continental materials corp - hvacBy Maj Soueidan, Co-founder of GeoInvesting

GeoInvesting first noted bullish commentary in Continental Materials Corp (AMEX:CUO) Q1 2016 10-Q, prompting the team to start tracking the company in July 2016. The stock was trading at $16.97 at the time of the Premium Member Alert and now trades over $24.00, a new 52 week high. We disclosed we were going long CUO on August 17, 2016.

I have been investing in the micro-cap universe for over 30 years. So I am very familiar with many microcap stocks as well as nano-cap stocks. I am aware that CUO’s business is exposed to cyclical headwinds:

The Company operates through two segments in each of the two industry groups: the Heating and Cooling segment and the Evaporative Cooling segment in the HVAC industry group, and the Concrete, Aggregates and Construction Supplies (CACS) segment and the Door segment in the Construction Products industry group.

But I am also aware that the Company has a history of using its SEC filings to provide a great deal of color on its business outlook, more so than it offers in its press releases.

This was significant to me and my team since the corresponding Q1 2016 earnings press release did not mirror the bullish commentary in the related Q1 SEC filing, resulting in what I viewed as an InfoArb opportunity. The Q1 press release did not expand upon the fact that near-term growth in sales and earnings could be in the cards, reversing a trend of choppy growth over the last several years.  However, the company’s SEC filings did cover this information. Well, CUO delivered an astounding EPS number of over $1.00 for its 2016 second quarter.

In our August 16, 2016 email to premium members we highlighted these strong Q2 results…

  • Sales of $42.7 million vs $34.8 million in the prior year
  • EPS of $1.08 vs $0.21 in the prior

… and stated we intended to take a small long position.

Shares currently trade at the following meager valuation multiples if we annualize the run rate of the first and second quarter of 2016.

  • P/E: 9.5
  • EV/S: 0.3
  • EV/EBITDA: 4.7

Continental Materials Corp Q2 InfoArb Analysis

We ended up initiating a position. The stock ended up 11.1%, closing at $22.25 on the day it released its numbers.  I am actually surprised that CUO did not trade higher on the heels of the company’s superb financial performance.  I presume that investors know that CUO can be a “one trick pony.” And the Q2 press release was mostly mundane. But just as the scenario that was present in Q1 2016, the Q2 10-Q offers a lot of detail on the health of the Company’s served markets.  It looks like CUO is benefiting from a common theme that is also positively impacting other cyclical stocks that we are tracking and own, all of which are benefitting from a gradual improvement in the U.S. economy.  We have noticed that as the housing/construction markets have seemingly reached the midpoint of their correction from the 2008 recession, a broader number of related companies in this industry are starting to gain momentum.

The Q2 filing revealed that unit volumes and prices are increasing in some of the company’s segments. More importantly, the company’s Concrete, Aggregates and Construction Supplies Segment

(50% of total revenue) had been facing challenges in two of its major served markets. The management commentary in the Q2 filing indicates that conditions have improved since the Q1 2016 filing.

Q1 2016 Commentary

The enhanced performance of the segment is attributable to a continuing improved construction market in the Colorado Springs area and, to a lesser extent, the Pueblo market combined with increased pricing in both markets.

Q2 2016 Commentary

The enhanced performance of the segment is attributable to sustained improvement in the construction market in the Colorado Springs area, an improving Pueblo market and increased pricing in both markets.

Finally, management provided an outlook section. Notice the

  • Subtle hints of positive momentum marked in bold in the Q1 and Q2 outlook.
  • The addition of the positive Q2 outlook commentary for the company’s door segment also marked in bold.

Q1:

Overall the Company expects consolidated sales in 2016 to exceed the 2015 level.  Revenues in the CACS segment are dependent of the level of construction activity along the Front Range in Southern Colorado as well as the level of selling prices.  Construction activity has exhibited modest and thus far sustained improvement during the past two years in the Colorado Springs market.  Construction activity in the Pueblo market has not experienced a similar recovery although there was some improvement in the most recent quarter.  Concrete pricing has improved as well, but the pricing on most bid jobs remains sharply competitive.  Further improvements in the CACS segment operating results will depend on a sustained improvement in the Colorado Springs construction market, the recovery of the Pueblo markets and the ability to maintain or enhance ready-mix concrete prices especially in response to any increases in cement and/or fuel costs that may occur.

The Company’s HVAC Industry Group anticipates some increase in sales in 2016 largely due to higher fan coil sales as construction spending in the lodging industry improves.

To date, fan coil sales have outpaced expected levels and appear to be sustainable for the near term.

Some improvement in furnace sales levels is also anticipated resulting from the full-year effect of a couple of new customers added during 2015.  Sales of furnaces, heaters and evaporative coolers are primarily for replacement purposes and therefore are not heavily reliant on new construction.  Sales of these products are generally dependent on the overall strength of the economy, especially employment levels, and are heavily influenced by weather conditions, particularly during their respective selling seasons.


Q2:

Overall the Company expects consolidated sales in 2016 to exceed the 2015 level. Revenues in the CACS segment are dependent of the level of construction activity along the Front Range in Southern Colorado as well as the level of selling prices. Construction activity has exhibited modest and thus far sustained improvement during the past two years in the Colorado Springs market. Construction activity in the Pueblo market has not experienced a similar recovery although there has been some improvement in the current year. Concrete pricing has improved as well, but the pricing on most bid jobs remains sharply competitive. Further improvements in the CACS segment operating results will depend on a sustained improvement in the Colorado Springs and Pueblo construction markets and the ability to maintain or enhance ready-mix concrete prices especially in response to any increases in cement and/or fuel costs that may occur.

Sales in the Door segment are also, to a significant extent, reliant on new construction. Bidding activity remains strong. The sales backlog at July 2, 2016 is 29.1% above the backlog at July 4, 2015.

The Company’s HVAC Industry Group anticipates some increase in sales in 2016 largely due to higher fan coil sales as construction spending in the lodging industry improves.

To date, fan coil sales have outpaced the prior year’s actual and current year expected levels and 
appear to be sustainable for the near term. Sales of furnaces, heaters and evaporative coolers are primarily for replacement purposes and therefore are not heavily reliant on new construction. Sales of these products are generally dependent on the overall strength of the economy, especially employment levels, and are heavily influenced by weather conditions, particularly during their respective selling seasons. In-season furnace sales later this year will be largely weather-dependent. July typically marks the end of the selling season for evaporative coolers.

I do have to point out the “elephant in the room” caveat – the possibility of volatility in margins, even at higher revenue levels.

For example, of the 22.5% increase in sales for the second quarter, $2.8 million (or ~8%) came from one project completed in the quarter with higher than average gross margins.  Also, weather conditions can impact some of the company’s business. Still, revenues were up 14.6%, absent of this project.

While there are caveats to the CUO story, there is enough intel in SEC filings to warrant a closer look.  A call to management is on my schedule, but the point of contact is on vacation. My goal is to gain clarity on the margin picture and overall health of the business.

More Lessons To Be Learned from Continental Materials Corp

Anyone that follows GeoInvesting probably knows that we are relentless SEC filing hounds. Reading them does not only gives you an edge in understanding a particular company’s growth opportunities, but is also gives you a glimpse into changes taking place in certain industries that may positively or negatively impact parallel stocks.  For example, We are currently looking at another microcap stock serving the HVAC industry that seems to be experiencing similar positive trends as CUO.  There’s a chance that this stock may even fare better.  As I and my team educate investors and uncover hidden gems in the microcap universe, join us to get more out of investing.

Note: Please note that COU is thinly traded stock with a tiny float, which may not fit your investment style or preference.

Disclosure: Long CUO