2018 was a rough year for investors in Acme United Corporation’s (ACU) stock, including CEO Walter Johnsen who owns 15% of the outstanding shares. ACU’s 2018 total return was -38%, worse than the Zack’s Micro Cap Index’s 17% decline. The significant underperformance was due to market-, macro- and company-specific factors.
ACU’s stock started out the year extending its gains from the end of 2017, in the market euphoria accompanying the Tax Cut and Jobs Act. The stock traded sideways from March through October, until the company announced disappointing third quarter earnings and reduced its full year guidance. The steep slide in ACU continued through November and much of December, somewhat in line with the broader market; but Acme’s stock began to perk up as the year came to a close and has extended those gains so far in 2019.
Business. Acme markets and sells products in three principal categories: School, Home and Office (SHO), First Aid Kits and Hardware Industrial and Sporting Goods (HIS). In SHO, it owns the Wescott brand of scissors, rulers, pencil sharpeners and related products. In First Aid Kits, it has three brands – First Aid Only, Pac-Kit and Physicians Care – and also Spill Magic, acquired in 2017, which makes absorbents that convert spills into dry powders. In HIS, Acme specializes in cutting tools with brands like Clauss, which serves the hardware & industrial and related channels, Camillus, which serves the hunting and sporting markets, Cuda, a line of fishing tools and knives, and DMT, which makes sharpening tools for knives, scissors and other edges.
Acme has grown substantially through acquisitions over the past fifteen years. All of the brands above, except Wescott and PhysiciansCare (I believe) have been acquired since 2004. Most recently, DMT was purchased for $6.3 million in 2016 and Spill Magic was acquired for $7.2 million in 2017.
Except for only a few of its businesses, like DMT, Acme either sources its products from contract manufacturers in Asia, principally China, or purchases the components of products (as in first aid kits) and assembles them in the U.S.
A key focus of the company is product innovation. For example, it has applied titanium bonding and non-stick coatings to many of its scissors, knives and other cutting tools. In recent years, the company has sought to have 30% of its portfolio consist of new products.
2018 Third Quarter Performance. Acme reported that sales increased 3% in the third quarter. In the U.S., where sales were up 3%, a 7% increase in first aid kit sales was mostly offset by a 6% decline in Wescott products, due to an overstock at a large online retailer (Amazon?) and continued store closings by Staples. Management said that about $1 million of sales were most likely shifted to the fourth quarter as a result of Hurricane Florence. Even so, third quarter sales were below management’s expectations.
Even with the 3% sales increase, Acme reported a 35 basis point decline in its gross margin to 35.8% and a 150 basis point increase in its SG&A expense ratio. The company had increased SG&A expenses in anticipation of growing sales; but it did not meet its sales targets. As a result, its operating margin fell by 185 basis points to 5.8%.
Interest expense increased, due to the combination of higher debt outstanding and higher interest rates, but this was more than offset by a sharp drop in the income tax provision. Even so, ACU’s net income fell from $1.2 million to $0.8 million and its diluted EPS dropped from $0.32 to $0.23.
Lowered Guidance. With the company’s weaker-than-anticipated third quarter performance, management lowered its full year 2018 guidance for revenues by $1 million to $39 million, net income by $1 million to $4.7 million and EPS from $1.53 to $1.30. It expects to shave $1 million off of inventories by year-end, close the year with $38 million in debt (down from $50 million at the end of September) and generate (full year) free cash flow of $3 million.
Management also said that it was talking steps to reduce SG&A by $1.5 million, including cutting personnel expenses by $700,000, advertising expense by $400,000 by shifting from print advertising to social media and other SG&A costs by $400,000 through productivity initiatives.
The company says that about 10% of its products have been effected by the imposition of a 10% tariff on goods imported to the U.S. from China. Acme has been seeking to pass on this cost; but it is working with its customers case-by-case to craft mutually acceptable solutions.
A Strong Fourth Quarter? Despite the downward revision, management’s guidance implies that fourth quarter results will be strong, especially for cash flow generation and debt reduction. By my calculation and estimates, management guidance translates into fourth quarter revenues of $32.8 million, up nearly 9% from the previous year, operating income of $1.7 million, compared with last year’s $0.7 million; net income of $0.7 million, compared with last year’s loss of $0.7 million; and EPS of $0.19 vs. ($0.18). Last year’s results included a $1.25 million charge related to the implementation of the Tax Cuts and Jobs Act.
The guidance implies that ACU’s debt will decline by $11 million from about $50 million at the end of the third quarter to $39 million; and my projections anticipate free cash flow of nearly $10 million for the quarter, substantially all of which will come out of working capital (with modest reductions in inventory and accounts receivable, but a big increase in accounts payable, which was down sharply at the end of the third quarter.
These projections seem aggressive, but doable. I presume that management had a good sense of what was realistically achievable when it provided its revised guidance on the third quarter conference call on October 19.
2019: Another Question Mark. While investor sentiment will almost certainly improve if the company achieves its full year guidance, the magnitude of the recovery in ACU’s stock price will depend more on the outlook and ultimately the actual results for 2019.
According to my analysis, there is the potential for significant improvement in profitability in 2019. The main driver, in my mind, is the SG&A cost savings initiative currently underway. The targeted $1.5 million savings (against anticipated 2018 sales of $139 million) would represent a 108 basis point improvement in both the SG&A expense ratio and ACU’s operating margin With a projected operating margin of 5.8% for 2018, that improvement would translate into an 18.6% improvement in operating profit (assuming no change in the expected gross margin of 37%).
Earnings would get a further boost from sales growth, but I am assuming only a 3% increase in sales for 2019, which is roughly consistent with the year-over-year growth posted in the second half of 2019. Acquisitions could provide more of a boost to sales in 2019 and especially in 2020, but no deals appear to be immediately on the horizon (even though the company is actively looking).
My 2019 projections also assume a modest reduction in interest expense, due to lower expected average debt levels, and an average tax rate of 24% (but this is really just a guess because the company has offered no guidance on its tax rate for 2019).
Overall, I project that Acme can deliver revenues of $143.2 million, up 3%; net income of $5.7 million, up 21.7% and EPS of $1.59, also up 21.7%. If indeed that is achievable, the stock seems cheap at the current price of around $15.65, since my projections equate to a forward P/E multiple of 9.9 times and a forward EBITDA multiple of 7.3 times.
It is important to note that my projections do not assume any additional headwinds from China tariffs. In fact, they implicitly assume that the trade negotiations will be resolved without any major disruptions to Acme’s business. Of course, any escalation in trade tensions and especially any further increases in tariffs will likely crimp Acme’s sales and profits in 2019 and spark at least a temporary decline in its share price.
Longer Term Considerations. Longer term, investors should also consider several issues: Walter Johnsen, who has been Acme’s CEO since 1995 is now 68 years old and it is unclear how long he intends to remain in the position. As noted, Mr. Johnsen owns 15% of Acme’s stock, so any transition would presumably include the monetization of his ownership stake. The most likely successor to Mr. Johnsen is Brian Olschan, who is 62 and has been Acme’s President and COO since 2007. Mr. Olschan owns 6% of Acme’s outstanding shares.
It is possible that the monetization of Mr. Johnsen’s stake will be accomplished through the sale of the company. Acme may be attractive to a private equity firm at the current valuation. Alternatively, Acme’s Chinese suppliers may also interested in owning the company.
Acme’s Chinese connection and the current trade relationship between China and the U.S. are major considerations for any other potential buyer of the company. That said, with more than 50% of Acme stock held by its employees (including Mr. Johnsen and Mr. Olschan) and two U.S. institutions, it is highly unlikely that any sale of the company will be achieved without the consent of Mr. Johnsen and his team.
Although acquisitions have been an important part of the company’s strategy and a major determinant of its success over the past fifteen years, I believe that there is a limit to their benefit. Acme has done a reasonably good job of sticking to its knitting: acquiring companies that are a reasonable fit with its two core businesses: cutting tools and first-aid kits. I believe that Acme’s acquisition strategy would have more legs, if it was able to acquire businesses that had strong revenue growth potential (either because they have been mismanaged or because they could grow sales quickly by “plugging into” Acme’s distribution system). However, I see most of Acme’s acquisitions, especially in recent years, primarily as financial buys: Acme has received an initial boost from their sales and there may be an opportunity to improve profit margins by cutting costs. However, these acquisitions have made Acme a more complex consolidated enterprise.
Besides these issues, Acme faces the ongoing challenge of managing declining sales to one of its largest customers, Staples, which has been closing stores in recent years. Staples recently acquired Essendant, whose businesses include an office supply wholesaler which may result in further cuts in inventories (and temporarily fewer purchases of Wescott products). So far, Acme has been able to offset these declines by boosting sales through other channels, most notably through hardware, industrial and sporting goods retailers and especially through ecommerce; but the downward pressures on sales from the office channel are likely to continue for some time.
For now, though, as long as Acme delivers on its implied fourth quarter guidance and the U.S.-China trade dispute is resolved successfully, I believe that there is a good opportunity for its profits to rebound in 2019. With recent increases, Acme’s stock now pays an annual dividend of $0.48 per share, which represents an attractive 3.1% yield at the current quote.
My initial report on Acme United, dated February 26, 2015, is available here.
January 9, 2019
Stephen P. Percoco
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