L.S. Starrett Stock: Lean Business, Pension Plan Issues Seem Resolved (NYSE:SCX)
I like to write about companies that lack coverage on SA and today I’m taking a look at The L.S. Starrett Company (NYSE:SCX). It’s a precision tools maker that has been around for over a century and I think it looks undervalued at the moment as FY23 is off to a good start and TTM net income stands at $13.7 million. The gross margin improved by 70 basis points year on year to 33.4% in Q1 FY23 as it seems the company is successfully passing on increased costs to customers. In addition, the lingering pension plan funding issues seem much smaller than they used to be. Let’s review.
Overview of the business and financials
The L.S. Starrett Company was founded 1880 in a small town in Massachusetts named Athol by Laroy Starrett, who invented and patented the first combination square two years before that. The company was set up to manufacture this product and today it has a portfolio of over 5,000 precision tools, cutting equipment, and metrology systems products for the metalworking, automotive, aviation, marine, and farm industries and the do-it-yourselfers (DIY) sector. It’s also the largest manufacturer of saw blades in the world. L.S. Starrett is still based in Athol and it has a total of 9 manufacturing facilities across the USA, Brazil, China, and Scotland. The largest of those is in Athol and about half of the company’s sales come from outside the USA.
Looking at the financial results for the past decade, L.S. Starrett started struggling with sales growth and low margins in the middle of the past decade due to recessions and stagnation across some of its main markets such as Brazil and the EU. The company responded by reducing its headcount and implementing saw plant consolidation and these measures helped it return to growth in FY18. In my view, this restructuring of the business positioned the company well to weather the effects of the COVID-19 pandemic as FY22 sales were the second highest in its history, just shy of the $260.1 million achieved in FY12. Yet, the cost structure was much better this time around thanks to optimized SG&A costs and net income came in at $14.9 million compared to just $0.9 million in FY12.
The company has been implementing price increases over the past several months to counter pressure from inflation and supply chain disruptions and this allowed it to boost its gross margin to 33.4% in Q1 FY23. Net sales and net income were negatively impacted by foreign exchange losses as the U.S. dollar strengthened against the currencies of Brazil, the UK, and New Zealand, but the effects should be reversed in Q4 2022. I expect net income for the last quarter of the calendar year to be above $3 million once again.
However, I find it concerning that L.S. Starrett complained about softened order intake in its foreign markets, particularly in Europe as a result of recession fears and the effects from the war in Ukraine. In my view, the impact should be limited considering that the major market of the company outside the USA is Brazil.
On that note, it’s still unclear what direction the Brazilian economy will take with the election of Lula as president. During his previous stint ahead of the country, average annual GDP growth was 4.5% but there were headwinds for the economy from strong global demand commodities. I’d be surprised if GDP growth in 2023 surpasses 1% and it’s possible that some of his policies are already negatively affecting the sales of L.S. Starrett in the country. For example, Lula’s plans to reverse Amazon deforestation could be already putting pressure on local saw blade demand.
Turning our attention to the cash flow picture, I don’t like the lack of free cash flow, but the situation should improve in the coming quarters. In Q1 FY23, L.S. Starrett increased inventories by $5 million due to global supply chain issues. They should decline over the coming months.
In my view, the balance sheet looks strong as net debt stood at just $17.5 million as of September 2022. In addition, L.S. Starrett is trading at only 0.63 price/BV as of the time of writing. This is close to the levels from 2012 when profitability was an issue.
In April 2022, fellow SA contributor Tomas Andrade Campanini pointed out that the company had underfunded pension obligations which require about $8 million in yearly funding. However, the situation looks better today thanks to rising interest rates around the world and L.S. Starrett revealed in its Q1 FY23 financial report that its two pension plans are expected to require contributions of just $2.2 million in FY23 (see page 13 here).
Overall, I think that L.S. Starrett is in good shape from a financial standpoint and that its FY23 financial results should benefit from rising interest rates and a weakening US dollar. In my view, the company should be trading at somewhere around 0.8 P/BV to reflect the improved financial performance and diminished pension plan funding issues.
Looking at the risks for the bull case, I think that there are two major ones. First, a potential recession in Brazil or a weak real could put pressure on international sales and margins. Keep a close eye on Lula’s policies and the growth of the economy. Second, a sharp reversal of global interest rate policy could create pension plan funding headaches once again.
L.S. Starrett positioned its business on a growth path over the past years and profitability has significantly improved compared to a decade ago. In addition, its pension plan funding issues have decreased. Yet, the company is currently trading at just 4.5x price/TTM earnings and 0.63x price/BV and I think that its market valuation in not reflecting the significant improvement in the financial profile. I think that the valuation could improve to about 0.8 price/BV over the coming months but I’m giving this stock a speculative buy rating considering the situation in the Brazilian market could become challenging.
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