Seeking Small-Cap Moats: Raven Industries
Fight big-city bias and find a hidden gem.
This article is part of Todd's monthly series "Seeking Small Caps With Moats." The introductory article can be found here. New articles in the series are published on the fourth Wednesday of every month.
When researching small-cap companies, one of the nontraditional factors that I like to see is that the company's headquarters are in a rural or small-city setting. This might sound a bit strange, but hear me out.
Investors as a group have a well-documented bias toward owning domestic equities ("home bias"). And it's not just a preference for companies based in one's own country, but also a preference for local companies--a study by Joshua Coval and Tobias Moskowitz found that "the average U.S. fund manager invests in companies that are between 160 to 184 kilometers, or 9 to 11 percent, closer to her than the average firm she could have held."
Given the high concentration of asset management firms in major cities, it stands to reason that firms located well outside major cities will attract less investor attention, on average, and will offer more opportunities for the enterprising investor to capitalize on information asymmetries. Indeed, a study by Tim Loughran found that rural or small-city firms have fewer sell-side analysts covering them and trade with a higher book/market ratio (lower price/book) than firms based in urban areas.
Of course, the location of a company's headquarters shouldn't be the determining factor as to whether you invest, but I do see it as a small net positive--particularly if the distance from the investing community helps management focus on expanding the business rather than on swings in the stock price.
A Hidden Gem in South Dakota
This month's small-cap idea is based in Sioux Falls, South Dakota, and has flown under many investors' radars (including mine) for years, even though the stock is up 2,927% over the past 20 years (18.6% annualized return). What's more, the company has increased its dividend for 27 consecutive years. Despite this strong long-term performance, only two sell-side analysts officially cover the stock today.
I think it's time for investors to more pay attention to industrial technology conglomerate Raven Industries (RAVN).
Here are some quick facts (as of May 23):
• Market capitalization: $1.1 billion
• Stock price: $31
• Trailing P/E: 26 times
• Debt/equity: N/A
• Five-year average return on equity: 25.7%
Raven's business serves three major end markets: agriculture (46% of fiscal 2014 revenue), industrial (37%), and government (17%).
Its applied technology segment specializes in precision agriculture--electronic global positioning systems, field computers, sprayer controls, and other information management systems that help farmers reduce costs and maximize yields.
This business has two potential moat sources. One is switching costs; once a farmer has installed a Raven precision ag system across a fleet of equipment and learned how to use the programs, there's an added cost of switching to a competitor's offering. The second source is network effects; a reputable, well-established company with a wide breadth of support, service, and training has an edge over any newcomer.
Raven faces a formidable list of key competitors in the precision ag industry, including Trimble Navigation (TRMB), Topcon (Japan), and Deere (DE). Nevertheless, Raven's applied technology operating margins have held steady between 29% and 35% since 2009, which speaks to the strength and durability of its competitive advantages. There also remains a fairly long growth runway for precision ag, particularly in emerging markets like Brazil where farming technology lags that of the United States.
Engineered films is Raven's second-largest business by revenue. It produces high-performance plastic films used as barrier films for high-value agriculture, moisture barriers for construction, and containment liners used in the energy sector, among other applications. Despite its reliance on cyclical end markets, the segment's operating margins have been healthy, ranging from 12% to 19% since fiscal 2009. Although Raven may have some competitive advantages in this area, I can't single out any that appear to be durable (that is, lasting 10 years or more).
Finally, Raven's Aerostar division produces proprietary high-altitude balloons, tethered aerostats (moored balloons), and radar processing systems. It also manufactures military parachutes, uniforms, and protective wear, though the company is strategically moving away from this area and concentrating on the aforementioned proprietary products.
Historically, the Aerostar business has been driven by U.S. federal spending, but I'm encouraged by the company's shift toward proprietary technologies. These efforts have already begun to bear fruit. In 2013, Raven agreed to supply the high-altitude balloons for Google's pilot project of delivering broadband Internet access in developing and rural regions. It's also partnering with Raytheon to supply radar systems to monitor remote regions. The Aerostar business probably possesses some intellectual property advantage, which I think could begin to show up in improving segment margins over the next five years as the company moves away from lower-margin contract manufacturing.
Raven's management team has done a good job allocating capital, having increased book value per share at a 15.9% annualized rate over the past nine years. Daniel Rykhus has been CEO since 2010 and has been with the company since 1990, including 11 years successfully running the applied technology business. Tom Iacarella has been CFO since 1998 and has been with Raven since 1991. Iacarella is shifting gears to become the company's chief risk officer, and Raven is searching for a new CFO.
The company doesn't carry any debt, which I consider appropriate, given its reliance on cyclical end markets. Its plan to use 70% of free cash flow for reinvestment and cash reserves and 30% for dividends also seems prudent, considering its plentiful growth opportunities. Though management sees cyclical headwinds in agriculture persisting this year, it still aims to increase earnings at 10%-15% per year over the next five years.
Risk and Valuation
The biggest risk to the firm's ability to generate long-term economic profit is if existing competitors or new entrants begin offering more technologically compelling products to farmers, which could diminish Raven's current advantages. To combat this risk, Raven invests between 3% and 4% of its revenue in research and development each year to develop new products.
With a trailing price/earnings ratio of about 26 times against management's targeted 10%-15% earnings growth, the stock isn't exactly a deep value, with a P/E to growth ratio anywhere from 1.7 and 2.6 times. Still, lower agricultural commodity prices and concerns about lower farmer incomes have helped drive the stock down off its August 2013 highs, and the valuation certainly looks a lot more attractive at $31 than it did at $43. It's also important to bear in mind that cyclical companies' P/Es are often high when the company is cheap and low when the company is expensive. Ideally, I'd look to start a position between $25 and $27 per share.
Other stocks highlighted in this series:
Todd owns shares of Sun Hydraulics. You can follow him on Twitter at @toddwenning.
Todd Wenning does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.