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Summary: Recent spin-off MFS is an attractive short opportunity with almost 6-to-1 downside / upside based on our current estimates. While we do think MFS has levers to grow margins in the near-term given past mismanagement, we ascribe meaningful execution risk on targets set ahead of the spin given (1) MFS is being run by an inexperienced management team from outside the foodservice equipment industry and (2) MTW faced significant challenges just placing its debt in order to consummate the corporate action and thus had every incentive to be as aggressive as possible with goals or there was a very real chance the spin-off may not have been able to be completed. Even if management executes on its initiatives, we see structural factors ultimately limiting peer-relative margin gains, and think end market growth will ultimately fall short of expectations given still soft public restaurant capex spending outlooks, while the company’s 80/20 initiative to improve margins should also act as a sales headwind for the next few years. MFS touts the business’s strong cash generation capabilities which it will use to de-lever and augment organic growth with M&A, but an expansion of off-balance sheet accounts receivable factoring accounted for over 60% of 2015 reported FCF, and we see meaningful headwinds to cash generation post-spin, including (1) a nearly full A/R factoring facility, (2) higher interest expense from the $1.4bn in debt placed to fund the spin-off, and (3) higher cash taxes, which will negatively impact MFS’s ability to de-lever and ultimately ramp M&A efforts. MFS currently trades at a ~10% discount vs. industry pure-play MIDD, which we think is in the right zip code, but we fundamentally question the 40% expansion in MIDD’s multiple over the past 3 years (vs. +10% for the S&P 500) given similar growth and margin profiles whiles returns on invested capital declined. Our $10.50 price target is based on a 10.0x our 2017E EBITDA (-8% vs. consensus), with our target multiple representing a 1x turn discount vs. MIDD’s historical multiple, which we think is appropriate given the two business’s margin and growth profiles.
Background on the Spin: Prior to its spin-off, MFS was one of two primary business units at MTW. MTW was founded in 1902 as a shipbuilding business, but over time diversified into cranes and refrigeration. In 2008, MTW acquired commercial foodservice OEM Enodis for $2.7bn following a protracted bidding war with ITW, transforming from a small ice machine business into a global commercial foodservice equipment OEM with a full range of cold and hot equipment for commercial kitchens. However, the price it paid was dear, ultimately paying 16x LTM EBITDA (~12x post-synergies) and the timing could not have been worse. To add insult to injury, the company was required to divest Enodis’s ice machine business for competitive reasons as a condition of closing the deal, and sold a business with ~$40mn in EBITDA for $160mn to Warburg Pincus in 1Q2009 (who ultimately re-sold the business 3 years later for $575mn). Since the deal closed, operating results and financial performance has lagged expectations, while execution in the past few years has been particularly disappointing.
In mid-2014, activity fund Relational Investors announced a large position in MTW, and disclosed its intention to push for a spin-off of the foodservice business. MTW’s Board initially rejected the proposal, but after Icahn Enterprises also took a large position later in the year, the company ultimately acquiesced to shareholder demands in Jan 2015. Since then, MTW rebuilt the foodservice equipment business’s senior leadership team, with most of the new executives new to the company, in addition to the industry. The company was officially spun-off on March 4th.
Bull Story: Self-Help Deleveraging Opportunity
Since opening at $11.50 in the when-issued market in February, MFS shares have risen 36% as investors have gravitated to what they view as a self-help / deleveraging story with favorable growth tailwinds in its core end markets. After years of being mismanaged by a parent company more interested in building cranes, Bulls expect significant margin growth coming from better execution, better focus on profitable products, headcount reductions, and footprint optimization. Moreover, foodservice industry sales are expected to be strong in the U.S. and throughout of the world, which should support demand for commercial foodservice equipment like the types sold by MFS. While leverage is high at over 5.0x (vs. 1.5x for peer MIDD), Bulls point to limited capital requirements and a historically strong cash flow profile for the business as evidence that the company will quickly delever and get back on the offensive with bolt-on M&A augmenting organic growth. Shares currently trade at a ~10% discount to industry pure-play MIDD, but that gap should close as the company executes and margins improve towards industry leaders.
Margin opportunity is real but execution risk is high and structural factors limit opportunity to narrow gap vs. peers: While MFS does have real opportunities to improve margins via (1) better execution, (2) restructuring, (3) its 80/20 initiatives, and (4) portfolio management, with its $100mn savings target (through the end of 2017) potentially driving over 600bps of margin growth, the reality is that execution risk is high given an inexperienced management team (that came from outside the industry and did not receive the best endorsement from former MTW management ), particularly when you consider the circumstances surrounding when guidance was provided. Leading up to the spin, MFS’s parent company MTW was dealing with a rapid deterioration in its Cranes business, while at the same time, the credit markets were proving increasingly challenging to the point that several analysts asked on MTW’s quarterly call whether it made more sense to postpone or cancel the spin altogether given the environment. Given that level of skepticism / inhospitality, why wouldn’t a management team provide the most aggressive guidance possible in order to get the best terms on its debt and ultimately allow the transaction to proceed? And even if the new management team captures the savings, a key question is how much of the savings fall to the bottom-line. Given the business's chronic sales underperformance vs. industry peers, we think it is reasonable to assume at least some of the restructuring benefits are reinvested to support sales.
Lastly, MFS faces structural challenges which limit its margin potential vis-à-vis peers that we think Bulls are not accounting for. Specifically, MFS’s product mix remains 50% skewed towards the ‘cold-side’ of the business, which generally has less innovation, resulting in structurally slower growth and lower margins than the ‘hot-side’ (35% of MFS sales). For comparison, MIDD's portfolio is 98% hot-side products and Rational is 100% hot (and has dominant market share in its primary product, the combi oven). In addition, MFS runs a centralized operating model, which has resonated well with large, global QSRs who constitute ~50% of sales mix (well above peer MIDD's mix) and generally require OEMs to trade pricing/margins for volume.
Restaurant capex outlook points to challenges reaching 2016 sales guidance: While global foodservice industry sales are expected to grow at a steady clip both domestically and abroad, foodservice equipment sales are much more dependent on restaurant capex spending, which is pointing to a more challenging outlook. Consensus estimates call for restaurant capex to be flat in 2016 and decline 1% in 2017, with the critical QSR end market expected to show the most severe declines (-1% in '16 and -5% in '17), suggesting MFS's guidance may prove challenging. As an added headwind, MFS’s product line simplification and dealer rationalization efforts under its 80/20 initiative is likely to negatively impact sales as it is implemented over the next few years.
Free cash flow story a lot less compelling when you peel back the onion: Ahead of its spin-off, management touted FCF as a % of adjusted EBITDA conversion metrics of ~90% over the past 4 years, but MFS defined FCF as adjusted EBITDA less capex. Using the conventional definition, FCF conversion has averaged ~65%. Moreover, almost 2/3 of 2015 reported FCF was generated through the expansion of off-balance sheet A/R factoring. Without the increase in factoring, FCF would have declined 72% to $50mn in 2015 and the de-leveraging story would look a look less compelling.
Looking forward, MFS has three cash generation headwinds: (1) it only has ~$10mn of incremental receivables factoring capacity remaining; (2) interest expense is set to average $24mn per quarter vs. ~$4mn of quarterly interest income prior to the spin; and (3) cash income taxes are set to converge towards book taxes whereas they were just a fraction of book taxes prior to the spin. Thus, reported FCF should be materially weaker going forward, which impacts how quickly the company can de-lever.
Valuation discount vs. MIDD appears to be appropriate though MIDD’s appropriate multiple remains a ?: Given lack of trading history, I expect most investors to benchmark MFS vs. industry pure-play MIDD. MFS currently trades at a 10-15% discount to MIDD, which is more or less in the right zip code. The key question, however, is whether MIDD’s recent multiple expansion is sustainable. From 2003 – 2012, MIDD traded at an average EV/NTM EBITDA of 10.2x. From 2013 – 2016, MIDD’s trading multiple has expanded 40% (vs. just 10% multiple expansion for the S&P 500 over the same timeframe) to 14.5x despite very similar growth and margin profiles over the two periods and declining returns on invested capital stemming from its investment in residential equipment. MIDD’s multiple expansion has been coincident with its investment in the residential business, suggesting to us that investors are discounting a sharp improvement in residential operations that has thus far proved elusive. Ultimately, we expect MIDD’s valuation to ultimately compress towards historical levels as either the company grows into valuation or investors ultimately lose faith on the residential story.
Estimates / Valuation: In 2016, I estimate organic sales growth of 1%, and pro forma sales growth of -1% vs. guidance of organic growth of 2-4%. On margins, our assumption is that roughly 2/3 of its $50mn of targeted cost savings fall to the bottom line. Our 2017 estimates embed 2% organic sales growth, with 2/3 of its targeted $4-mn in cost savings falling to the bottom line. Net/Net, our 2017 sales and EBITDA estimates are 6% and 8% below consensus, respectively. Our $10.50 price targets assumes a 10.0x multiple on our 2017 EBITDA estimates, with our target multiple ~1x below MIDD’s historical multiple. Assuming MFS delivers in-line with consensus and its discount vs. MIDD narrows to 5%, we estimate an upside risk of $16.50, implying $4.50 of downside vs. $1.50 of upside.
Set-up: As a recent spin-off, MFS does not yet have a significant amount of coverage with only 4 sell-side analysts covering the stock, and quarterly estimates are going to be unreliable at best early-on. We think that MFS is set-up to show solid margin expansion in 1H as it laps Kitchen Care execution challenges (~200bps opportunity), delivers on some cost savings (100-200bps opportunity), and benefits from the KPS sale in 4Q (~25-50bps opportunity) and there is a decent chance the valuation gap vs. MIDD could narrow early on. At this point, we would recommend scaling into the short. In 2H, margin expansion should slow on tougher comps despite the bar getting higher, and investors are likely to realize sales targets are proving too high despite only modest expectations, resulting in lower expectations in 2016 / 2017. With FCF coming in below expectations, leverage reduction progresses more slowly than anticipated, which impacts MFS’s ability to use M&A to augment growth in 2017 now, too. We see MIDD’s valuation gradually compressing as it grows into current levels (or investors lose faith in residential), resulting in multiple compression for MFS as numbers are also going down.
Risk factors: (1) M&A: Given potential spin-off related tax consequences, we see little near-term risk that MFS is acquired. It is also highly likely that Goldman shopped MFS to everyone ahead of the spin given how challenging the environment was heading into the spin-off. As an acquirer, MFS carries too much leverage to make a meaningful deal in the near-term, and MIDD’s recent expansion into Residential says a lot of about the opportunity for M&A to move the needle in commercial foodservice equipment. (2) Execution: If MFS is able to successfully execute a turn-around of the company, improve margins, and re-energize sales which have lagged peers and foodservice industry sales for several years, investors would likely re-evaluate MFS’s investment merits and valuation. We are skeptical on the company’s prospects given prior MTW management likely looked within the industry for new management prior to hiring the present team and were forced to hire the only person who wanted the job when they conducted their executive search. We would be more concerned if they had brought on a senior executive at ITW or MIDD from within the industry. (3) Valuation: MFS will most likely be pegged to MIDD’s valuation for some time while it develops a trading history, gains a larger following. If MIDD’s valuation remains elevated vs. historical levels, it will likely support MFS valuation even as numbers move lower.
Catalyst comes with 2H results as sales guidance becomes increasingly unreachable and margin expansion gains start to slow with more challenging comparisons.
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