Description

Thermon is the #2 global provider of heat tracing solutions for petroleum and chemical plants, oil & gas production facilities and power generation facilities. While over 50% of the business is linked to oil & gas end-markets, including the challenged Canadian oil sands, the company generates meaningful annuity-like MRO/aftermarket revenue from its growing installed base. The excellent MRO business (about â…“ of total revenue), which is not directly tied to commodity prices, is likely worth slightly less than the current stock price, creating a significant margin of safety. Furthermore, the overall business is a high quality, albeit cyclical, niche business which benefits from sustainable barriers to entry and has attractive economics. I don’t have a view on commodity prices or the energy CapEx cycle, but the risk of permanent capital impairment is likely minimal due to the attractive valuation, clean balance sheet, variable cost structure and profitable MRO cash flow. THR is trading around 7-8x EBITDA, 8-9x EBITDA less CapEx, 10-11x FCF and 65% of my $23-27 estimated intrinsic value per share.

The company sells (and sometimes installs) heat tracing solutions which “provide an external heat source to pipes, vessels and instruments for the purposes of freeze protection, temperature and flow maintenance and environmental monitoring.” The products include heat tracing cables, tubing bundles and control systems. The company also provides services including design optimization, engineering, installation and maintenance. A typical installation includes up to hundreds of thousands of feet of heat tracing cable attached to pipes, valves, fittings, etc. linked to temperature control and monitoring panels. Heat tracing is low-tech (R&D is only around $3mm or 1% of revenue) but has a high value relative to its cost -- heat tracing is mission critical, ensuring efficient and safe plant operations, but generally costs less than 1-2% of total capital spend. The company’s end markets are highly weighted towards oil & gas:

• Oil & Gas (46%): roughly 50% upstream and 50% downstream. Midstream pipelines generally use boiler stations. The “Distribution Channels” “end market” mentioned below also includes oil & gas exposure.

• Chemical (16%)

• Power (8%): includes coal, gas, nuclear.

• Other (7%)

• Distribution Channels (23%): includes some oil & gas exposure.

Thermon reports Greenfield and MRO/UE (upgrades & enhancements) revenue.  In most years, about 40% of the revenue is derived from Greenfield and 60% from MRO/UE which translates into roughly 40% Greenfield, 30% MRO, 30% UE. It’s worth noting the Greenfield/MRO/UE distinction is imprecise -- Greenfield is defined as orders over $1mm and MRO/UE is orders under $1mm.

Thermon is a high quality, compounder with sustainable barriers to entry

The company benefits from a sustainable competitive advantage derived from economies of scale and customer captivity:

• Economies of scale

• Top two industry participants occupy a preferred position for Greenfield projects. Pentair Thermal Management (formerly Tyco Thermal Controls / Raychem) and Thermon have 26% and 20% market share, respectively, whereas the #3 (Bartec) has only 4% market share.

• Pentair and Thermon are generally the only two pre-qualified providers on large Greenfield projects and the company usually sees no more than 3-4 bidders on small projects.

• Economies of scale are derived from a combination of manufacturing, R&D, engineering expertise, distribution and country/regional certifications.
  
  

• Customer captivity

• Greenfield & UE projects: strong reputational advantage (quality, safety, reliability) as a result of long-standing relationships with large customers and EPC (engineering, procurement & construction) companies.

• MRO: strong incumbent advantage with a near 100% win rate due to reputation advantage and high switching costs (warranty and compatibility issues). Being out of stock is the primary way to lose MRO business according to the company (distribution economy of scale).

• This reputational advantage is likely enforced by the high value-to-cost ratio mentioned above -- why bother switching?

The competitive advantage is demonstrated in the company’s financial results. Thermon has profitably grown revenue (8% organic CAGR since F1990), generates high and consistent margins (~ 45% gross margin, ~ 25% EBITDA margin), has low capital intensity (2% CapEx / sales) and possesses excellent returns on capital (~ 30%).

Growing, annuity-like MRO business worth around $15 per share

I believe the excellent MRO business is being overshadowed by the challenging energy CapEx environment. Although over 50% of the company-wide revenue is from oil & gas end-markets, including the challenged Canadian oil sands, a significant percentage is from the excellent MRO business. I believe the MRO business is truly excellent and very valuable:

• 2nd largest installed base was built over 50+ years and includes thousands of customers

• very high switching costs (compatibility, warranty) translate to near 100% retention

• installed base creates significant MRO revenue equal to 5-10% of initial project cost beginning 1-3 years after installation

• while a cable is certified up to 20 years, it rarely remains in the field that long -- underlying in-line equipment can wear out every 2-5 years and it’s easier to rip out insulation & heat tracing when performing facility maintenance

As noted above, the company reports MRO/UE revenue, however, I have made an attempt to isolate the highly-valuable and less cyclical MRO business (although there is a highly recurring aspect to the UE business as well). The table below attempts to calculate the installed base, which, according to the company, generates MRO revenue equal to 5-10% of its value per year. My basic calculation assumes the installed base grows by the Greenfield revenue (assume UE revenue offsets asset retirements). The company has noted the MRO/UE gross margin runs 50-60% and was 57% in F2015. Based on the low cost nature of MRO, I estimate mid-60% gross margins and 35-40% EBITDA margins for MRO.

The $35mm of estimated MRO EBITDA earnings power translates into about $25mm of NOPAT. The MRO business should grow in the mid-single digits over time and I believe it is worth around $15 per share at 20x NOPAT (about 14x EBITDA).

THR is worth around $23-27 per share

A significant portion of Thermon’s revenue is cyclical as noted above so I’m taking a flexible approach to valuation. First, I start with management’s F2016 revenue projection of a mid-to-high-single digit decline (after the impact of the 3 announced acquisitions). F2016 could be worse but the company has already reported two quarters in F2016. Next, I model out various Greenfield, UE and MRO scenarios over the next few years. Finally, I reach a value of about $23-27 per share in NPV terms after discounting a forward value back at 10%.

Below is my “base” case summary model:

Risks

As mentioned above, risk to permanent impairment of capital seems minimal. First, the margin of safety is compelling: the high quality MRO business alone is worth around the current stock price. In terms of the business quality, Thermon generates significant free cash flow and has a highly variable cost structure, which should help the company navigate a challenging energy CapEx environment (chemical end-markets should benefit from lower chemical feedstocks). Lastly, the balance sheet is conservatively levered (0.6x net debt / EBITDA). It is worth noting that the company ran with 4x leverage (at 9.5% coupon) under private equity ownership.

One point of potential concern is that Thermon’s management has become acquisitive over the past year. To date, the company has spent over $40mm to acquire 3 companies. Two of the targets seem reasonable: a distributor in South Africa and an insulation contractor in the Gulf Coast. The third acquisition (Sumac) is more of an adjacent acquisition. It’s too early to evaluate management’s capital allocation skills but it’s certainly something to monitor.

Catalyst

• energy CapEx

• future acquisitions