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 on Morningstar.
So far in this series, we've highlighted ten small cap shares 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 ten 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 can see a handful of window cleaners and 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 you quickly become 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 & 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), a U.K.-based company that specialises 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 or incline. Even better, about 40% of its sales are generated by patent-protected products.
Below are some quick facts about the company:
Market capitalisation: £116 million
Headquarters: Devizes, Wiltshire, U.K.
Dividend yield: 3.9%
Director ownership: 5% of shares outstanding
Even though European manufacturing and construction activity has remained soft following the financial crisis and has weighed on Latchways' top-line, the company has still generated consistently strong performance.
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 & 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 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 last ten 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 & Valuation
In addition to the risks outlined in Latchways' annual report, there are a few additional risks to bear in mind. First, the company has a long sales replacement cycle, with its products typically lasting ten years or more. Whilst this certainly speaks highly of the product quality, 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 benefitted from being an early mover in fall protection systems in Europe and establishing a solid reputation in the region; however, it's unclear if 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 September 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 1,100p and 1,300p. Trading around 1,040p on Friday, 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 950p, which affords a decent margin of safety from the low-end of my fair value range.
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