Description

FLOW INTERNATIONAL (NASDAQ: FLOW)

At the current price of approximately $2 per share, we believe that there is little downside risk to an investment in FLOW with the potential for greater than 300% appreciation by fiscal YE 2010 (April 2010).  Today’s total enterprise value represents just 5x the ebitda associated with currently identified FLOW cost reductions, OMAX cost synergies (relating to a recent acquisition discussed below), and D&A (approximately $23 million in total for all these areas).  This gives no value for the $27 million of operating income related to core operations on a trailing twelve month basis, significant NOLs, $2 million minority investment in Dardi, and upside to the OMAX deal related to revenue and cost savings.  $7 per share or 350% upside would equate to 10x 2010E free cash flow or 6.5x EV/EBITDA. 

 

Flow International engages in designing, developing, manufacturing, marketing, installing, and servicing ultrahigh-pressure waterjet technology. Its ultrahigh-pressure water pumps generate pressures from 40k to approximately 87k pounds per square inch (psi), and power waterjet systems that are used to cut and clean materials.  The company provides waterjet cutting and industrial cleaning systems for various industries, including aerospace, automotive, defense, semiconductors, disposable products, food, glass, paper slitting and trimming, sign, metal cutting, stone and tile cutting, marble, job shop, and industrial cleaning. It has operations in North America, Europe, South America, and the Asia-Pacific. The company was founded in 1974 and is headquartered in Kent, Washington.

 

Investment Positives

·         Market Leader in an attractive and growing niche.  Dominant provider of a patent protected niche product that will likely be acquired by a larger manufacturing tool company in the next 2-3 years.  Deal multiples are typically high single digit ebitda multiples and close to 20x FCF.  Based on 2010 estimates, a deal valuation represents over 500% upside.  Waterjets as a category are displacing alternative cutting methods and currently penetrate less than 20% of the addressable market in the Americas, 15% of Europe, and 5% of Asia.  FLOW is the global leader in the waterjet niche – invented the category in 1980, first to introduce 60k psi in 1998, and first to introduce 87k psi in 2006 which remains unmatched to date.  40% of the business is somewhat recession resistant, relating to high margin consumables and resilient aerospace backlog.

 

·         New CEO.  Charley Brown joined FLOW in July 2007 following a successful executive management career at larger diversified industrial companies where he was instrumental in integrating acquisitions and driving growth and operational improvements.   He was most recently President and COO of the Tools Group at Pentair following senior positions at Masco and Black & Decker.  Charley is transforming FLOW from a manufacturing, marketing, and product positioning perspective – all of which he believes can drive 10% revenue growth and 20% operating income growth in a normal end market environment.  Key areas of opportunity include segmenting the product portfolio, geographic expansion, lean manufacturing, sourcing improvement, streamlining R&D, and manufacturing plan rationalization.  Since Charley became CEO, operating margins have improved over 400 bps with improvements driven primarily below the gross margin line.

 

·         Transformative Acquisition of OMAX.  By February of 2009, FLOW is expected to close on the acquisition of OMAX, its largest competitor.  The combined company will have over 90% market share in the US and over 60% market share on a global basis.  The two companies do compete, but FLOW is more successful at the high end and OMAX is more successful in the economy segment.  Moreover, the two have complementary sales channels (FLOW direct vs. OMAX indirect).  Finally, the acquisition settles significant and long-standing litigation between the two companies and the combined company will own key industry patents. 

 

Attributing $26 million to the litigation and including cost synergies of $10 million, FLOW paid ~3.75x ebitda for OMAX before the earnout.  The $10 million in currently identified cost savings represent less than 4% of the combined company’s cost basis and the company has yet to outline any revenue synergies.  Given that the two companies are based across the street from one another we believe that there is upside to the cost synergy number (e.g., OMAX’s lease on its one plant is up in 16 months and FLOW has sufficient excess capacity in its nearby Kent plant to fully absorb OMAX’s manufacturing operations).  Moreover, given that the combined company will have dominant market share, we believe price increases are likely.  As a result, synergies may be double what the company has outlined (an incremental $10 million at 5x would equal another $1.25 of upside or >60% of the current market value of the company).  Finally, the combined company will basically require the same capex as FLOW does on a standalone basis and provide working capital and tax benefits that will drive significant free cash flow leverage.

 

We firmly believe the company will come out of this economic downturn a much stronger and better positioned company across the board.  On a combined basis and in a recovering end market environment we believe there is close to $1 in free cash flow potential and $60 million in ebitda.  At reasonable multiples that would place the equity value of FLOW at over $10 per share.

 

·         Broad-based Insider Buying and Incentives Tied to EBIT and Share Price.  In recent months, we have seen broad-based insider buying at FLOW despite the difficult economic environment.  Several members of the board and senior management have bought shares.  Charley Brown has bought ~$250K in common stock on the open market and his incentive comp is closely linked to operating income improvements.  Moreover, key OMAX executives are motivated by an earn out which they do not earn a penny on until FLOW’s stock price exceeds $7 per share with the maximum earn out if FLOW’s stock reaches $14 per share within 3 years after closing.  The minimum payment of the earn-out is $5 million if the stock price exceeds $7 with the maximum $52 million if the stock exceeds $14 (straight-line interpolation).

 

·         Resiliency During a Recession.  Approximately 40% of FLOW’s revenue come from parts (which are still growing through the current recession and grew through the last recession) and dependable aerospace backlog related to the Airbus A380 program (not volume sensitive as the current backlog of waterjets are required to meet the manufacturing of the early order book).  This 40% of the business carries higher combined gross margins (estimated ~60%).  Moreover, in the Standard Systems Segment (60% of revenues) 90% of gross margins are variable providing minimal gross margin erosion as volume declines.  Management expects gross margins to be stable in the 40-42% range even during a severe recession.  Moreover, 25% of current sales and marketing expense is commission related and there is some variability in G&A and R&D.  In short, 40% of revenue and 50%+ of gross profitability is recession resistant and 70% of the cost structure is truly variable, providing a further buffer to the downside.

 

 

Investment Community Concerns (With Mitigating Factors)

·         60% of the business is system sales.  These sales have little visibility and are extremely sensitive to worldwide GDP.  This is should be mitigated by the following: (1) waterjets have low penetration and FLOW did not benefit from explosive industrial growth in Asia or Eastern Europe during this last cycle (Asian scandal and no Eastern European presence until late); (2) 87K, which is higher priced, is still under-penetrated; (3) potential OMAX revenue synergies; (4) customer/industry diversity; (5) likely beneficiary of Obama stimulus package and significant commodity cost declines.

 

·         CFO Departure.  Doug Fletcher left as CFO in November 2008.  The investment community worry is that the company will not capture synergy opportunities and that Doug left because of weakness in the business.  This should be mitigated by the following: (1) FLOW was quick to hire an experienced interim CFO; (2) Doug was not responsible for synergies; (3) Charley has a track record of successfully integrating acquisitions; (4) Doug left FLOW for a more lucrative pay package with a private equity funded company – a key part of the incentive package was an upfront cash bonus (he has been under financial duress) and upside in an IPO

 

·         FLOW is Levering up to Buy OMAX at the Wrong Time.  The investment community seems worried that FLOW took a balance sheet with net cash and has levered itself up at the wrong time to buy OMAX.  Moreover, financials on Omax from the S-4 might lead one to believe that it is a deteriorating margin business.  Mitigating factors are the following: (1) 20 million of debt pay-down in year one solely from working capital reductions and tax shields related to the transaction that bring gross debt to TTM ebitda to 1.5x (well under the 3x covenant that steps down to 2.5x after 5 quarters); (2) cost synergies plus D&A plus cost savings being realized at FLOW irrespective of the deal basically equate to the minimum 25 million ebitda covenant; (3) based on our estimates, the combined company could withstand a massive drop in both its systems business and/or its consumables business and still be well within the covenants; (4) OMAX margin deterioration is easily fixable as it completely relates to investments in sales force, marketing and R&D to compete more directly with FLOW at the high end and legal costs which now go away.

Catalyst

1). Closing of OMAX deal, synergies start to flow through and exceed expectations
2). New CEO continues to transform the company and significantly improve product positioning and margins
3). Waterjet as a category proves more resilient than expected in an economic downturn and penetrate new market areas in an economic downturn
4). Potential acquisition of FLOW