Company Description

SHS is a global manufacturer of hydraulic and electro-hydraulic components that generate power for off-road mobile equipment that serve agriculture, construction, road building, turf care and material handling end-markets. Operating segments include: 1) Propel 2) Work Functions 3) Controls 4) Stand-Alone Businesses. Sauer is a global leader in mobile hydraulics for off-road equipment benefitting from secular urbanization/infrastructure and food production themes. Customer base include OE manufacturers Caterpillar, Deere and Agco, among others.

Business Segments

* Propel (51% of Rev): Manufactures transmissions that transmit power from the engine to the wheel to propel a vehicle.

* Work Function (22% of Rev): Develops and manufactures steering units, gear pumps and motors that transmit power within a vehicle.

* Controls (20% of Rev): Manufactures electrohydraulic controls, microprocessors and valves that control and direct the power of a vehicle.

* Stand-alone (6% of Rev): Smallest segment manufactures gear pumps/motors, control valves, piston pumps and wheel motors which transmit and direct power of a vehicle

Investment Thesis:

Year end 2012 price target $55, 60% upside vs 15% down (4:1)

We are recommending an investment in shares of Sauer-Danfoss, an underfollowed cyclical industrial name. Like many cyclical names, it is often difficult to hang your hat on valuation, however in the case of Sauer-Danfoss, we believe macro fears have punished the shares to levels that are at an unsustainable discount to intrinsic value. Our summary thesis is as follows:

* Sauer is an under the radar name with no sell-side coverage given limited float and lack of potential banking fees, off the path of typical industrial focused investors.

* Under-levered balance sheet and cash flow generation gives SHS optionality.

o Net cash position and growing (as of 9/30/11). Relatively new management has systematically reduced debt levels following the 2008 economic crisis. Going forward, management now has an opportunity to create value for shareholders via small bolt-on M&A or, more likely in our view, returning cash to shareholders through a special dividend ($5-$10 per share).

o Capex intensity well below run rate D&A. The company meaningfully invested during the downturn in capacity. As such, capex will be just 60% of D&A for some period driving FCF> Net income.

* Minority stake possible buy-in. Potential for majority shareholder to buyout remaining 25% of float. Danfoss A/S (majority shareholder) has shown strong interest in mobile hydraulics space and had previously offered to buy the company in several tenders.

* Attractive valuation mitigates risk of a cyclical business

o We estimate 2011/2012 EPS of $4.85/$5.50 which implies 7.3x/6.4x earnings compared to peers (PH/ETN) which trade closer to 10x calendar 2012e estimates. A 30+% discount in our view is too steep despite liquidity differences.

* EBITDA - SHS trades @ 3.5x our 2011e estimate suggesting the market believes the global ag and mining markets are at a cyclical peak.

* $55 target = 5x run-rate EBITDA or 10x earnings.

Downside: Inexpensive valuation with limited downside.

* In a macro dominated tape with relatively light volume, shares of SHS have been and will continue to be more volatile than the broader market and peer group. As such, short term downside is difficult to determine but believe shares are trading at a steep discount to intrinsic value

* We see downside to $30, supported by cash flow generation (15% yield), net cash and growing and minimal capital intensity.

Key Risks

* Slowdown in global agriculture markets would hurt mobile equipment OEM customers of SHS. Investors could hedge this risk by shorting companies like DE, PH and ETN.

* Infrastructure spending (road construction) is dependent on government spending, which could see pressure given budget restraints. Again, public markets offer several possible hedge candidates including aggregate companies and large machinery names like CAT.

* Concentrated shareholder base. Danfoss A/S is largest shareholder with 76% of the shares outstanding. Any attempt by Danfoss to exit would pressure shares near-term

* Given Danfoss stake, trading liquidity could be a risk.