Seeking Small-Cap Moats: Latchways
U.K.-based Latchways' fall protection products keep workers--and the firm's competitive advantages--safe.
Stock Strategist
So far in this series, we've highlighted 10 small-cap stocks (a full list is below) that I believe possess durable competitive advantages, or economic moats, that should enable the firms to generate returns above their costs of capital for at least 10 years.
To date, all of these companies have been U.S.-based, but since small caps with moats can be found across the globe, I thought I'd look further afield for this month's small-cap idea.
Don't Look Down
Looking across Chicago's skyline from my desk at Morningstar headquarters, I often see a few window washers or construction workers suspended more than a hundred feet in the air. All I can think is, "I hope they're getting paid well." They also must put a lot of faith in their fall protection systems--the harnesses, cables, and anchors--that keep them securely aloft. I'd imagine that in that line of work one quickly becomes brand-loyal to a particular system that has proven effective.
Given the frequency of fall-related injuries and deaths in the workplace, the U.S. Occupational Safety and Health Administration (OSHA) requires employers to provide fall protection at elevations above four feet for general industry workplaces and when "working over dangerous equipment and machinery, regardless of the fall distance." Even at relatively modest heights, employers in developed markets (and increasingly in emerging markets) are required by law to provide employees with some type of fall protection.
Enter Latchways LTC.L, a U.K.-based company that specializes in this attractive niche of fall protection systems. Its ManSafe brand has solutions for various industries (including aerospace, utilities, and telecommunications) and working requirements (such as vertical, horizontal, and incline). Even better, about 40% of its sales are generated by patent-protected products.
Here are some quick facts about the company (as of Sept. 19, 2014):
- Market capitalization: GBP 116 million ($190 million)
- Headquarters: Devizes, Wiltshire, U.K.
- Dividend yield: 3.9%
- Director ownership (as of March 2014): 5% of shares outstanding
To reduce its reliance on European customers, Latchways recently opened a new sales and distribution center in Houston, Texas, which should benefit from increasing capital investment by petrochemical companies near the Gulf of Mexico. This seems a smart move, as it should help drive Latchways' top line in the coming years and help it strengthen current customer relationships in North America.
Moat and Financials
Even though Morningstar doesn't cover Latchways, and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, I'd argue that it has established a narrow economic moat based on intangible asset and switching cost advantages.
Latchways' intangible asset advantages are anchored in its intellectual property. As mentioned earlier, 40% of its fiscal year 2014 revenues came from patented products, including its Constant Force Post technology, which reduces the force generated on the structure in the event of a worker fall. From what I gather, near-term patent expirations are not a concern, and this should help the company deliver strong returns on capital in the coming decade. The company spends about 3% of its revenue on research and development each year to replenish its innovation pipeline.
The mission-critical nature of Latchways' products contributes to its switching cost advantage. Due to the fact that Latchways’ products contribute a very small portion of its customers’ cost structure but have a very high cost of failure, few customers are willing to switch to another vendor on the basis of cost alone.
Financially, Latchways is in very good health. The company has no debt, which is appropriate given the cyclical nature of its customers' operations, and consistently generates free cash flow. Encouragingly, Latchways has a solid track record of consistently raising its dividend--from fiscal 2007 to 2014, the dividend grew at an annualized rate of 12%. Despite a weak fiscal 2014, the board of directors raised the dividend payout another 10%, citing its long-term confidence in the business as a reason for the increase.
Stewardship
Overall, Latchways’ management seems to be steering the company in the right direction, and I like that company leaders own about 5% of outstanding shares, which should help align their interests with shareholders. The company's stock has also significantly outperformed the FTSE Small Cap Index over the past 10 years--even with the recent dip in the share price, Latchways shares have gained 190% since September 2004 compared with a 53% gain for the FTSE Small Cap Index.
I do find it strange, though, that in fiscal 2014 Latchways didn't have long-term financial incentives for management. The previous long-term incentive plan lasted from 2010 to 2013, and it seems some of the previous plan's hurdles were simply too high for the company to clear. Hopefully a new and suitable long-term incentive plan will be implemented this year, as the absence of long-term financial incentives could encourage too much focus on short-term results.
Risks and Valuation
In addition to the risks outlined in Latchways' annual report, there are a few other risks to bear in mind. First, the company has a long sales replacement cycle, with its products typically lasting 10 years or more. Though this certainly speaks to the high quality of the company's products, it can result in lumpy year-to-year operating performance. In fiscal 2014, for instance, Latchways' results were down due in large part to the absence of a sizable Airbus project that came to an end.
Latchways benefited from being an early mover in fall protection systems in Europe and establishing a solid reputation in the region; however, it's unclear whether the company can do the same in the U.S. and in emerging markets.
Valuation-wise, Latchways has become more attractive in recent months, as the market seems concerned about its lackluster fiscal 2014 results. As of Sept. 19, the stock is down about 18% year to date.
By my estimates, which are based on a blend of relative valuation metrics, a reasonable fair value range for Latchways is between GBX 1,100 and GBX 1,300. Trading around GBX 1,040 on Sept. 19, the stock isn't a deep value at current prices, but I do consider the recent weak operating results to be temporary, and I think the company's strong balance sheet and steady cash flow generation will help it endure. I'll look to pick up shares in my own portfolio around GBX 950, which affords a decent margin of safety from the low end of my fair value range.
Reader's Note
A number of U.S. brokers will allow you to purchase foreign-listed companies. Please check with your broker for more information. Unfortunately, there isn't an American Depositary Receipt (ADR) for Latchways.
Other stocks highlighted in this series: