One of the cheapest stocks in our Acquirer’s Multiple, Small & Micro Cap – Stock Screener is Continental Materials Corporation (NYSEMKT:CUO). With a market cap around $34 million, few investors have ever heard of this undervalued nano-cap.

Continental Materials Corporation (Continental) produces and sells heating, ventilation, and air conditioning (HVAC) products; and construction products in North America. It operates in two groups, HVAC Industry Group and Construction Products Industry Group. The HVAC Industry Group offers gas-fired wall furnaces, console heaters, and fan coils, as well as evaporative coolers. The Construction Products Industry Group produces and sells concrete, aggregates, and construction supplies; and hollow metal doors, door frames and related hardware, wood doors, lavatory fixtures, and electronic access and security systems.

Continental flies under the radar of most institutions simply because of its size and its thinly traded shares. In fact, there are no analysts currently covering the company.

A quick look at the company’s share price over the past twelve months shows the stock has risen 55% to $20.15 and 35% off its 52 week high.

(Source: Google Finance)

Latest Results

Continental recently released its FY2016 results. The company reported net income of $3,686,000, or $2.21 per share for the 2016 fiscal year on sales of $151,592,000 compared to net income of $1,413,000, or 85 cents per share and sales of $136,835,000 for FY2015. That equates to a revenue increase of $14,757,000 or 10.8% compared to 2015.

The most significant increase was generated by the company’s Concrete, Aggregates and Construction Supplies (CACS) segment which reported a 21.3% growth in sales. Continental is benefiting from stronger construction markets in Colorado Springs and Pueblo as well as increased pricing in both markets.

Sales in the Heating and Cooling segment also increased by 6.0% as both furnace and fan coil sales exceeded prior year levels. Sales in the Evaporative Cooling segment improved marginally while sales in the Door segment were relatively flat.

The company’s consolidated gross profit ratio in 2016 increased to 20.7% from 18.7% in 2015 as all segments showed improvement; more so in the CACS segment and to a lesser extent in the Door, Evaporative Cooling and Heating and Cooling segments.

Growing Revenues

A quick look at the company’s annual income statements below over the past few years shows that Continental has a compound annual growth rate of 7.7% in revenues since 2013. At the same time the company has grown its earnings from ($859,000) to $3.6 million.

Annual Income Statement (values in 000’s)
Period Ending: 12/31/2016 1/2/2016 1/3/2015 12/28/2013
Total Revenue $151,592 $136,835 $131,876 $121,541
Gross Profit $31,431 $25,578 $18,833 $20,456
Operating Income $5,841 $2,516 -$8,591 -$1,089
Net Income $3,686 $1,413 -$5,459 -$859

(Source. Company Reports)

To understand how this small company has achieved these growth rates lets take a look at the company’s latest annual report.

Outlook

Continental expects consolidated sales in 2017 to exceed the 2016 level. Revenues in the CACS segment are dependent on 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 markets.

Construction activity in the Pueblo market has shown some improvement in the current year as well. Concrete pricing has also improved, 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.

Continental’s HVAC Industry Group anticipates some increase in sales in 2017 primarily from higher fan coil sales due to continued construction spending in the lodging industry. 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. Sales of furnaces, heaters and evaporative coolers are also significantly influenced by weather conditions particularly during their respective selling seasons.

So, the main catalyst for the company’s growing revenues and profits is the cyclically driven construction activity in Colorado Springs and Pueblo, and it looks set to continue through 2017.

Strong Economic Headwinds

Evidence of continued growth in construction activity is provided by two reports. The first is the Quantum Commercial Group report, and according to the Colorado Springs Business Journal:

The Colorado Springs-based real estate firm Quantum Commercial Group expects 2016’s strong economic trends to continue during 2017 — across both the commercial and residential markets.

“We all believe that 2017 is staged for continued expansion and growth in both new and existing companies and employees for our city,” according to Quantum’s annual report, which cites population growth and a strong jobs market as two of the top predictors for the year ahead.

According to the report, the local office market continued to strengthen in 2016 and is expected to maintain that trend throughout 2017; the industrial market “may shine even brighter in 2017,” with the construction of new space; and retail growth is expected to remain strong, driven by developments at Interquest Parkway, Powers Boulevard and along the I-25 corridor.

A portion of this growth — namely in the retail and multifamily segments of the marketplace — will continue to be driven by local, regional and out-of-state investment activity, Quantum predicts.

“Investors see Colorado Springs as a great market for real estate acquisitions with opportunities for acquiring properties significantly below replacement cost with the potential for increased value as properties are stabilized,” according to the report.

Along with population growth and a strong jobs market, the Colorado Springs real estate industry is also reaping the benefits of peak consumer confidence throughout the country, said Quantum President Dale Stamp.

“The most exciting part is that the overall consumer confidence — which relates directly to commercial real estate — is very high,” Stamp said. “Everybody seems to be feeling that the economy is heading in the right direction; that there aren’t many negatives taking place right now.”

The Quantum report is further supported by the Chicago-based real estate company Cushman & Wakefield — which has a large presence in Colorado Springs and recently published its 2017 U.S. Macro Forecast. The forecast said the U.S. economy generally, and the real estate market specifically, should perform well in 2017, surpassing the successes of the past 12 months.

“Even before the election, the U.S. economic fundamentals were showing signs of heating up,” said Kevin Thorpe, the company’s global chief economist. “We observed a big [gross domestic product] number in Q3, accelerating wage growth, surging consumer confidence — a string of really robust trends were already forming. Now when you layer in the expected tax cuts and spending multipliers from the new administration, it creates an even stronger economic backdrop for the property markets heading into 2017.”

Cushman & Wakefield anticipates GDP growth to reach 2.3 percent in 2017 and 3 percent in 2018, which could generate up to 3 million new jobs and work wonders for the real estate market — especially in already-strong local economies such as Denver and Colorado Springs.

The strength of U.S. consumer confidence is underscored by campaign promises made by President-elect Donald J. Trump to invest in the Department of Defense, which translates to support of Colorado Springs — a community that has long relied on defense spending and its large military presence for economic and community support, Stamp said.

Family Operated Business

In addition to ongoing growth in construction activity, one of the other important aspects of Continental is that on March 24, 2017, the company had just 1,682,167 common stocks outstanding. Approximately 70% of the company’s shares are held by the Gidwitz Family and according to Nasdaq.com just 13.52% are held by institutions. This explains why the shares in this small company are so thinly traded with daily average volumes of just 2,600 per day. This amount of insider ownership keeps larger investors away and helps to protect Continental from institutional shenanigans. It also serves the company well in terms of its ability the manage the company prudently.

Strong Balance Sheet

Continental continues to be well managed with a strengthening balance sheet and ability to generate solid free cash flows. A quick look at the company’s balance sheet below over the past four years shows that the company had cash and cash equivalents of $301,000 and short-term debt of $2 million at the end of FY2016. What’s most noticeable however, is that Continental reduced its short-term debt from $6.2 million at the start of 2016 to $2 million for FY2016, and the company has reduced its long-term debt from $4.4 million in 2013 to zero in 2016. This has been achieved using cash generated from its operations and without the need to issue additional shares, demonstrating the company’s prudent approach to capital allocation.

Annual Balance Sheet (values in 000’s)
Period Ending: 12/31/2016 1/2/2016 1/3/2015 12/28/2013
Cash and Cash Equivalents $301 $547 $675 $924
Short-Term Debt / Current Portion of Long-Term Debt $2,000 $6,200 $5,800 $0
Long-Term Debt $0 $0 $0 $4,408

(Source, Company reports)

Loads of Free Cash Flow

When you combine the company’s strengthening balance sheet with its significant amounts of free cash flow, you start to get an idea of the financial strength of this great little nano-cap.

A quick look at the company’s trailing twelve month cash flow statements below shows Continental generated $8.1 million (ttm) in operating cash flow compared to $1.6 million in 2015. At the same time, the company had $4.4 million (ttm) in capex, which equates to $3.7 million (ttm) in free cash flow. With a current market cap of $34 million that means Continental has a FCF/Price yield of 11% (ttm).

Quarterly Cashflow Statement (values in 000’s)
Quarter: 4th 3rd 2nd 1st
Net Cash Flow-Operating -$106 $4,461 $2,308 $1,436
Capital Expenditures -$788 -$841 -$1,694 -$1,082

(Source, Company reports)

It’s also important to note that during 2016, the company used its free cash flow to repay $4.2 million on its revolving credit line, while $50,000 was used to repurchase stock from a former officer of the company.

Valuation

In terms of the company’s valuation. Continental has a current market cap of $34 million, with total debt exceeding cash and cash equivalents by $1.7 million that means the company has an Enterprise Value (EV) of $35.7 million. With $3.7 million (ttm) in free cash flow, that means the company has a FCF/EV Yield of 10%.

We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents.

With an Enterprise Value (EV) of $35.7 million and Operating Earnings* of $8 million (ttm), that means Continental is currently trading on an Acquirer’s Multiple of 4.46 or, 4.46 times Operating Earnings*.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

Tangible Book Value

The other thing to consider in terms of Continental’s valuation is the company’s tangible book value. A quick look at the company’s latest balance sheet for FY2016 shows that Continental had total equity of $$52.2 million and $7.3 million in intangibles. If we subtract the intangibles from total equity that leaves $45 million in tangible book value (TBV). If we divide that by the number of shares outstanding (1,682,167), that equates to a TBV of $26.73 compared to the company’s current share price of $20.15.

Therefore, Continental has a FCF/Price Yield of 11% (ttm), a FCF/EV Yield of 10% (ttm), an Acquirer’s Multiple of 4.46, or 4.46 times Operating Earnings*, and the company is trading at a 25% discount to its current TBV. That places Continental squarely in undervalued territory.

Summary

Continental is a great little nano-cap. The company has a compound annual growth rate of 7.7% in revenues since 2013. At the same time the company has grown its earnings from ($859,000) to $3.6 million.

Continental expects consolidated sales in 2017 to exceed the 2016 level driven by stronger construction markets in Colorado Springs and Pueblo as well as increased pricing in both markets. The company’s outlook on continued growth in construction activity in Colorado Springs is supported by Colorado Springs-based real estate firm Quantum Commercial Group – which expects 2016’s strong economic trends to continue during 2017, and the Chicago-based real estate company Cushman & Wakefield — which said the U.S. economy generally, and the real estate market specifically, should perform well in 2017, surpassing the successes of the past 12 months.

The company is also benefiting from strength in U.S. consumer confidence, underscored by campaign promises made by President-elect Donald J. Trump to invest in the Department of Defense, which translates to support of Colorado Springs — a community that has long relied on defense spending and its large military presence for economic and community support.

Continental is a family owned and operated business with approximately 70% of the company’s shares held by the Gidwitz Family. The company is thinly traded with daily average volumes of just 2,600 per day. This amount of insider ownership keeps larger investors away and helps to protect Continental from institutional shenanigans. It also serves the company well in terms of its ability the manage the company prudently.

The company has a strengthening balance sheet and ability to generate solid free cash flows. Continental has reduced its short term debt from $6.2 million at the start of 2016 to $2 million for FY2016, and the company has reduced its long term debt from $4.4 million in 2013 to zero in 2016. This has been achieved using cash generated from its operations and without the need to issue additional shares, demonstrating the company’s prudent approach to capital allocation.

In terms of Continental’s valuation. The company has a FCF/Price Yield of 11% (ttm), a FCF/EV Yield of 10% (ttm), an Acquirer’s Multiple of 4.46, or 4.46 times Operating Earnings*, and the company is trading at a 25% discount to its current TBV. That places Continental squarely in undervalued territory.