Description

CIRCOR International – 1L Term Loan – Investment Thesis

Situation Overview:

CIRCOR International (“CIR” or the “Company”) engages in the design, manufacturing, and marketing of a diversified portfolio of flow and motion control products to industrial and aerospace and defense (“A&D”) customers. 

We believe the Company’s 2028 1L Term Loan (“1L TL”) at a yield to maturity of 10.9% and current yield of 10.3% presents a highly compelling risk/reward.  An investor in the 1L is underwriting to <5x leverage, with a gross loan-to-value (“LTV”) of ~50% and substantial equity cushion.  

Break-even to negative FCF since FY19, a financial restatement of FY19-FY21 financials (and subsequently an announcement of material weaknesses in the Company’s internal controls), and a negative macroeconomic outlook have weighed on CIR’s share price and credit outlook.  However, recent business momentum and the Company’s announced strategic review make for a compelling investment thesis moving forward. 

New management has demonstrated strong order growth and pricing momentum since taking over the business in early 2022 despite macroeconomic conditions, indicating the Company’s fundamentals and market position remain strong.  CIR’s announced strategic review is ongoing and further de-risks the thesis.  The Company’s underlying businesses are discrete with distinct management teams and go-to-market functions, such that a sale of either the entire business or individual businesses is feasible. 

KeyBanc estimates 7.5x and 12.5x EBITDA multiples for the Industrial and A&D businesses, respectively [1].  CIR equity currently trades roughly in line with these assumptions, with multiples indicating an equity value per share of $25.91 based on LTM numbers (vs. current share price of $26.92, or ~4% downside).  As a result, we believe the debt offers downside protection vs. the equity in the event a transaction does not materialize.

If a divestiture occurs instead of a WholeCo sale, management has indicated proceeds will likely be used to paydown debt [2].  Annualized returns remain attractive in this scenario if the 1L TL is taken out at par, with the investor collecting income along the way for a yield to take-out of 13.7% if the debt is paid off in 12 months.

On a standalone basis, our thesis is: 1) Despite macroeconomic uncertainty, CIR’s portfolio will remain strong given mission critical, customer-specific offerings that are often sole-source and recurring.  2) Diversification across geographies and end-markets reduces cyclicality, mitigating risks associated with the broader economic environment.  3) FCF will improve as one-time items fall away in FY23E and further pricing increases are pushed on to customers.

We recommend buying CIR’s 1L TL at 96.75, indicating a yield to maturity of 10.9% and current yield of 10.3%.

Capital Structure:

Outstanding liquidity is $87.9m, with undrawn revolving credit facility of $40.8m and cash on hand of $47.1m. 

Historical Financial Data [3]:

Credit Stats [4]:

As of Q3 FY22, the Company is currently unhedged against changes in interest rates.

Investment Thesis:

1. Market leading position in mission critical, differentiated offerings

CIR engages in the sale of flow and motion control products to two main segments: Industrial: (67% of FY21 revenue, 7.9% segment AOI margin) and A&D (33% of FY21 revenue, 22.2% segment AOI margin) [5], [6].  Its portfolio of products serves a variety of mission-critical applications within each segment, ranging from use in chemical processing, to downstream oil and gas, to commercial aircraft.  

Applications typically require precision movement and zero leakage and are often non-standard (i.e. engineered or designed to specific customer specifications [7]).  As a result, pricing is not the main driver of business in either segment.  Instead, customers require vendors with reliable product availability that offer safety, durability, and know-how relative to customer needs [8]. 

Despite a fragmented industry, CIR’s portfolio is made up of market leading, recognizable brands that are differentiated through their ability to produce high pressure, high temperature, and caustic flow solutions.  Notable brands include Aerodyne Controls, a leading supplier of critical products to the defense market, Allweiler, a market-leading German pump supplier, and Warren Pumps, a critical supplier to the U.S. Navy, among others [9]. 

As a result of specialized use-cases, CIR’s revenues are highly recurring in nature, supporting future cashflow generation.  90% of A&D revenue is sole-source for customers and 40-45% of industrial revenue is made up of aftermarket sales. Both management and a former employee have indicated that these revenue streams should be thought of as recurring [10], [11].

Recent results demonstrate the portfolio’s strength and CIR’s market position.  Despite macroeconomic uncertainty and supply chain constraints, the Company exhibited 26% organic order growth, 14% backlog growth, and 10% organic revenue growth YoY in Q3 FY22, with no slowdown in demand in North America or Europe to date. 

Management has indicated that FY22 was a particularly good year for A&D orders (74% organic order growth YoY in Q3 FY22, driven by aftermarket missile programs, medical growth, and continued recovery in commercial aerospace). While normalized growth rates are not disclosed by the Company, a former employee indicated sustainable organic revenue growth may be in the 4-6% range [12]. Preliminary Q4 FY22 results indicate continued growth, with 19% organic order growth anticipated YoY.

The Company has also demonstrated pricing power, with management expecting to deliver $35m of pricing benefit in FY22E (~5% of the ~9% organic growth guidance for the full year) principally through the lower-margin industrial segment.  CIR is in the process of executing another round of pricing increases with stickiness and minimal pushback expected [13], driving margin expansion.

2. Diversified customer base across geographies and strong end-markets

The Company has over 14,000 customers in ~100 countries, with no customer accounting for more than 10% of revenues in FY21.  Customers span across geographies and end-markets, reducing cyclicality and dependence on any particular industry and reducing risks associated with the broader economic environment.  Revenue segmentation can be seen below:

• Geography (FY21 revenue): North America: 43%, EMEA: 38%, ROW: 19%
• End-Markets (FY22E end-market sales mix):
  • Industrial – General Industrial: 56%, Commercial Marine: 15%, Downstream O&G: 20%, and Other: 9%
  • A&D – Defense: 61%, Commercial: 17%, and Other: 22%

Over time, the Company has been simplified and is increasingly focused on areas with better growth and earnings potential, including the aftermarket space which is higher margin and more recurring in nature than the base business [14].  Notably, CIR exited the distributed valves business in FY20, based on the Company’s strategic decision to exit upstream oil and gas and other commodity businesses to better focus on core mission-critical flow control platforms. 

CIR additionally exited the loss-making pipeline engineering business in FY22 following accounting irregularities impacting revenues, net income, goodwill, cash, and other working capital accounts.  The impact was ~$40-45m on a cumulative pre-tax income basis over five years through Q3 FY21.  Material weaknesses in the Company’s internal controls associated with the accounting issues are being addressed through the Company’s remediation plan. 

3. Financial characteristics

In a normalized environment, CIR expects 90% adjusted net income to FCF conversion assuming flat sales [15] (implying normalized FCF of $28.0m based on LTM adjusted net income of $31.1m).  This indicates LTM normalized FCF / net debt of 5.9%. 

The Company’s ability to produce FCF has been clouded by recent performance.  FCF has been break-even to negative from FY19-FY21, driven by consistent working capital outflows and one-time charges.

This has continued into FY22, with FX headwinds, unwinding of a downstream Russia project booked in prior years, remediation plan in relation to the Company’s internal controls, and ongoing strategic review representing a ~$25-30m headwind to FY22E FCF.  Additionally, the supply environment remains challenged vs. pre-COVID levels.  CIR has built working capital specifically due to supply chain issues in the pumps and navy businesses driving a $30m headwind to FY22E FCF generation. 

Excluding these one-time items, LTM FCF / net debt would be 4.0-5.0%.  With one-time items falling away next year and signs of supply chain constrains easing, FCF should return to positive levels in FY23E. 

CIR has several levers that could provide upside to FCF going forward.  One such opportunity is the monetization of the Company’s real estate portfolio, which generated $26m and $28m through sale leaseback transactions in Q2 and Q3 FY22, respectively (3 facilities sold).  FY21 disclosures indicate that the Company continues to own 12 facilities, although future proceeds are likely to represent less than what has already been executed [16].  The Company’s strategic priority to drive growth in higher margin aftermarket revenues and further price increases in the near-term should also drive margin expansion. 

Risks:

1. Macroeconomic environment

Slowdown in industrial demand could pose a threat to growth, particularly given international exposure, where markets may be under more strain from the macro environment.  Management has indicated no slowdown in demand in North America or Europe to date.  CIR is additionally sensitive to the cost of inputs, particularly materials, freight, and logistics, which have been rising given inflation.  If additional pricing is not obtained, margins could be impacted.

2. Supply chain constraints

Supply environment remains challenged vs. pre-COVID levels.  CIR has built working capital specifically due to supply chain issues in the pumps and navy businesses ($30m headwind to FY22E FCF generation), and this could continue to be a drag on FCF in FY23E if supply chains don’t improve.

Catalyst

• Continued improvment in business fundamentals (pricing power, organic revenue and order growth, etc.)
• Sale or divestiture as a result of the strategic review