This dividend stock's potential appears to outweigh the risk

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K-Bro Linen Inc.'s stock price has taken a beating this month, sinking from more than $50 to about $43, on unusually high volume. The stock's valuation has compressed – but is the recent correction a buying opportunity? Let's take a closer look.

The company

K-Bro is an industry leader as the country's largest provider of laundry and linen services. Through its nine processing plants and two distribution centres, the company services customers in two key markets: health care and hospitality. In the fourth quarter, roughly 71.9 per cent of the company's revenue was from the health-care industry.

Key attributes

• Long-term contracts. The company has long-term contracts with its customers, such as hospitals and hotels, providing K-Bro with stable revenue with good visibility in forecasting revenue. Contracts with health-care customers, in general, range from between seven and 10 years, while contracts with hospitality customers are shorter in duration, normally between two and five years.

• Potential contract wins and expansions. On the fourth-quarter conference call, management highlighted two potential new health-care contracts that could be announced over the next six months. One opportunity is in Quebec City, valued at approximately $11-million in annual revenue, and the other is in Montreal, worth roughly $7-million in annual revenue.

• Steady growth. Health-care revenue increased 13.6 per cent year over year in the fourth quarter, while hospitality revenue rose 6.4 per cent.

• Sustainable dividend. In 2015, the payout ratio was 45 per cent, suggesting the dividend is sustainable.

Overshadowing these positive characteristics are concerns surrounding the competitive landscape, along with expansion costs squeezing corporate profitability.

• Competition heats up. Ecotex, a laundry and linen service provider with operations in British Columbia and in several U.S. states, has entered the Ontario market with the acquisition of Booth Centennial, a health-care laundry-facilities company that K-Bro had an interest in acquiring. In addition, Ecotex was awarded an $11-million-a-year, 20-year contract to service several hospitals in British Columbia.

• Expanding for future growth. This year, the company is relocating a facility in Toronto, slightly west to Mississauga, expanding its capacity, but in the near term, there could be a negative impact on profitability. In addition, management plans on building a new facility in Vancouver within the next 30 months.

• Dividend policy. Management is committed to returning capital to its shareholders, announcing occasional increases to its dividend. The company has maintained its current monthly dividend of 10 cents a share since 2014. This equates to a yearly dividend of $1.20 and an annualized yield of just less than 3 per cent.

Valuation

According to Bloomberg, the stock is trading at a price-to-earnings multiple of more than 22 times the 2016 consensus estimate and at more than 21 times the 2017 consensus estimate. This is relatively close to its five-year average multiple. On an enterprise value-to-earnings before interest, taxes, depreciation and amortization (EBITDA) basis, the stock is trading at more than 10 times the 2017 consensus estimate, just above its five-year average.

The consensus EBITDA estimate is $33.3-million in 2016, rising 8 per cent to $36.1-million in 2017. The consensus earnings-per-share estimate is $1.93 in 2016, climbing 4 per cent to $2 in 2017.

Analysts' recommendations

This small-capitalization stock with a market cap of roughly $350-million is well covered by the Street with analysts at large firms such as TD Securities and Scotia Capital covering the company.

According to Bloomberg, there are three buy recommendations, three hold recommendations and no sell recommendations. The average one-year price target among these analysts is $49.27, implying the share price may appreciate approximately 13 per cent. Target prices range widely from a low of $45 to a high of $54.

Chart watch

Over the years, this stock has been a top performer; however, its positive momentum appears to be stalling. Year to date, the stock price has realized a double-digit loss. However, in 2015, the stock price appreciated more than10 per cent, rose 16 per cent in 2014, gained 38 per cent in 2013 and jumped 30 per cent in 2012.

There is overhead resistance around $46, and then near $48, which is close to its 50-day moving average. After that, there is resistance at $50, just above its 200-day moving average. There is large downside support around $40.

The relatively strength index is at 31. Generally, a reading of 30 or lower indicates an oversold condition.

The bottom line

The company is undergoing growing pains as it expands. That being said, the upside potential appears to outweigh the downside risk, especially given the two near-term catalysts that could raise analysts' earnings estimates and make the stock's valuation more compelling.

I strongly encourage readers to consult a financial adviser, and to do their own proper due diligence before taking any investment action.

The author does not personally own shares in the security mentioned in this story.

Jennifer Dowty, CFA, Globe Investor's in-house equities analyst, writes exclusively for our subscribers at Inside the Market.