Value Investors Club / REGAL BELOIT CORP (RBC)

Description

Unlike many ideas posted to VIC, there is no hidden asset here, value creation through an acquisition (i.e. Rayonier)

or some other unique factor. I think the market is valuing this slow-growing cyclical at too much of a discount

relative to other industrials and less volatile non-cyclicals. I am unable to find many businesses with low-single-digit

growth and a margin improvement story trading at ~11x FCF. Due to an amortization charge that overstates

economic D&A, FCF averaged 138% of net income over the past five years. Therefore, headline PE-ratios are not

reflective of the true trading multiples.

Regal Beloit produces high efficiency motors and power transmission systems. The company is poised to benefit

from trends in energy efficiency and end-market recovery. After several years of negative growth in oil & gas,

mining and agricultural and weak general industrial demand, I believe Regal is poised to show organic growth at

least in line with its 2%-4% guidance and margin improvement from volume and cost savings as its “simplification

strategy” is completed. This growth plus a reasonable valuation sets the stock up for outperformance.

Business Description

Regal manufactures fractional HP motors, blowers, integral HP motors, generators, drives, gearing, bearings,

couplings and other products. The company is split into three segments: Commercial and Industrial Systems

(“C&I”), Climate Solutions (“CS”) and Power Transmission Solutions (“PTS”).

Commercial and Industrial (47% of sales / 36% of EBITDA / 30%-35% incremental margins) produces fractional,

integral and large HP motors and (variable speed) controls, blowers, generators, starters, relays, variable frequency

drives and controls, alternators, switching gear and integrated solutions for the HVAC, pool and spa, power (standby

and critical), oil & gas, mining, metals, chemical and other industries. Products include pumps, fans, compressors,

conveyors, augers, blowers and irrigation equipment. US & Canada comprise the majority of sales followed by

Asia-Pacific and Europe.

Climate Solutions (30% of sales / 35% of EBITDA / 25%-30% incremental margins) produces small motors,

(variable speed) controls and air moving solutions for residential and light commercial HVAC, water heaters,

commercial refrigeration and general industries. These air moving solutions move air into and away from furnaces,

heat pumps, air conditioners, ventilators and other equipment. This business has a large installed base and significant

replacement demand. US & Canada represent the majority of sales followed by Mexico, Europe and ROW.

Power Transmission Solutions (23% of sales / 29% of EBITDA / 35%-40% incremental margins) consists largely of

an acquisition from Emerson for $1.4 billion in 2015. This segment manufactures and services highly-engineered

belt and chain drives, various bearings, gearing, couplings, plastic belts, conveying chains, pump drives and other

mechanical products. Similar to CS, a large installed base creates significant replacement demand (~45% of sales).

Industries served include HVAC, food & beverage, materials handling, oil & gas, metals, special machinery,

aerospace and general industrial. US & Canada comprise the majority of sales followed by EMEA, Mexico and

Asia-Pacific.

Overall, production is split roughly equally between the US & Canada, Mexico and Asia, with a small sliver in

Europe. OEM comprises ~64% of revenue with the balance in the distribution channel. CS is more OEM (75%-

80%) whereas PTS is more distribution (60%+). The latter is typically repair and replacement demand in the MRO

channel which shows higher margins. Cost of goods sold is tied to copper, steel and aluminum prices.

Drivers

C&I performance is correlated to industrial production trends, including oil & gas but less tied to the auto and

aerospace markets. Roughly two-thirds oil & gas is related to upstream and one-third to downstream. Other drivers

include transport refrigeration, commercial HVAC, residential pool and data centers.

The CS business is tied more to residential and light commercial end-markets. New housing growth, pent-up

demand and a continued transition to higher SEER provides some tailwinds.

PTS is exposed to general industrial, materials handing, oil & gas, renewables and metals and various other verticals.

Capital Structure

The capital structure is straightforward.

Net Debt $1,034 million

Minority Interest $33

Market Capitalization $3,458

Enterprise Value $4,525 million

Regal purchased Emerson’s PTS* business in early 2015 using debt but has reduced leverage (debt to EBITDA)

since to the 2.5x area. Target leverage is 1.5x-3.5x.

*Paid 11.7x trailing EBITDA or 8.7x including tax benefits and synergies.

Financials

Over the past five years, sales ranged from $3.1 to $3.5 BN. After 1.6% organic growth in 2014, the company

experienced negative growth of 6% and 7.9% in 2015-2016 due to oil & gas weakness, a slowdown in industrial

demand in North America and China, a reduction in the Middle East HVAC market and raw material declines

(passed through to customers). Sales recovered in 2017 so far with organic growth of 5.2% and 3.5% in 3Q and

year-to-date. As an industrial name, EBIT and EBITDA margins are on the low side at 10.3% and 14.3%,

respectively.

For specifics, 2017 guidance is for LSD-MSD organic growth. In 2018 and 2019, management guided to 2%-4%

growth as a function of general market growth and company-specific initiatives (discussed below). Margin

improvement of 200-250 bps is expected - 140-190 bps remain after 2017’s year-to-date improvement. Higher

margins are expected from volume growth, remaining PTS synergies, simplification - restructuring initiatives and

automation.

Part of the margin improvement was masked in 2017 due to rising raw material prices (aluminum, copper and steel)

and LIFO accounting. Regal should catch up over time, although management did note that 1H 2018 would also

suffer from a pricing lag (typically 1-2 quarters).

Projections

The aforementioned organic sales growth of 2%-4% coupled with operating margin improvement and share

shrinkage over the next several years should drive FCF/share higher. I think this will prove conservative for two

main reasons: 1) the global economy is stronger than when management initially guided to these figures and the oil

& gas backdrop has improved markedly and 2) a strong suite of new products and regulatory trends should back-end

load this growth to 2018-2019. These trends include energy efficiency, more stringent regulations in commercial

refrigeration and HVAC (in 2017 and 2018) plus increases in Fan Energy Rating (in July 2019) to drive greater

electrical efficiency in gas furnaces. The primary consumer of electricity in a gas furnace is the HVAC motor. This

should cause a shift to ECM (variable motors) which Regal expects to drive incremental sales of $40 to $60 million

by 2020.

Technological leadership in electric motor efficiency is key – two-thirds of Regal’s 180+ products launched recently

are targeted to improve energy efficiency. An important new C&I product is UlteMAX. This product was introduced

in 2017 and shows substantial improvements in energy efficiency and 50%-75% less weight compared to the

technology it replaces. This is expected to drive incremental sales of $70 million over through 2024 before any

impact from penetrating adjacent markets.

Margin improvement should be driven by cost savings from completed and ongoing restructuring programs (some

completed recently and some scheduled to be finished shortly) and fixed cost leverage. A target of 90% of sales via

one ERP system in 2018-2019 (80% in 2017), a further 10% manufacturing square footage reduction (on top of an

already completed 15%) plus supply consolidation are a few examples of cost cuts. Furthermore, the fastest growing

business (currently) is PTS which also has the highest incremental margins at 35%-40% comparedto 25%-30% and

30%-35% for C&I and CS.

My estimates are for sales to grow at the top end of management’s range in both 2018 and 2019 and for a small

pick-up in margins. Using these assumptions and factoring in a small decline in shares outstanding, I calculate

FCF/share of >$7.00 in 2018 and close to $8.00 in 2019.

Valuation

The industrials space trades at >12x EBITDA, >20x EPS and at a 4% FCF yield using 2018 estimates. The

compares to Regal’s multiples of 8.9x, 13.6x and 11.0x. Despite slower growth prospects, I believe Regal is

compelling at current levels.

Cash generation is earmarked for targeted acquisitions, share repurchases, dividends (20%-24% payout ratio) and

further debt reduction.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-Organic growth and margin improvement

-Cash generation (share buybacks and dividend increases)

-Bolt-on acquisitions

show sort by

			2018	2019
Price:	78.05	EPS	5.75	6.50
Shares Out. (in M):	44	P/E	13.6	12.0
Market Cap (in $M):	3,458	P/FCF	11.0	9.9
Net Debt (in $M):	1,034	EBIT	433	462
TEV (in $M):	4,525	TEV/EBIT	10.5	9.8