Art's Way Manufacturing - ARTW

Today's topic is one of my favorite tiny manufacturers, Art's Way Manufacturing Company. Art's Way, founded in 1956, is based in Iowa and trades on the NASDAQ. Art's Way had 2012 sales of $36.5 million and has a market cap of $28.4 million.

Despite its small size, Art's Way is the nation's largest manufacturer of sugar beet harvesting equipment. Sugar beets are the source of 20% of the world's sugar production and are grown around the world, especially in cooler climates where sugar cane cannot survive. Art's Way also makes a variety of other agricultural implements, like grain augers, hay balers and manure spreaders. Art's Way avoids competing in the market for extremely sophisticated and costly tractors and combines, instead focusing on simpler farm implements.

Over the last decade, Art's Way has added business lines including pressurized vessels and modular buildings commonly used for animal containment and agricultural research.Art's Way's agricultural products accounted for 67.8% of revenues in 2012. Modular buildings accounted for 26.5%, while pressurized vessels made up 5.7%.

While Art's Way is now a profitable and growing company, it wasn't always so. The company flirted with bankruptcy in 2002 after several years of sustained losses. An infusion of capital kept the company afloat, and J. Ward McConnell, Jr. took over as chair.

Mr. McConnell has orchestrated quite a turnaround. Under his leadership, Art's Way has been a shrewd acquirer, adding many new product lines as well as the vessels and modular buildings segments. Since 2005, Art's Way has made small tuck-in acquisitions and introduced new product lines at the rate of nearly one per year.

All of these transactions were financed by internally-generated funds or through bank debt. Shareholders have seen diluted shares outstanding increase by only 4.5% since 2002.

The result of these small, easily-digested acquisitions has been steady expansion of revenues and profits.

Annual revenue growth of 12.8% and earnings growth of 16.7% over a decade is extremely impressive. Art's Way was affected by the financial crisis and saw its annual revenue decline 18% from 2008 to 2009, but the long-term trend shows sustained growth. An investor who purchased Art's Way at a split-adjusted price of $1.45 on December 31, 2002, made an annualized return of 15.5% over the next decade.

Results through May 31, 2013 show a slight decrease in revenue and EBITDA compared to the half-year ended May 31, 2012, but net income and free cash flow reached new highs. Revenues in the agricultural products division rose 22.7%, but the modular buildings division saw its revenues decline 62.2% as some large contracts were completed. Since the quarter's end, Art's Way has announced additional contracts for the modular buildings division.

Art's Way's trailing valuation looks quite reasonable. At a share price of $7.00, the company's trailing P/E is 9.9. Art's Way carries net debt of $6.02 million, for a trailing EV/EBITDA of 7.2. Trailing results do not include Agro Trend's contribution, since it was purchased so recently. If agricultural sales stay strong and the modular building segment rebounds, Art's Way's valuation could be much lower a few quarters hence.

Truth be told, Art's Ways short-term results concern me very little. That's because I believe Art's Way is one of those rare companies capable of earning a high return on capital, and capable of reinvesting the great majority of its earnings at high rates of return. The combination of the two results in swift growth in book value per share, which ultimately drives returns. Art's Way's average ROE for the past decade was 17.9%. The company pays out about 15% of its earnings in dividends, leaving plenty of capital to compound.

The chances of that compounding continuing are good. Art's Way's capital allocation policy has been excellent under Mr. McConnell. The company's practice of identifying and acquiring the neglected divisions of other companies at modest prices is scalable and repeatable. For all its growth, Art's Way still does less than $40 million per year in revenue. Another decade of similar growth would result in annual turnover of $122 million. That's not hard to imagine in a world where Deere & Co. does $36 billion in annual revenue and Case New Holland does $20 billion.

Risks to Art's Way's continued success include a slump in crop prices, particularly in sugar beets. Changes to sugar subsidies in the US farm bill could result in fewer acres of sugar beets planted. And of course, extreme drought or flooding could disrupt Art's Way's customers. Despite these risks, Art's Way looks attractively priced relative to current earnings and the long growth runway ahead of it.

I own shares in Art's Way Manufacturing.