Description

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Situation/Thesis Overview

Enerpac Tool Group (EPAC) designs, manufactures, and distributes hydraulic tools and controlled force products. It has a #1 market position across most of its largest product categories, especially pumps and cylinders, and its reputation is built on a 65-year track record of reliability and durability in mission critical industrial applications. The strength of the Enerpac brand creates a moat around the business, which allows the company to price its tools at a premium to its competitors and enjoy mid-cycle returns on invested capital of over 25%.

Despite its strong competitive position, compelling growth opportunities, recent share repurchase programs (outstanding shares have been reduced by ~10% so far), and track record of operational execution, Enerpac’s P/E multiple is near a five year low, representing a significant discount to public peers and comparable private market transactions.

The company’s relatively new management team (CEO joined October 2021) is partway through implementing a 2-year operational improvement program (using an “80/20 improvement” playbook that we are deeply familiar with) which has already expanded EBITDA margins from 14% to 25%. We believe the recent margin expansion is durable and has room to run further to 27-28% as they complete the second half of the program.

EPAC currently has an under-optimized capital structure (0.6x net leverage / 1.6x gross leverage) and has publicly expressed the intention to aggressively repurchase shares and redeploy capital in accretive acquisitions. Enerpac’s size, cost of capital, operational improvement framework, and extensive network of distribution relationships should allow them to make deals that are accretive at close and become even more accretive over time.

With a combination of organic growth, 80/20 enabled margin expansion, and disciplined acquisitions, we believe Enerpac could follow in the footsteps of successful industrial compounders like ITW, Danaher, Graco, TransDigm, and IDEX.

We believe the company can compound value in the mid-to-high 20s% IRR over the next several years, reaching our mid $80s target price within 4-5 years, representing an MOIC of ~2.4x.

Company History and Business Highlights

Although the company was founded in 1910, Enerpac has existed in its current form as a pure-play industrial tools and services company since September 2019, when it changed its name from “Actuant Corporation” upon divesting its Engineered Components segment. The tenure of the former management team was marred by many quarters of missed guidance and disappointing results, largely due to the now-divested Engineered Components segment.

EPAC’s core industrial tools business is a high-quality and durable business with industry-leading market share and pricing, advantages to incumbency, and growth tailwinds from several key end markets that enables it to generate 25%+ ROIC across the business cycle. Below are examples of its key product categories.

EPAC’s hydraulic tools are generally used in heavy infrastructure and industrial projects where the cost of the tools represents a tiny fraction of the overall project cost, but can result in expensive project delays if the tool breaks down. As a result, EPAC’s reputation for reliability allows the company to price its tools at a premium to its competitors. Based on our channel checks, Enerpac is regarded as the McKinsey or Goldman of the hydraulic tool world – it’s the premier go-to option and it’s not worthwhile to try to save a few bucks on a $1,200 cylinder if it runs the risk of breaking down and delaying a multi-million dollar project. Empirically, the top hydraulic tool manufacturers have taken an average 3-5% annual price increase for years.

Closest peer to Enerpac is SPX FLOW, which sells tools under the “Power Team” brand. Power Team is #2 in many product categories after Enerpac and these two companies have operated in a relatively stable oligopolistic environment for decades. The distant #3 is BVA Hydraulics (owned by Taiwanese company SFT Corp) – they are known as being the low cost option, often priced at a 20%+ discount to Enerpac / Power Team’s products. Over the last 20 years since its founding, despite being meaningfully cheaper than Enerpac and Power Team, BVA has struggled to gain meaningful market share (still <10%).

CEO Paul Sternlieb’s Background and 80/20 Business Improvement Model

CEO Paul Sternlieb was appointed in October 2021 and launched an 80/20 business improvement plan called “ASCEND” that focuses on catalyzing organic growth and margin expansion. This 80/20 program is an application of the Pareto principle in the context of industrial manufacturing and takes teachings from the Danaher Business System, ITW Business Model, and related business optimization strategies to focus on identifying and reinvesting in the “20%” of the business that drives “80%” of the profitability. Some examples of key operational initiatives include:

• Product rationalization – conducting a holistic review of all products sold, systematically allocating all expenses (including things often overlooked like SG&A and the time/attention of the sales staff), and cutting out SKUs that do not generate returns that exceed the company’s cost of capital.
• Tactical value-based pricing and margin enforcement.
• Simplifying the business through footprint optimization (e.g. shutting down underutilized facilities, consolidating production, and streamlining logistics).
• Consolidating global sourcing & procurement.

None of these concepts are entirely novel, but it takes a disciplined and experienced management team to properly execute them. The successful cases we come across generally fit these key criteria:

• Core business is durable with a defensible moat.
• Industrial / manufacturing companies with analyzable processes that can apply the 80/20 business optimization tools.
• New management that had a long tenure at an organization with a strong 80/20 and continuous improvement culture and has early success executing the business optimization playbook in their new role.
• Once the business has harvested the early benefits of the 80/20 optimizations, there’s an opportunity to accretively deploy capital into M&A and apply those same 80/20 optimizations to the acquired businesses, effectively becoming a roll-up / tuck-in acquisition platform.

This is the playbook used by many of the successful multi-industrial compounders like Danaher, TransDigm, etc. We believe Enerpac fits all of these criteria and Paul is now effectively drawing on his experience from Danaher and ITW to run this 80/20 business improvement plan at EPAC.

Aside from the previously mentioned and well known ITW, Danaher, Graco, TransDigm, and IDEX, other companies with similar success from 80/20 business transformations that we have followed in the past include Modine (MOD), ESAB (ESAB), Federal Signal (FSS), and Gibraltar (ROCK).

Why Opportunity Exists

• Lack of institutional awareness – after changing its name from “Actuant Corporation” upon divesting its Engineered Components segment, Enerpac lost all of its sell-side analyst coverage. CL King picked up coverage in October 2023 and the company is beginning an aggressive investor outreach program. We believe there are other sell-side analysts who could pick up coverage and some of them have been asking questions on quarterly calls. Enerpac is set to become a regular investment banking client as they look to make acquisitions – this is likely to spur more interest in picking up coverage.
• Transition from legacy shareholder base – as mentioned earlier, the former Actuant Corporation had burned a lot of investors. Over the last year, there have been several top 10 holders of the stock that have exited their positions after holding their investment since ~2015. Our conversations with folks in the investor community reveal that many of the analysts that initiated these positions in EPAC at these firms have since left, and the selling is largely driven by natural portfolio turnover rather than a loss in conviction in the new Management team by these legacy shareholders.
• Skepticism of recent margin expansion – folks that are unfamiliar with the powerful impact of an 80/20 operational transformation may look at Enerpac’s financials and assume that the significant margin improvement could be a signal of temporary overearning due to short-term tailwinds. With every quarter that passes and every incremental earnings report that shows the stability of these structurally higher margins, we believe this concern will fade.
• Doesn’t screen well – if you pull up this company’s financials on Bloomberg, it may look like a company that hasn’t grown topline much over the last couple years. This is largely due to (i) divestitures that are obfuscating organic growth, and (ii) 80/20 product rationalizations that result in walking away from unprofitable business, which can result in loss of revenue even though it improves EBITDA. In reality, organic growth on EPAC’s core business has been in the 4-6% range annually over the last couple years (even with the SKU rationalization headwind), driven by both pricing and volumes.
• Misunderstanding of “Oil & Gas” end market disclosure – in the latest quarter, EPAC disclosed a breakdown of its end markets, and showed that ~27% came from “Oil & Gas / Petrochemical”. Some analysts we spoke with looked at this disclosure and assumed it meant EPAC’s sales were levered to upstream production and oil rig counts, and therefore highly cyclical. In reality, Enerpac’s tools are primarily used for maintenance and repairs on refineries and chemical plants, and demand is therefore much less cyclical than the end-market labeling may suggest. The CEO explains this nuance during calls and the company updated the language to “Refining / Petrochemical” in their latest investor presentation.
• Under-optimized capital structure and no significant M&A… yet – Enerpac has a cash heavy, debt-light balance sheet (0.6x net leverage / 1.6x gross leverage) and management has made clear their intention to use that dry powder on disciplined M&A and further share repurchases. Enerpac hired a head of M&A from Trane in mid-2023 to focus on their deal pipeline and we expect the company to announce its first significant acquisition this year. A $200mm acquisition at 10x EBITDA could increase EPS over 10% and leave further EPS accretion upside in future years as 80/20 is applied to the acquired operations. Enerpac can also unlock revenue synergies by leveraging its existing distribution network to increase exposure and drive improved volume throughput for its acquired businesses.
  

Financial Highlights and Valuation

The Company has an August fiscal year end. As of the date of this write-up, EPAC’s latest report was for the Q1 ended Nov 2023 and is set to report results for Q2 ended Feb 2024, on March 20, 2024 after market close.

We believe the company can grow organically at ~7% annually – this is in line with Management’s guided long-term 6-7% organic growth target. We build up to this growth target through the following components:

• 1% general overall industrial growth – industrial activity has historically grown at ~0.5-1.5% CAGR when evaluating various periods of time over the last several decades.
• 1.5%-2% idiosyncratic price actions – we believe this is conservative relative to the 3-5% price hikes that the hydraulic tool manufacturers have taken annually historically.
• 1.5%-2% – incremental impact of high-growth end markets, including infrastructure, wind, rail, and industrial MRO (maintenance, repair, and operations). I’ll explain these in greater detail below.
• 1% – digital & e-commerce penetration. Currently less than 10% of revenues are from e-commerce. Increasing e-commerce sales improves average realized selling price as EPAC disintermediates distributors on the sale.
• 0.5%-1% – geographic expansion to under-penetrated markets in APAC region (mostly Australia).
• 0.5%-1% – new products, including battery-operated tools that have lightweighting and convenience benefits, as well as tool upgrades that have a lower cost-of-ownership.

Key end markets that Management is targeting for outsized growth are infrastructure, wind, rail, and industrial MRO. The Infrastructure Investment and Jobs Act (IIJA) passed in Nov 2021 and the Inflation Reduction Act (IRA) passed in Aug 2022 still have ~$600bn+ allocated to key EPAC end markets that have yet to be spent, according to the latest data we have seen as of October 2023. We believe that this federal stimulus will provide a gradual but steady tailwind for years to come.

Key assumptions that go into our Base Case financial projections and key takeaways include:

• Organic growth at ~7% annually.
• Management’s 80/20 improvement plan along with incremental volumes lifts EBITDA margins from ~25% currently to ~28% by 2028.
• Free cash flow largely deployed into M&A at ~10x pre-synergy and ~8x post-synergy EV/EBITDA multiples using a target 2.0x net leverage.
• Annual CapEx at ~2.5% of revenues – this is in line with Management’s guidance of ~2-4%.
• Putting this all together gets us to ~$4.20 of FCF per share in 2028 vs. ~$1.70 currently. This represents annual FCF per share and EPS growth of mid-to-high 20s% per year over the next several years.

For valuation, we think it’s informative to look at some comps:

• Enerpac’s closest peer, SPX FLOW (which owns the Power Team brand discussed earlier in the write-up), was acquired by Lone Star in 2022 at ~18.1x LTM EBITDA and ~15.3x consensus FY1 EBITDA. It’s important to mention that SPX FLOW also had other lower-quality business lines in addition to their hydraulic tools business, so it can be inferred that the multiple attributable to the higher-quality hydraulic tools business may have been even higher. We think this transaction is the best indicator of value because SPX FLOW is by far the best comp in terms of the products, market position, as well as the size of the company.
• Enerpac trades at a meaningful discount to industrial peers with comparable EBITDA margins and ROICs. Although no other industrial company is a perfect comp to Enerpac, industrial peers with similar ROICs and EBITDA margins include ITW, ZWS, PH, ETN, AOS, and AME. All of these peers trade in the range of 19x-27x P/E and 14x-18x EV/EBITDA.
• An important caveat is that a lot of these peers are much larger than Enerpac, so perhaps a small-cap size discount is warranted. But on the other hand, Enerpac’s smaller size allows them to find more accretive acquisitions at better ROICs that can enable faster EPS growth than the larger peers, so there are pros and cons to EPAC’s size.

Ultimately, we are valuing Enerpac at a 20x forward P/E, which is roughly equivalent to 14x EV/EBITDA. We believe this multiple is justified given (i) EPAC’s attractive and defensible 25%+ mid-cycle ROIC, (ii) incredibly disciplined Management team that has already successfully raised margins from ~14% to ~25% and has more room to go, (iii) attractive cash flow redeployment opportunities through M&A, (iv) ability to grow EPS and FCF per share at mid-to-high 20s% annually for multiple years, and (v) transaction precedents and public comps at much higher multiples.

Applying this 20x forward P/E (~14x EV/EBITDA) multiple to our 2028E estimates gets us to a target price of ~$80-90 per share over 4-5 years vs. ~$34.50 per share currently. This translates to a ~2.4x MOIC and mid-to-high 20s% IRR.

Risks and Mitigants

• Some of Enerpac’s end markets are cyclical and may face volume declines in a recession.
  • Mitigant: EPAC has historically been able to generate positive FCF during recessions. Its safe balance sheet and management’s slate of self-help initiatives can further reduce the risk of permanent capital impairment. During COVID, most of the revenue decline was due to paralyzed supply chains rather than a drop-off in demand.
• There is some uncertainty around the pace of electrification of hydraulic tools, and there may be some new entrants that focus on battery-powered tools.
  • Mitigant: EPAC is actively electrifying parts of their product portfolio and is already expanding their technology capabilities both through R&D and acquisitions.
• Supply chain disruptions – EPAC has an international supply chain and sales were more negatively impacted during COVID by a lack of availability of components than a decline in demand.
  • Mitigant: Since COVID, Management has implemented a global footprint rationalization that resulted in a sale leaseback of the manufacturing facility in China, as well as diversifying the Company’s production lines. Management claims the supply chain is now more resilient and we have reason to believe them, but it’s difficult to test or know for sure unless the world shuts down again.

Disclosures

We are long shares of EPAC and may trade or make investment decisions that are inconsistent with the views expressed. We are not obligated to update or revise any information presented herein.

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Catalyst

• Continued earnings and FCF growth – earnings releases that show sustainable EBITDA margins in the mid-20s% along with strong organic growth, as guided by Management
• Increasing investor visibility as the company picks up more sell-side coverage
• Accretively deploy capital into M&A at attractive multiples, taking advantage of the company’s currently under-optimized balance sheet