Acme United Corp: The Past Year Worked Out Well, An Upgrade Is Warranted (NYSE:ACU)

Introduction

It’s been over a year since I covered Acme United (NYSE:ACU), so an update is in order since the company has improved quite a bit since my “hold” rating, specifically margins, which in my opinion were the drivers of price appreciation since top-line growth was poor. In the article, I argued that there were no buy signals for the company yet but given the following quarters with improvements across the board, the company surpassed my expectations and has changed my mind, therefore, I am upgrading the company to a buy. The company has a lot of potential going forward in its distribution of products across the NA region, and further margin improvements are on the table.

Briefly on Performance

As of Q1 ’24, which ended March 31^st ’24, the company had around $2.4m in cash and equivalents, against $23.3m in long-term debt. For a company the size of ACU, it is quite a decent amount of debt, however, is it worrisome? After all, the debt amount has come considerably down as compared to the same period last year, when the debt outstanding was around $40m. So, it is less worrisome than it was then. Furthermore, the company’s debt obligations in terms of interest expenses are manageable. The company’s interest coverage ratio is over 5x, which is much higher than what analysts consider healthy, which is 2x. So, with debt reduction, coupled with a decent coverage ratio, the company is at no risk of insolvency. Now, let’s look at how other important metrics progressed throughout ’23.

Starting with revenues, we can see that y/y, revenue went down around 1.3%, which isn’t terrible in my opinion, given the tough macroeconomic backdrop we saw throughout ’23, and it isn’t better so far in ’24 either.

In terms of profitability and efficiency, it seems that 2023 for the company was a decent year of efficiency. Margins across the board have improved, which is commendable given the macroeconomic difficulties. The management was able to find inefficiencies and cut them out to improve the company’s operations during the tougher times, and that is admirable.

Unsurprisingly, the company’s ROA and ROE have also seen a massive boost due to the company’s improved bottom line. However, I am expecting this to come down because the company’s bottom line has been inflated due to the Gain on the sale of the business line, which was its hunting and fishing business, which was sold for around $20m. So, over the next couple of quarters, I am expecting ROA and ROE to come down substantially, to be more in line with Q3 ’23.

In terms of competitive advantage, the company says they are competing with 3M (MMM) Fiskars (OTCPK:FKRAF), Honeywell (HON), and Cintas (CTAS), however, all these competitors are out of the company’s league in terms of size, so, I am going to compare its ROTC to the pick made by default by Seeking Alpha. Here, we see that ACU is somewhere in the middle in terms of competitive advantage, and well below the first place, which is Virco (VIRC). This tells me that the company could do better, but low ROTC is not uncommon with companies of similar size. As I mentioned before, these will not be perfect competitors for the company, but they will give an idea of how it stacks up against similarly sized companies.

Overall, we can see the company did decent in 2023. Even if the company’s top line didn’t change much, however, I often say if the company can improve efficiency and profitability through margin expansions, the company will see its value appreciating, even if top-line growth is non-existent.

Comments on recent earnings

As I’m writing this article, the company released its Q1 results, and there was something that the market didn’t like because the company is down over 8% currently. So, let’s look at the numbers.

Revenue for the quarter came in at $45m, or down 1.7% y/y. Diluted EPS came in at $0.39 a share, an increase of 39% y/y. The company has improved profitability while improving operations, which were helped by reduced shipping costs and lowered SG&A expenses. The decrease in revenues was due to the inclusion of the company’s discontinued fishing and hunting business products, Camillus and Cuda, which were sold to GSM Holdings in November ’23. Excluding these products, the company saw a marginal increase in top-line of around 1% in the US and 7% in Europe. Gross margins have expanded significantly y/y, over 300bps So, it seems that the report wasn’t bad in my opinion, so why the selloff? To be honest, it is hard to tell. After listening to the earnings call, I didn’t find anything alarming, and the management was very happy looking at the company’s upcoming quarters. So, the selloff may well be just some profit-taking, and given the company is very small and had a decent runup in a year, coupled with a bad day in the markets in general (April 19^th ’24), I don’t think the selloff is due to anything that the management said in the call.

Comments on the Outlook

The company recently acquired a first-aid company Hawktree Solutions at an auction for just $1m, and already the company is going to put it to work by acquiring an exclusive license deal with the Canadian Red Cross.

Furthermore, the company has been expanding its footprint of most of its product line by making deals with many throughout the United States. The company has just begun shipping its first-aid kits to a major drugstore in the US, expanded its presence at a large hardware chain in the US and Canada, and also started shipping its Spill Magic products to a large mass-market retailer in the US.

Other products include Wescott, which is being shipped to another prominent mass-market retailer, as well as craft products. Also, DMT sharpeners bagged a new mass-market retailer going forward. So, it looks like there is going to be a lot of growth in the upcoming quarters, which doesn’t seem to be very well received if we look at the price action on the day of the earnings, which is baffling.

The company is also committed to improving its margins further, and I believe that the management is more than capable of achieving this going forward.

Valuation

It has been over a year since I have done a DCF model for the company, and I think I was a bit too conservative back then, therefore, an update is in order, given how positive the management is about the company’s future. However, I am still going to be on the conservative end, to give myself some margin of safety.

For revenues, there are no estimates available from analysts and the management doesn’t provide these numbers either, so I will have to make some educated guesses for modeling purposes. Now that the fishing and hunting business segment is out of the way and won’t be pulling down the company’s top line, I am modeling a rather conservative top-line growth over the next decade, which matches the United States’ long-term inflation goal. In the past, the company managed to have much higher sales, but as I said, I will keep it conservative and would like to be surprised to the upside. In addition to my base case, I am also going to model a more conservative case, and a more optimistic case to give myself a range of possible outcomes. Below are those estimates, and their respective CAGRs.

For margins, I trust that the management continues its remarkable efforts of making the company much more profitable and efficient, which will drive its margins up over time, however, I am going to model only a tiny improvement here too, to keep it safe. Below are those estimates.

For the DCF model, I was going to go with the company’s WACC of around 7%, however, I decided to add an additional 1%, which should act as a further margin of safety and give me more room for error in the calculations above. It’s better to be safe than sorry and conservatism is what I tend to go for with these assumptions. See below the calculations of the WACC.

Additionally, I went with a 2.5% terminal growth rate, which is close to the target inflation of the US, and I would like the company to at least achieve that too. To just completely bring it home, I am adding another 10% discount to the final intrinsic value calculation for that extra cushion of safety. With that said, ACU’s intrinsic value is around $50 a share, which means the company is trading at a decent discount to its fair value.

Risks

The biggest risks stem from the uncertainty of the economies in the US, Canada, and Europe. Inflation is still not tamed, with the most recent CPI data coming in hotter-than-expected, putting a damper on the hopes that the FED is going to cut interest rates very soon. The negative sentiment will bring most if not all companies down, especially small caps like ACU.

I’ve been harping about the management’s fantastic efforts in improving the company’s profitability even as revenues decline/stagnate, however, if because of tougher macro conditions persist, prices of shipping come up once again, and the management drops the ball in reducing costs internally, margins could suffer once again, and without revenue growth and no profitability improvements, my bullish thesis changes.

As the company is a small cap, expect a lot of volatility in the long term, especially during important events like quarterly earnings. However, if the long thesis is intact, any such massive swings to the downside should be looked at as an opportunity to start a position or add to an existing one.

Closing Comments

It seems to me that the company is well on its way to becoming more profitable and the company’s top-line growth should be coming back in the next year or two, now that the underperforming segment is gone, which lets the management focus on products that will deliver results.

I view this drop in share price on the day of the earnings as a good entry point for anyone who is looking at the company and was wondering if they should jump on board. Therefore, I am upgrading my rating to a buy, as it seems that the company has improved significantly since the last time I covered it. There is a decent upside, but be cautious due to uncertainty in the economy.