The equity of SPX Corp ("SPX") is an attractive investment opportunity that we feel is being overlooked. The stock trades at an attractive valuation of 12.7x 2018 and 11x 2019 free cash flow, despite the fact that it is poised to benefit from regulatory and economic tailwinds. The street’s focus on the company’s EPS ignores the fact that recurring capital expenditures are roughly half of reported depreciation and amortization which understates economic earnings by $0.28 per share. In addition, there is limited sell-side research covering the stock, and a perception that the business units are an amalgamation of “cats and dogs” subsequent to the spin-off of the company’s flow division in 2015. While some of the businesses needed to be optimized following years of neglect within SPX, each of the company's segments is a market leader and generates the majority of revenue from the replacement market, which helps to buttress earnings during a downturn. In fact, 88% of the company’s revenues come from sales of a product that holds a #1 or #2 market position and 69% of the aggregate sales are replacement related.
Our view is that the stock is worth $44-$46 in the next 12-18months and potentially $60-$70 per share in a buy-out.
The company is comprised of three business units: 1) HVAC (37% of revenue) 2) Engineered Solutions (45% of revenue) and 3) Detection & Management (“D&M”) (17% of revenue). Roughly half of the HVAC segment is from the sale of cooling products primarily to the commercial end-markets. The best gauge for the end-market demand for these products is the Dodge Index, which advanced by 21% year-over-year in December 2017. Non-residential construction activity is still well below where it was prior to its peak in 2007 and could be bolstered by an infrastructure stimulus plan. The other half of the revenue comes from the sale of heating products. After two abnormally warm winters, sales from this business have been depressed and are due for a nice bounce following this brutal winter. Through our conversations with industry participants, we learned that the company's heating product offering was somewhat outdated and suboptimal prior to the spin-off. Sales consisted primarily of replacement sales to the residential marketplace, while the company was having a difficult time penetrating the new build market. Since the spin-off, the new management team has successfully reinvigorated the product development efforts and the company can now participate in the higher growth segments of the heating market.
Management has also done an admirable job of turning around the Engineered Solutions Segment. Prior to the spin-off, this division was barely generating a profit and its sales were primarily tied to the provision of cooling towers and heat exchangers to nuclear and coal power plants. Over the last three years, management has divested of the majority of its businesses tied to the secularly challenged power industry and has improved the margins of the core power transformer business by 300 bps. SPX is the only US based company targeting the medium and large transformer markets, which is a good position considering we have an increasingly protective government. It is worth noting that the US government is currently reviewing imposing anti-dumping duties on the Korean transformer manufacturers, who represent 20% of the market. Replacement sales (average age of transformers in the US is approximately 40 years) should buttress top line for the foreseeable future; however, there is overcapacity in the transformer industry. Current transformer EBIT margins are at 10%, yet in past industry upturns, EBIT margins approached as high as 30%. For our investment case, we are content to underwrite bottom-of-the-cycle margins and expect earnings to grow as the company increases its after market sales and its penetration of the large voltage transformer market, where it is under represented relative to its strong position in the medium-sized market. We do think that the company's 2019 EBIT margin target of 10% for the Engineered Solutions division is conservative. The transformer-related business (60% of division revenue and 90% of profits) is already operating at a 10% margin and the company has begun selling aftermarket components and services to the cooling tower industry. These latter revenue streams carry an EBIT margin of roughly 20%.
While D&M only represents 17% of SPX revenue, it generates 32% of the company's profit. It is comprised of three segments: Radiodetection (40% of segment revenue), Communications Technologies (30% of segment revenue) and Genfare (30% of segment revenue). Radiodetection, the leading provider of scanning equipment to identify the presence of underground infrastructure, is experiencing strong demand from telecom/cable network builders and construction companies who are legally obligated to inspect underground prior to build-out. The majority of Communications Technologies revenue is derived from the replacement of blinking lights that are on top of wind turbines and telecom towers while the remaining 40% comes from the sale of SMS communications intelligence equipment, which is used by governments to counteract terrorism and detect drones. Sales of the latter products have been depressed as second and third world country governments had pulled back on procurement activity in the face of low commodity prices. The remainder of D&M sales is from Genfare, a manufacturer of bus fare collection equipment, which should continue to benefit from the funding provided by the 2015 Transportation Bill. Collectively, these businesses should continue to grow moderately, yet at very attractive incremental margins of approximately 50%.At a high level, D&M is benefit from the following tailwinds: cable fiber network construction, counter terrorism efforts and the modernization of the community bus industry.
We are impressed with management's turn-around of the company's HVAC and Engineering Solutions businesses and believe it has put the company in a solid position to grow not only organically, but also via acquisition. The company generates very solid and consistent free cash flow (we project $400 million or $9.70 per share over the next three years) and has a very solid balance sheet (under 2.0x debt / EBITDA). Management has been searching for acquisitions over the past couple of years but has yet to pull the trigger. In September 2017, SPX hired Frank McCelland to head its M&A efforts. Mr. McCelland created a lot of value at Allegion, which was spun off from Ingersoll Rand in 2013, where he was the VP of Strategy & Business Development. Management is evaluating deals which can be completed at a 8.0x EBITDA multiple after synergies. If management is able to invest the $400 million of free cash flow at this multiple, the accretion to 2020 free cash flow per share would be $1.00. It is possible that the right deal could accelerate the overall growth rate of the company and help to re-rate the stock. As such, we think under such a scenario, the multiple could expand to the high teens, which is in line with industrial peers and the stock could trade up to $60- 70, or 18x our 2020 free cash flow per share estimate.
Please see financial summary below:
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.
Accretive M&A is likely to be a catalyst for the stock to re-rate higher.