Description

 SPX FLOW is a value play on the bottoming out and potential cyclical upturn in industrial end-markets. An ongoing restructuring and cost savings program that represents ~40% of 2014 peak Ebitda  and 7% of 2016 revenue should result in a company capable of generating ~$3.50 per share of trough free cash flow in 2018E (~10.1% yield) on a revenue base that will be down >30% from peak-to-trough. Recent industry commentary and FLOW’s 4Q16 order trends indicate stabilization/the beginning of underlying growth in end-market demand. Any meaningful rebound in FLOW’s depressed oil & gas and dairy end-markets could result in $4.00+ of free cash flow by 2019E. A large one-time pension contribution in 2016, elevated capex from its Poland facility expansion, and cash payments related to the restructuring have masked the normalized cash flow profile of the business. But with restructuring expenses expected to mostly conclude by the end of 2017E, we expect actual free cash flow in 2018E to begin to inflect. We also expect FLOW’s leverage (currently ~4.1x) to start trending down from both Ebitda growth and cash generation and the stock to begin to narrow its valuation gap with peers.  At a conservative 12.5-15x FCF (versus US flow control peers currently at 18-30x), the stock could be worth $50-60 in 12-24 months (+44-73%).

Company Background:

SPX FLOW is a pure-play flow control company and global supplier of highly specialized engineered solutions consisting of pumps, valves, mixers, filters, hydraulic tools, heat exchangers, etc. It sells original equipment/components/systems (65% of revenue) along with aftermarket parts and services (35% of revenue) to its installed base of customers in the oil/gas, dairy, chemical, power generation, and other various industries. FLOW has three reportable operating segments, Food & Beverage, Power & Energy, and Industrial.

The company was formed through a series of acquisitions by SPX Corp (SPXC), with the largest and last being the $1.1bn acquisition of ClydeUnion in Aug 2011. After a failed acquisition of Gardner Denver in 2013, activists pushed SPXC to focus on profitability as opposed to “growth-at-any-cost.” This set in motion the ultimate decision in Oct 2014 to spin-off FLOW (trading as a separate entity began in Sept 2015 at $37.50 per share).

Food & Beverage:

• The F&B business provides flow control and processing equipment such as mixers, dryers, evaporation and separation systems, and heat exchangers to the dairy, food, and beverage end-markets. Its customers include large multinational companies like Danone, Abbott Nutrition, Nestle, Unilever, and Arla. FLOW’s expertise is in dairy processing systems and it is one of only a few companies that can provide turnkey solutions to dairy customers given the highly regulated industry. It sells primarily through a direct sales force.
•  FLOW believes it has unique IP in the value-added whey protein and liquid/fresh dairy products systems (versus commodity powders) and is focusing new business on this part of the market, specifically in higher growth emerging markets like China. The whey protein and liquid/fresh part of the market has more aftermarket revenue potential attached to it than the commodity skim/whole milk powders.
• F&B revenues peaked at $965m in 2014 in conjunction with milk prices (the FAO Dairy Price Index peaked in Feb 2014). From Feb 2014 to the recent trough in April 2016, the Dairy Price Index declined -54% as a result of oversupply, specifically in whole and skim milk powder. The oversupply was in large part due to EU sanctions against Russia, which prevented EU milk producers from exporting to Russia, the world’s second largest importer of milk.
• However, since the April 2016 trough, the Dairy Price Index is +51% as production in the EU has declined and imports into China have accelerated. We think the recent rise in milk prices likely means capital spending on dairy systems has or is close to bottoming and 2016/17E will mark the trough of the capital investment cycle. Reflecting the notion that the cycle is bottoming, sequential core orders in 4Q16 grew +2% organically (exc FX). While 1Q17 orders will be down YoY due to large projects wins in 1Q16, we expect core order volumes to improve.
• From peak-to-trough (2014-2017E), F&B revenues are expected to be down around 30%. Backlog is down ~45% from peak levels in 2013 and is down ~8% YoY as of 4Q16. The book-to-bill ratio has been <1x for the last three years.
• Of the $237m decline in revenue from 2014 to 2016, about 90% of it was from a decline in original equipment/systems revenue (down 30%). The aftermarket business was much more resilient, down only 9%. FX also played a significant role in the revenue decline.
• Aftermarket revenue was ~30% of 2016 revenue (up from 25% in 2014) due to the decline in OE orders. One of FLOW’s key organic growth objectives in all businesses is to capture a larger share of aftermarket revenue on its installed base (more service centers and self-manufactured equipment in OE orders) as the margins are higher and more recurring/resilient in nature as customers are willing to pay for availability of parts/service.
•  Gross margins in F&B are currently ~30% and Ebitda margins are ~12%. Ebitda margins have ranged from 10.7-13.9% over the last 5 years.

Power & Energy:

• The P&E business provides pumps, valves, and filters to the oil and gas and power end markets. About 55% of 2016 revenue was from the oil industry, with upstream accounting for 23%, midstream at 19%, and downstream at 14%. Nuclear and conventional power represented ~25% of revenue. Oil prices, rig count, and capital spending are the key drivers of the business.
•  Revenues in P&E peaked in 2012/13 at just over $1.0bn. Revenue in 2017E is forecasted to be ~$500m, or -50% from peak-to-trough. About 85% of the revenue decline from 2014 to 2016 was from lower original equipment sales (down ~55%). The aftermarket business, which comprised ~48% of 2016 revenue, was only down ~20%.
• With oil prices up almost 100% from the Jan 2016 lows and rig counts +50% YoY as of mid-Feb 2017, we think oil and gas capital spending is also likely near trough levels. In 4Q16, orders grew +3% sequentially (+7% organically exc FX) in one of the first signs that capital spending is returning and the business is bottoming.
• While uprooting incumbents in the aftermarket is tough, growing the P&E aftermarket business is a core strategy due to the high margins and the long tail of revenues associated with OE orders. Lifetime aftermarket revenues in P&E are ~3-5x the original order size (versus F&B at 30-40%).

Industrial:

• The Industrial business makes air dryers, filtration equipment, mixers, pumps and heat exchangers for a variety of industrial end markets, including the chemical industry, air treatment, mining, pharma, water treatment, and general industrial. It is more of a short-cycle business than F&B and P&E.
• The Industrial business has been a relative outperformer compared to F&B and P&E, with revenues down ~22% from the 2012 peak. FLOW has been quite successful in growing the aftermarket revenue in this business, from $125m in 2014 to ~$205m in 2016. The percentage of revenue in 2016 that came from aftermarket revenue was ~29% (up from 15% in 2014).
• Industrial has had the least amount of pressure from FX as it has the largest exposure to North America at ~48% of revenue.
• The Industrial business also has the highest margins, with gross margins ~35% and Ebitda margins recently at ~16%.

The Restructuring Program:

• While still part of SPX Corp, the businesses that comprise FLOW today were operated inefficiently as disparate portfolio companies each with full corporate and global functions, as opposed to one unified operating company with shared functions. As a result, FLOW’s operating margins were ~500-600bps below peers (bloated SG&A). One of the key strategic reasons for the spin-off was to transform FLOW into a more efficient operating company.
• In October 2015, FLOW announced it was building a 300k sq ft manufacturing facility in Poland for $20m in order to consolidate the manufacturing of heat exchangers, valves, and other products for the F&B and Industrial businesses from two facilities in Germany and Denmark.
• In February 2016, management revealed a more comprehensive realignment plan aimed at streamlining the global business and reducing SG&A expenses. Total cost savings were originally forecast at $110m by the end of 2017, or 5% of sales, at a total cost of $140m.
• Due to declining end-market demand, the restructuring plan was subsequently increased twice to the current target of $140m of annualized savings by 2018 at a total cost of $160m. To put the $140m of savings in perspective, it will represent ~7% of 2016 sales of $1.996bn, and will be 40% of the $346m of peak Ebitda in 2014.
• Of the $140m in savings, management believes ~66% is structural and 33% is related to volume declines. However, because of the drop in demand, the Poland facility utilization is below that originally anticipated. We think FLOW will see very high incremental margins from the Poland facility when demand does initially pick back up and that part of the 33% volume savings could be quasi-structural for the first 10-15% of demand growth.
• The components of the structural savings will come roughly from the following
  • Footprint optimization and consolidation of manufacturing sites, including the Poland facility. There have been 4 plant consolidations thus far, and 2 more beginning in 1H17 under the realignment program. Since 2014, manufacturing sites have been reduced to 30 (from 38).
  • Simplification and streamlining of a bloated and complex cost structure consisting of over 150 legal entities and the associated compliance/personnel costs. The goal is to get to less than 100 legal entities.
  • Moving global shared functions to lower cost regions (India, Manchester, Shanghai, Czech Republic).
  • Total global headcount is expected to be reduced by ~20% once completed.
• In addition, management is implementing a standardized SAP based ERP system to better manage the supply chain, improve working capital, and better track orders across different businesses to more efficiently cross-sell.
• Beginning in 2017, incentive compensation will be better aligned with the strategic objectives of the business. Employees will be compensated on Ebitda, cash flow, orders, ROIC, and TSR. The sales force will be repositioned and trained to target more aftermarket revenue as opposed to large lumpy OE/systems orders.
•  Management believes that as of the end of 2016, it had already achieved $70m of annualized savings, and that the key structural actions were largely completed in 2016. The realignment is expected to be substantially completed by 2H17 with full benefits realized in 2018. There is $50m of cash restructuring expenses remaining that will hit in 2017.
• The company has hinted that the current $140m program is only the beginning of the potential cost savings and that there could be more actions taken in the years ahead. We think this is a source of incremental upside.

 Ebitda Valuation:

• At $34.65, FLOW currently trades for 11.1x the midpoint of 2017 Ebitda guidance and 9.8x the midpoint of 2018 framework guidance. While guidance has consistently disappointed in the past, we think the initial 2017 guidance could prove to be conservative as it only assumes the 2H16 run-rate of orders and doesn’t assume any large project wins. The 2018 framework guidance is also likely conservative as it only assumes 0-3% revenue growth off of the conservative 2017 base.
• FLOW currently trades at a ~2x Ebitda discount to peers like PNR, FLS, IEX, CFX, MWA, XYL, WTS, FELE, and ALFA which trade for an average multiple of ~13x 2017E Ebitda.
•  FLOW has the highest leverage among the peer group at ~4.1x. It also has gross margins at the low end, and post-restructuring will still have one of the lower operating and Ebitda margins, which is another reason we think there is further room for margin improvement. It also has one of the lower percentages of aftermarket revenue.
•  Rolling forward the current 11x multiple and 2x discount to peers, if FLOW can achieve the targeted cost savings, the stock could be worth $48 (+39%) in a year on our 2018E Ebitda of $268m, which is slightly above the 2018 framework guidance. With multiple expansion to 12x (still a 1x discount to the peer group), FLOW could be worth $54 (+56%) over the next year.
• At the current valuation, the market appears to still be discounting a further downturn in FLOW’s end-markets and/or the ability of FLOW to achieve its targeted $140m of cost savings.
• Pentair recently sold its Valves & Controls business to Emerson for ~12.6x fwd Ebitda. This is a good comp for FLOW as its primary end market was oil & gas. Historical M&A of flow companies has ranged from 10-12x.
• The flow control market is very fragmented and most companies are constantly looking for acquisitions. We see further upside potential in the event of a takeout and note that FLOW’s two-year post-spin period ends in Sept 2017.

 Free Cash Flow Valuation:

• At $34.65, FLOW currently trades for 10.2x the midpoint of 2017E normalized cash flow guidance of $130-150m (excludes $50m of cash restructuring expense) and 9.7x the midpoint of 2018 actual free cash flow guidance of ~$3.50 per share ($140-160m). The peer group average 2017 FCF multiple is ~21.5x (range of 18-30x).
• Even taking into account leverage, FLOW is trading at a wide discount to peers. On an unlevered basis, FLOW currently trades for a ~8.7% 2018E yield (11.5x), versus peers at ~5.3% (18.9x).
• Given its higher leverage, we think FLOW should continue to trade for a discount until it sufficiently de-levers. At a conservative 12.5-15.0x multiple on $3.50 per share of 2018E FCF, FLOW could be worth $44-53 on 2018E (+27-53%). We see FCF growing to $4.00+ by 2019E, which would yield a $50-60 stock price at a 12.5-15x multiple (+44-73%).
• With leverage expected to be down to ~2.4x by the end of 2018, if FLOW can obtain a peer multiple of ~18x, the stock could be worth $72+, or more than 2x the current price.
•  FLOW (along with the peer group) has always had the ability to generate good cash flow due to low maintenance capital requirements. On a 2018E Ebitda base of $250m, maintenance capex is forecast to only be ~$30m. In good times we see normalized capex only rising to ~$40m.
• Note that in 2013/2014, adjusting for the current capital structure, FLOW would have generated ~$5.30 of FCF per share. We think there is a lot of operating leverage and an ability to generate significant cash flow if order activity returns.
• In 2016, actual FCF usage was ($72m). However, the underlying normalized free cash flow profile of the business was masked by $59m of post-tax restructuring spend, $41m of post-tax pension contributions related to the retirement and lump sum payment of three long-time executives, and $19m of capex related to the Poland facility. Excluding those, items, FCF was ~+$47m, or $1.13 per share.

 Leverage:

• We see FLOW generating roughly $90m of actual free cash flow in 2017E, which will reduce net leverage to ~3.4x by the end of 2017. With ~$150m of incremental free cash flow in 2018E, leverage should get down to ~2.4x by the end of 2018. At less than 2.5x, we think the market will no longer penalize the company for its capital structure.
• While the equity market is currently putting a large discount on the value of the business, we think in large part because of the capital structure, the debt markets do not appear nearly as concerned. FLOW has been granted relief on its covenants several times over the last year, and was even able to refinance $600m of 6.875% notes in August of 2016 at a lower rate (5.625%/5.875%).
• The two new $300m tranches of Notes are not due until 2024 and 2026. The next big maturity is not until a $330m bullet payment of its current $390m term loan ($20m annual amortization). The 2024/26 notes are currently trading above par at a 5.25-5.59% YTW.
• The current leverage covenant is 4.75x. It will step down 0.25x every 6 months beginning October 2017. Ebitda in 2017 would need to decline by ~$65m from the current forecast of $210-230m to trip the covenant.

 Management:

• Marc Michael is a first-time CEO who has been with FLOW/SPXC since 2003. He is an operationally focused CEO with prior experience as President of the F&B business and the EMEA region. He has been in intimately involved in the cost actions, but his number one priority is growing the business organically. His #1 goal post-spin was to increase aftermarket revenues from ~$700m in 2016 to ~$900-1000m by 2018 and has put incentives in place to achieve this.
• Jose Larios is the head of both P&E and Industrial and has extensive experience in the oil and gas industries, working for GE for over 15 years as the VP of sales for O&G surface products. He joined FLOW in July 2015.
• Dwight Gibson is the President of F&B, joining FLOW in June 2016 after 11+ years at Ingersoll-Rand, most recently as the head of strategic initiatives for its $10.5bn Climate business.
• Behind the scenes, Barry McGinley, as head of supply chain is working towards achieving incremental savings not included in the realignment plan. He had many years of supply chain experience with industrial gas company Praxair.

 Key Risks:

• The restructuring program doesn’t yield the expected savings or is delayed/ends up costing more than expected. While still within SPX Corp, the business had a history of not achieving its targeted cost savings goals.
• If the restructuring doesn’t yield the expected results, it would likely mean FLOW trips its debt covenants if end-market demand also doesn’t pick up.
• The peer group is trading at historically high multiples. Part of this is due to the belief many end-markets are near trough. If an inflection in industrial end-market demand doesn’t materialize as quickly as the trough multiples are reflecting, then a de-rating of the group is possible.
• Marc Michael is a first time CEO responsible for both a complex restructuring and driving organic revenue growth, which could prove to be too much to handle.
• FX could continue to hurt topline growth due to the strong dollar. FX accounted for ~35% of the total decline in revenue since 2014 ($275m).

Catalyst

An inflection in orders from improved industrial capital spending (including from any government infrastructure bills) and/or the unexpected announcement of large orders that are not included in current guidance.

·         Free cash flow generation and the reduction of leverage.

·         Positive updates on the progression of the restructuring program and/or an increase to the cost savings targets.

·         Industry M&A validating the high multiples being reflected by the peer group.