Summary Thesis: FLOW (Mkt Cap $170m, ADV $600k) is a high quality, under-managed business that announced it is exploring strategic alternatives
on June 7th, in conjunction with a negative earnings pre-announcement. The pre-announcement provides an attractive entry point and I recommend
purchasing the stock today at $3.50. I think FLOW is worth $4.5 (+30%) to a private equity buyer and $5.60 (+60%) to a strategic buyer. The strategic
process was likely catalyzed by a 13D filed by 5% holder Otter Creek Management on March 27th as well their subsequent proposal to de-classify the board.
The downside is $3.0 (-14%), based on 7x NTM EBITDA or 0.6x NTM Revenue. FLOW also carries no debt and in the absence of a sale, could take
on 1.5x-2x of debt and tender for 15-20% of the shares outstanding.
http://www.sec.gov/Archives/edgar/data/713002/000071300213000013/flow-ex991_20130430xq4prer.htm
Business: FLOW is a machine tool company that manufactures waterjets and associated consumables. A waterjet consists of an ultra high pressure hydraulic
pump that generates a stream of water with pressure up to 94,000 PSI. Pressure is converted to velocity via a tiny jeweled orifice that creates a stream the
thickness of two strands of human hair. Small garnet particles are then introduced to the high velocity water stream to generate abrasive cutting. The water
and garnet exit at nearly four times the speed of sound and are capable of cutting steel over two feet thick.
Customers: Foundry, metal service center, job shops, OEM’s. 2/3 of their customers use waterjets to cut metal.
Competitors: FLOW has 1/3 of the waterjet market. They are fully integrated, in that they make the table, cutting space, pump, software controls.
Their revenue is 3x their nearest competitor. Other companies are Omax (
http://www.omax.com/) who FLOW tried to buy in 2007, got a consent decree
from the FTC in 2008 (combined share would have been 55%) but terminated the deal in May 2009 because of the lack of financing and their inability to
Dardi supplies the tables for its economy segment and FLOW supplies the pumps and controls. FLOW also owns 4.6% of Dardi. Otter Creek’s letter
was profiled in Barron’s 13D section that week and as part of that article, Mitsubishi was mentioned as a potential buyer because they also have a
waterjet division.
Waterjets also compete with laser, plasma, Oxy Acetylene and EDM as alternative cutting technologies. Laser is the lowest cost per to part to cut
thin metal very quickly. As you slow down the required speed and increase the thickness of the metal, waterjets become the most cost
advantageous technology.
Activist History: Third Point owned 13.6% of FLOW in 2007 and tried to convince them to explore a sale at that time when their CEO Stephen Light
resigned suddenly. The market capitalization at that time was >2x of what it is currently. Third Point made an indicative offer (no price) themselves.
The agreement to purchase OMAX later that year effectively served to have Third Point go away. Recently on March 27, Otter Creek filed a 13D/A and
sent a letter to board imploring them to hire an investment bank and explore strategic alternatives.
http://www.sec.gov/Archives/edgar/data/713002/000119312513129323/d513473dex992.htm
Why I like FLOW:
Consumables – $86m of annual revenue (30% of total), at 45% Gross Margins. This is a high quality revenue stream consisting of seals in the pumps,
tubing, hose, orifice, mixing tubes etc. Each part lasts a couple of hours and the demand for them is driven by capacity utilization in the installed base.
Advanced System Sales – $20m of annual revenue (8% of total). Backlog as of January 30th (FQ3 13) was $37m up from $14m the prior quarter.
These high end systems ($7-8m each) are used in aerospace to cut composites (specifically A350 and Boeing 787). I believe the increasing production
rates of these aircraft will provide a tailwind to FLOW for some time to come.
Cost Structure – 1) FLOW spends 20% of its revenue on sales & marketing and 10% on G&A. 2) Both Third Point & Otter Creek criticized
the high costs incurred to remain a public company. 3) FLOW said on their last call that they have excess plant capacity. As recently as March,
they said they have the infrastructure in place to support $300m of revenue vs $250m current run rate. 4) FLOW launched two new products targeted
at the economy segment, Mach 4 and Mach 2 in June 2012. They are still in the early stages of achieving optimal cost efficiency on the manufacturing
and expect 10% GM improvement on these products in FY 2014
Free Cash Flow – At first glance FLOW has generated negligible FCF, i.e. $0.3m in 2011, $8.8m in 2012 and -$1.3m YTD. This poor cash flow has
been caused by working capital. Working Capital consumed $14m in 2011, $14m in 2012 and $20m YTD in FY 2013. It has primarily been a combination
of inventories and receivables. I think this WC consumption is explainable by a) the launch of Mach 2 and Mach 4 in June 2012 b) The ramp in Advanced
System backlog over the last few quarters. Receivables have consumed $7m of WC YTD and FLOW has mentioned in the past that its Advanced customers
traditionally have longer payment terms. I think FLOW can cut its working capital consumption by 50% as its sales mix normalizes,
implying $13-$15m of annual FCF or a 8-9% yield.
Why I think FLOW will be sold:
The board is serious – “The Board of Directors and the management team are committed to further enhancing value for all Flow shareholders,"
continued Mr. Brown. "Over the past few years, we have invested in new products, channels to market and internal systems and have taken other steps to
grow our business and increase margins. With these important building blocks in place, we believe now is an excellent time to explore strategic alternatives
to maximize value for our shareholders”. In my opinion the board telling you now is an “excellent time to explore strategic alternatives” is VERY instructive
and speaks to their confidence in a successful completion. Previously during the Third Point days, their posture was evasive and defensive as articulated in
Third Point’s 13D filings. It is possible, that Otter Creek’s March letter led to inbound interest to FLOW, and the nature of this inbound interest is the basis
for the board’s confidence. In addition, management and the board own 6.4% of the NoSH.
Stephen Light is available – Third Point liked former FLOW CEO Stephen R Light. According to their 13D’s, they started investing in FLOW because of him,
pushed for a sale when he retired suddenly and asked to work with him during their indicative bid for FLOW. He had been CEO of Xerium Technologies (XRM)
and recently retired from there in Feb 2013. Although he is 65 and it is unclear what his plans are, it is noteworthy that an accomplished executive with a
detailed understanding of FLOW is available to work with potential bidders.
Earnings: In FQ3 13 (Q ending Jan 13), FLOW did $67.7m in revenue and $6.3m in EBITDA (9% margin). For many quarters, FLOW has targeted run rating
$75m of revenue and $10m of EBITDA per Q.
“As you can see, we are continuing the march to our next quarterly milestone of $75 million of revenue and $10 million of EBITDA. Our trajectory is consistent
and sound, even in the face of several years of macro-economic variability. Our formula is no secret, continued emphasis on our new products through our dual
distribution channels into diverse end markets all over the world. Our expense profile remains steady at a level to support these significant ambitions. Our profitability
continues to be solid with EBITDA margins at 10% and margin expansion available through operating leverage as we grow to that next milestone. Allow me to illustrate.
Our backlog in the Advanced Segment is at record level, giving us good visibility to $2 million to $3 million more per quarter from this segment in fiscal 2014.
Bridging from Q3, that puts us at about $70 million quarterly. Next, add continued growth in our after-market business based on continued favorable manufacturing trends
and our ever-increasing install base, and you are left with about $3 million to $4 million per quarter of incremental Standard Systems needed to finish the push to
$75 million per quarter. This represents one to two additional machines per week”
FLOW did acknowledge weakness related to sequestration on their March call but still guided to $65m of revenue for FQ4 13 (Q ending April 13).
“Based on our discussions with a good cross section of the US machine tool market, there was a temporary slowdown in machine tool orders during that four to
six week period. We believe it was due to the uncertainty that existed leading up to the sequestration deadline. Our orders slowed during this time frame but are no longer
at the reduced rate. In total, we estimate the US market pause or sort of wind pocket had a short-term effect, probably reducing our Q4 revenue by about $3 million to $4 million,
versus our previous expectations. This includes a dozen or so machines, plus a brief slowdown in North American after-market sales. As I mentioned, we are now back to more
normal order rates. However, this pause in the market means that in Q4 we will probably break our string of record quarters. We like setting new records but we are not concerned.
We anticipate we'll continue to grow on a year-over-year basis in Q4, likely at a rate similar to Q3's 3% range. This brief US wind pocket has not changed
our long-term trajectory or outlook at all”
However on June 7, FLOW said FQ4 13 revenue would be $58m at a 0% EBIT margin and guided to the same revenue for FQ1 14 (Q ending July 13). The unknown for me
and the main risk to the thesis is what caused this earnings miss, why it is expected to persist into FQ1 14 and what the growth trajectory is for the remaining of FY 14.
In their June 7, press release FLOW blamed macro uncertainty but we will have more information on this point when FLOW reports its results by July 15, 2013. I estimate
that the revenue miss was largely driven by the standard segment where revenue probably shrank from $41.9m in FQ3 to ~$32m in FQ4. FLOW had seen $3-4m of this
revenue headwind coming, but they probably underestimated it.
Ilustrative LBO: For FY 14 (Year to April 2014, I estimate $238m of Revenue, -8% y-o-y), which implies 1.7% sequential growth in each quarter from FQ2 14 driven by
some rebound and further adoption of Mach 4 and Mach 2. For FY 14, I estimate $21m of EBITDA (9% margin), pro forma for the recently announced cost saves,
putting the current valuation at 7.8x EBITDA.
My other LBO model assumptions are –
Offer Price - $4.5, +30% (10.1x FY 14 EBITDA)
Leverage – 5x (Debt 50% / Equity 50%)
Exit Multiple – 8.5x
Annual Revenue Growth – 2.5%
Annual Margin Expansion – 1%
Interest Rate – 7%
Tax Rate – 35%
Under this construct, in Year 5, FLOW is doing $262m of revenue (basically back to what it did last year) and still well below the targeted $300m in revenue
and $33m in EBITDA (12.6%) margin. This construct generates a 15% IRR to a LBO sponsor.
Strategic Valuation: FLOW’s first offer for OMAX was 1.6x EV / Sales and its revised offer was 1.13x EV / Sales. At 1.13x EV / Sales,
FLOW would be worth $5.60 (+60%)
Comps: There are no pure play public waterjet comps. Extending the analysis to machine tool companies, there are smaller companies like Hardinge (HDNG),
Gildemeister (GIL GY), Hurco (HURC) and larger ones like ITW and KMT. In addition there are laser companies such as Coherent (COHR) and IPG Photonics (IPGP).
Their current valuations span a range from 0.5x revenue / 5x EBITDA for the smaller companies to 2x revenue / 10x EBITDA for the others
Risks:
The earnings miss was due to serious issues, such as market share losses, order cancellations or prolonged capex slowdown which would make a sale untenable
as well as the current valuation unsustainable. We will have more information by July 15, 2013 and I will update the board.
The sale process is just to placate Otter Creek and the company is not serious about selling nor has any firm buyers.
FLOW is a 0.5x revenue (i.e $2.70 per share, -23%) type business. One could construct an argument that it is a niche market, with no barriers to entry and similar to
HDNG and GIL GY, it will always command a depressed multiple. My belief is that its market share and the versatility of the technology make it a more valuable business
that HDNG or GIL GY and its cost structure provides upside to a financial or strategic buyer.
Reading:
http://waterjets.org/index.php
http://www.wsw.com/webcast/roth27/flow/
http://www.flowwaterjet.com/~/media/pdfs/investor/investor-presentations/Investor-Pres-June2013.ashx
http://www.flowwaterjet.com/~/media/pdfs/investor/investor-presentations/Investor-Pres-March2013.ashx
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.