension was overfunded by $34 million as of the end of 2012, which is 5% of its total assets.  Given the company’s history with the UAW, it makes sense that it has taken this position. Lord knows it couldn’t survive another nine-year strike.

The other reason overfunding makes sense is that employees aren’t lending money to the company. In a second article[5] about pensions, Trainer points out that AT&T (T[6]) has an underfunded pension to the tune of $44.4 billion, which in essence is an interest-free loan made by employees.

Now back to its business.

Microcaps often have shareholders who own significant positions in the company. In Park-Ohio’s case CEO Edward Crawford owns 12.9% of its shares, and his son Matthew — the company’s COO — owns another 15.4% for a combined 28% of its outstanding stock. The only other shareholder that comes close to those numbers is Mario Gabelli’s firm, which owns 13% of PKOH shares.

Edward Crawford took control of PKOH in 1992 and has been running it ever since. With a 73-year-old CEO, you can expect the company to transition from father to son in the not-to-distant future. Generally, I like stocks that are family owned and operated as long as they respect the other shareholders. From where I sit, there don’t appear to be any red flags.

Park-Ohio both manufactures and sources industrial parts throughout North America. Its three segments — Supply Technologies, Assembly Components and Engineered Products — generated $595 million revenue in the first six months of 2013, a 4% gain over the year-ago period.

Its business is exceptionally slow at the moment due to some of its end markets suffering economically. As I said earlier, this is a business with ups and downs, but over the past 10 years, it has increased annual revenues by more than 10% on six occasions.

Park-Ohio’s bottom line has suffered as a result of weak revenue growth so far this year. In the first six months, operating income grew a meager 1.9% to $47.4 million. On a positive note, its gross margin in the first half increased by 20 basis points to 18.5%. (Hooray for small miracles.)

Of its three segments, only its assembly components business was able to increase operating profits in the first half, delivering a 112% increase year-over-year to $17.6 million. It earned the same amount of money as its supply business on 17% less revenue. The silver lining in all of this: Park-Ohio’s got a truly diversified business in terms of revenue and earnings.

Why Care?

This is an exceptionally boring business; however, boring is good when it comes to investing. PKOH stock has traded in a very tight range around $20 the last three years until it started moving this past March. Strong fourth-quarter results pushed its stock up 90% in the span of two months. Although I’m not a technical analyst, I can say with certainty that Park-Ohio began its impressive run after falling below both its 50-day and 200-day moving averages. With weakness expected for the next quarter or two, it’s very possible this same scenario will play out over the next few months.

Beside the technical aspects, there’s the simple reality that despite a weak business environment at the moment, it intends to deliver at least $3.65 in earnings per share in fiscal 2013. That’s a P/E of less than 10, much lower than the S&P 500’s 17 and its peers’ ratio of 21. In addition, PKOH expects to hit $2 billion in annual revenue by the end of 2017.

If it simply treads water from a margin standpoint over the next four years, Park-Ohio’s P/E will be in the low single digits. I just don’t see that happening given its tremendous move between March and May. A good report in the fourth quarter will most certainly prevent that from happening.

Bottom Line

Park-Ohio Holdings’ biggest drawback is the amount of debt on its books, which is slightly less than $400 million. Fortunately, it generates plenty of cash to cover the $26 million in annual interest. In addition, if it continues to make smart bolt-on acquisitions, its inflow of cash will grow far faster than its outflow because it requires a small amount of maintenance capital expenditures to keep the business running.

At the very least, you know it won’t have a pension crisis in the next few years like some businesses will.

Look — this isn’t a stock you throw in a drawer and forget about. Having said that, I see the markets being kind to Park-Ohio’s stock over the next five years … but not without some serious turbulence along the way. Caveat emptor.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Endnotes:
  1. a series of articles: http://seekingalpha.com/article/1605092-overfunded-pension-plan-assets
  2. “economic earnings”: http://seekingalpha.com/instablog/753641-david-trainer/863661-economic-versus-accounting-earnings
  3. PKOH: http://studio-5.financialcontent.com/investplace/quote?Symbol=PKOH
  4. [Image]: http://investorplace.com/wp-content/uploads/2013/08/Overfunded-Pensions.jpg
  5. article: http://blog.newconstructs.com/2013/08/16/pension-net-funded-status/
  6. T: http://studio-5.financialcontent.com/investplace/quote?Symbol=T

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