I think the common shares of Allied Motion (AMOT - $5.75) represent a compelling long term investment. I’ve been following this company for five years and it is a well-managed, strong moat and solid return business with no debt. I have a quarter-sized position for the long term and will be confident about buying more shares in the event the stock drops because the economy gets worse. 

Summary:

• Company makes motion control products including high precision motors, controllers, encoders, etc.
• 30% return business model with a strong moat: 80-85% of its revenues are sole sourced and customer switching costs are high
• 12% free cash flow yield today; cash flow could double in four or five years
• The CEO and CFO are strong operators, run the company for long term value creation, and own a combined 15% of the company
• Insider buying; no insider selling this year

Why the Opportunity?

There appear to be several reasons why the opportunity exists. Management put its focus on the business since the 2002 restructuring and spent very little time on investor relations. The company has no analyst coverage and management has never presented at a conference or otherwise.  On the surface it is not apparent why this company earns strong returns on capital, so investors doing a quick look might pass. The company is at the beginning stages of a mix shift toward higher margin solution sales that isn’t yet evident in results. Finally, the earnings power of a recent acquisition is not fully evident.  

On last quarter’s conference call, management discussed the possibility of an increased investor relations effort. Management is proceeding cautiously here, however, and doesn’t want to divert is attention away from running the business. They feel that the stock price will take care of itself over the long run if they deliver earnings results. Still, I suspect based on what they’ve said recently that a more significant IR effort may happen within the next year.  

Valuation and Model

• 12% free cash flow based on 3Q11 results and a 7% free cash flow yield using the company’s two toughest recent years of 2008-2009*
• Using annualized 3Q11 results:
  • Return on tangible net operating assets = 30% (net income divided by the quantity stockholder’s equity less intangibles and net cash)
  • P/E =8
  • EV/EBITDA = 4
  • EV/EBIT = 5
  • Using an expected value framework results in an expected value of $12/share in 2015, or a 20% annualized return.

The company’s 3Q11 return on tangible net operating assets was a solid 30%. Looking at the company’s business, one might not expect such solid returns. I think they are sustainable and can even increase for quite a while (with some volatility; 2012 recessions in the U.S. and Europe seem very likely), as I explain in the business model section below. I think there is ample opportunity for the company to reinvest at these strong rates for quite some time.

Since I’m making the case for a longer term investment, let’s look at today’s financial results and what I think they could look like in 3-5 years, let’s call it 2015. I am unsure about the path over the next 3-5 years (a 2012 U.S. and European recession seems highly likely to me), but I am confident that the company will do quite well over the long term. The 2015 numbers are in the ballpark of what you will get if management can execute on its plan. But bad stuff happens, so let’s say the results in 2015 have a 50% chance of happening. See below for the rest of the scenarios. Note that all of the scenarios are end outcomes, with indeterminate paths to get there. In other words, it is entirely probable that in one scenario the stock goes down a lot next year before it goes to $15.

Other Valuation Assumptions

The revenue mix of solution sales increases by 10% points per year. Solution sales have 10% points higher margins than the corporate average. Revenues today include very little in the way of solution sales. So, these assumptions together mean GM% should go up by 1% point per year. I assume the company has 25bp of GM% improvement by scaling fixed overhead. I assume no fixed or variable cost improvements, which seems conservative since the company has been able to boost GM% by over 6% points in the last five years through cost improvements and scale (mostly cost improvements).

5% revenue growth per year from 2012-2015 (I think there is a good chance next year will be down, but the company will make it up later). The company should be able to grow in line with its end markets of medical, vehicle, aerospace and defense, electronics and industrial, so call it a nominal GDP grower without share gains. I think the company will gain share with its solution sales, so 5% is hopefully conservative.

Growth in tangible net operating assets is 70% of sales growth through 2015. This is less than sales growth because inventories should grow less than sales due to margin improvements and Allied has a large deferred tax asset from a goodwill writedown that is declining.  From the end of 2008 through the last quarter before the Ostergrens acquisition, the company grew sales by 20% and tangible net operating assets only grew by 0.5%.

Management and history

Prior to 2002, the company was focused on its power and processing business, Hathaway, and its motion control business received little attention. This changed in July 2002 when the company sold Hathaway and put 100% of its focus on motion control. Two months prior to this shift to motion control, Dick Warzala left Allied’s competitor, Danaher, to join Allied as President. He is now CEO. Dick Smith, CFO and Chairman, has been with the company since 1983. The VP of Marketing also came from Danaher at the beginning of 2003. In short, management turnover at these positions has been zero since the company’s change in focus to motion control.

One worry with small caps is their ability to weather downturns, especially today. Management cut costs immediately when the downturn became apparent in 2008, but not to the detriment of the long term health of the company: management continued spending at a full rate on R&D, a decision that paid off following the downturn. The company generated free cash flow in both of the years of 2008 and 2009.

The company is generating excess cash so management recently instituted a dividend. The yield is 1.4%.

The CEO and CFO have a significant incentive to achieve a high return on equity. In 2010 the board set performance based deferred contributions of 25% of any net income generated over an 8% return on equity. This resulted in deferred compensation of $236k to each of Dick Warzala and Dick Smith in 2010. In the future the board may set a higher hurdle rate.  Warzala’s base salary is $350k and Smith’s is $300k. There is also an annual incentive bonus, 40% of which is based on an EVA calculation. I think the level of comp is on the high side for a small company, but at the same time I am hoping management makes a ton of money the way this is set up.

The company issued an average of 1.8% of shares outstanding per year in the form of restricted stock during the past five years.

The CFO will be retiring on March 31, 2013 but will remain on the board. The company has begun searching for a replacement.

The CEO, Dick Warzala, owns 730k shares and the Chairman and CFO, Dick Smith, owns 509k shares. Combined they own 15% of the company.

Management targets an after tax return on capital of 15-20%. A 20% ROE translates into about a 30% return on net tangible assets given today’s levels of net cash, payables and other liability accruals.

Business model

Solid Returns

At first glance, Allied’s business does not look like one that would generate strong returns on capital. However, the company is earning 30% return on tangible net operating assets today. Here is why returns are strong:

• 80-85% of the company’s revenue comes from products where the company is the sole source.
• In some bids, Allied has no competitor because there are no competing products. Other times Allied bids against only one to four other competitors. Competitors are few in a bid situation because Allied’s customers don’t want to qualify too many products as the qualification process is expensive plus…
• …Allied focuses on niche applications where there are fewer competitors.
• Switching costs are high: The cost for a customer to switch out Allied’s product for a competitor’s is very high between design cycles. In fact, switching is extremely rare between design cycles unless the motion control system fails.
• Customer turnover is low. Allied has had some customers for twenty years. Often an existing Allied customer will only ask Allied to bid and won’t invite competition.
• Allied’s customers’ primary criteria in choosing a motion control system is usually performance and quality, not price. Many of Allied’s customers require a high level of accuracy. Allied won the business for the Raytheon JSOW missile because Allied had the best accuracy. Raytheon is not going to try to save a couple bucks on a $300,000 missile if saving that money would mean less accuracy.
• Ongoing focus on process improvements and cost reductions (Allied System Tools is what they call it).

Solution Sales (System Sales)

From Wikipedia: “The basic architecture of a motion control system contains:

1. A motion controller to generate set points (the desired output or motion profile) and close a position and/or velocity feedback loop.[1]
2. A drive or amplifier to transform the control signal from the motion controller into a higher power electrical current or voltage that is presented to the actuator. Newer "intelligent" drives can close the position and velocity loops internally, resulting in much more accurate control.
3. An actuator such as a hydraulic pump, air cylinder, linear actuator, or electric motor for output motion.
4. One or more feedback sensors such as optical encoders, resolvers or Hall effect devices to return the position and/or velocity of the actuator to the motion controller in order to close the position and/or velocity control loops.
5. Mechanical components to transform the motion of the actuator into the desired motion, including: gears, shafting, ball screw, belts, linkages, and linear and rotational bearings.”

In the past Allied’s customers would typically integrate the motion control system using, for example, an Allied motor, a competitor encoder and an in-house drive. Solution sales, which the company defines as it supplying two or more integrated components of a system, are a small part of the company’s revenue mix today.

Solution sales have a 40% gross margin, about ten points higher than the company average, which results in a 20% operating margin contribution, about double the company’s operating margin. I’m guessing management can shift revenue mix toward solutions by about 10% points per year.

Management is focused on shifting its business to solution sales. Last quarter the company booked a $5m solution sale order that represented 15% of that quarter’s orders. An off road vehicle manufacturer placed the order. This customer originally requested a high specification motor from Allied and planned to use its own in-house drive. Allied developed a combined solution with a drive that fit inside the motor. The customer loved it, ditched its in-house drive and ordered the solution from Allied.

Ostergrens Acquisition

Ostegrens adds about $0.13/share in annualized EBITDA today, but will probably add $0.40 within a few years if all goes to plan.

At the end of 2010 Allied purchased Ostergrens, a Swedish motion control systems integrator that uses Allied products as well as Allied’s competitors to build a system. Allied could ultimately pay $11m, comprised of $7.4m cash paid at closing, $0.9m in stock, and $2.7m in contingent consideration. Allied probably won’t pay the full amount of contingent consideration based on the latest 10Q note. Let’s make a guess and call the purchase price $10m (we’ll know at the end of the year what contingent consideration was). 2010 EBITDA was $800k using the 2010 year end exchange rate. Management believes it can cut SG&A by 10-15%, which would bring EBITDA to $1.4m. I believe only half of these cost cuts have been made (it takes a long time in Sweden to fire someone in an economic way). So there is probably another $0.03-0.05/share of EBITDA that the company can realize here by cutting SG&A. But the largest opportunity with the acquisition is to replace the competitor products with Allied’s products. This could add another $1.8m of EBITDA, or $0.21/share, but over a longer time frame, probably 2-3 years. As written above, customers don’t switch out parts of a motion control solution unless something fails, so Allied will have to wait to switch out competitor products for Allied products until the next design cycle for each product. Putting it all together, I’d guess Allied pays about $10m for a company that in 2-3 years will generate $3.2m in EBITDA, perhaps more with some growth in the business. Capex for this integration business is very small ($20k in 2010). Management estimates that it will earn the cost of acquisition back within 3-5 years, which fits with the above analysis

Risks

Illiquid small cap. This stock was under $2 in 2009. If a large seller wants out, the stock will go down a lot. If there is a recession, the stock could go down a lot.

Europe. The acquisition of Ostergrens increased Allied’s revenue to Europe. In 3Q Europe accounted for 40% of sales. My guess is that Allied’s customers’ end market mix is more like global GDP mix, because a significant part of Allied’s sales to Europe are for products (forklifts for example) that are then sold to customers around the globe.  Plus if Europe goes into a major recession I’d bet other countries follow.

The company is moving to a new company-wide ERP and CRM system, Microsoft Dynamics. This could create near term disruptions, though in the long run I think it will benefit the company. For one thing it will enable faster integration of acquisitions, one of management’s strong suites. So far the ERP transition has been smooth.

A competitor could pressure pricing. This happened somewhat when a Canadian competitor went bankrupt in 2009.

Fixed manufacturing overhead is 10% of sales today. If sales decline a lot, GM% will be pressured.

*When the company faced headwinds in 2008 and 2009 (the company’s orders “fell off a cliff” in 3Q08; business is stable now), management was quick to cut costs (other than R&D) and the company generated free cash flow each year that averaged $0.41/share.  (If you calculate free cash flow for 2008-2009, you have to use the sharecount from back then as they subsequently made an acquisition that increased the share count. The assumption here is that the acquisition will generate as much free cash flow per share in a downturn. I think that’s valid.)

Continued long term earnings growth above its cost of capital.

Company is acquired or goes private. The company has been approached by private equity shops in the past. I have no insight into this topic other than that.

Stepped up investor relations effort.