Background & Thesis Valmet Corporation (HEL: VALMT), a recently spun-off equity, is a misunderstood high quality industrial company that trades for a discounted valuation.
Valmet is a global supplier of technology and services for the paper, pulp and energy industries. They make big machines and then service those machines as well. It completed its spin from Metso (HEL: MEO1V FH) in January 2014.
It has leading market share in installed equipment for the paper, tissue, board, pulp, and bioenergy industries, as well as a #1 market position in servicing this equipment worldwide. This services business is their crown jewel. It is highly profitable, has recurring revenues, and has good growth prospects.
The company is organized into three segments:
pulp and energy (35% of revenue),
paper (26% of revenue), and
services (39% of revenue).
Over 30% of its revenues are in emerging markets where it maintains its strong market share, and where there ought to be higher growth rates.
Valmet posted weak results at the end of 2013.
The Capital division (non-services business lines) fell 20% from €2.0B to €1.6B. Historically it has been a very cyclical and lumpy business.
Due to those declines, EBITA profit margins fell to 2% in 2013. EBITA, which was €192mm in 2012, dropped to €54mm in 2013.
While the service business continued to chug along, the paper, energy and board lines really struggled.
Another reason that Valmet’s profits fell off was due to a timing delay of one large project in Brazil, a delay that impacted profits by €30mm, but has since been resolved and will not repeat.
2013 = anomaly
But, there’s a decent argument to believe that the 2013 results were an anomaly and not simply a structural change to the business.
While it is likely that the newsprint business will continue to decline, it has been in decline for a long time and yet they’ve managed to maintain 6-8% EBITA margins for the last several years.
Given the cyclical nature of the energy, board, and paper divisions, and the growing demand in emerging markets, the odds favor a rebound in demand over the coming years. The ever growing services business provides additional support for the business.
Already in 2014, the orders have stabilized and backlog improved 28% y/y in June 2014, ending at €2.4B.
EBITA improved to 3.7% in Q2 and management says they can return to 6% to 9% profit margin over the long-term.
We usually take management expectations with a grain of salt, but last quarter demonstrated they are making some progress.
Cost Cutting Program
Further supporting the odds of an improvement in profitability, Valmet implemented a €100mm cost cutting program in 2013, right-sizing its paper and energy businesses.
The results of this program have started to show up in 2014.
These changes alone should bring Valmet’s EBITA to the 4-6% range, and they do not factor in any improvement or recovery in the end markets of the other businesses.
As Economies mature, they use more tissue and board materials
In addition to these cost improvements, Valmet should also face improving business conditions over the next few years as developing and emerging economies improve living standards.
Developed markets use much more tissue and board material than emerging markets and countries like China and Brazil are investing heavily to catch up as those economies support higher standards of living.
And even in the US, which has the highest per capita tissue and board consumption in the world, Valmet continues to find pockets of growth as well.
The company estimates that its pulp, energy, board and tissue markets should grow at low single digit rates going forward, while its paper and newsprint business should decline 1% per year.
Finally, and most importantly, Valmet’s services business should grow at mid to high single digits. This is supported by global data which shows that paper consumption in aggregate will continue to increase.
This will be the primary growth driver for Valmet going forward.
With €1.0Bn of revenue, it is 38% of the company’s overall revenues.
It has long-term contracts, high renewal rates, and generates above average margins.
Whereas the selling of equipment is highly cyclical and lumpy (a single order can be as much as €400mm), the services business is steady.
Since 2006, the services business has grown every year (except for a modest decline in 2009.)
· While Valmet has a 40% market share of installed equipment, it only has about a 16% market share in services and this market is highly fragmented globally.
We believe Valmet can continue to grow their highly profitable service business at mid-single digit rates over the next several years both organically and through acquisition.
Strong Balance Sheet
Unlike many other spin-offs, Valmet was launched with minimal net debt leaving it substantial strategic flexibility.
It has the opportunity to make roll-up acquisitions in the industry which could be highly accretive given its market share, or they could buy back substantial amounts of stock.
In March, the company authorized a share buyback of 10mm shares.
Valmet traded independently at the beginning of the year at about €7.00
Currently trades for €8.35 (8/25/14).
At this price, the enterprise value of the company is €1.3Bn.
This is approximately 6.9x 2015 EBITA (4.8x EBITDA)
We expect the company to generate €2.8B in revenue and 6.5% EBITA margins (€184mm of EBITA) in 2015, hitting only the bottom end of their profit targets.
We get there by assuming modest growth in services (3-4% per year), and a rebound in non-services businesses from €1.6mm to €1.75B.
This should prove conservative on the services side since they have many ways to grow (organic market share, acquisition, etc…) and that provides some margin of safety should the non-services business take longer to bounce back.
Assuming a modest 10x EV/EBITA multiple (a discount to its comparable companies and US industrial companies), and counting for the cash generation, the company could be worth €13 within eighteen months.
Of course, if they achieve better than the low point of their targets, the stock could be worth more than €20 per share.
Sum of Parts
Another way to think about the valuation/margin of safety is to pull apart the Services Division from the Capital Division.
The company does not give great details on the margin profile of each division other than to say that the Services division has higher than corp average.
So let’s assume a 10%-12% EBITA margin here.
The Services division ought to produce between €100-€120mm EBITA, which has continued to grow over time.
Given the stability of this business, and the growth opportunities organically and through M&A, it would seem that a 12x multiple could be justified.
At the lower margin assumption that would give us a valuation of €1,200. This is essentially the enterprise value today, giving us the Capital division for only €100mm
This implies the Capital division has a lower than corp average (4-5% EBITA) to get us to the 6-9% EBITA margin total.
Even if we give the Capital Division a low margin, low revenue, low multiple assumption…€1450 in revenue and 3% EBITA margin and a 5x EBITA multiple. That would be worth €217mm.
Combined, you have €1400mm EV or €9.50 per share. These assumptions produce €2450mm in Revenue and €144mm in EBITA for a 5.8% EBITA margin, below the lower end of the company’s target.
We believe that the stability and growth opportunity of the services business provides a margin of safety to the investment even at the lower end, and the market is undervaluing the Capital division despite the more volatile nature of that business.