Description

THMD is at a major inflection point and that the stock has significant upside (2-3x) from these levels. Management holds the cards to improve margins by 500 bps within the next year, translating into an incremental $30 million of pre-tax earnings on only 13.3 million shares, or $2.25 of incremental pre-tax EPS. Having followed THMD closely since it emerged from bankruptcy in May 2003, I have finally become very bullish. I know that THMD has twice been written up on VIC since emergence, but I believe we are now at the inflection point. I would refer you to the previous write-ups for an excellent explanation of the business. THMD is an underappreciated and powerful operating leverage story driven by basic cost cutting, blocking and tackling - with no analyst coverage. On top of this, I assume a 6% growth rate for revenues; however, I believe revenues could grow 8-10% a year for the next few years, and would only be further upside to my $31 price target.

New Management

THMD has essentially put a new management team in place over the last year. THMD was poorly managed in the past, but survived on the strength of its brands. And now THMD has switched from survival mode to growth, margin expansion, operating efficiency and cost cutting modes.

Good Business: Razor Blade Model

THMD is a pure-play global supplier of welding and cutting machines, consumables, and accessories. THMD manufactures plasma, arc, and oxy-fuel welding/cutting systems and supplies, plus assorted welding and gas flow products and accessories under numerous brands around the world, such as Victor, Thermal Dynamics, Stoody, and Tweco.

THMD has #1 or #2 share in 90ish% of its products. THMD gets around 2/3rds of its revenues from the "razor blade" consumables, which provides a solid recurring base of revenue.

The Good Old Blocking and Tackling Opportunity

For the last year, management has spent much of its time and energy focused specifically on “on time” delivery. As such, THMD’s “on time” delivery numbers have risen from the 70% range to the current 95%+ range. However, the “on time” delivery issue has prevented THMD from focusing on its biggest opportunity: cost cutting and lean initiatives. In the last quarter, THMD also let go the senior executive mostly responsible for the working capital disappointment. I fully believe most of the problems are in the rear view mirror and the opportunity going forward is tremendous

In the most recent quarter, EBITDA margins came in just shy of 10%; management explained that YOY raw cost inflation cost the company almost 300 bps of margin. THMD is increasing its prices on 12/01 to keep up with inflation. Assuming the price increase, EBITDA margins are more like 12.5%. As a reference, for the 5 years from 96’-00’, THMD had EBITDA margins at 19-20% every year. ITW has 20% EBITDA margins and LECO has 13-14% EBITDA margins. Management believes over the next 9-12 months its EBITDA margins will be at least 15%, which I believe to be conservative.

How do they get there? In Q3, management took $6.7M costs out on a YOY basis. Management stated that there are still meaningful costs that need to be taken out of the system. THMD recently opened a venture in China that will provide them with cheaper sourcing on some of its products. Management also believes that some of its operations are built out to support a much larger revenue base, essentially requiring no incremental costs to grow revenues.

I have been able to verify some of the opportunities by visiting one of the manufacturing plants. The whole factory is going through a lean initiative. For example, some processes that used to take 60 days have been shrunk to 1 day. As the plant gets more efficient, there will be more and more cost savings. Add all these opportunities together and I believe by Q4 of 06’ you will have EBITDA margins that are higher than 15%.

Top Line Trends

THMD also happens to have the wind at its back as the industry is going through a very strong cycle. Management believes its end markets are very strong and the recent hurricanes only added fuel to those fires. The end demand users I have contacted have reiterated management sentiments.


Hidden Asset in Working Capital

The next big opportunity is in the area of working capital. Management has been disappointed with the results in that area and a change of leadership has been made. Management is now confident that it is back on the right track. THMD has publicly stated that working capital is now 35% of revenues and that it should be more like 20% of revenues. Translated into dollars, THMD believes it can take $75-80M ($5.50-$6 per share) out of working capital and use that money directly to pay down debt. Although it will probably take 18-24 months to hit that target, it will be a continual process and you should see improvement every single quarter.

Selling Non-Core Assets

It also appears from management comments that THMD will soon be in a position to de-lever a bit. Management stated on the last call that they are exploring the possibility of selling some non core assets that don’t fit into their vision of the future THMD. I believe they are well along in this process and have gotten significant interest and should have something announced within the next 3 months. Although I can’t put a number on it, I believe this may provide an opportunity to de-lever meaningfully.

The Numbers

13.3 Million shares outstanding: $170 million Market cap; $8M Cash; $267M Debt; TEV = $429M; NOL = $136M

Below I have listed my estimates for pro-forma Q4 numbers for both 05’ and 06’. I have run rated and annualized those numbers to give you an idea of what a full year of earnings should look like based on those numbers.

Q4 05’ Q4 06’
Revenue- $550M $585M
EBITDA- $60 $90M
D&A- $26M $26
Interest- $25 $20m (assumes they de-lever a bit between asset sales and working capital improvement)
Taxes- $2M $10M (THMD has a $136M NOL but will pay some foreign taxes)
EPS- $0.45 $2.25
Capex- $15M $15M
FCF per share- $1+ $3+/share

In Q1 of ‘07 numbers should get even better driven by a legacy (overly generous) warranty program that expires on Jan. 1, 2007.

Valuation

Current comps (ITW, LECO) trade at 9-10X 05' EBITDA and 8-9x 06'. THMD historically traded at an 8-10X multiple. If I assume a somewhat conservative 7X multiple on my estimated $90M EBITDA Q4 2006 run-rate and assume $210M of net debt by end of 06', THMD is a $31.50 stock.

Insider buying and management incentives

Lastly, there has been insider buying by the CEO, CFO and board members in and around these levels. Most of management options are struck at or above these levels. Management wants to get the stock listed and I believe a stock listing should happen within the next 3-6 months. After THMD gets listed, I expect management to become aggressive about telling its story to the Street (i.e. hire an IR firm, get analyst coverage, etc..)

Catalyst

Q4 numbers which will show both EBITDA and working capital improvement
Asset sale
Stock listing on an exchange
IR road show
Analyst coverage