Description

Summary

C&D Technologies (CHP) is a small-cap industrial battery manufacturer in the process of divesting assets, de-leveraging its balance sheet, cutting costs and recovering (hopefully) from astronomic increases in the price of its main input, lead.  Much of the asset sales and de-leveraging already has occurred; the company is still in the midst of the cost cutting and addressing the lead increases.  Earlier this week, the company announced the sale of its Motive Battery business unit, the second divestiture this year; this removes a money losing division and allows management to focus on the sole remaining division, Standby Power, which is profitable and growing.

When management completes the cost-cutting initiatives by the end of the next year, the company should be producing EBITDA of at least $45MM in calendar 2008 compared to a current adjusted EV of $160MM (adjusted for exercised convertible debt) or 3.6X.  As the company’s financials begin to reflect the cost cuts, I believe the company will be selling at 8X EV/EBITDA or at least $8.90 per share versus a recent price of $4.50 (this include $42MM in cash recently received from the sale proceed of the Power Electronics division earlier this year).

Background

CHP is a 100+ year old company whose sales recently had peaked at over $500MM.  This principally was due to 2 acquisitions in 2004 for over $125MM which were consolidated into its Power Electronics division.  That division ultimately was sold earlier this year.  Severely increasing lead prices, expensive and increasing debt loads and a botched acquisition integration sent the share price down to nearly $4 per share from a recent high of $20 per share in 2003.  A new CEO from electronic components manufacturer Kemet and CFO from competitor Exide came in 2005 and began upgrading the senior team and turning things around.

New management refinanced expensive debt with less expensive convertible debt, consolidated facilities, sold off 1 of its 3 divisions for $85MM in cash and paid down all non-convertible debt leaving $42MM of cash.  They are now in the process of slashing operating expenses by an incremental $30MM to be completed over 2 years.   Finally, as mentioned above, they just announced they sold off the smaller of the 2 remaining businesses, Motive Power, that has been losing money since 2001 in spite of having revenues of $58.7MM in FY 2007.  Terms were not disclosed and warranty liabilities, which has been a historic problem for that business unit, has been retained by CHP.  For analysis purpose and conservatism’s sake, I assume it is a wash though it is likely to be over $10MM of cash proceeds (a rough approximation after speaking with management).

With this backdrop, management is firmly focused on its remaining segment, Standby Power, completing the cost-cutting initiative and stabilizing the business.

Standby Power

This business manufactures and distributes lead acid batteries and associated electronics and systems; these products monitor and regulate electricity and provide backup power if the power is interrupted.  End markets include UPS systems (uninterruptible power supply) used for data center rooms which house servers and network hubs, telecommunications equipment, cable TV systems and utilities.  Telecom is their largest market.

Their equipment is OEM’ed into equipment made by companies such as Emerson, GE and Mitsubishi.  About 60% of the business is for new projects and 40% is replacement.  Management believes the market for Standby Power should grow 5-6% per year.  The product serves as an insurance policy of sorts for important data servers and vital networks.  While price is an issue, reliability and reputation are very important to purchase behavior.  C&D has an excellent reputation and has been a long time player in the market.

Competition

CHP has a leading market share of 26% in Standby Power in the United States.  Enersys (ENS) has 21% market share followed by Exide (XIDE) with 16%.  There are a few smaller players as well.  Strategically, CHP and ENS focus on the upper end of the market and are well known for product development while XIDE is the low cost provider.  XIDE is the only vertically integrated player.  They own their own smelters which gives them a distinct cost advantage.  In spite of this advantage, XIDE has experienced difficulty since emerging from bankruptcy in 2004 and remains heavily levered.  Soaring lead prices aside, pricing has been rational, competitively speaking.

Lead

Lead, like many commodities in recent times, has experienced an astronomic increase in price.  Lead started 2004 at roughly 34 cents per pound and currently is quoted around $1.70 per pound.  Three quarters of all lead world-wide is used for batteries.  Consumption in India and China, heavy speculation and a few mine disruptions in Australia and Peru are fueling the boom.  In Standby Power, lead is roughly 35% of COGS which made addressing the increase in lead prices central to the company’s turnaround plan.

One part of the plan in reaction to this issue was to get rid of any fixed price contracts.  This move was in response to agreements where the company was not contractually able to tack on increases to reflect price changes in lead.  With the ability to raise prices as the price of lead increases, management believes that price increases will now recoup losses due to lead price increases; however, there is a time lag between cost increases they experience and prices increases they put through to the customer which harm margins in the short term.  There has been very little push back in raising prices in reaction to lead increases, though this was not a common practice in the industry until present management started doing it in 2005.  Everyone in the industry generally has followed suit.  Removing fixed price contracts also has diminished the need for hedges. 

The other part of the plan has been to acquire recycled lead and use a third party to smelt it thereby moving up the value chain to gain cheaper finished lead (this creates an all-in price of 70-80 cents per pound versus $1.70).  Currently, they are satisfying ~30% of their lead needs with a goal to get to 50%. 

Analysts are expecting a modest supply surplus in 2008 and they anticipate prices will return to the $1 per pound range.

Cost Cuts

Management put forth a plan earlier in the year to cut $30MM of costs (it was $25MM-$30MM at first though they recently affirmed a $30MM target).  The plan is expected to take all of calendar 2007 and 2008 to implement.  Approximately $7MM of the cuts come from sourcing cheaper lead via the acquisition of recycled lead as described above.  Improvement of product design is expected to create ~$12MM of savings through more efficient design.  Finally, manufacturing improvements should be worth ~$11MM.  This includes consolidating facilities as well as the opening of a new plant in China.  Incidentally, over 1/3 of sales occur outside the United States and this plant should help grow sales in Asia.

Financials and Valuation

The capital structure:

Note:  This assumes full conversion of $54.5 MM of 5.5% debt at $4.84 and $75MM of 5.25% debt at $8.46 per share.

Financials for Standby Power Division  (FY Jan 31 YE, in thousands)

You can see that increase in lead costs, among other things, diminished operating margins severely while the division grew revenues at around 3.5% per year.  Management did not disclose gross margins by division until 2005.  For the last 3 years, Standby Power GM% has been:

Management believes they will be able to get GM% back to the 25% range, where they had been in the past prior to the large lead price increases.

My estimates for the Standby Power division (which essentially is the company now) are below.  Given this previously was one of three business segments, I have had to cobble together financials for this division from conversations with management, an 8-K put out to show the affect of the Power Electronics division divestiture and my estimates.

FY Ended Jan 31—Standby Power Division

Note 1:  6 Month 2007 EBIT adjusted for $15.2 sale of Chinese plant gain

Note 2:  I assume most of lead cost increases get passed through in FY’08 and FY’09

Note 3:  Increased S,G&A in FY2008 from FY2007 is the result of increased corporate overhead burden attributed to Standby due to the sale of the Power Electronics and Motive divisions.  FY2007 as shown above is the actual Standby Power segment financials, not the entire company. FY2008 and FY2009 represent the entire remaining company including estimated corporate overhead that remained with the company post sale of the two divisions.

Management has stated that they are taking $30MM of costs out of the business, 85% of which are in the COGS of Standby Power.  The rest was slated to be used to get the Motive Power segment to break even; I assume the difference will still be used to remove overhead burden that did not go with the sale of the Motive division.  In addition, the Standby Power business grew 8.9% in FY 2007 and has posted revenue growth in the first 2 quarters of FY2008 13.4% and 17%, respectively.  The 17% increase in Q2 was comprised of half from price increases and half from volume increases.

I conservatively assume 10% revenue growth in FY 2008 and 7% growth FY 2009 and that management achieves most of the targeted $30MM in cuts (I did not give them full benefit of the cuts to reflect the fact that margins may not catch up to price increases by FY2009).  Remember, revenues are currently rising faster than volume of sales due to the implementation of price increases;  the steady state growth rate is expected to be more in the 5-6% growth range. 

If one were to use the pro-forma financials the company released earlier this year in an 8-K to reflect the sale of the first division sold off (Power Electronics division), and after the $30MM of expected operating cost reductions, operating margins would be closer to 13%.  If that were to occur, then EBITDA should be closer to $50MM in FY 2009 (which ends in January of 2009).

Competitor Xide trades at 8.2X LTM EV/EBITDA and ENS at 8.6X.  Using 8X creates a $360MM EV or $7.98.  Cash of $42MM is worth $0.93 / share, or $8.91 per share total.  Even if the cash is required to fund losses due to increasing lead costs and/or any shut down costs, then the stock still should trade at over $7.80 per share on a more steady state.  Management has not yet disclosed what the NOL tax shield will be per year, but with a book value of $60MM, it should be worth at least 50 cents per share of incremental value.  With the cash, the NOL and the proceeds from the Motive division sale, the stock could be worth over $9 per share within 2 years. 

Risks

1. Lead prices could continue to spiral out of control (it has increased 5-fold since 2004, but it could continue further), creating a operating losses that need to be funded
2. Management fails to achieve the $30MM in cost cuts
3. Irrational pricing breaks out in the industry
4. Growth slows down due to economic slowdown

Catalyst