SPX is an manufacturing company that my short screen has identified in the capital goods sector. While there are reasons to be short SPX based on micro factors, the macro backdrop will be key, and it doesn’t look strong. The recent sharp downturn in core capex orders, including an acceleration of the decline in the month of September, suggests that SPX’s organic revenue will soon shift from growth to decline, which would be a disappointment relative to expectations. Please see the recent report on SPY for more detail on core capex orders. Other things to consider:

• Accounting
  • Operating cash flow was an outflow of $192m in 1H12 vs  an inflow of $21 in 1H11. This is due in part to a large decrease in accounts payable and accrued expenses; the inevitable reversal of these accruals will put pressure on future operating margins.
  • DSO is high at 95 days.
  • The company dropped its allowance for doubtful accounts, customer returns, discounts and invoice pricing discrepancies from 4.6% of gross accounts receivable at Dec-2010 to 3.6% at Dec-2011. Had the company maintained this ratio at 4.6%, operating income would have been 5% lower last year. The company does not disclose this figure quarterly.
  • Liquidation of LIFO inventory added 5% to operating income over the 2010-2011 recovery period.
• Mediocre leveraged ROE averaging 9% in the last 5 years
• Insider selling; no buying
• Expectations are for a more back-end loaded 2012 than normal and a very large ramp in EBITDA in 2013 on strong revenue growth and management’s margin improvement programs.
• Valuation allows room for the stock to decline 30-40%.

Business description

% of 2012E revenue of $5B

• 53%       Flow technology
• 28%       Thermal equipment and services
• 19%       Industrial products and services

Flow technology is the company’s strategic focus. This segment’s products include pumps, valves and heat exchangers; mixers and homogenizers; filtration and dehydration equipment. Key competitors include GEA Group AG, Flowserve, Alfa Laval AB, Sulzer and IDEX Corporation.

Thermal equipment and services products include dry, evaporative and hybrid cooling systems, heat exchangers, pollution control systems, boilers and HVAC products. 60% of this segment’s 2011 sales were to power generation markets. Key competitors Evapco, Inc., GEA Group AG, Alstom SA, Siemens AG, Hamon & Cie, Baltimore Aircoil Company, Thermal Engineering International, SHOUHANG IHW Resources Saving Technology Co., Harbin Air Conditioning Co., and Beijing Longyuan Cooling Technology Co.

SPX’s industrial products segment makes transformers, industrial tools, hydraulic units, precision machine components, crystal growing machines for solar power market and broadcast antennas, for example. Key competitors include ABB Ltd., GE-Prolec and Hyundai.

2011 Pro Forma Revenue by End Market

• 28% power generation
• 11% oil and gas
• 5% power and T&D
• 19% food and beverage
• 10% HVAC
• 27% Other

Geographic revenue split

• North America 46%
• South America 2%
• Europe 21%
• APAC 21%
• Middle East and Africa 10%

Recent major acquisitions and divestitures

SPX purchased Clyde Union at the end of 2011. Clyde generated $448m in revenue selling pumps to the oil and gas industry and power generation. SPX is in the process of selling its Service Solutions division. The sale has been delayed and is now expected to close in 4Q12.

Core Capex Orders vs SPX Organic Growth

U.S. core capex orders are correlated with SPX’s organic growth one quarter ahead, using quarterly data since 2006. The correlation coefficient is 0.83. The coefficient of the slope of the regression is significant at p<.01 with a t stat of 7. We can’t say the intercept is significantly different from zero.

The model below underestimates SPX’s growth heading into downturns and overestimates it heading into upturns. I believe this is because SPX has a late cycle component to its business.

Here is the equation:

SPX organic growth (t+1) = .016 +.56*Core Capex Orders y/y change (t)

This predicts an organic decline in revenues of 3% in 4Q based on the 8% decline in 3Q core capex orders. If true, I think this will call into question the Street’s expectations for 4Q12 and for 2013 revenue to grow 6% and for EBITDA to ramp aggressively.

And for the Flow Tech segment:

SPX Flow tech organic growth (t+1) = .029 + .61*Core Capex Orders y/y change (t)

The stats for Flow tech: p=.78, R2=.60, slope coefficient significant at p<.01, t stat of slope coeff=6

Data is in the tables at the end of the report.

When the company last had a major disappointment in August of 2011, the stock went from the $70s to the low $40s. During the 2008 downturn the stock went from the $130s down to the $30s. I’m not saying that today is the exactly the same, but that this company’s fundamentals and stock price are sensitive to slowing growth due to the company’s financial and operational leverage.

Book value is $42. Tangible equity is negative. With a volatile history of ROE and average ROE of 9% in the past 5 years, I don’t see why the market would pay more than book for this business in a downturn. That’s about 11x earnings over the cycle for a very capital intensive business with a lot of competition.

Risks

In addition to the standard risks of short selling, part of the company’s business is late cycle and the model I’m using to predict a decline in business does tend to underestimate SPX’s growth early in a downturn. So maybe we don't see weakness until SPX reports 4Q, if we see it at all. However, the decline in capex orders has been so sharp that based on history there is less than a 5% chance of any growth in 4Q. The sample size is also small. I didn't go very far back in time because the company's business has shifted substantially in the past ten years. Further, the transformer business appears to be picking up. This is about 7% of revenue. The company is working on margin improvement programs and perhaps these efforts will mitigate enough of the downturn, if it occurs, in revenue growth.