Description

Colfax Thesis

Short-term end-market weakness and FX headwinds are temporarily depressing earnings, distracting investors from participating in a long-term compounder. CFX is a solid FCF generating business with a roll up strategy that is being executed by a very high quality management team and is backed by the masterminds of Danaher, the Rales Brothers. Danaher is arguably one of the most successful roll-up stories of all time. Mitch Rales serves as the Chairman of the Board and has been instrumental in recruiting the current CFX management team, who are former Danaher executives. Insiders own about 20% of the company.

The management team is not shy and lays it all out on the table. For a general industrials company, they are targeting solid long-term growth targets of GDP + 1-2% and impressive operating margin targets of mid-teens (currently ~11%). If executed, growth and margin improvements should lead FCF/Share to reach ~$4-$5 within the next two to three years. Applying a Danaher-type multiple of 16.5x on FCF/Share of $4 implies a share price of $66 or 36% upside. Any additional M&A is incremental upside to FCF and they have been busy since the transformational Charter acquisition (completed end of 2011), which quintupled the company’s revenue. Since Charter, CFX has spent over $1.5bn, while the Street has been modelling any excess cash to pay down debt. Another incremental $0.50-$1.00/share of acquired FCF is not unreasonable. FCF/share of ~$4.50 implies a share price of $74 or 53% upside.

Lastly, there is a call option on CFX making another transformational “platform” deal similar to the Charter deal, which should further open up the M&A runway.

CFX Business Description: A Story of Margins and M&A

Colfax has two reported segments (the welding segment and the gas and fluid handling) served by three “platforms” (ESAB, Howden and Legacy Colfax). The welding segment is served by ESAB. The gas and fluid handling segment is served by Howden (gas handling) and the legacy Colfax business (fluid handling). Both ESAB and Howden were part of the Charter business.

ESAB is the 2nd largest welding consumable (75% of ESAB) and equipment (25% of ESAB) global manufacturer behind Lincoln Electric, ESAB’s closest competitor. ESAB was previously under-managed under Charter. Under CFX’s management team, ESAB operating margins improved from HSD to ~12% over the span of ~3 years against stagnant to weak volumes. LT mid-teen operating margins are very reasonable given that Lincoln Electric is currently running operating margins of mid-teens. ESAB margins are spring-loaded as an eventual improvement in end-markets (volume) coupled with management’s operational prowess will help unlock substantial margin potential. The welding market is fragmented and there should be a long runway for additional bolt-on acquisitions that should also boost margins due to further economies of scale. In Q2 2014, management completed a major acquisition, Victor Technologies that will help strengthen their welding equipment portfolio (higher margin business) and distribution channel in North America (ESAB has a stronger presence in Europe and South America). CFX is also investing further in the equipment business. Growth in the equipment business should be another tailwind for margins.

Howden sells heavy-duty fans, heat exchangers and screw compressors. Howden’s fans and heat exchangers are used in coal-fired power plants, while Howden compressors are typically sold into the oil, gas and petrochemical end-markets. Management has long-term growth targets for the business of 4-6% and operating margin targets of mid-teens versus LDDs in the past. Growth will be driven by pending emission regulations in the US, the upcoming emissions plans through China’s next “5 Year Plan” and new power plant constructions in Asia.

The legacy fluid handling business sells specialized fluid pumps, controls and valves and other fluid handling systems. The fluid handling business serves a wide variety of end-markets. Management has targeted long-term growth targets of 3-5% and operating margin targets of mid-teens, consistent with previous peak margins. CFX has pieced together a portfolio of strong brands such as Allweiler, IMO, Sicelub and Warren. The gas and fluid handling space is highly fragmented which allows CFX to continue tucking in businesses.

The Next Great Roll-Up: Case Study of Danaher and the Rales Brothers

Mitch and Steven Rales co-founded Danaher Corp., arguably the most successful roll-up ever, in the 80’s.Through 30 years of industrial tuck-in and platform acquisitions, Danaher’s share price and EPS have compounded at ~20% from 1992 to today and operating margins expanded from MSD to high teens. Today, CFX may be where DHR was in the late 1990’s (early innings of the roll-up story).

The Rales Brother playbook was to acquire market share leaders in niche markets who are capable of being the most innovative and lowest cost manufacturer in the space. Once they have a “platform,” they build scale with bolt-ons that enable operating efficiencies and pricing power (via increased market share). CFX is following a very similar playbook with three platforms to add bolt-ons: ESAB, Howden and Fluid handling. Another “transformational” deal would add another platform and add to the M&A addressable TAM.

The backbone of Danaher’s success is the management process. CFX management cultishly preaches operational efficiency through “CBS Tools” or Colfax Business System Tools, similar to Danaher’s DBS (Danaher Business System). DBS is an array of lean methodologies and best practices collected over time and implemented to provide Danaher with a sustainable competitive advantage, which manifests largely as world-class excellence in customer satisfaction. The system is focused on the concept of kaizen events, or constant improvement, which requires every employee, from janitor to CEO, to seek ways to improve the way work is done. Through its cleverly-named Colfax Business System, Colfax applies all the tools and best practices learned over 30+ years at Danaher to its own operations.

Lastly, in early February 2015, Mitch Rales has “signaled the bottom” by purchasing $20mm worth of stock at high 40s. This might be chump change for Mitch Rales but it serves as a vote of confidence in the business and the management team.

Explanation for the Recent Stock Price Pressure

A potentially bigger driver of the stock price pressure is related to the gas and fluid handling business. Growth for the gas and fluid handling business has been stalling due to the completion of projects related to power plant emission regulations in the US and China. Lower oil prices may also help explain the recent stock price pressure.

1.   Temporary revenue air-pocket related to China “SCR”: Management has highlighted an air-pocket in 2015 related to China SCR projects. These projects are part of the coal power plant emission reduction initiatives in China. The Chinese government is focused on cutting smog and emissions from its large fleet of coal-fired power plants. The upcoming “5-Year Plan” will most likely include new emission standards and/or clean air initiatives that will benefit CFX in 2016 and beyond. Probably less than 5% of the GFH business is exposed to the Chinese power generation end-market and the GFH business is half of the overall business.

2.   Regulatory uncertainty delaying US coal plant retrofit/maintenance projects: Clearer regulation should be communicated by end of 2016. Although, there may be further delays and new projects may not be seen until 2017/2018. CFX is already looking at other opportunities in the Middle East and in Japan to fill the air-pockets for its power generation business.  Roughly less than 10% of the GFH business is exposed to the US power generation end-market.

3.   Low oil price impact on CFX may be overhyped: It seems investors have unfairly punished CFX for low oil prices as CFX is exposed to downstream applications (production) and not upstream applications (drilling). Projects are locked in for 2015. However, long-term sustained oil prices may impact oil project activity in 2016. As a mitigant, CFX is exploring additional natural gas applications. Roughly 20% of the GFH business is exposed to the oil, gas and petrochemical end-market.

The ESAB business has also encountered one-time issues in their Midway facility and temporary disruptions due to a SAP implementation. These one-time issues are understandable due to the pace of activity as management is attempting to double margins. Management has seemed to have worked through most of these issues. Lastly, a potentially less fleeting issue is weak Latin American welding markets. Although, ESAB has been able to improve margins so far under weak welding markets.

Valuation

Assumptions: CFX gets back on track with long-term growth targets in 2016. 2015 will be a temporarily depressed year in terms of earnings and FCF. Margins are spring-loaded as volumes recover in 2016. Assuming end-markets hold up, margins will continue to expand through 2016.

2016 assumptions include 5.3B of revenue with Adjusted ESAB op margins of 14.3% and Adj. GFH op margins of 14.3% producing ~$4.20 in FCF / Share ex-M&A and ~$4.38 FCF / Share with M&A.  Note:  Adjusted operating margins are as defined by the company.

Key Risks

1.   Sustained end-market weakness may delay management from achieving LT margin and growth plans: Latin American welding markets seem to be bottoming out and CFX has a commanding welding market share in Latin America. Secondly, once again, GFH end-markets are diverse and hard to predict. The current CFX business may prove more cyclical than Danaher’s business. Although, continuous execution of the platform acquisition strategy should diversify the business away from sustainably weak end-markets over time.  CFX CFO has publicly stated that they will be looking to make another platform acquisition after completing the ESAB restructuring. As an analogy, Danaher’s business in 2001 looks drastically different from its current business given the evolving portfolio.

2.   Increasing competition against ESAB’s consumables business: Chinese steel consumables may eventually become comparable in terms of quality and brand recognition, but still maybe a few years away. Currently, the weight-to-value ratio of ESAB’s products (steel wire is heavy and thus costly to ship) and import duties insulate many markets from Asian competition.

3.   Operational issues may prove longer to fix: There has been a few ESAB operational hiccups identified by management as “temporary” and CFX should be able to get fully past them over the next 12 months.  These hiccups may have also alienated customers more so than what management has suggested. Any new operational issues over the next 12 months could lead to lower conviction in the quality of the management team. Although swift and significant changes increase the chances of mishaps, even with rock star managers.

Disclosure: We and our affiliates are long CFX and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of CFX. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalyst

Earnings, time, execution.