Description

INVESTMENT THESIS:
I recommend purchase of THMD shares. The company is a leader in the welding industry, has very high product quality and brand strength, is compellingly valued, and positioned for significant earnings leverage from even a small improvement in global industrial production. The company is also reasonably well-capitalized following its emergence from Chapter 11 bankruptcy in May of this year.

BUSINESS DESCRIPTION:
Thermadyne Holdings Company is a pure-play global supplier of welding and cutting machines, consumables, and accessories. THMD filed for Chapter 11 bankruptcy protection on November 19, 2001 (for the second time in the last 10 years) and emerged on May 23, 2003. THMD management levered up the company by some $350MM in LT debt and $50MM in preferred stock during 1998 and began an eight-company acquisition spree during 1998-2000. The combination of a much higher debt load, the Asian downturn (beginning in 1997-98) and generally weak global economies, underperforming acquisitions, and weakening cash collection eventually made it impossible for THMD to meet its debt service payments.

THMD manufacturers plasma, arc, and oxy-fuel welding/cutting systems and supplies, plus assorted welding and gas flow products and accessories under about 11 primary businesses/brands around the world. Brands of note are Victor, Thermal Dynamics, Stoody, and Tweco. Oxy-fuel welding is based on the use of oxyacetylene gas in a portable (no electricity) apparatus or torch ignited when mixed with air. The flame is then applied to a manually added rod (consumable) to form a weld, joining two pieces of metal together. This method can also be used for crudely cutting various alloys. Arc welding uses electricity flowing through a machine and interacting with an electrode and the metal to be welded forming an electric arc (i.e. the characteristic sparks). Resultant high temperatures help form a weld when a filler metal is introduced, usually shielded by some type of gas to prevent contamination. There are several types of arc welding processes including MIG, TIG, stick, and the slightly different plasma arc welding—the first three of which are used primarily for joining metals in various industrial applications. Plasma arc systems are primarily used for quickly cutting ferrous and nonferrous alloys with minimum heat distortion using only compressed air/gas and electricity. Uses are primarily in the fabrication and repair of sheet metal and plate products.

THMD’s FY’02 sales of $414MM were geographically: U.S. (64%), Europe (12%), Australia/Asia (11%), and Other (13%), with “Other” consisting of 25 countries but primarily Canada, Mexico, and Brazil. FY’02 sales on a product basis were gas apparatus (38%), arc welding consumables (30%), arc welding equipment (16%), plasma and cutting equipment (14%), and other (1%). In the welding business, equipment is the lower-margin “razor” while consumables/accessories are the higher-margin “blades.”

Despite several acquisitions over the past seven years, THMD’s product mix has remained pretty stable, while its geographical mix has seen a shift toward Europe and Other Geographies with Asia/Australia becoming a smaller part of the mix. Domestic profitability has historically been higher and more stable than international, and contributes about 80% of total operating profits. Much of the decline in the Asia/Australia segment can be traced to the Asian devaluation in the late 1990’s.

The vast majority of THMD’s products are manufactured in the U.S., Mexico, Brazil, and Italy. THMD is currently moving one of its U.S. plants to Malaysia to exploit labor and other cost savings. From these manufacturing centers, products are either shipped to company-owned distribution centers or directly to customers, or to other manufacturing centers for additional fabrication or subsidiary branding (e.g. green machines in one country and purple ones in another, but still the same machine).

THMD’s end customers are primarily in heavy industrial segments including autos, HVAC, shipbuilding, steel working, construction, transportation, machinery manufacturing, utilities, electronics, medical, metal fabrication, and general welding. As such, demand for welding machines and supplies is driven by economic growth, particularly industrial production. Conversations with THMD, its competitors, and its distributors indicate a bottoming/early stage recovery in demand for welding products and supplies. Recent strong readings from the ISM and the persistent decline in the dollar also bode well for at least modest growth in the industrial economy.

THMD’s products are distributed through a domestic network of 1,100 independent distributors in over 2,800 locations and supported by product and national accounts salesforce. International sales are conducted through a direct salesforce and independent distributors. I’ve spoken with several domestic distributors, and without exception they noted THMD’s very high product quality. It also appears that most welders “grow up” with certain products and develop brand loyalty, and THMD has benefited from this by being in the business for more than 90 years.

COMPETITION:
Having been around for a few thousand years, welding is a mature field. The US market is about $3B growing historically at 3% with cyclicality. The global market is about US$12B growing marginally faster than the US market. The US market is dominated by an oligopoly consisting of Lincoln Electric (LECO), the Miller and Hobart subsidiaries of Illinois Tool Works (ITW), and THMD. Foreign competition in the U.S., at least to this point, remains relatively low due to quality and distribution barriers, though the Esab unit of Britain’s Charter plc (CPLCF–OTC) and France’s L’Air Liquide (AIQUY–OTC) can be seen domestically and abroad.

Average Historical Product Sales Mix:

THMD LECO ITW
Machines 20%-35% 40%-45% 70%
Consumables 30%-40% 55%-60% 15%-20%
Gas apparatus 40% 5% 10%-15%

Each competitor has its own niche. Domestically, LECO is widely recognized as the leading consumables company, ITW’s Hobart is the runaway leader in arc welding machines, and THMD (Victor) is the acknowledged leader in gas apparatus. THMD, through its Thermal Dynamics subsidiary, is also one of only two significant players in the plasma cutting equipment market. THMD’s share in the plasma market is a multiple of privately-held Hypertherm, which was founded by former THMD employees. Note that THMD and LECO are pure-play welding companies, while ITW is much more diversified.

THMD’s EBIT margin, excluding non-recurring charges, has declined from mid-teens at the last cycle peak to about 9% year-to-date. LECO has experienced a similar margin decline, to now at about 7%. THMD appears to have an operating margin in-line with or slightly higher than the competition, despite having a lower consumable mix, which I think is likely due to a leaner cost structure.

CAPITAL STRUCTURE:
Upon emerging from Chapter 11, THMD wiped out $832MM in debts and all of its common and preferred equity. In its place, THMD issued 13.3MM common shares, $180MM in senior notes (maturing 2004-2008, paying LIBOR plus 3%–7.5%), 1.157MM Series A warrants ($13.85 strike expiring in May-04), 700K Series B warrants ($20.78, May-06), and 271K Series C warrants ($27.70, May-06). THMD currently carries an additional $46MM in debt (revolver, capital leases, other). Interest expense is running about $17.2MM annualized. The estimated reorganization value was $523MM, implying a value per common share of ($523MM-$180MM-$46MM) / 13.3MM = $22.33 (or slightly lower assuming exercise of warrants). As of Sep-03, THMD had $11.1MM in cash, so net debt is $216MM. FY’03 EBITDA, before non-recurring, looks to be around $54MM (a depressed 12.8% margin). Debt/EBITDA is 4.0x, and EBITDA/interest is 3.2x.

REVENUE & EARNINGS ESTIMATES:
FY’03 revenue should be around $420MM (up slightly yoy). Although the numbers are extremely messy due to the bankruptcy distortions, I calculate pro forma EBIT, excluding one-time expenses and intangible amortization, is around $36MM, an 8.5% margin. Backing out interest expense of $17.2MM, other expenses of $2MM, and a theoretical tax rate of 38% leaves net income of $11.6MM, or about $0.80 per share. I would characterize this result as very depressed.

Cash flow should remain significantly higher than reported EPS for the foreseeable future for three reasons. First, THMD has $153MM in NOL’s expiring between 2003–2022 that it can use to offset U.S. taxes. Second, capex should remain below depreciation. Annual capex has run at only $10MM for the past two years during the sharp economic downturn and strain of the bankruptcy process. It should increase to around $15MM, or 3.5% of revenues, but still below depreciation of $20MM. This difference adds $0.37 to cash EPS. Capex should remain below depreciation until THMD has experienced a material increase in business activity. Third, reducing working capital is an opportunity. Days-in-inventory is currently around 140 versus 83 at LECO, and DSO is 70 versus 60 at LECO. At THMD, working capital is 32% of revenues and the cash cycle time is 175 days, much higher than comparable companies. Management thinks it can get $10MM out of working capital over the next couple of years, but I think the number should be higher, perhaps $30MM at best. Add these three factors together and FCF should meaningfully exceed reported earnings.

EARNINGS POTENTIAL:
It is likely that only a slight improvement in business conditions will result in significant earnings leverage. EBIT margins collapsed from around 15% to the current 8.5%, as revenue declined from its peak just above $500MM to now around $420MM. THMD is in a position where mild revenue growth (mid-single-digit) over the next two years should allow EBIT margins to recover to 10%, at a bare minimum. That conservative performance would produce EBIT of $46MM, still far below the $79MM in FY’00. Enhanced by lower interest expense from $50MM in FCF-based debt paydown, fully-taxed EPS could be $1.35 in two years. Cash EPS would obviously be considerably higher. I think a more likely scenario is that modest revenue growth for two years will produce an EBIT margin of 11%-12%, or fully taxed EPS of $1.55 to $1.75. This would put cash EPS around $2.00. An EBIT level similar to the prior peak would produce fully-taxed EPS close to $3.00.

VALUATION AND TARGET PRICE:
THMD currently trades at EV/EBITDA of 6.9x and a “pro-forma” P/E of 14.6x, on what I believe are very depressed results. Assuming only modest topline recovery, EPS should reach $1.35–$1.75, with significantly higher cash EPS. This should at least support a stock price in the high-teens, or 50% above today’s price. Looking at that scenario another way, keeping the EV/EBITDA multiple at 7x produces a stock price in the low $20s, almost a double from current levels.

One of the problems has been very poor investor communications. The company web site is barren of financial information, few press releases have been issued since emerging from Chapter 11, and management does not hold conference calls. The CFO recognizes this deficiency and says that THMD plans to remedy it, plus seek sell-side research and present at investor conferences. Better communications and coverage should aid the stock’s valuation and liquidity.

RISKS:
Economies. For the THMD story to work, global economies must demonstrate some level of improvement at the basic industrial level. Absent any economic improvement, the stock is likely to dead money. Perhaps one way to mitigate this risk would be to pair THMD with another cyclical name that has already rallied strongly (should have plenty to choose from).

Foreign encroachment in domestic markets. To date, the U.S. market has been relatively underpenetrated by foreign suppliers, save efforts from Esab and Air Liquide. This has historically been due to U.S. companies' dominance in product quality and distribution channels. Other smaller, low-cost foreign suppliers have entered the market, though primarily in the consumables segment where production is easy to duplicate and margins are generally higher. The risk is that foreign competition in the U.S. could heat up if the industrial economy significantly rebounds and/or U.S. suppliers' cost-quality slips.

Unclear foreign strategy. It appears that the company has planted a flag via acquisition in a particular country in order to catch the economic winds that happen to be blowing during a certain period. The risk in such a strategy can be seen in the lack of scale present in its foreign subsidiaries and the year-to-year volatility of THMD's foreign margins (absolutely and relative to its U.S. operations and peers). While some of this can be explained by difficult economies and volatile currencies, I believe it also demonstrates a lack of focus. THMD would probably serve itself well by either retrenching in those foreign markets where it is strong and/or abandoning those in which it is weak.

Dilution. The 1.157MM Series A warrants are in the money at $13.85. If exercised, they could dilute EPS depending on how the proceeds were used.

Management issues. THMD is currently searching for a CEO following the retirement of Karl Wyss in October. Wyss was a former DLJ banker, and CSFB/DLJ owned 80% of the company pre bankruptcy. From discussions with management, I do not believe THMD is close to finalizing this search despite its stated intent to complete it by year end. The CFO (Tate) and Controller (Maddox) were career E&Y employees, and E&Y is THMD's auditors. THMD made loans to executives that still have balances outstanding. Executive pay seems rich for a company that has been declining. Obviously, not knowing who the CEO is going to be creates uncertainty. On a side note, the CEO and CFO of LECO, who were key in turning that company around, are both stepping down, though I have no reason to believe that either is being considered for the THMD job.

Liquidity. THMD is thinly traded, and there are days when the stock does not trade. Consideration of this factor should be taken when entering or exiting positions in the stock.

Catalyst

CATALYSTS:
Industrial-cyclical stocks have rallied strongly over the past six months anticipating a better environment in the coming year. Recent weakness in the dollar and very strong ISM readings support this expectation. THMD should particularly benefit from such an environment, yet the stock hasn’t budged.