Description

Pro forma for stock splits, Twin Disc (TWIN)is up over 160% since I posted it in early 2005.  Despite this increase (which has been accompanied by a dramatic increase in profitability as opposed to multiple expansion), I believe TWIN remains an undervalued and vastly misunderstood stock.  With organic revenue up 19% last Q, organic 6 month backlog up 34%, margins expanding, a great balance sheet, a conservative management which owns lots of stock, and many one time items masking true profitability, TWIN’s real run rate eps is far in excess of $3.00 (and growing) and thus is trading at less than 10x p/e (maintenance capex is comparable to depreciation).  I am posting this brief update because there is an opportunity to buy this relatively illiquid stock as some institutions are trimming their positions because they do not fully understand the company’s somewhat confusing financials and/or they are reducing their exposure to anything “industrial” but not recognizing that TWIN is not your typical industrial stock (as evidenced by large increases in organic revenue and backlog).  Other sellers might be concerned that TWIN is vulnerable to a downturn in oil prices; however Twin’s energy business is driven by exploration and production, not retail prices.  Naturally, if oil fell to a level where it was no longer economical to explore for oil, that would be bad for TWIN…but our industry sources project exploration to increase in coming years, not decrease.

As a reminder, TWIN manufactures heavy-duty off-highway power transmission equipment.  It has the #1 or #2 market share in all of the niche markets it serves.  Its largest end markets are 1) oil field services (where the company is NOT experiencing any slowdown, even with falling oil prices) and 2) marine (an end market which remains very strong, especially as a result of some acquisitions that enable TWIN to get more TWIN product on each boat, and 3) military which continues to grow as military rebuilds its depleted machinery (Iraq and Afghanistan climate is not conducive to long lived machinery).   Top 10 customers represent 30% of revenue.  For a further business description, see my previous write up or the company’s website/10k. 

TWIN’s reported financials are confusing and deceiving.  I will focus on eps since it’s a fairly good proxy for free cash flow and it’s easier to tie the numbers.  For the fiscal year ended June 2006, the company reported EPS of $2.43.  However, that figure does not reflect an acquisition the company made in May 2006, buying a privately held Italian company called BCS for $22mm.  Pro forma for BCS, EPS was $2.58, but that figure is incredibly conservative since it does not reflect any immediate cost savings (high salaries and perks that one might expect at a privately held Italian company).  Nor does it reflect any synergies which should be meaningful because the acquisition provides TWIN a greater presence in the European luxury yacht market and enables TWIN to now offer customers a complete line of transmission, propulsion and boat management systems  (which should greatly enhance both TWIN’s and BCS’ market share).  BCS’ products were also sold primarily in Italy and TWIN intends to also sell these products to its existing customers in other markets including Australia, the Riviera, etc).  Finally, the acquisition further enhances TWIN’s operations in Italy which should enable it to extract some SG&A savings throughout its Italian operations. 

Also last FY, as noted in 10k’s md&a section, the company incurred 1.9mm in sarbox costs, virtually all of which is non- recurring.  The $1.9mm translates to $0.19 of eps (($1.9*(1-40%)/5.9 shares).  So, we can estimate that normalized FY June 2006 EPS is really $2.77 (2.58+.19), not the $2.43 headline figure.  At $2.77, the stock would be trading at 12x p/e, which we view as very cheap given the company’s growth prospects…however, TWIN’s business has been (and will continue to) grow significantly since the June Q.

In the September 2006 Q, TWIN reported organic revenue growth of 19%, total revenue growth was 32% if you include BCS.  However, the company’s profitability was clouded by a few things. 

#1) As a result of the BCS acquisition, the company took a non-cash, non-recurring $734k pretax ($0.07 eps) charge for purchase price accounting which reduce gross profit.  Note, this charge is somewhat confusingly noted in the earnings press release and I don’t think even mentioned in the 10Q.  Adding back the non-cash charge, EPS last Q would have been about $0.69 or a 64% increase y/y.  This demonstrates the incredible operating leverage inherent in the company especially when you consider this growth came in what is typically the company’s weakest quarter (Sept Q is seasonally slow as European production slowed by European holidays).

#2) The company did not provide PF data the acquisition for the June 2005 quarter, so it’s challenging to get a true LTM PF.  However, they say the acquisition added $0.01 to EPS in Sept 2006 Q, excluding the $0.07 charge.  Put another way, had the company NOT done the acquisition (which we know is highly accretive as reflected in the FY 2006 figures), eps in Sept 2006 Q would have been $0.68 (0.62+.07-.01) or a 62% organic increase from $0.42.   So, while not precise, we can derive a very conservative LTM EPS by taking PF JUNE FY 2006 of $2.77 and adding/subtracting Sept Q’s non-pro forma figures to derive Sept normalized LTM EPS of $3.03  ($2.77+.68-.42)..this eps would have 3 quarters of PF and 1 of non-PF. 

One might wonder if last Q’s organic eps improvement was driven by the lack of sarbox costs, and we believe it is not.  As a frame of reference, in the Sept Q pre tax profit increased $4.8mm last Q (6.1+0.7-4.0).  Management estimates that it only spent approximately $0.5mm (of the $1.9mm) in the first half of the fiscal year.  Even if they spent it all in Q1 (the Sept Q) it would be dwarfed by the $4.8mm total increase in pretax profit on y/y basis.  In the Sept Q, gross profit (which would not be impacted by sarbox) last Q (excluding the charge) increased $6.6 mm (20.3+0.7-14.4) or $0.67 aftertax per share.  So, the good news is that the eps increase did not come from easy sarbox comparisons.  The better news is that EPS growth figures will be even more impressive in coming quarters as the company begins to comp against heavier sarbox impacted FY 2005 quarters and shows even more operating leverage as business continues to improve in its seasonally stronger quarter.  The company incurred most of the sarbox expense last year in the 4^th Q, which is its seasonally strongest quarter, so this year’s Q4 should show an especially large increase in earnings as TWIN co will benefit for the strength in its operating business and much less sarbox expense.

Another way to derive the company’s run rate is to examine quarterly contributions.  Q1, the Sept Q, is the company’s seasonally slowest quarter due to summer vacations at the European operations.  For the past 2 years, Q1 has represented approximately 17% of the company full year eps and 20% of its full year revenue.  If we assume the same pattern continues this year (and neither we nor the company have no reason to believe it will not) FY 2007 EPS would be $4.00 ($0.69/17%) implying an 8.5x p/e for this unlevered, rapidly growing company.  While this analysis is simplistic, it actually is consistent with our more detailed model.

Other random points

Leverage : the company is vastly underlevered.  EBIT/interest expense last quarter was 11.0x.  This overcapitalization is a function of management wanting to keep its powder dry (they have done great acquisitions in each of past 2 years) and their conservative nature in not wanting to lever up too much.  The company might increase its now meager 1% dividend, but a buyback is unlikely given the illiquidity of the stock.  As I discuss below, ultimately I believe this company goes private.

Capex : capex this year will be $10-15mm, about double D&A.  Most of the incremental spend is discretionary will be on growth capex….maintenance capex generally equates to depreciation.  Much of this growth capex involves very large machines which will not begin to positively impact the P/L until next year due to the long lead time in obtaining the machines.  The incremental capex is not required for the company to meet its current backlog.  The company is simply opportunistically seeking high ROI investments to improve profitability (as they have in recent years by outsourcing certain tasks and streamlining other operations).  This is a very financially discipline management team, as illustrated by their acquisition of BCS at 5.2x EBITDA (before any cost savings or synergies).

Takeout potential – TWIN is an incredibly well run $200mm market cap co, high free cash flow, leading market share company with little debt, insiders who own more than 20% of the stock and no analyst coverage.  The Chairman and CEO is in his 60s.  This is a perfect company for a private equity firm to buy.  While we have no reason to believe a take out is imminent (in fact we believe management feels the stock is undervalued at these levels and will move significantly higher as the market realizes the benefits of the BCS acquisition), we believe an eventual take out is certainly is logical.  Although the CEO’s son does have a senior managerial role and a board seat at the company, he is an impressive person in his own right, and the company’s board is impressive and independent.  There are no related party transactions, etc.  I would also note the company used all cash to finance its past acquisitions which should tell you what they think about their stock’s valuation.  Other management’s might have issued stock to help increase the float or to reduce their % ownership. 

Investor relations – The company does a poor job on IR.  Their business and financials are not explained well in their releases, they do not give guidance, they don’t road show a lot, and they do not have conference calls.  However, management is extremely accessible if you call them or want to meet with them.    Furthermore I expect they will visit NYC in the next few months to meet with investors, which should provide a catalyst.

Business Outlook - TWIN does not give guidance, but they have exceeded our estimates every quarter.  Given the conservative nature of this management team, we are comforted by their comment in shareholders letter that “Based on our continued strength in backlog, margins, and industry dynamics, TWIN is well positioned to expand sales and earnings throughout the year.”  Furthermore, management has said its sees improving business trends through at least FY 2008 (which is a major statement for such a conservative management team). 

Pro Formas – The company has filed some 8ks which give you detailed PF for June 2005.  While we encourage you to look at those figures, please bear in mind that both TWIN and BCS have seen significant improvements in their businesses since then and the 8ks do not show any cost saving or synergies.

Hidden  Liabilities – None…no asbestos, legal, etc.

Note: It will be difficult for me to access VIC in near term, but I will try to respond to all questions.  Better yet, I sugest you call the company’s CFO.

Catalyst