Most of the time, I prefer to stick with stocks that have larger market capitalizations with growing dividends. Sticking to larger names can often be less risky, since they are most likely better covered, are more liquid, and are better targets for international investors. But sometimes it can be an interesting challenge to look for smaller stocks that may be undervalued. If you get one of these investments right, they can move in a hurry.
One stock that has come off in recent months is Cascades (TSX:CAS), a paper packaging and tissue company. It has a long history in the business, having been established in 1964. The company uses primarily recycled paper to create packaging products like boxes and display boards as well as toilet paper and paper towel rolls.
The main reason I started looking at this company was its valuation. The stock currently trades at a low price-to-earnings ratio of 13.7 times trailing earnings and a price-to-book ratio of 0.5. Both of these valuations indicate the company may be attractively priced at this level, especially considering the fact that Cascades has fallen considerably over the past year. With any individual company, though, valuation is not enough to go on. It is always possible that there is an issue with the company that warranted the fall in the share price.
One of the more positive aspects of Cascade’s 2018 full-year report was the growth in sales, which increased 8% over 2017. Operating income increased 31% over the full-year results of the previous year. Adjusted earnings per share were up about 15%, and adjusted free cash flow was also up slightly.
The biggest issue, as seems to frequently be the case with many companies, is its debt. Cascades has a large amount of long-term debt — about $1,769 million of net debt. That makes its debt load approximately twice as large as its market capitalization. Much of this debt has come from acquisitions, such as the recently acquired American manufacturing plants Urban Forest Products and Clarion Packaging. While these companies provide Cascades with more manufacturing capabilities, they come at a cost.
In addition to the increased debt load, the acquisitions also may have led to an increase in goodwill on Cascades’s balance sheet. Goodwill is associated with the intangible value of assets that a company might own, such as the value of a brand name. In this case, while its goodwill is high, it still has significantly more value tied up in assets like plants and equipment. Therefore, the company’s goodwill does not represent an unreasonably large portion of its assets at the moment.
Cascades also has a dividend that might appeal to some investors. At the current price, the dividend is just under 2% — a decent payout from a small company. The payout ratio has generally remained quite low at around 30% of earnings historically. But this dividend has also not grown in years, sitting at the same level for more than a decade. But given the company’s debt level, keeping the dividend static might be the best idea.
Is this a value play worth buying into?
Cascades appears to be an excellent value play considering how cheap it is on basic valuation metrics. It has had some growth and is attractive for investors focusing on sustainable companies because of its focus on recyclable materials. The low price-to-book valuation seems reasonable, since most of the company’s value comes from its hard assets like its plants and equipment. The biggest issue is with its debt, which is quite significant considering the size of the company.
Due to its leverage risk, this is not a massive bargain, but it does appear to be undervalued. Value investors looking for a smaller company who are comfortable with high debt levels could take a chance on this environmentally friendly company.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Kris Knutson has no position in any of the stocks mentioned.