Description

Trading at 8.5x 2003 operating EPS of $4.40, 10x '03 GAAP EPS, and <10x '03 FCF per share, SPX represents an attractive value at current prices. I believe that SPX's intrinsic value is >$50, and I believe that this 25% discount to intrinsic value could be closed very quickly (starting with tomorrow EPS release).

I would like to discuss what SPX Corp does, why the stock has gotten hammered over the past several months, and why I think the stock is undervalued today.

First, what is SPX Corp? SPX Corp is an a diversified manufacturing company that actually consists of 30+ business units that fall into four broad segments: Technical Products, Industrial Products, Flow Technology, and Service Solutions.

Within technical pdts, 7% of total SPX Corp sales go to the life science/medical lab equipment market, 6.7% of sales go to fire security market, 7.0% go to storage network/telecom pdts, 2.5% go to radio broadcast antennas, 2.8% go to bus toll collection equipment, and 2.5% goes to other.

Within industrial pdts, 11.6% of total SPX Corp sales go to construction equipment (road paving, etc), 9.2% goes to highly engineered auto components (a nice niche), 8.2% goes to transformers for the power market, 3.1% goes to fluid power for industrial, and 1% goes to aerospace.

Within flow tech (mainly valves), 5.1% goes to waiter, 3.1% goes to cooling towers for construction, 3.1% goes to industrial, 2.6% goes to power, 2.4% goes to food, 2.0% goes to HVAC, 1.5% goes to chemical, and 2.2% goes to other.

Within service solutions, 13% of SPX goes to equipment that is sold to auto dealers for warranty repair servicing (tools, manuals, etc) and 2% goes to other.

The above split will play an important role to the analytical framework that I will discuss later on how I look at SPX Corp.

Now, why has SPX Corp taken a hit? For those of you who have access to First Call notes, I would point you to the Oct 22 Note from Banc of America, Oct 24 from Lehman Brothers, Dec 12 note from JP Morgan, and Dec 13 note from Bank of America.

To make a long story short, SPX Corp got hit by a triple whammy. First, SPX, while not being a serial acquirer like Tyco, has evolved into its current form through two big acquisitions: General Signal in 1998 and United Dominion in 2000. SPX also has done some tuck-in acquisitions, but not to the level that would quality as a "serial acquirer" in my book. Nonetheless, the General Signal and United Dominion acquisitions required a lot of restructuring, and SPX has taken a number of restructuring charges after those acquisitions to transform those businesses.

It is my view that in early 2002, the market's sentiment towards acquisitive companies that take lots of restructuring charges took a turn for the worse, and SPX's stock came under pressure.

This pressure was compounded by their Q3 EPS release on Oct 22. In that release, organic growth was -0.6% vs. expectations of flat to up slightly (which was still good as far as industrial companies go) and the company highlighted a couple of issues that could theoretically impact 2003 EPS (option dilution if expensing were to be adopted, dilution from a Lyons conversion if it were to happen, and higher pension charges). As the Lehman notes from Oct 24 discusses in detail, the market reacted strongly to these issues.

Then, in December, SPX put out a prospectus that included a cautious outlook on some end markets that the sell-side used to lower guidance. The market reacted negatively again.

The way I see it, the market has overreacted to negative news flow without regard to valuation and long-term fundamentals, creating an undervalued stock opportunity.

I have a general framework for looking at multi-industry companies:
1) does the company exhibit operating prowess?
2) what is the 2003 organic top-line growth rate (total portfolio)?
3) is the ortfolio early cycle or late cycle in nature?
4) what is the secular growth rate?
5) at the end of 2003, wil the company be below or above normalized demand levels?

I also like to consider,
1) does management run the company in a value creating way and in the interest of shareholders,
2) are there any catalysts to get the stock going.

Here are my beliefs,
1) the company has indeed exhibited operating prowess through its ability to outgrow its end markets over the past several years while expanding operating margins at the same time. While the market has reacted to a slowing in SPX organic growth rate, I think it has forgotten that SPX continues to outgrow its end markets which is a key sign of operating prowess for a manufacturing company (especially when it does not come at the expense of price or operating margins),
2) SPX's '03 organic growth rate will be -1%. The company will be able to cut costs so as to expand margins in the face of this headwind,
3) SPX is equally weighted between early cycle and late cycle businesses, and thus while it will not see the uptick in demand that other companies like Parker-Hannifin will see in 2003, it will see stabilization and growth in 2004. 2004 will not be a down year.
4) SPX's secular organic top line growth rate is 2.6%
5) at the end of 2003, SPX will be BELOW normalized demand levels by 3.1% (i.e. the company will be underearning).

In terms of management, I believe the company's huge focus on EVA generally serves them well and results in making management decisions that are aligned with shareholders. SPX recently announced a stock buyback, which I construe as a sign of shareholder friendliness. However, detractors might point out a couple of things. First, the CEO last year negotiated a huge package for himself and some people (including myself) found the details behind how he negotiated the package to be a little troubling. Second, a focus on EVA can cause a company to pursue operating gains as quickly as possible (since a dollar today is worth more than one tomorrow) and thus cause a business to "max out" sooner rather than later.

I believe that SPX has done a masterful job of integrating businesses, downsizing during the downturn, and investing for growth. The company has some decent growth platforms that can drive the 2.6% secular growth rate that I talked about.

Besides value being its own catalyst, there are a couple of things that could serve as catalysts. First, the company has announced a buyback and that could serve as a positive force on the stock. Second, the company is reporting earrings tomorrow. I expect the release to show a strong end to 2002 and I expect guidance to be taken positively by the stock. There is just so much confusion and fear that has entered the stock, and many of the concerns are concerns that have no bearing on intrinsic value. I have generally found that when this is the case, a decent entry point exists.

When I compare SPX Corp to TYC, it seems that SPX seems like a much more attractive risk/reward situation. SPX trades at a much cheaper multiple of EPS, the company has had nice EPS to free cash flow conversion so I have confidence that the EPS figures are real and not the result of accounting manipulation (though SPX does have a couple of minor "quality of free cash flow" issues), and the company does not have all the uncertainty that TYC has from past mismanagement.

I am hoping that this posting will stimulate a lively discussion on SPX and I look forward to hearing more of the bear case from the skeptics out there. To start the discussion, I will relay a couple of things that I have heard from the bears. First, people who knew General Signal and United Dominion (the two big acquisitions that basically made SPX what it is today) just can't believe could have been brought up to the level of profitability that SPX has taken them to (14-15% operating margins). While this notion does scare me, I take solace in the fact that SPX has generated strong free cash flow along with improved profitability which adds legitimacy to SPX's reported profit numbers. Second, some people believe that SPX's EVA compensation system might drive managers to mismanage their business.

I have to say that I generally view acqisitive companies that take lots of restructuring charges negatively. However, in the case of SPX Corp, I believe these issues are issues why you would not want to value the company at $70 (where it traded last year) and not issues that make it worth only $37 (where it trades today). The pendulum has gone too far and people have put this otherwise solid company in the penalty box for no good reason.

Catalyst

1) stock buyback, 2) better than expected Q4 02 EPS and/or 2003 EPS guidance, 3) valuation