Safety Net: A Contrarian Micro Cap

Marc Lichtenfeld By Marc Lichtenfeld, Chief Income Strategist, The Oxford Club

Dividend Investing

I’ve pursued goals some would say are far from the run-of-the-mill variety.

The idea is even more apparent in my approach to stocks. Working for a boutique research shop that often received death threats for its strong opinions, I was trained by one of the greatest contrarians in recent decades.

When I look through the lists of stocks that Wealthy Retirement readers leave in the comment section for me to review and measure the safety of the company’s dividend, I typically pick the stocks that will have the most appeal to readers.

But every so often someone asks for my take on a stock that’s too interesting to shy away from… even if it’s a very small and unknown company.

It’s worth looking at these stocks because you won’t read about them in the mainstream press. In fact, you probably won’t hear about the company I’m about to tell you about anywhere but here.

Exclusive Insight

Orchids Paper Products (NYSE: TIS) is an unknown micro-cap stock. It boasts a market cap of just $173 million and average trading volume of only 23,000 shares per day.

Now, why would I bother writing about such a tiny company?

Because it’s a perfect example of the advantage small investors have over a mutual fund.

Most mutual funds couldn’t go near this stock. In order to make a purchase worth a fund’s effort, it would have to buy hundreds of thousands or even millions of shares, which would shoot the price skyward.

But an individual investor who wants to add $10,000 worth of the stock can pick up 500 shares without budging the price.

Orchids Paper is in the oh-so-exciting toilet paper, napkins and paper towel business.

That’s it.

From the private-label paper products it made and distributed, Orchids generated $100 million in sales last year. That income led to $17 million in cash flow from operations and $10.6 million in free cash flow (cash flow from operations minus capital expenditures).

During the same time, the company paid $6.4 million in dividends for a payout ratio of 60%.

In other words, Orchids Paper returns 60% of its free cash flow back to shareholders in the form of dividends.

As you know, that’s a ratio I’m comfortable with. Typically, I want to see a payout ratio of 75% or less. That tells me that even if the company has a bad year, it should be able to continue to pay (and hopefully raise) its dividend.

A Short History

Orchids Paper first started paying a dividend in 2011, when it paid $0.10 per quarter. Nine months later, the company doubled the dividend.

At the end of 2012, it raised the dividend to $0.25 per quarter. And in March of this year, bumped it to $0.30.

The payout is currently worth a 5.3% dividend yield.

So Orchids has a payout ratio that is safe and has raised the dividend three times in the past six quarters. That’s great.

But here are a few concerns.

Orchids has only paid a dividend since 2011. That’s not much of a track record.

Management is trying to do right by shareholders and return more cash to them when the company is able. But I like to see a longer history of annual dividend raises to feel entirely comfortable.

Plus, management said it will increase capital expenditures to $10 million this year. That will hurt cash flow. But profits are projected to increase 25% in 2013, which will partially (but only partially) offset the increase in capital expenditures.

If the trend continues in 2014, I would not be shocked to see a dividend cut.

If the company had a longer track record of paying the dividend, I’d be more confident that a reduction would be avoided. That is what makes this a tough one to grade from a dividend safety perspective.

The track record is so new.

I’m not worried about the dividend in 2013. But we need to watch how the year goes and what kind of guidance the company gives for 2014 to feel comfortable about next year.

While I don’t think there’s a high risk of a dividend cut, I also don’t think we can say there is a low risk.

With a moderate level of risk, I have to give Orchids Paper’s dividend a grade of “C.” I don’t do pluses and minuses, but if I did, it would be a “C+.”

Orchids has an attractive yield and strong business and is an interesting opportunity for individual investors.

Dividend Safety Rating: C

P.S. Make sure to leave ticker symbols in the comments section below if you want me to take a look at the dividend safety of one of your stocks in a future column.