Description

Thermadyne is the best risk-reward opportunity I have seen in 2 years. I think this stock will easily return 50% and should do much more, and the downside from here is very limited. THMD has frustrated and disappointed investors for the last year and people have completely misunderstood what the progress that the company has made. People have been waiting for this company to start executing, and it is finally happening. Last week they reported 1st quarter numbers that demonstrated the first glimpse of the improvement they have made in the business, and nobody is paying for it yet. A very conservative valuation based just on the run rate of where they are today, giving no credit for any of the fundamental improvements that I will describe below, gives a $15.70 stock and a 30% return. With half-decent execution, the stock will be $30-40 in 2 years, which is a 3-4 bagger. On the downside, the bottom for this stock was in October-November of last year, when the company was putting up terrible numbers with no end in sight, the bulls on the story like Mark778 were throwing in the towel in frustration, and the stock never really traded below $11. Since then the company has demonstrated enormously improved results. So the low tick was about 10-15% below current prices under much worse conditions. There was also insider buying at $11.80, which is only 3% below the current price.

Mark778 originally wrote this idea about a year and a half ago, and he gave an excellent summary of the company and the industry, which I would recommend that you read. Mark’s thesis and analysis of the potential is right on, but he was a year early. Since his writeup, the company has underperformed woefully in the best welding market in recent memory. Thermadyne’s revenues were very strong along with the market, but margins got worse every quarter and inventory and debt bloated. Investors got frustrated with what they perceived to be a poorly managed company that could not figure out how to make money, and I think everybody has pretty much given up on them by now. The reality, however, is that the weakness last year was the result of a calculated, deliberate, and intelligent plan by the company that required some short-term pain for a lot of long-term gain. The THMD investment has required patience, but the good news is that now the company is delivering, the numbers are showing up, and you are not going to need to be patient much longer.


Industry

I will again refer you to Mark’s writeup for the industry background, but there are a few points I would like to add to help understand THMD’s positioning. The first point is regarding filler metal. If you think of the razor/razor blade/shaving cream revenue model, the torches and equipment are the razors, consumables like tips that wear out after a few hours or days are the razor blades, and filler metal is the shaving cream. THMD does not sell filler metal, which is basically a commodity metal product. Filler metal represents a large part of industry revenues, so when looking at THMD on a total market share basis, their size is understated. With respect to the products and segments that they play in, THMD has #1 or #2 share in about 90% of their products. Also, the filler metal skews the growth rates when you look at YoY revenue growth. Last year, with commodity prices going to the moon, comps like LECO put up huge numbers largely because of the price increases in filler metal, which makes it look like THMD’s revenue grew less than the industry. In reality THMD is gaining share in the products they sell. It is also worth noting that THMD gets about 65% of its revenues from the “razor blade” consumables, which provides a solid recurring base of revenue.

The other point worth understanding is that most of THMD’s brands are the high-end, gold standard brands in the industry. I have found it interesting that in my conversations with THMD’s competitors, they all love to bash Thermadyne because of their financial history, but they all uniformly agree that the bands and products are excellent. This brand strength is what has kept the company in business through all of the turbulent times – as poor as the customer service has ever gotten, the customers still buy the products because of the quality and brand power.


History

The company emerged from bankruptcy in 2003, and investor expectations were based on the assumption that the market would get better and there would be natural earnings leverage that would return the company to its historical levels of profitability. But when Paul Melnuk took over as CEO in early 2004, he identified problems in the business that needed to be fixed in order to bring the company back to its premium status. Because of strength of the brands and products, the company had historically been rather arrogant. They basically made the products they wanted to make and pushed them onto the customers. There was no attempt to understand what customers wanted, and no feedback loop; in fact they did not even measure basic things like on-time delivery. As a result, customer relations were very weak. Prior management’s clumsy attempt to deal with this problem was to put in an un-economical rebate program that we will unfortunately be shackled with until the end of next year (this program is costly, but it is already fully in the numbers, it is not getting any more costly, and the good news is there is a large potential margin pop available when this legacy program rolls off next year). When Paul took over, he realized that on-time deliveries were around 50% and that the company did not have the infrastructure or the culture to service the customers properly. So had made the conscious choice to take the time and money to restore customer confidence, build a responsive, customer-focused organization, and make Thermadyne a premium company again.

This of course meant that the company had to spend a lot of extra money last year. They took on a big increase in inventory (and therefore debt) and incurred extra costs on things like overtime, shipping, and freight (in some instances Fed-Exing parts overnight to China). They hired a completely new and significantly stronger management team (new CEO, COO, CFO, EVP of sales, etc.). But the result is that customers are a lot happier, and the investments and one-time costs have now set the company up to be able to grow revenues, drastically cut costs, and take an enormous amount of working capital out to pay down debt.


Strategy

There are three components to Thermadyne’s strategy: grow revenues, cut costs, and reduce working capital. One major opportunity for revenue growth will be from a multi-tiered brand strategy. THMD has an extremely strong presence in the high end of the market and to some extent the middle. But they have seen erosion from low-priced knock-offs over the last 10 years. They have recently introduced new low-priced brands, as well as providing private label products for some of their largest customers. They were already seeing plenty of competition at these price points, so the new brands should no cannibalize their existing products, and they will source much of this product in China, so they will still earn very healthy margins. The other major growth opportunity is that the Company thinks there is big potential from just designing products that customers want – they have never had a feedback loop before and there are a lot of opportunities to meet customer demand based on ideas and requests they are getting directly from the users. My conversations with customers confirm that this is a real opportunity.

On the cost-cutting front, there are two main opportunities. The first is the company’s Production, Sales, and Inventory (PSI) planning process. For the first time in its history, the company has cross-functional teams working to figure out what end-user demand will be. Their largest customers have recently started sharing detailed data with the THMD on inventory, sales forecasts, etc., information that prior management had never thought to ask for. The result is better planning and cost control, lower overtime, shipping, freight, etc. The second major cost opportunity is in sourcing. Part of the story here is that THMD was an agglomeration of several acquisitions in the 90’s, which never acted together like one company. They are getting a lot of leverage right now by moving to one global sourcing function and consolidating suppliers. The other part of the story is the development of sourcing and production capacity in China. They have recently created a JV with the largest manufacturer of gas equipment in China. This has the potential for huge input cost reductions when it gets going in the second half of the year.

PSI will also have a huge impact on inventory. The planning and forecasting will certainly give the company a much stronger ability to manage their inventory. They have also started implementing a lean manufacturing system – again, not rocket science but something that prior management teams had simply never lifted a finger to try to do. The company has identified substantial low-hanging fruit right out of the box that can reduce finished goods inventory.


The Opportunity

If Thermadyne were to be able to get back to historical levels of profitability and working capital, the numbers would be off the charts. In the 90’s, you could set your watch by the company’s steady, $95+ EBITDA numbers every year based on revenue numbers that were lower than what they will likely do this year.

FY 1996 FY 1997 FY 1998 FY 1999 FY 2000
Sales 439.7 520.4 532.8 521.1 510.1
Op Inc (14.1) 78.5 83.5 71.9 52.0
EBITDA 95.7 102.2 105.1 98.6 95.3
Capex (11.4) (16.3) (17.5) (10.2) (16.3)
EBITDA - Capex 84.3 85.9 87.6 88.4 79.0

Margins
EBITDA 21.8% 19.6% 19.7% 18.9% 18.7%
EBITDA - Capex 19.2% 16.5% 16.4% 17.0% 15.5%


FY 2001 FY 2002 FY 2003 FY 2004
Sales 438.2 413.6 426.4 482.6
Op Inc 26.4 37.8 25.2 18.7
EBITDA 46.7 57.0 50.1 45.4
Capex (15.3) (9.4) (12.2) (16.1)
EBITDA - Capex 31.4 47.6 37.8 29.3

Margins
EBITDA 10.7% 13.8% 11.7% 9.4%
EBITDA - Capex 7.2% 11.5% 8.9% 6.1%


The post-reorg plan called for EBITDA margins of 20% by 2006 on only $462M of revenues. The plan has admittedly been delayed by at least a year, but revenues have come in much stronger. If they actually put up those margins, the stock would be $50. I happen to think that this is possible, but that’s certainly not my base case.

A more conservative approach would be to use management’s plan. They have always avoided giving guidance or making commitments, because until recently they were still in the process of building out all of the infrastructure to fix the business. But a month ago, once they were clearly past the “inflection point,” the CEO made the following commitments: (1) “You should fire me if I don’t get to 15% margins” and (2) “We will double inventory turns” (implying about $70M of cash generation/debt paydown assuming reasonable revenue growth), both within “a reasonable period of time.” I believe they mean a reasonable period of time to be by the end of next year/early 2007.

A third and more conservative method would be to just take the run rate of where they are today and give them no credit at all for getting anything else right. I show the valuation using all of these metrics below, assuming that revenue growth slows in the back half of the year to a total of $520M and capex of $15M (guidance was for low end of 10-15 range).

Cash 9.3 9.3 19.3
Debt 256.1 215.0 175.0
Shares 13.3
Price $12.14
Equity Cap 161.5
EV 408.3 367.2 317.2

BK plan MgtGoal RunRate My 05 My 06
Revenue 520.0 520.0 520.0 526.0 551.8
EBITDA 104.0 78.0 62.0 65.2 75.1
Capex 15.0 15.0 15.0 15.0 15.0
Int. 23.0 23.0 23.0 23.0 21.0
Taxes 22.0 11.6 5.2 5.3 10.6
EPS $2.48 $1.31 $0.59 $0.62 $1.24
FCF 44.0 28.4 18.8 22.5 30.1
FCF/Sh $3.31 $2.13 $1.41 $1.69 $2.26

EV/EBITDA 3.9 5.2 6.6 5.6 4.2
EV/(EBITDA-Capex) 4.5 6.5 8.6 7.2 5.3
P/E 4.9 9.5 20.6 19.6 9.8
P/FCF 3.7 5.8 8.6 7.2 5.4

If pull out $40M of Working Capital
EV/EBITDA 3.5 4.7 5.9

If pull out $70M of Working Capital
EV/EBITDA 3.2 4.3 5.4

Note that the FCF number is fully taxed using a 40% tax rate and includes no benefit from working capital. I calculate the PV of the NOL to be worth $1.70/share.

Notice that a little execution on the working capital can make a big difference in the multiple. My estimates are for $65M of EBITDA in 2005 and $75 in 2006, and I expect them to take out $20M of working capital this year and another $20M next year. Combined with cash generated from the business, I get net debt at the end of 2005 of $205M and debt at the end of 2006 of $155M.

Lincoln trades at about 9.1X EBITDA and ITW trades at over 11X. If I use 8X trailing on Thermadyne and add $1.50 for the NOL, I get a valuation at the end of 2005 of $26, and $36 at YE2006, returns of 115% and 195% respectively. Obviously if you believe the upside scenarios then the price is much higher. If you want to take a worst case and assume no further improvement in margins and absolutely 0 improvement from working capital, put a 7X multiple on EBITDA (or 11X fully-taxed FCF), and give no credit for the NOL, then you still get a $15.70 stock, which is still a 30% return from here.


Why is it so cheap?

- Many frustrated investors who have been waiting for a long time for this company to execute
- 4th quarter report was a disappointing to some investors, and there were material weaknesses cited in 10-K
- Company amended covenants in March, which included a change in minimum EBITDA covenant to as low as $39M for March and June 2005 quarters, which made everybody nervous that EBITDA was going to fall off a cliff
- Nervousness that raw materials would continue to crush margins
- The S&P downgrade that happened the day before earnings. In its report, S&P acknowledged the progress that THMD has made and the huge opportunities available to them, but the rating is based on trailing 12 months. This is a bit like driving while looking in the rear-view mirror.

The material weaknesses (which have hit hundreds of good companies this auditing cycle) were very minor. In terms of EBITDA trend, I think the company safely put pretty much all of these issues to rest with the strength of its first quarter report and clear internal improvements. For some reason nobody seems to care right now.

- The company used cash in the first quarter

I think the reason that nobody is willing to believe the numbers yet is that the company used cash in the 1st quarter despite the strong operating numbers. This was due to the timing of 2 major payments: One was the semi-annual payment of interest on the bonds, and the other was the January payment of accrued rebates for 2004. These factors combined for about a $10M effect on cash in the quarter where spending was greater than reflected in earnings. Both of these factors will normalize throughout the course of the year. If you back these out then THMD generated $3-4M of cash in the quarter. I think a lot of people are still not believing it and are waiting for the Q to see exactly what happened to cash.

- The other major concern out there is that the economy is getting weak and that the top line is going to fall apart on this industry.

First of all, if this scenario happens because of high commodity prices, then it is worth noting that any use of metal requires welding and that sales to the oil & gas end market are just starting to ramp up now. Second, the company does have a lot of opportunities to grow revenue faster than the industry average in their core markets, as described above. Third, one of the great aspects of this story is that there are a lot of ways to win and they are somewhat negatively correlated. The main reason that inventory has been high and margins have been low is that the company has not had time to implement the necessary process changes because of the strength in revenues. They know what they need to do in terms of implementing a lean manufacturing system, and they will get a lot of benefit when they do, but right now orders are so strong that they cannot afford the downtime. A slowdown in revenues will enable them to get a lot of the working capital and margin benefits. Fourth, based on the backlog growth we have pretty good visibility through the end of the second quarter, and at that point the trailing 12 month revenues will be about 505-510. I expect revenues for the year of at least 520. If revenues do drop back to 500, then they should still be comfortably in the low 60’s of EBITDA and the stock should still be $15+.


Why I think it will work
- I have talked to a lot of customers and competitors, toured several of Thermadyne’s facilities, met several layers of management, and the story checks out.
- Management is very strong. Most of these people have been hired since mid-2004 and represent a huge improvement over their predecessors.
- Insider buying: One of the board members who is a representative of Angelo Gordon bought stock at $11.80 in December, and business has gotten a lot better since then. Angelo Gordon owns 37% of this company and this director wanted to buy more in his P.A. That seems like a pretty bullish sign to me.
- The fact that the opportunities are somewhat negatively correlated, as I described above.
- The huge progress they have made through the first quarter is before getting any real benefits from Lean Manufacturing (which they just started putting in place in April), PSI (which they started in February), and China (which should start hitting in 2H)
- The nice built-in pop in revenues and margins when the legacy rebate program rolls off in late 2006
- Sentiment on this stock is about as negative as it can get. Nowhere to go but up.

Catalyst

- One more quarter of execution will show that the results are real and that the company is generating real free cash flow
- Working capital reduction will start to happen in the second half, which along with cash from operations will generate meaningful debt reduction (I am expecting $40M)
- Listing on an exchange
- Potential for more insider buys: Because of the timing of its SEC filings, the executives have been in blackout from buying stock since December. If they were to buy any stock then I think it would be a very positive sign.