Description

I believe with some modest financial engineering, you can buy a great company for 9x earnings, or pair it against a vastly inferior company at a higher valuation. Enersys (ENS) is the world’s largest manufacturer of industrial lead-acid batteries. Its batteries are used as reserve power for telecomm systems, uninterruptible power supplies, and utilities (reserve power division, 45% of sales), as well as to power electric forklifts (motive power division, 55% of sales). These markets grow slightly in excess of GDP, though last quarter the company grew 8% on a like-for-like basis, with 17% growth in motive (adjusting for 7% fewer days vs the prior year’s quarter and stripping out forex) and reserve power down slightly. Motive is a better end market, helped by the growth of international trade with the accompanying need for material-handling equipment and the secular shift from gas-powered to electric forklifts, as well as the relative lack of competition from Chinese manufacturers due to higher transportation costs than reserve power batteries.

On its face, ENS does not seem compelling from a valuation perspective. Enterprise value is $1 billion and 2005 EBIT is $95m; eps are roughly $1 on a $14 stock. However, I believe there are two interesting ways to unlock the true valuation potential of the company. Disclosure: I currently have both of these trades on.

The first way to invest in ENS is in tandem with Ivernia (IVW.TO)—please refer to the “idea of the week” prior VIC writeup in IVW from last month. Reading through the idea, it is apparent that the primary risk of owning IVW (aside from the potential of fraud or mine collapse) is that the price of lead will collapse. Fortunately, in a precisely symmetrical manner, the primary risk of owning ENS is that the price of lead will increase dramatically. The increase in the lead price from around $.20/lb in 1q04 to over $.50/lb in 1q05 was responsible for a lot of the financial carnage at many of the battery makers, including Enersys, Exide, and C&D Technologies, as lead is the single biggest element in their cost structure.

Ivernia is a Canadian company with a single low-cost Australian mine. Their cash costs for 220 million pounds of annual production are around $.20/pound (going to $.15/pound after some capex is put in), which is in the lowest quartile of world production. It is also an extremely simple company, such that operating profit equals (lead cost - .20) x 220m pounds – $3m overhead and capex. Owning Ivernia in conjunction with Enersys (in a 2:1 ratio, as ENS consumes around 440 million pounds of lead annually, 2x IVW’s production) gives a vertically integrated battery producer that has no net exposure to the lead price, and is trading at 6.3x EBIT and 8.7x earnings. I cannot remember the last industry-leading growth industrial company I have looked at that trades at this valuation.

The other option is a more traditional pair trade. C&D Technologies (CHP) is also an industrial battery manufacturer. However, it is an inferior company to ENS in many ways, namely:

1) Most of its industrial battery business is reserve power, which is a much slower growth business than motive. CHP’s motive business loses money. ENS is gaining share in motive while CHP is losing it.

2) It has ~25% of its business coming from power electronics, which are basically AC/DC and DC/DC converters. As you might imagine, this is an extremely commoditized business with significant pricing pressure, a fragmented competitive landscape, and tepid growth. This business loses money and needs to be restructured.

3) CHP’s manufacturing footprint is destined for restructuring. Their plants are old and inefficient (too small), concentrated in the US, and have unionized labor. For this reason, when compared with ENS’s optimized manufacturing footprint, CHP has a structural margin disadvantage to ENS to the tune of 5-7%. By my calculations, 20% of ENS’s capacity can be regarded as inefficient due to the size or location of the factory, versus 40% of CHP’s.

4) More generally, ENS’s management is of the “Kaizen” school, constantly removing costs from the business, while CHP’s is of the “hope things get better and then take a big charge” style. This may change with CHP’s new CEO, but it is too early to tell.

CHP trades at a slightly lower revenue multiple than ENS and has slightly less debt. However, the cost differential is such that there for these companies to trade at the same EBIT multiple, margins would have to reach incredible (read: impossible) heights. It is my assertion that under any lead price or economic scenario, ENS will trade at a lower EBIT and EPS multiple than CHP, despite being an enormously better company in almost every respect. In addition, ENS should show better cash conversion, due to its superior management and rationalized manufacturing base (with capex < depreciation). There is a real risk that CHP will enter financial distress if lead prices resume their upward climb (they have already renegotiated covenants earlier this year).

Risks
The risks as I see them are:
1) CHP manages to restructure its power electronics business, in conjunction with the industry returning to rational behavior. If you believe this is possible, or that commodity electronics products are a good industry, consider owning ATSN or PWER to hedge this risk.
2) ENS installs an ERP system and the usual issues arise. Management has assured me that this will be a 5 year process or more—ie, no rushed installation. But you know how it can be…
3) Something happens at Ivernia’s mine that disrupts production or increases costs

Catalysts
ENS was recently downgraded by Bank of America on 7/29 for valuation reasons, ironic because CHP trades at an even higher valuation. They also cited lead costs as a primary risk. Given the 10% drop in ENS’s price versus the 2% drop in CHP’s price, I would expect either a CHP downgrade as well or an ENS upgrade as the fundamentals play themselves out.

ENS also reports earnings on August 18th.


Pro-Forma ENS/IVW financials
enersys +
enersys ivernia 2x ivernia
ebit at .45 lead 95.0 52.0 199.0
interest 24.0 (1.0) 22.0
pre-tax 177.0
tax at 35% 62.0
net income 115.1

market cap 656.3 174.6 1,005.4
p/e 8.7

enterprise value 1,013 116 1,245
tev/ebit 6.3

ENS/CHP comparison
enersys c&d tech
ENS CHP
price $ 13.95 $ 10.25
basic shares 46.2
dilute shares 46.2 25.4
mkt cap 644.5 260.4

cash 15.0 22.0
debt 372.0 135.0
minority interest - 10.0
net debt 357.0 123.0
tev 1,001.5 383.4

04 revenues 1,200.0 415.0
tev/revs 0.83 0.92
gross margin 23.6% 16.1%
ebit margin 7.4% 0.0%

C1q05 revs 285.6 122.8
tev/revs 0.88 0.78
gross margin 23.5% 17.8%
ebit margin 6.3% 1.0%

2005e EPS 0.95 0.14
x eps 14.7 73.2

2006e EPS 1.09 0.54
x eps 12.8 19.0

Catalyst

ENS was recently downgraded by Bank of America on 7/29 for valuation reasons, ironic because CHP trades at an even higher valuation. They also cited lead costs as a primary risk. Given the 10% drop in ENS’s price versus the 2% drop in CHP’s price, I would expect either a CHP downgrade as well or an ENS upgrade as the fundamentals play themselves out.

ENS also reports earnings on August 18th.