Description

Recommendation: Long SPX Corp

SPX Corporation (“SPXC”) is a misunderstood and significantly undervalued business trading at just 6x 2016E adjusted EBITDA and a 10% unlevered FCF yield. On September 28, 2015, legacy SPX separated into SPX Flow (“FLOW”) and SPXC. The transaction was structured as a spin-off of FLOW leaving SPXC as the remaining company. FLOW includes legacy SPX’s Flow Technologies segment and a small Hydraulic Technologies business previously included in the Industrial Products and Services segment. SPXC includes the Thermal Equipment and Services and remaining Industrial Products and Services businesses. Senior management of legacy SPX went to Flow. Historical investor focus on FLOW, preoccupation with SPXC’s challenged Thermal segment, a diverse business mix relative to the company’s market capitalization, and relative sizes (FLOW is 3x the current enterprise value of SPXC) has led to SPXC’s depressed valuation. As investors become more familiar with SPXC, we expect the company’s valuation to converge to a more reasonable 8% unlevered free cash flow yield leading to >30% equity upside.

Business: As noted above, we believe investors primarily view SPXC through the lens of its legacy Thermal business, which manufactures cooling towers and heat exchangers for power generation, commercial, and industrial uses, medium and large power transformers, and residential heating products. In 2014, Thermal represented 70% of revenue and 44% of pre-corporate operating income. At first glance, this business appears deeply challenged. Revenue and operating income have fallen 19% and 63%, respectively since 2011.  A limited number of contracts to provide cooling and other thermal components to the Medupi and Kusile South African power projects, however, are the primary driver of these poor results. The original contracts were signed in 2007 and 2008 and SPX has recognized ~$1.1bn of the ~$1.2bn total contract value.  A revenue decline as the projects are completed (SPXC’s manufacturing is ~90% complete) is not surprising. Nontheless, significant project delays outside of SPXC’s control (expected completion pushed to 2021) have driven the contracts significantly below breakeven. Net of taxes and minority interest, we expect SPXC’s South African business to lose ~$23mm in 2015. The company has been reluctant to provide further guidance on expected losses. After peaking in 2014, losses have been declining and we model ~$15mm per year from 2016 through 2020. In contrast to most analysts, we do not believe it is appropriate to capitalize these losses in perpetuity and include the present value of the losses as a liability in our valuation. It is worth noting that the South African business also includes a profitable $30-40mm revenue per year services business that we implicitly assume ceases to exist in 2020.

Recent company disclosures and a re-segmentation concurrent with the spin-off have provided a clearer picture of SPXC’s various businesses and true profit contributors. SPXC’s recent investor presentation provides a good overview of the various businesses (http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NTkzOTY1fENoaWxkSUQ9MzAzMTI2fFR5cGU9MQ==&t=1). As denoted in the table below, higher margin modestly growing businesses with non-power generation customers contribute over 80% of EBITDA. Management expects these businesses (HVAC and Detection & Measurement) to grow at a 2-6% CAGR through 2018 and generate modest margin expansion.  

Valuation: We look at unlevered after-tax free cash flow burdened by stock based compensation and recurring restructuring costs. As noted above, South African losses are excluded and their estimated present value is included as debt in the enterprise value. On this basis, SPXC trades at a 10% yield on our 2016 estimate. Unsurprisingly given the diverse set of businesses, there is no perfect comparable for SPXC. A broad peer set of industrial businesses trades at 9x EV/EBITDA and a 6% UFCF yield. Amongst that backdrop, SPXC current valuation is attractive and our assumed 8% unlevered free cash flow yield is reasonable.

Risks:

Unexpected South African losses - while low probability, it is possible that South African losses exceed our estimates

Cyclical downturn - many of SPXC’s business are cyclical and performance would suffer in an economic downturn

Catalyst

Reporting of clean standalone results

Management achieving revenue growth and margin expansion targets

Additional analyst coverage

Further detail on South African contract expectations