Description

Summary

TNC is an industrial cleaning equipment manufacturer that is pricing in an ill-conceived, activist-inspired merger with its competitor, Nilfisk (NLFSK DC) in spite of both companies publicly stating that a deal is off the table.  We believe that the stock has near immediate downside to $55-60 (dn 25%-30%) when the market pays attention to the fact that the merger isn’t happening (and makes little strategic sense). Then, as Tennant resumes its organic operational deterioration, we think the stock has another leg down to at least $35 (-55%).

A quick overview of this organic deterioration at Tennant is nicely outlined in the Primestone activist presentation (here).  This reminds us of the activist presentation advocating the MW/JOSB merger of 2013, which perfectly laid out the short thesis that eventually came to pass...and the MW/JOSB merger actually happened.  Meanwhile, in spite of TNC’s +26% move in reaction to the activist presentation on 12/13/17, both companies have publicly confirmed that a deal has been reviewed and isn’t on the table -- TNC on its Q4 2017 earnings call in February and then Nilfisk’s on its Q2 2018 call last week.

TNC Q4 2017 Call on 2/22/18

After thoroughly evaluating the potential merger that was suggested by PrimeStone, the Board, in consultation with its advisers, concluded that continuing to execute the Company's business plan represents the best path forward and is in the best interest of Tennant and its shareholders. We regularly evaluate our strategic direction, and have considered transactions across the industry multiple times over many years as part of the company's regular review of potential options to enhance shareholder value. Prior to announcing the IPC acquisition, we reviewed a range of potential transactions, including the same concept shared by PrimeStone. And we ultimately concluded that the acquisition of IPC was the best way to enhance shareholder value. With the significant progress that we've made to date with the IPC integration, we remain highly confident in that decision.

~ CEO Chris Killingstad, Q4 2017 Earnings Call

Nilfisk Q2 Call on 8/14/18 (note NLFSK DC dn 14% since)

Q: Sorry about that. And what I said was, I think you've already commented a little bit in the press this morning, but if you could just clarify the process regarding tenant, there has been talks of mergers, acquisitions, et cetera. You know the story, could you please give an update on where you are on that process, if there is a process?

A, Hans Henrik Lund, CEO: Thank you. So, Casper, we have examined it very carefully regarding that transaction and that opportunity for transaction over the last six months. We have, so to speak, done our homework and with that homework we are now confident to say that we believe there is more value in our own stand-alone plan. Hence, we are fully focused on executing that plan. I think that answers your question, right?

Q: I suppose it does. But does that mean that you no longer see potential synergies or is it just because you believe that if you were to sort of marry with Tennant, you would have to acquire them and then pay too higher price. Is that the thinking?

A: Let me not comment on that, Casper, I think the fair point is to say that we really, really examined it thoroughly and we have looked at every opportunity, and we have now concluded that there is more value in our own plan and I don't want to comment too much in the process or any further, but we've reached a conclusion after we've done a really serious homework on that topic.

Note: The following write-up was dated 8/1 before Nilfisk said publicly that a deal was off the table.  Therefore, we’ve contemplated the potential for a deal.

Business Description: Tennant Company (NYSE: TNC) manufacturers and markets industrial floor cleaning equipment (64% of sales) – scrubbers, sweepers, extractors, buffers, and burnishers.  The Company sells its equipment, mostly in North and South America (64%) through a large, direct sales team. Tennant also sells spare parts and consumables (20%) through its equipment maintenance program, often bundling this revenue stream with the upfront hardware sale and a service agreement (13% of revenue).  The Company’s field service team is comprised of nearly 900 on-the-ground technicians globally. While selling direct still accounts for the bulk of TNC sales (67% of total revenue), the Company’s sales channel has slowly shifted more towards the lower-margin distribution channel (now 33% of total sales, up from 20% in 2012). Tennant offers two main categories of equipment: 1) Industrial and 2) Commercial. The Industrial-grade equipment (representing 44% and 36% of equipment sales before and after the IPC acquisition, respectively) includes riding scrubbers, large walk-behind buffers, and other large cleaning devices capable of servicing warehouses and other large spaces. Individual Industrial-grade products range in price from $40,000-50,000.  The Commercial-grade equipment (representing 52% and 56% of equipment sales before and after the IPC acquisition, respectively) includes medium- and smaller-sized scrubbers, buffers, and sweepers that are designed for use in narrow store aisles and other confined areas. Unlike the large Industrial equipment, Commercial equipment is typically small enough to be stored in a janitor’s closet. Typical Commercial-grade products are sold at a much lower price, coming in around $10,000-15,000. Handhelds and other small Commercial products are typically sold for $2,000-5,000. Although Tennant has historically focused on selling large, Industrial-grade equipment, changes in end-user demand are shifting the sales mix towards the smaller, more affordable, Commercial-grade machines.

Short Investment Type: 1) Broken business model 2) “Subtraction by addition” merger 3) Overvaluation due to flawed activist proposal

Fulcrum Issues: 1) Price competition for large strategic account customers in North America 2) Margin drag of bundled equipment + service offering 3) IPC merger’s ability to gain traction for Tennant in Europe 4) Strategic / financial benefit of a merger with Nilfisk

Investment Thesis: Tennant’s industrial cleaning business has been deteriorating for nearly 4 years, marred by slowing organic growth, failed M&A efforts, and margin pressure.  However, on the heels of activist PrimeStone’s public presentation outlining a proposed Tennant/Nilfisk (NLFSK DC) merger, TNC is trading at all-time highs, +42% off 52-week lows and a whopping 36x NTM EPS.  We believe a successful deal is priced into the shares, but also expect that if a deal does happen it will qualify as a “subtraction by addition” merger that drives substantial downside. Conversely, if a deal does not materialize, the declining organic business at TNC is worth 50% less than what it’s valued at today.

Tennant is the market share leader in North America, historically taking advantage of its superior scale, product quality, and bundled equipment / service offering to establish footholds in large customer accounts such as Walmart, Kroger, Home Depot, and Pepsi.  However, over the past few years, competition from large, global manufacturers Nilfisk and Karcher, as well as cheaper, “good enough” foreign alternatives has heated up. TNC has lost much of its negotiating power with strategic accounts and these powerful, profitability-focused customers have exploited it.  Not only have large customers pushed back on price increases, but they’ve also demanded top-tier service on machines that require maintenance and repair. Additional end-market headwinds are starting to weigh on growth, including brick-and-mortar retailers opening fewer and smaller new stores, malls closing as customers increasingly shop online, and hospitals cutting costs to offset insurance reimbursement declines.  Consequently, we expect TNC’s already-slow, GDP-like growth in North America to decelerate to low-single digits just as margins suffer from underinvestment in its service organization (i.e. scrambling to service customers with fewer techs and depleted parts inventory). These headwinds will persist in conjunction with management promising the market (and core to the PrimeStone proposal) that it can reach long-term operating margin targets of 12%.  Mind you, the Company has never exceeded 9% adjusted operating margins and posted a meager 6.2% in 2017, a 230bps year-over-year decline.

In Europe, TNC has tried and failed to gain share against market leaders Karcher and Nilfisk.  In a desperate move last April, it acquired IPC Group which lacks strategic fit with the Company’s existing offering and has been a complete disaster.  In addition to organic margin headwinds mentioned above, the negative mix shift from more commoditized product offerings at IPC has further weighed on consolidated results.  Our work indicates that Europe will go from bad to worse as management scrambles to justify this highly dilutive deal.

While the bull case centers around a merger with Nilfisk, our work indicates that cultural differences between the firms and TNC management’s desire to maintain leadership of the combined Company make a deal unlikely.  TNC management also believes it’s already made its bet on Europe in IPC and is unlikely to entertain a merger with Nilfisk until it’s clear that IPC hasn’t been successful. After all, the IPC deal was consummated to steal share from Nilfisk.  However, if TNC management seeks a lifeline due to continued organic declines, we believe much of what PrimeStone is proposing has already been priced into TNC shares. Operating margins at TNC (and Nilfisk) would need to nearly double from ~6% to 12% over the next several years, all while the combined entity achieves $140 million in synergies (6% of total combined revenue) for merger plans to drive the upside that PrimeStone envisions.  Much like the JOSB and MW merger, PrimeStone’s presentation is actually a perfect summary of the short case on the organic struggles of the two businesses. And similar to MW, we expect that putting two bad companies together won’t fix the problems, it will exacerbate them.

Risk/Reward: TNC is not widely covered by the Street, but the consensus view indicates EPS of $2.04 in 2018 (~$0.02 above the midpoint of guidance) and $3.00 in 2019 (vs. our base case of $2.10).  Our primary variant views are three-fold: 1) after 2018 acceleration against easy comps, 2019 organic growth in the Americas will revert back to GDP growth (or worse) as Tennant suffers from limited pricing power due to increased competition and end-market headwinds, 2) the EMEA segment will continue to flounder as IPC weighs on margins, and 3) consolidated operating margins will languish below historical averages of 8.5% and the 12% target that management touts.  We believe that the likelihood of a Nilfisk merger is fully baked into the ~$83 share price (trading at 36x NTM EPS) with the stock having rallied 38% from February-lows of ~$60 but have given some credence in a dream scenario to Primestone 2022 price targets. Our bull case assumes Tennant is able to turn around its organic business, returning operating margins to historical ~9% levels amidst 6.5% annual growth due to share gains globally – a scenario that we think is even less likely than a Nilfisk merger.   This scenario yields PT of ~$95. We’ve also been conservative on our assumed multiple ranges (20x-26x in bear-bull range) based on historical performance, but would expect that once the market converges to our view that a Nilfisk merger is unlikely, TNC’s low-single digit top and bottom line growth should garner something closer to a market multiple or worse.

Investment Merits:

Tennant’s North American Organic Business Model is Broken

Similar to the razor/razorblade model, the direct selling of professional cleaning equipment is largely predicated on the concept of selling the initial cleaning equipment at or below cost and then charging higher margins on the on-going maintenance and consumables (bristles, squeegees, cleaning solution, batteries, etc.) required to keep the equipment running properly during the life of the contract.  This method works particularly well for companies that have 1) the lowest cost structure of their peers, and 2) the best quality and availability of parts and service. Historically, TNC has had both, which is why the Company has largely prospered since its 1870 inception. However, three recent developments are eroding Tennant’s once-formidable competitive advantage.

First, Tennant faces more legitimate competition today than ever before, which is driving down contract prices and making products increasingly commoditized.  Low-priced, foreign-manufactured alternatives are now of “good enough” quality to compete with TNC. However, perhaps the biggest threat to Tennant is German-based Karcher – the clear #1 global player in the space and dominant force in Europe.  Karcher is 100% committed to bringing their global excellence to the United States. In addition to Karcher, Nilfisk is also starting to sell direct as a way to steal large, strategic accounts away from Tennant. All the while, the heightened competition is effectively commoditizing the industry as the leaders now have very similar products.

Second, Tennant’s customers – particularly the core, large strategic accounts – continue to demand more robust services at lower prices.  TNC is no doubt better positioned to win large strategic accounts because of their direct sales model, but these contracts are very price competitive due to the buying power of these large customers, and they require an expensive service infrastructure to fix machines quickly, which has driven many of TNC’s recent operational missteps.  Our conversations with past Costco employees, for example, outlined competitive RFP process and described the negotiating power that Costco wields to secure discounts. As a low-cost provider, Costco is extremely focused on the total cost of its cleaning equipment over the entire useful life (typically 3-5 years for medium-sized, walk-behind machines; 7-10 years for large riding machines).  This dynamic is critically important when considering the service required pre- and post-warranty expirations. Given the nature of this long sales cycle, Tennant increasingly finds itself fighting customers over who pays the maintenance in the period between when the product’s warranty expires and when they go back for renewal. More often than not, Tennant ends up footing the bill in an effort to renew the contract.  Things don’t look much better on the distributor side, where TNC risks losing large “JanSan” and office product customers who are tired of competing against the OEM for business on the direct side.

Third, recently Tennant has been more focused on taking international market share (to hit their lofty sales and margin targets) than maintaining high levels of quality and service here at home.  Our calls with customers noted that since that time, Tennant has really fallen down on the service side with not enough local coverage on the people or parts side of the equation. These customers believe that this very well could’ve been the driver of 2017 margin headwinds.  Furthermore, we learned that Tennant is using fewer and fewer proprietary parts in their machines – this is huge because it means that frustrated distributors and customers can now bypass Tennant altogether and quickly buy replacement parts at their local hardware store or even order them from Amazon.

Tennant’s Operating Margins Will Remain Below 12% for the Foreseeable Future

TNC management has a long history of overpromising and under-delivering.  Tennant’s long-term financial goal has been to reach $1 billion in revenue with a 12% operating margin. They first released that target in 2010 and then did so again in 2014 (both three-year targets).  Core to these targets was that Tennant could grow consolidated top-line organically 5% to 9% and scale SG&A accordingly. However, growth has been lumpy and operating leverage has been non-existent. Organic growth even slowed to 1-2% in 2016 and 2017.

Operating margin has historically hovered around 8.5%.  However, in 2017, operating margins fell to ~6% (near 2010-11 post-crisis recovery levels) due to issues with their U.S. service business as well as the dilutive IPC acquisition overseas.  In our calls we discovered from past employees that coming close to 12% operating margin (i.e. doubling their 2017 number) bakes in significant market share gains, which we believe is far-fetched.

The North American market is a GDP-grower (at best) with ever-increasing competition.  Pricing pressures from large customers, as well as product mix shifting to lower-priced / lower-margin products will hamstring Tennant’s ambitions.  Highlighted on their recent Q2 2018 earnings call, Tennant management expects large strategic accounts to continue weighing on margins:

[Strategic accounts are] the most important source of growth from an absolute level. And it did matter in Q1, it mattered in Q2. And we have solid visibility that strategic account revenue will positively affect, from a revenue standpoint, Q3 again also. But we are calling out -- from our original expectations, for example, we gave guidance a quarter ago, we think that the full year margin impact due to higher strategic accounts will negatively affect our gross margin expectation by about 20 basis points. And it's a good problem to have. I mean, the more strategic account revenue we can get, the more efficient we get, but it doesn't directly affect our gross margins. But it's one of those problems -- we want to call it out, but it's a good problem.

~ CFO Thomas Paulson, Q2 2018 Earnings Call

Interestingly, in an effort to shrug off these concerning admissions, management also championed the “efficiency” of these strategic accounts.  As mentioned above, large strategic accounts get less efficient during the life of the contract as machines need repairing. Faced with the prospect of angering a large strategic account in advance of renewal negotiations, TNC is increasingly forced to service equipment at its own expense (in spite of customer neglect) with an infrastructure that lacks the personnel, equipment (i.e. trucks), and parts to seamlessly repair broken products.  In Europe, TNC’s operating margin outlook is plagued by the dilutive IPC deal (which we’ll discuss later), while APAC is still too small / nascent to move the needle.

Accelerating End-Market Headwinds Are Adversely Impacting Tennant’s Sales Mix

Tennant is highly exposed to a number of end-market headwinds that are impacting its clientele.  TNC names several brick-and-mortar retailers (Kroger, Walmart, Carrefour, and IKEA) as well as consumer goods manufacturers (Nestle and Pepsi) among its largest accounts.  It’s been well documented that these customers and their competitors are all working to reduce overhead and move online.

In January of this year, Walmart announced that they were converting 63 Sam’s Club locations across the country into new ecommerce fulfillment centers as the company increases its online push.  In speaking with a former Walmart employee, we learned that Walmart continues to refurbish its existing stores and when they open new stores, the locations have a smaller average footprint – these two factors are impacting the company’s cleaning equipment purchase decisions.  Larger, open stores require the more expensive, large ride-on machines (Tennant’s historical bread and butter), while smaller stores are better suited for smaller, less expensive equipment. This is no doubt shifting Tennant’s sales mix towards the smaller, more commoditized Commercial-grade equipment.

Kroger announced a slew of store closures in January as well, as the chain plans to cut back on new store development.  Similarly, just last month IKEA announced that they were “slowing the growth pace it has sustained in the U.S. market”, axing plans for new stores in three U.S. cities to “focus on ecommerce growth.”  Last August, Nestle announced that they were closing a Swiss factory which makes products for its Skin Health business, responding to a slowdown in a business once seen as one of its rising stars. Because of the disappointing results, Nestle has responded by launching an overhaul of its Skin Health business, where it aims to “simplify its organization and its geographical footprint.”  Carrefour announced in May that they were going to close more than 270 stores in plans to cut €2 billion in costs and make the company “more productive and more competitive.”

The scene is much bleaker in the mall space, where some experts predict that a quarter of all American malls will close by the end of 2022 – around 300 out of 1,100 that currently exist.  This is largely driven by the fact that anchor tenants (i.e. large department stores like JCPenney, Sears, and Macy’s), who are sizeable cleaning customers in their own right, are pulling out of malls as they reduce their brick-and-mortar footprints.

Even end-users that are truly dependent upon heavy-duty cleaning services are becoming more cost-conscious.  It’s well-known that hospitals are cutting costs to offset insurance reimbursement pressure. School systems, which typically source their cleaning equipment through distributors (vs. the higher-margin direct channel) given the difficult nature of nationwide service and delivery that are required, are suffering from budget cuts.

As these trends persist, it will only make things harder for Tennant.  Already brandishing immense negotiating power, large strategic accounts will continue to put pressure on OEMs and increasingly award contracts to the lowest-priced bidders as long as quality is “good enough”.  Gone are the days when Tennant could hawk large, “premium” products for premium prices – the world is accelerating towards lower-cost, smaller machines.

IPC Deal Shows That Tennant Recognizes N.A. Stagnation, But Can’t Find Accretion in Europe (Again)

Simply put, the IPC acquisition is a head-scratcher.  From our work, it’s clear that TNC recognized the N.A. troubles described above and tried to buy its way deeper into a new market while simultaneously diversifying its product offering (towards the value-end).  Instead, what TNC ended up getting for its €330 million purchase was a mid-tier, Italian brand that was not widely known in Europe (~6% market share in 2016, i.e. a distant #4).

The recurring themes that emerged from our calls included:

• TNC “paid too much”
• The integration is not going very well for a plethora of reasons: cultural / labor, market, and business model differences
• IPC is fundamentally more of a Commercial product manufacturer, not Industrial
• TNC has focused on front-end integration, while neglecting the critical product / go-to-market side
• Unlike TNC, IPC sells only 25% direct, and 75% through distributors

Interestingly, we also heard from a former employee that this deal reminded him of the Green Machines purchase that he had worked on.  Green Machines is a Scottish urban street sweeper manufacturer that was acquired for $68 million by TNC in 2008 and was henceforth a complete disaster (TNC ended up divesting the business in 2016 for a whopping $6 million).  Although unfamiliar with the IPC deal, the rationale and integration strategy he described for the Green Machines deal is eerily similar:

• The goal was to expand further into Europe and diversify the product portfolio by adding smaller, less expensive cleaning products (in this case, urban street sweepers)
• TNC wanted to keep the new brand separate, but integrate selling
• The Company tried to integrate sales channels, but ignored the different go-to-market strategies required for each brand
•  

Similar to Green Machines, it’s clear that IPC’s failed integration, coupled with a low-margin product portfolio and discounted sales method are diluting TNC’s consolidated margins.

Turning now to gross margins. Tennant's gross margin in the 2018 first quarter was 40.5% compared to 41.7% in the prior year quarter. A 120 basis point change mainly reflects an inventory write-off related to our coatings business as well as negative impacts from a higher mix of revenue from strategic accounts and IPC. We expect further progress on gross margin improvement as we move through 2018 and still expect to remain within our guided range of 41% to 42%.

~ CFO Thomas Paulson, Q1 2018 Earnings Call

Management subsequently guided gross margins down to 41% on the Q2 call.  Our math indicates that IPC is creating a 50-100bps drag on TNC’s profitability on top of organic margin degradation of 100-200bps.  

Nilfisk Merger Idea Yet Another Way for Tennant to Repeat the Past

With much of the rationale for a proposed merger with Nilfisk overlapping with rationale for the IPC deal (complimentary geographic reach and distribution channel offerings), TNC management is unlikely to even consider the Nilfisk deal until 1) they’ve fully integrated IPC successfully, or 2) IPC turns into a complete disaster and TNC and Nilfisk are forced to combine for survival.  We think both scenarios are at least 12-24 months from playing out.

What’s more, TNC management announced the outright rejection of the proposal on the Q4 2017 earnings call:

After thoroughly evaluating the potential merger that was suggested by PrimeStone, the Board, in consultation with its advisers, concluded that continuing to execute the Company's business plan represents the best path forward and is in the best interest of Tennant and its shareholders. We regularly evaluate our strategic direction, and have considered transactions across the industry multiple times over many years as part of the company's regular review of potential options to enhance shareholder value. Prior to announcing the IPC acquisition, we reviewed a range of potential transactions, including the same concept shared by PrimeStone. And we ultimately concluded that the acquisition of IPC was the best way to enhance shareholder value. With the significant progress that we've made to date with the IPC integration, we remain highly confident in that decision.

~ CEO Chris Killingstad, Q4 2017 Earnings Call

Simply put, every single one of our research contacts who was familiar with the PrimeStone proposal voiced concerns regarding go-to-market and cultural integration.  Although many felt that the proposal “looked good on paper” geographically and that some of the cost synergies represented low hanging fruit (i.e. combining headquarters and personnel, closing the Netherlands manufacturing plant, and reducing combined R&D spend), the deal falls apart when you consider the integration of two very different go-to-market strategies.

Nilfisk, a company which relies upon distributing their products through a vast dealer network, has an entirely different sales model than Tennant’s direct method.  Trying to maintain both techniques at this level of scale would create inherent problems for the new company, as they would effectively begin competing against their own distributors.

Additionally, we learned during our calls that neither company has true geographical dominance, unlike the analysis set forth by PrimeStone.  The combined company has the potential to compete more effectively against Karcher in Europe, but they would have to execute the integration perfectly to steal share.  It’s therefore far more likely that the pro forma entity would face the exact same headwinds as standalone Tennant, relying upon market share gains to generate organic growth.

Investment Risks & Mitigants:

IPC Gains Traction for Tennant in Europe

The largest near-term risk that we see is if IPC actually does give TNC a foothold in Europe.  Tennant is laser-focused on making this deal a success – in essence, they’ve bet the proverbial fattoria (farm) that IPC will be a huge windfall.  If integrated properly, one former employee said that IPC had the potential to be a “Karcher killer” in Europe, with the hopes of taking revenue from ~€200 million to €500 million.

Mitigant:  The former employee in question led the IPC acquisition during his tenure at Tennant, so we are skeptical of anything he says regarding the deal.  Our organic growth analysis indicates that IPC has and will continue to dilute Tennant’s consolidated profitability. Furthermore, our calls confirm that the U.S. cross-selling opportunities that many are excited about are unlikely to materialize as Tennant’s customers already source their non-machine cleaning equipment through industrial suppliers like Grainger and McLane.

Tennant Continues to Muddy the Water with Bolt-on Acquisitions

As we have discussed ad nauseam, Tennant has a track record of buying scale (albeit to the detriment of their margins).  Notable bolt-ons include Water Star in 2011, Crawford Laboratories (Florock) in 2016, and of course IPC in 2017. What’s more, there is no indication that this practice will stop any time soon:

We've kept our acquisition pipeline active…we’d love that -- doing another transaction. And we've talked about a few of those over time, but we'd certainly hope that sometime in the not-too-distant future when our leverage gets to where it could be that we would close on another smaller transaction. It would be much smaller [than IPC], and we don't expect to lever back up.

~ CFO Thomas Paulson, Q2 2018 Earnings Call

As such, there’s a distinct possibility that Tennant could continue to hide the ball from investors through more acquisitions.

Mitigant:  Although the Company generates strong free cash flow today, as margins continue to be squeezed, this tactic is unsustainable and will ultimately play out in the numbers.  Our work suggests that the Company will be forced to put the majority of their FCF towards de-leveraging and substantial acquisitions will be difficult as IPC continues to falter.  Besides, if the Company continues to dilute their margins through scale-enhancing acquisitions, this will ultimately be a positive for our thesis.

Consummation of a Nilfisk / Tennant Merger

The largest medium-term risk is the obvious one: Tennant merges with Nilfisk.  Our VAR calls confirmed that PrimeStone has laid out a very compelling and serious proposal that in many regards appears to make sense. If the deal were to play out exactly as PrimeStone forecasts, the combined entity could be worth as much as $134-164 per share by 2021 (representing a 60-100% increase from current levels).  

Aside from the PrimeStone report, the only other indicator that materially increases the likelihood of a deal is the recently-announced retirement of Tennant’s CFO, Thomas Paulson.  During the Q2 2018 earnings call, Tennant announced Paulson’s retirement and stated that they will begin sourcing external candidates through executive search firm Crist Kolder Associates.  Paulson, 61, has served as the CFO for over 12 years and will continue working in that capacity until his expected retirement effective date in Q1 2019.

Mitigant:  For all of the reasons already discussed (cultural and strategic differences, a lack of achievable synergies, integration concerns, etc.) we, again, do not believe that Tennant management would seriously consider merging with Nilfisk until 1) they’ve fully integrated IPC successfully, or 2) IPC turns into a complete disaster and TNC and Nilfisk are forced to combine for survival.  As previously stated, we think both scenarios are at least 12-24 months from playing out.

In their stated long-term growth plan , Tennant management has made no indication that they are seeking a “mega merger” of any kind.  In fact, management hasn’t discussed Nilfisk publically since rejecting the proposal outright on the Q4 2017 earnings call.

However, even if the merger does go through, PrimeStone’s pro forma valuation (above) makes two critical assumptions: 1) the merger is consummated with smooth integration, and 2) the combined entity can solve both companies’ standalone organic growth issues, and return operating margins to 12%.  From our work, we know that these two assumptions are far from certain. Finally, the market is clearly putting a premium on PrimeStone’s glossy merger proposal but if you analyze their previous deal, we are not so sure that’s a good idea:

Dormakaba Case Study

The Dorma + Kaba Proposal Looked Good on Paper…

In their December 2017 proposal for the combination of Tennant and Nilfisk, activist investor PrimeStone cited their previous success in investing in a Swiss commercial security equipment company called Kaba in 2014.

Kaba subsequently merged with German-owned Dorma in 2015 and PrimeStone professed (as seen on right) that the deal had many similar characteristics to their Tennant / Nilfisk proposal, including:

• Similar company sizes / scales
• Slow / GDP-type growth industry
• Mix of direct and indirect sales channels
• Service and aftermarket maintenance making up a large percentage of revenues
• Benefits of capturing global and local scale
• Similar expected magnitude of cost synergies (~6% of total revenues)
• Perceived footprint “rationalization”
• Low level of required R&D spend
• Virtually identical value creation rationale and go-to-market strategy

And for a time, PrimeStone appeared to be correct.  The deal was consummated for CHF 215 million, and shares of the new entity, Dormakaba Holding AG (SWX:DOKA), outperformed.  Dormakaba had improved its profitability, was on-track to hit their lofty margin targets, and had even acquired Stanley Black & Decker’s Mechanical Locks business (for a whopping $730 million) to gain further scale in the United States.  PrimeStone believed that the company was tracking to be the next Assa Abloy and was thoroughly enjoying their 140% shareholder return. HBS even published a case study detailing the activist’s involvement.

By the time of the Tennant proposal in December 2017, PrimeStone was too busy slapping themselves on the back to notice what was really going on inside DOKA.

… But What Has Happened Since the Merger?

Today, Dormakaba’s shares sit ~40% below their October 2017 all-time high.  Organic growth has eroded from 5.4% in FY15 to 2.5% in FY18. On the 1H18 call, management lowered its organic growth guidance for the full year from 4.0-4.5% to 3.5%, and then lowered expectations again on the FY18 call to fall “in-line with the previous financial year”.  Mind you, DOKA’s competitors have actually increased their guidance and are now projecting 5% organic growth. 2019 EBITDA margin targets of 18% (see bridge below) were subsequently pushed out 2021 on the latest call and sit at a meager 15% currently. Management blames unfavorable product mix, merger-related integration costs (both sound familiar) and also hurricanes in the US, but continues to target 18%.  Somehow they expect to achieve this, despite 1) guiding on the 1H18 call that full year numbers would be a “slight improvement” over the 15.4% margins last year and then falling ~40bps short (~80bps decline YoY) and 2) never having surpassed 16% margins in the company’s 156-year history. Management is currently guiding 16.0-16.5% margins next year, claiming that price will be a major factor for how they get there.  It should be noted that the company has already been feverishly increasing prices to offset raw material cost increases.

What’s more, the company’s capital expenditure needs have exploded, booming from its historical norm of 2.5% of sales, to 4%.  Management anticipates that this new level will be required through 2020, along with increased R&D spend for digitization and IT improvements.

Finally, the company has struggled to realize the full synergy potential of both the original Dorma/Kaba merger and the Black & Decker acquisition, mainly due to revenue cannibalization on the top-line and unexpected integration-related expenses.

Takeaways

Two things become crystal clear from analyzing DOKA: 1) despite its professed prowess, PrimeStone has a fundamental misunderstanding of how to drive successful business development through both organic and inorganic initiatives, and 2) combining two slow-growing, low-margin, disparate manufacturing companies that have been underinvesting in their service infrastructure simply does not produce a high-growth, margin-accretive juggernaut.

Exhibit 1: Industry Overview & Trends

The Professional Cleaning Equipment & Services industry is a small and highly fragmented global market of only ~$9 billion.  TNC and its four main competitors (Karcher, Nilfisk, Hako, and Taski/Diversey) comprise less than 40% of total market share worldwide.

The industry largely tracks GDP, growing at a nominal annual rate of ~3-5% (1-2% real) and is fairly stable.  Geographically, the Americas (~43%) and EMEA (~41%) dominate global market share while APAC makes up the remainder (16%).  This is largely due to the nature of the mature U.S. and European markets where industrial cleaning equipment is a necessity, versus the nascent APAC region where abundant and affordable manual labor remains the norm.  The industry is generally characterized as having low barriers to entry, however it is difficult for companies to develop global scale. Additionally, there is a strong industry bias towards “buy” versus “build” and OEMs benefit from a fragmented supplier network of small, commoditized component producers.  Manufacturers like Tennant are only indirectly impacted by input and raw materials costs, however this has become of increasing concern due to on-going steel import tariff negotiations.

On the customer-side, OEMs suffer from substantial concentration.  In Tennant’s case, large accounts such as Walmart, Home Depot, Costco, Coca-Cola, Pepsi, Kroger, Nestle, and IKEA wield considerable buyung power.  The typical method for winning these large account contracts consists of an extremely competitive RFP / bidding process in which clients pit OEMs against each other.  Manufacturers that can provide both a full suite of competitively-priced, reasonable-quality products and a reliable maintenance package typically win the three-year contracts.  Industrial cleaning machines are essentially commodity goods with limited differentiation in quality among the top manufacturers.  At the end of the day, customers don’t need fancy bells and whistles – they just need clean facilities. As a former Costco buyer described it: “[you] want these cleaning products to complement your business, not complicate it.”

OEMs are trying to push back against downward pricing pressure by adding valuable improvements to their machines.  New innovations include movements towards autonomous cleaning, robotics, and telematics (long-distance transmission of computerized information).  Through our research discussions we gathered that these initiatives could have an especially powerful influence in “low-complexity environments”, such as large warehouses, after-hours retail locations, and other open floor layouts.  Regulatory trends in the industry have generated moderate demand for more environmentally-friendly products that require less water and energy to operate, however these trends are perceived to be relatively minor.

Catalyst

• Results: Organic growth slows as comps become more difficult and TNC laps the IPC deal (next quarter) plus margins are flat to down versus consensus expectations that management can nearly double margins to hit aspirational targets
• Market pays attention to thinly traded, underfollowed name (Stonegate, CJS Securities are only sellside coverage) to realize what's priced in and that a deal isn't happening
• Primestone sells stake in TNC, signaling they've given up on their activist proposal