Here Are Some Cheap Stocks (I Think!)

This blog has been a little heavy on market observations and light on actual stock ideas lately, so this is my attempt to correct that. Here are three stocks I think are cheap. I very much own each these on behalf of clients and could buy or sell shares at any time. This is not a recommendation to buy these shares.

You will notice a theme. It’s no secret I prefer low profile, little known companies doing something unexciting but essential. I don’t require a rosy growth outlook, but in the absence of organic growth, a company has to have a plan to generate value through accretive acquisitions or aggressive return of capital. If there are growth opportunities, wonderful, I just don’t want to pay much for them. I typically end up owning companies that are robust cash generators and have a few growth opportunities, internal or external, but are valued as if they are intractably stagnant or in long-term decline.

Let’s start with a Canadian company. Supremex Inc. manufacturers envelopes and packaging. It has operations in the US and Canada. The envelope industry is in long-term decline, but still extremely profitable for Supremex. The company is managing the decline in volumes through a combination of opportunistic acquisitions in the envelope industry and strategic acquisitions of packaging producers, with the goal of achieving 50% packaging revenue and earnings by late 2025.

COVID and the ensuing supply chain disruptions created a whiplash effect for Supremex. In 2021 and 2022, customers over-ordered, worried about the availability of product. This heightened demand, combined with price increases, helped Supremex earn a record $1.09 per share in 2022. However, as supply chain concerns began to ease, Supremex’s customers found themselves over-supplied and reduced their orders. This “air pocket” has cut into Supremex’s profits this year. Investors have punished the stock, sending shares down 50% from their peak in February 2023.

For its part, Supremex believes that inventory de-stocking is very close to bottoming and the market is normalizing, which should benefit revenues and earnings in coming quarters. The recovery is happening a little more slowly than the company had originally projected due to interest rate pressures and lingering inflation, but it is happening. The market being forward-looking, cyclical stocks typically trade at a high multiple of current earnings at cyclical lows and a low multiple of earnings at cyclical peaks. If a fair multiple for Supremex on mid-cycle earnings is 8-10x (pretty conservative in my view) then investors might expect shares to trade at 6-7x earnings at cyclical peaks and 12-13x earnings at the lows. And yet, Supremex shares are trading at just 6x annualized depressed Q3 earnings. As it becomes clear that earnings lows are behind us, I think the market will change its assessment.

Here’s what Supremex CEO Stewart Emerson had to say about its revenue and margin outlook on the third quarter earnings call.

On envelope volumes: “Envelope business continues to be affected by customer inventory destocking, although we feel the worst of that is behind us and more predominantly by the effects of inflation on fundraising and direct mail, and the impact of high interest rates on credit card solicitation mail. That said, conditions are improving…”

On packaging segment margins: “…the absorption rate as the market bounces back these facilities that we have remaining can produce a voracious appetite for volume. So as the market bounce back higher absorption rate will also lead the margin expansion. It will be a progressive increase in the -- we think the 9 [% EBITDA margin] number that we posted this month is the bottom and it's only upward from there.

Management referenced some version of “improving conditions” multiple times on the call, though they cautioned investors not to expect an immediate return to the boom times of 2021 and 2022. I think a useful barometer for assessing the market’s optimism or pessimism around a company’s prospects is the ratio of enterprise value to invested capital, measured across time. Five years ago, in November 2018, Supremex had an enterprise value of $117 million and invested capital of $67 million for a ratio of 1.7x. At peak valuation in February 2023. the ratio was 2.6x. Today, Supremex’s enterprise value is $176 million (including leases) and its invested capital is $138 million, a 1.3x ratio. Despite management’s projections of a recovering market, investors appear more gloomy on Supremex’s prospects than they have for several years.

By mid-2024, and with a rebound in volumes in packaging and steady performance in envelopes, I think Supremex is capable of producing EBITDA of around $50 million, earnings of 75 cents per share, and free cash flow of $1.01 per share, adding back non-economic intangibles depreciation. It’s always important to reality check projections, and I think mine are very reasonable. $50 million in EBITDA is 36% of net working capital plus fixed tangible assets, below the post-2018 average. Supremex’s operations have become more profitable over this time period thanks to a greater contribution from the packaging segment.

At under $4, Supremex shares sure look like a bargain to me. Company management seems to agree. Supremex has repurchased a healthy number of shares this year and insiders have also been buyers. If I had to speculate on the reasons for the current depressed valuation, I would point to tax-loss selling as a contributor, as well as the company’s return to stodgy mature manufacturer status after a moment of stardom.

Shifting back to the US, consider LICT Corp. Investors may recognize this one as one of the market’s highest-priced stocks. At a price of $18,000 per share, OTC-traded, and non-SEC reporting, it’s pretty unlikely that LICT will become a meme stock or Robinhood favorite any time soon. But I believe LICT offers incredible value and an upcoming catalyst will cause earnings to jump in 2024.

LICT Corporation is a collection of rural incumbent telcos in several Midwestern and Western states. Over time, LICT has transitioned from mostly offering traditional telco services like land lines to being mainly broadband services. The company has invested tens of millions in upgrading old copper lines to fiber optic, and has also made the foray into fixed wireless access. Famed value investor Mario Gabelli is LICT’s controlling shareholder. Gabelli was among the first to understand and appreciate John Malone’s strategy with respect to the communications business, and there are similiarities in how Gabelli has chosen to run LICT over the years. Like Malone’s companies, LICT eschews dividends. Instead, LICT has opted to buy back huge numbers of shares over the years and occasionally spin off assets. But unlike Malone, who routinely employs generous leverage, LICT has opted to pay down nearly all its debt in recent years. This nearly unlevered capital structure is very unusual for a telecom, but it does give LICT an exceptional amount of flexibility.

LICT’s most recent move was the spin-off of its Michigan assets into a company named “Mach Ten.” While there is a lot to like about Mach Ten, I think the parent company looks cheaper.

At $18,000 per share, LICT’s market capitalization is $309 million. It has net debt of $21 million, offset by a promissory note from the recent spin-off of its Michigan operating businesses (MachTen Inc., ticker “MACT” and still holds MachTen stock worth $4 million, putting LICT’s enterprise value at $311 million. Prior to the spin-off of MachTen, LICT was on pace to produce 2023 EBITDA of around $60 million. Adjusted for MachTen’s contribution, annual EBITDA is roughly $52.5 million, so LICT is trading at a normalized EV/EBITDA ratio of 5.9x. That seems pretty fair for an incumbent rural telco. Currently, LICT’s business is roughly half unregulated broadband services and half regulated phone services, though the mix is rapidly shifting toward the broadband side of things. If we assume traditional telco is worth 4x EBITDA and broadband is worth 8x (conservative if you ask me) then LICT is trading right in line. I happen to think LICT deserves a slightly higher multiple given its strong balance sheet and limited competition, but the valuation is in the range of reasonable.

However, a recent change in federal subsidies will create a major uplift in LICT’s EBITDA and earnings. Enhanced A-CAM replaces the previous “Alternative Connect America Cost Model” plans, increasing annual payments to telcos in return for commitments to provide higher speeds in their service areas. LICT is set to begin receiving an additional $13 million in annual revenue for 15 years beginning 2024. I don’t expect the increased subsidy rate to create major additional capex obligations for LICT. The company is already well into the process of rolling out high speed broadband access to all customers in its coverage area.

As a result of Enhanced A-CAM, run-rate EBITDA will hit at least $65 million in 2024. Capitalizing the increase at 6x would mean additional equity value of $78 million, or $4,500 per share. Besides Enhanced A-CAM, LICT will also benefit from multiple other state and federal subsides designed to ensure broadband access for all Americans. When the original A-CAM funding program was enacted, LICT shares doubled in the ensuing three years. I don’t expect shares to do the same this time around, as Enhanced A-CAM is less incrementally beneficial than the original and LICT is much less levered than it was back in 2017. But I do expect the market to wake up to the step change in LICT’s EBITDA and earnings in 2024.

Finally, there is Monarch Cement. The thesis here is pretty simple: cement producers are decent businesses that in many cases have strong economic moats and enjoy barriers to entry. US Cement producers typically trade around 10x mid-cycle EBITDA and sometimes higher in buyout transactions. Monarch Cement is a well-run Kansas cement producer with annual capacity in excess of 1 million tons. Monarch is a family company, controlled by the founders for over 100 years. The company treats shareholders well, repurchasing stock and paying dividends while improving the technical capabilities and output of its plant. Monarch Cement trades at a large discount to peer valuations thanks to its small size and relatively illiquid stock.

This week CRH Plc, a major global cement producer, announced the purchase of cement assets in Texas. CRH will pay Martin Marietta Materials $2.1 billion for these assets, a 12.4x multiple of 2023 EBITDA before any synergies. Were Monarch Cement to be sold at the same multiple, it could fetch $280-300 per share. Pretty good upside from the last trade of $147.50. Now, it’s pretty unlikely that Monarch Cement goes up for sale any time soon. But these small family-controlled industrial companies have a way of maintaining they are not for sale under any circumstances, right up until they sell for a huge premium when nobody expects it. It happened a few years back with another cement producer, Ash Grove. I am happy to hold Monarch Cement until that day arrives, if it ever does.

The market environment has been pretty hostile for small-cap value stocks for a while now, and I don’t know what it will take for that to change. Still, the values are compelling if you just turn over some rocks. It’s lonely out here but I will keep looking for value in the market’s obscure and overlooked companies. Thanks for reading and happy Thanksgiving!

Alluvial Capital Management, LLC holds shares of Supremex, LICT, and Monarch Cement for client accounts it manages. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.