Description

Investment Summary

Momentum Group (MMGRB or the Company) is an underfollowed ~$270mm market cap Nordic distributor. Due to a recent pull back in the stock price largely caused by macroeconomic uncertainty, shares in this attractive niche business can be purchased for ~10x Fwd FCF (with limited financial leverage). There is also meaningful upside to future earnings due to in-progress margin improvement initiatives and the Company’s active and highly accretive M&A program. The combination of a low starting valuation and continued earnings growth should lead to a mid-teens to mid-20’s IRRs over the next 3-4 years. The ultimate outcome will largely depend on the pace of acquisitions.

Historical Background

There are several companies that can trace their roots back to the Swedish industrial conglomerate Bergman & Beving. Over multiple decades, these businesses have all been backed and supported by two families with super voting rights, the Hedelius family and the Borjesson family (the former CEO of Bergman & Beving). These long-term oriented families have helped create incentives and a group culture that has significantly rewarded patient shareholders.

Momentum Group was recently spun out of Bergman & Beving in June 2017 and represents the third time a niche distributor has been spun out from the group (the remaining business was then renamed B&B Tools and primarily manufacturers industrial tools). The prior two distribution spinoffs, Addtech and Lagercrantz, continue to be publicly traded and have both gone on to do exceptionally well post-spin. Both companies were spun-off in 2001 with Addtech compounding at a ~25% TSR (46x MOIC) and Lagercrantz at ~21% TSR (~27.5x). Both businesses have highly decentralized operating structures, pursue attractively priced M&A as part of their growth strategy, and have significantly improved their margin structures in the years after their spin-offs. This margin improvement was primarily achieved by methodically focusing on higher margin acquisition targets and by adding higher gross margin proprietary products. As a result, Addtech has increased its operating margins from 5% in 2001 to 10.2% in 2018 and Lagercrantz has improved its margins from 5% to over 12%.

Lagercrantz Gross Margin Expansion

Lagercrantz mix shift to proprietary products

As the underlying quality of these two businesses improved, their trading multiples expanded in tandem creating a classic “Davis Double Play” investment.

I expect Momentum Group to follow a very similar playbook to its predecessor spin-offs based on its clearly defined financial targets. These financial targets are nearly identical to those still used by Addtech and Lagercrantz today:

• Annual EBIT Growth of 15% over the cycle
• P/WC of 45%+ (Operating profit to Net Working Capital ratio)
• ROE of 20%+
• Dividend payout ratio of 30-50%
• Leverage typically between 1-2x EBITDA (but will temporarily exceed for certain M&A)

Given the similar business models to its peers and all the same people involved, I do not expect Momentum Group to significantly “change its stripes”. The long tenured CEO of Lagercrantz, Jorgen Wigh, actually serves as the Chairman of Momentum Group. The current CFO and head of M&A, Niklas Enmark, was also the CFO for several years at Lagercrantz and was previously the CFO at the private industrial conglomerate Axel Johnson International (which follows a similar playbook).

Just recently (February 22, 2019), the Axel Johnson family investment company, Nordstjernan, purchased a 15% voting stake in the Company. These shares were purchased from the Borjesson family at what appears to be a substantial premium to the market (>15% premium or $102.50 per share). Nordstjernan has significant experience in the industrial manufacturing space and takes an active role with its companies (and is likely to receive board representation at the upcoming annual meeting). Nordstjernan typically holds less than 20 investments and has compounded assets at 15% from 1999 to 2017 (vs. 8% for the Stockholm Stock Exchange index). Importantly, Nordstjernan already holds several existing industrial investments that are similar to MMGRB including privately held Axel Johnson International as well as publicly traded Swedol (68% ownership) and Lifco (another active M&A consolidator). Swedol is actually one of MMGRB’s close competitors in the Tools space, but there are no plans to combine the two businesses in the immediate future. If they do ultimately combine, there will be substantial synergies to share between the two companies due to likely footprint rationalization. Given Swedol’s slightly larger size, I anticipate Momentum would be the company that is acquired at a premium.

After shares increased by over 75% in the first 12-14 months after the spin-off , MMGRB shares have recently given up most of their gains (spin priced at $67.25 and ended the first day trading at $74). I believe this is due to general macro economic worries in the Nordics and concerns about the impact on industrial activity if the U.S. places punitive tariffs on European auto exports. In Q4 2018, the majority of senior management (CEO, CFO, and the heads of several divisions) purchased shares in the open market in the $80-84 per share range.

Business Overview

MMGRB is a Nordic industrial distributor with operations primarily in Sweden, Norway, and Finland. Products sold include industrial tools, personal protective and workwear equipment, consumables, components, and services. These include Maintenance, Repair, and Operations (MRO) parts such as bearings, seals, fasteners, lubricants, and transmissions. The closest analogs in the United States include WW Grainger, MSC Industrial Direct, and Fastenal. None of these U.S. peers have a significant presence in the Nordic markets.

Momentum Group operates using a highly decentralized model with each of its businesses functioning autonomously. The CEO, Ulf Lilius, is a big believer in a decentralized model and there are currently only 7 employees at corporate headquarters. Each business is responsible for its own P&L and is given discretion around how they plan to achieve the 45% P/WC target (part of compensation is based on this ratio). Local autonomy makes sense for distributors selling different types of products and services, because they must target higher (or lower) operating margins depending to the velocity of inventory turnover.

While there are multiple business units spread across both products and regions, the Company reports results between two primary segments: 1) Tools & Consumables and 2) Components and Services. The Tools and Consumables segment is the largest portion of the business in terms of sales (~75%), but accounts for only 55% of profits due to its low profitability (currently generates 3.7% operating margins).

YTD FY2019 Sales and Profits by Segment

The low profitability of the Tools & Consumables segment was the primary reason for the spin-off. Prior to the spin, this division was pressured to sell products manufactured by its parent company B&B Tools at either uneconomic prices or to favor its captive products over better suited 3rd party products. Momentum’s CEO, Ulf Lilius, also believed housing the captive distribution functions and manufacturing business under one roof did not create a culture of accountability. For these reasons he pushed to split the company apart after taking over as CEO.

Now that it has seperated from B&B Tools, Momentum Group can sell whatever product is best suited for its customers at a market driven price point. Additionally, there are several cost saving measures already completed or in motion that will improve profitability including:  re-negotiating supply contracts on an arm's length basis, reducing labor costs, utilizing value-based pricing, pruning low margin product lines and customers, rationalizing the branch network, increasing the proportion of direct and ecommerce sales, and moving inventory to several new centralized warehouses to improve NWC efficiency and logistic costs. The Tools & Consumables segment already generates healthy gross margins of ~36% so I believe there are no structural reasons their operating margins can’t approach peers levels between 5-12%. Momentum Group also generated operating margins in excess of 5% prior to the financial crisis and some of their local Tools branches already exceed their 45% P/WC target.

The second reporting division, Components and Services represents ~25% of sales but nearly 45% of total operating profits. This segment primarily consists of the business known as Momentum Industrial (which I’d consider the crown jewel of the Company). Momentum Industrial sells industrial components such as bearings, pumps, and lubricants that are mission critical to its customers daily operations. These products must often be delivered within hours and often require technical expertise and services. As a result, operating margins are consistently healthy in this division at ~12%. The current MMGRB CEO first started working in this division and was responsible for improving profits from ~3% in 2002 when he took over to ~12% today.

Profitability Targets

While I don’t expect MMGRB to reach all of its profitability targets immediately, the below figures show what earnings power could look like if those targets are achieved. The ROE target of 20% is already within reach but the P/WC target will require either significantly faster working capital turns or much higher profitability as shown in the below chart.

Implied valuation depending on how MMGRB achieves its 45% P/WC target:

No M&A Forecast and Expected Returns

While I expect Momentum group to complete additional acquisitions in the coming years, the below standalone financial forecast highlights the growth opportunity at the core business from margin improvements. I believe the Company can reach a ~30% P/WC target by Mar-2023 (vs. a 45% stated target). Because of the cash generated by the business and only a ~40% dividend payout ratio, the company de-levers rapidly to a net cash position over the next two years. Without further M&A, the reported ROE should fall from 18% to 15% by 2023 due to excess retained capital.

Even without further M&A, I believe mid-teens returns are achievable over the next 3 years.

M&A Program

Like its sister companies, Momentum Group is expected to be an active M&A consolidator. The Company targets niche distribution businesses that ideally have a margin accretive profile, a meaningful services component, and contribute new product lines, geographies, or proprietary brands.  MMGRB has 15-20% market share in its addressable markets with its main competitors Ahlsell, Swedol, and Wurth possessing similar market shares of around 10-30% depending on the specific country. While there are few very large targets available, there are still numerous tuck-in acquisitions available.

In the last year the Company has already completed 5 tuck-in acquisitions, split between the Tools & Consumables segment and the Components & Services segment. Going forward, Management expects the majority of acquisitions to take place in the Components & Services segment since it is already near its target profitability and has the management bandwidth to actively pursue M&A. I also don’t anticipate much additional M&A in the Tools segment because it is structurally less attractive in terms of the stated goal of increasing the consolidated margin profile.

Like Lagercrantz and Addtech, MMGRB expects to be highly disciplined with the multiples it pays for acquisitions. Deals are typically completed at MSD to HSD LTM EBITA multiples (management suggests 5-7x EBITA). Management is also unwilling to pay for uncertain future growth. As a result, it will sometimes use earnouts to bridge valuation gaps with the seller. Management does not typically compete in auctions and is clear that if profit maximization is the seller’s goal, there are likely better acquirors.

The largest acquisition completed since the 2017 spin-off was the purchase of Brammer’s MRO division (privately held by Advent International). This acquisition added ~3% to sales growth in FY2019 and ~6% to profits. The Brammer MRO division was acquired at a 0.3x sales and <4x EBITA multiple based on 10-12% operating margins post integration (which was completed last quarter). The below table illustrates how accretive M&A is for the Company. This is due to a combination of these attractive purchase multiples and cheap debt financing in Sweden of less than 3%. This combination allows MMGRB to immediately achieve 20%+ returns on equity capital deployed.

Forecasted Returns Including Future M&A

Momentum should be able to grow earnings in the teens or faster if the Company is able to funnel all its excess cash flow into M&A (other than the 30-50% it distributes via dividends each year). While it will ultimately depend on the dividend payout ratio and ROIC on M&A, the Company should be able to grow FCF ~5-14% annually solely through acquisitions. This even assumes the Company conservatively pays HSD EBITA multiples (in-line to above the high end of Management’s target range). Including forecasted organic EPS growth of ~6-7%, Momentum should be able to easily grow reported earnings faster than 10% in the medium term.

Capital deployment may be lumpy in any single quarter or year. Over time though, results within the ranges presented above should materialize. I have chosen a scenario in the middle of the range to illustrate a 15% earnings CAGR is achievable while simultaneously paying out ~40% of earnings as a dividend (currently a 3.5% dividend yield). Applying a 13x exit multiple to FY2024 EPS would translate into a 25% IRR over the next 4 years. Based on the growth profile of the company in this scenario, I believe at least a 13x Fwd P/E multiple is justified.

Peer Set

The below peer set includes distributors most similar to Momentum Group in terms of product assortment as well as the most acquisitive distributors. Momentum’s “product” peers typically command low teens Fwd P/E multiples while the “M&A focused” peers typically command more premium valuations (high teens to low 20’s Fwd P/E). I would expect MMGRB’s to trade around it’s historical average of 12-13x Fwd P/E until the pace of acquisitions is more fully proven out.

On a relative valuation, I believe a Swedish company with a 10% FCF yield paying out 30-50% in dividends each year while continuing to grow is attractive when compared to Swedish 10-year government debt currently yielding 0.3%.

Risks

• Cyclicality of end markets (industrial, construction and engineering, oil & gas)
• Margins do not improve as anticipated in the Tools & Consumables segment
• Disintermediation in the Tools & Consumables segment from online vendors
• Low share liquidity (~USD$200k 3-Month ADTV) but blocks can be fairly easily sourced
• Due to its ~$270mm market cap, the Company has limited sell-side coverage and could be orphaned if the business does not perform as planned
• Slightly increased reported leverage post IFRS-16 implementation of ~2x (due to operating leases at most distribution facilities) could increase the optical risk profile of the business
• Slow organic growth, especially in the Tools division
• Supplier concentration - B&B Tools sourced products still makes up ~25% of sales; these have been sourced on an arm’s length basis for several years now

Disclaimer: The information contained herein reflects the views of the author as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. The author has an economic interest in the price movement of the securities discussed in this presentation, but the author’s economic interest is subject to change without notice. All information provided in this presentation is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. In addition, there can be no guarantee that any projection, forecast or opinion in this presentation will be realized. All trade names, trademarks, service marks, and logos herein are the property of their respective owners who retain all proprietary rights over their use. This presentation is confidential and may not be reproduced without prior written permission from the author.

Catalyst

• Large deal announced or more frequent pace of M&A
• Continued margin expansion
• Acquisition by larger distributor (Nordic or foreign peer)