Description

When considering a potential investment opportunity I generally like to find companies exhibiting three characteristics: (1) a good business with strong economic returns and FCF production, (2) a favorable price that will reward long-term investors, and (3) a management team focused on creating value for shareholders.  If I can find a company that exhibits all three of these characteristics and appears to be mis-priced due to short-term concerns and/or a misunderstanding about the business, then I am doubly excited. 

I believe Williams Controls (WMCO), the worldwide leader in manufacturing gas pedals for the heavy truck and bus market, fits these criteria well.  The company is small ($135M mkt cap) with an under-followed stock (one analyst w/ minimal coverage) and is somewhat pressured by concerns over cyclical revenue growth headwinds that should subside within a quarter or two.  Looking at the larger picture, WMCO offers a business with a dominant and growing market position, excellent returns on capital (ROIC = 35%+ in cyclically down years, 55%+ in cyclically strong years), a long-term secular growth tailwind, and an already strong but improving (and not yet understood) margin structure that, thanks to some recent layoffs, should allow for a nearly 30% stair-step increase in EBITDA and a 16%+ increase in EPS in FY08.  Further, all of this can be had for a price that, under rather conservative Base Case assumptions, works out to 13x FY08 Unlevered Free Cash Flow (7.5% yield), 14x FY08 earnings, and 8x FY08 EBITDA and 9x FY09 ULFCF (11% yield), 11x FY09 earnings, and 5.4x FY09 EBITDA.   

I think a growing business with the kinds of ROICs and FCF production that WMCO delivers deserves something closer to a 15x multiple on forward earnings and cash flow, which would imply a share price of ~$24, representing ~44% upside from current levels.  My DCF valuations tend to corroborate that view as my Base Case DCF yields a price of $27 (61% upside) while my Bull Case DCF yields a much higher price of $36 (115% upside) and my Bear Case DCF yields a price of just $17 (basically no downside). 

Financial Overview:

Price:                                                                $16.72

Fully Diluted Shares:                                          7.8 million

   Mkt Cap:                                                        $129.6 million

Cash (@ 9/30/07):                                              $1.6 million

Debt:                                                                $1.0 million

Underfunded Pension/OPEB (1):                         $5.1 million

   Enterprise Value:                                            $134.1 million

 

Avg. Daily Volume (3 mos.):                    7.7K shares

Avg. Weekly $$$ Volume:                       $655K

(1)     Pension has been closed to new employees since ’03

Business Summary

Before delving into the details of WMCO’s business I think it’s worthwhile to first provide a summary of the historical financials to provide some context around the strength of the company’s margins, its low capital intensity, and its solid returns on capital.  I’ll discuss the weakness exhibited in FY07 – which was entirely driven by short-term cyclical factors related to emissions regulations and, in turn, demand for heavy trucks – in more detail below.   

WMCO: Review of Margins, Cash Flow, and Returns
	Sep	Sep	Sep	Sep	Sep
	2003A	2004A	2005A	2006A	2007A
Revenue	$51.3	$58.1	$67.4	$74.6	$68.9
% YOY Growth		13.2%	16.1%	10.7%	-7.6%
Gross Profit	$11.0	$18.8	$23.0	$26.4	$23.8
% Margin	21.4%	32.4%	34.1%	35.4%	34.5%
EBITDA	$3.5	$11.0	$13.8	$16.4	$13.8
% Margin	6.9%	19.0%	20.4%	22.0%	20.1%
Operating Income	$1.8	$9.7	$12.7	$14.8	$11.8
% Margin	3.5%	16.7%	18.9%	19.9%	17.2%
Net Income	$1.0	$5.5	$7.5	$9.5	$7.9
% Margin	2.0%	9.6%	11.1%	12.8%	11.5%
CAPX	$1.0	$1.0	$3.0	$2.3	$2.2
% of Rev	1.9%	1.8%	4.4%	3.1%	3.2%
ROIC(1)		58.1%	66.0%	56.5%	34.3%
ROCE(2)		79.6%	66.8%	55.0%	38.9%
ROE		Neg Equity	Neg Equity	330.9%	60.7%

(1)     ROIC: NOPAT / (Avg. Assets – Cash – NIBCLs)

(2)     ROCE: After-Tax EBIT / (Operating Assets – Operating Liabilities); ROCE has declined due to short-term inventory build

Williams Controls, based in Portland, OR, was founded in 1937.  It was bought by Dana Corp in the 1980's and then sold in the 1990's.  New mgmt made some ill-advised acquisitions at rich prices and took the company's focus away from the core business.  By 2000-01, WMCO was on the verge of bankruptcy.  A new CEO (who has since left...more on him later) and a new CFO (Dennis Bunday...still there) were brought in as turnaround specialists.  They recapitalized the company, sold off the bad businesses, avoided bankruptcy, and refocused the company on the electronic throttle controls (ETC) pedal business, which has great economics and was/is growing nicely.  Since that time the board has decided to actively build the pedal business further.  With a virtual monopoly on the US market, WMCO is now working to increase its share in Europe and, more importantly, build its business in India and China which, together, produce 2.5x more trucks each year than the US and, therefore, could potentially require 2.5x more pedals someday as well. 

Market Overview

As touched on above, WMCO’s primary business involves the design, manufacturing, and selling of gas pedals for heavy trucks, transit busses, and off-road equipment.  ETC systems are connected to the gas pedals in vehicles.  They contain sensors which, based on how much pressure the driver is putting on the gas pedal, send impulses to the engine to tell it how fast the driver wants the vehicle to go.  ETC systems are crucial in controlling vehicle emissions and are found in all vehicles with electronic fuel-injected engines (as opposed to carburetor engines, which are not as eco-friendly and tend to use mechanically controlled pedals).  Thus, in its simplest form, WMCO is a play on ever more stringent vehicle emissions standards throughout the world and, in turn, the growth of electronically controlled engines. 

The ETC pedal market in North America and Europe began to develop in the 1980s as governments on both continents began to clamp down on vehicle emissions.  The regulators started with the heaviest trucks (known as Class 8) and gradually worked their way down to Class 5-7 trucks and busses.  Similar emissions standards are now spreading to even smaller off-road equipment like skid steer loaders, forklifts, farm tractors, and – eventually – even lawn mowers. 

Importantly, as these standards spread to more vehicles the demand for electronically controlled engines and, in turn, ETC pedals grows too.  What’s more, the standards are becoming stricter every few years.  Thus, a truck or bus manufacturer can’t simply buy a pedal design today and expect to use it for the next 20 years.  It needs to update its engines every few years to ensure compliance.  This process requires continuous innovation and customization in ETC pedal design as well, thus providing the ETC pedal manufacturer with some protection from commoditization.   

Finally, the last point to note on the market is that India and China are just now beginning to implement their own emissions standards for heavy vehicles with a goal of bringing those standards in line with N. American & European standards (known as “Euro 3”) in the not-too-distant future (you can read about the existing Euro 3 standards here: http://www.dieselnet.com/standards/us/hd.html and about China’s mounting truck pollution problems here: http://www.nytimes.com/2007/12/08/world/asia/08trucks.html?_r=1&oref=slogin).  While the NAFTA area produces about 250K to 300K Class 8 trucks per year and another 200K+ smaller Class 5-7 trucks per year, China and India produce about 600K heavy Class 8 trucks per year, so the market opportunity as these trucks convert to electronically-controlled engines is very significant.  WMCO is in the process of forging relationships with the leading truck manufacturers in both of these countries and has already begun winning some business.  Even modest success in these markets could create a huge longer term growth opportunity (but that assumption isn’t necessary for this stock to work; it simply allows for upside). 

The Business

Pricing for an ETC pedal averages ~$50, but can range from $20 to $300.  WMCO focuses exclusively on the heavy truck/bus/off-road market and no longer competes in the higher-volume car market because competition is too severe, the manufacturers are in perpetual financial trouble, and the margins are lower and less stable due to lower ability to customize (WMCO sold its car pedal business a few years ago).  Thus, WMCO runs a "low volume, high mix" business.  It is basically a custom job shop through which it provides its customers a high degree of flexibility in their ETC pedal designs and for which it receives strong gross margins.  A large order might be for 70K ETC pedals from a major truck manufacturer that can be custom designed, assembled, and shipped within a month or so thanks to WMCO’s scale and investments it has made in R&D.  By comparison, a typical order for a car ETC pedal might be for 1M or more units and would be highly inflexible due to assembly line demands.  Plus, a truck pedal must be much more durable than a car pedal as a truck pedal can face more elements and must endure as many as 10 million “presses” over its life since a truck can go 1 million miles over its life (vs. a car, which may last 150K miles and may have to endure only 1 million “presses”).   

There is very little retro-fit, so most sales are for new trucks and, increasingly, the off-road vehicles that are converting to electronically controlled engines and pedals.  WMCO customizes its ETC pedal systems for each of its major customers to meet their specific engine design needs.  This is inexpensive to do, keeps the customers loyal, and creates a “stickiness” to the revenue stream which allows for much recurring business.  Manufacturing was historically done in Portland, but mgmt has just completed an effort to outsource a portion of it while opening a secondary lower-cost facility in China (more on this later). 

The company won’t discuss its market share, but I believe it is 80%+ in the US.  This seems to be reflected in the numbers as the major US truck manufacturers – Freightliner, Paccar, Volvo, and Navistar – accounted for 13%, 14%, 17%, and 6% of FY07 sales and that mix has held roughly constant over the years.  WMCO has maybe 40% to 50% share in Europe.  And the game is just beginning in India & China and elsewhere.   

WMCO’s competitors include companies like AB Electronik, Teleflex, and Siemens.  However, my research indicates few companies compete directly in the ETC pedal market for trucks/busses/off-road (most make pedals for other segments, like cars, industrial engines, etc).  The market is too small for them to make the necessary investments to make more durable and reliable truck pedals and deal with the potential hassles of customization for each customer.  Unfortunately, none of them has any public information that can be used to compare their business directly to WMCO’s.  Still, I think WMCO’s hefty margins, returns on capital, and cash flows are consistent with those of a dominant market leader. 

Yet, despite this strong market share the company is not resting on its laurels.  Instead, it is investing in ways to improve its customer service and maintain + build its share.  For example, mgmt just completed a $1 million investment in a new Concept Development Center which will increase the speed to market for new ETC pedal designs for customers at a rate competitors cannot match.  The company has also decided to begin manufacturing sensors, a key component of ETC pedals, in house because the third party automobile sensors WMCO was using previously were becoming too unreliable and weren’t durable enough to meet the needs of trucks, which generally last for 1M miles vs. cars at 150K miles.  What’s more, this will SAVE money (mgmt won’t say how much) while improving customer service and order turnaround times.  Finally, the company’s new manufacturing facility in China will provide a low-cost means to serve its existing customers in the Western world while also establishing local presence to serve the significant market opportunity China presents.  Further, this effort improves the company’s competitive positioning from an operating cost perspective.  I highlight these points to show that mgmt, despite its market leadership, is very focused on exceeding its customers’ expectations. 

The Revenue Outlook

FY07 was a tough year for WMCO, although by no fault of management as the company actually gained market share during the year.  The company’s NAFTA truck business, which accounts for ~30% of its total sales, suffered from a massive pre-buy that occurred during 2006 and pulled forward sales that otherwise would’ve been realized in 2007.  This pre-buy was caused by new heavy truck engine emission regulations that went into effect on 1/1/07.  These regulations made the engines more environmentally friendly.  The downside of that improvement, though, was that engines built in 2007 cost materially more than engines built in 2006.  As a result, the massive fleets that dominate the trucking industry in the US bought several more trucks with 2006 engines than they needed to save money.  This is a common occurrence in the US market and will likely happen again in the latter half of 2008 and throughout 2009 as fleets pre-buy ahead of another round of emission regulations that will take effect in the US on 1/1/10. 

The net effect of these factors was a -7.7% decline in revenue in FY07 to $68.9 million as a -14.6% decline in NAFTA area sales was offset by a +15.4% increase in Europe and a +15.4% increase in Asia.  Within NAFTA, the truck segment was down -36% YOY but that weakness was offset by strength in the growing off-road category, which is unaffected by the emission standard timetables implemented for heavy trucks.  The truck markets in Europe and Asia are generally unaffected by such cyclical factors too as their emission regulations are implemented on more of a rolling basis.   

Looking ahead, WMCO likely has another quarter or two of YOY revenue declines before the aforementioned cyclical factors are digested and growth resumes.  If we look at industry data on truck production in the NAFTA region we see that industry volumes for Class 8 and Class 5-7 totaled about 677K trucks in 2006, should total 450K units in 2007 (down 33.5% YOY), and should bottom out at maybe 420K units in 2008 (down 7% YOY).  However, it’s important to note that the weakness in 2007 was back-end loaded and should be front-loaded in 2008.  This is because (1) truck production remained strong through about April of 2007 b/c manufacturers were still building and selling trucks with the cheaper 2006 engines, thus making YOY comparisons tough for another few months and (2) because the pre-buy for engines ahead of the latest 1/1/10 emission standard deadline should begin in earnest in the second half of 2008. 

As we look forward to 2009 NAFTA truck production, some industry forecasters are calling for a production level that could be comparable with 2006’s (i.e., 677K units), depending on the prevailing economic environment at the time (every point of GDP growth tends to create incremental demand of as much as 25K additional trucks).  Thus, 2009 could show a NAFTA sales rebound as strong as 50% or more.  WMCO’s dominant position in that market suggests that piece of its business (again, ~30% of total rev) should grow at a similar rate.  With no new emission standards on the horizon beyond 1/1/10 the market should eventually move to a more consistent growth profile that’s consistent with GDP growth, although there could be another brief cyclical downturn in the 2010-2011 time frame. 

However, I’d note that the NAFTA market is hardly the most interesting part of WMCO’s growth opportunity.  Its market share suggests it will simply grow with the market in that region.  The most exciting opportunities are, again, in China and India which together produce more trucks than the US and should lengthen that lead over time as their economies grow and highway systems improve.  Maybe 2% of these trucks run on more environmentally friendly electronically controlled engines and, in turn, use the electronically controlled gas pedals for which WMCO is the world’s leading manufacturer.  As these countries move toward Euro 3 emission standards and beyond over the next several years and transition to electronic engines and pedals they could become markets at least as big if not bigger than WMCO’s existing revenue base.  Further, WMCO is just now exploring opportunities in Russia, is gaining some traction in other parts of Eastern Europe, and is doing some exploratory work on getting a foothold in Brazil.  As pollution and environmental concerns gain greater attention amidst the ongoing global boom it seems inevitable these developing nations will begin taking quicker action to address these issues.  Heavy truck equipment is historically where stricter emission regulations are implemented first. 

Below is my Base Case forecast for WMCO’s NAFTA vs. non-NAFTA sales over the next several quarters.  Note that I assume only a modest rebound in revenue in 2H08 and then only 30% growth in 2009.  These numbers could prove conservative if NAFTA truck production returns to levels closer to 2006 output.  Further, I expect non-NAFTA growth could/should accelerate into 2009 and beyond as the company wins more and more business in newer markets and gains further traction with off-road vehicles in the NAFTA region and in Europe.  However, for the sake of conservatism I’ve assumed only modest 8% to 10% growth.   

WMCO: Overview of NAFTA and Non-NAFTA Sales Forecasts
	Sep	Dec	Mar	Jun	Sep	Sep	Dec	Mar	Jun	Sep	Sep	Sep
	2006A	12/06A	3/07A	6/07A	9/07A	2007A	9/08A	9/08A	9/08A	9/08A	2008A	2009A
Total Rev	$74.634	$18.442	$18.309	$15.822	$16.351	$68.924	$16.731	$18.477	$16.947	$17.623	$69.777	$80.271
% YOY Growth	10.7%	14.3%	-2.6%	-20.5%	-17.5%	-7.7%	-9.3%	0.9%	7.1%	7.8%	1.2%	15.0%
Est. NAFTA Truck Rev	$30.561	$6.639	$5.639	$4.706	$3.611	$20.595	$3.983	$4.793	$4.941	$3.864	$17.582	$22.856
% YOY Growth		11.2%	-25.0%	-45.0%	-57.6%	-32.6%	-40.0%	-15.0%	5.0%	7.0%	-14.6%	30.0%
Rev Ex-NAFTA Truck	$44.073	$11.803	$12.670	$11.116	$12.740	$48.329	$12.747	$13.684	$12.005	$13.759	$52.195	$57.415
% YOY Growth		16.1%	12.3%	-2.0%	12.8%	9.7%	8.0%	8.0%	8.0%	8.0%	8.0%	10.0%
NAFTA Mix	41%	36%	31%	30%	22%	30%	24%	26%	29%	22%	25%	28%
Other Mix	59%	64%	69%	70%	78%	70%	76%	74%	71%	78%	75%	72%

Margin Outlook

The above revenue outlook is significant mostly because it suggests the company can endure another year of modestly negative revenue growth in FY08 yet still grow its EBITDA, EPS, and free cash flow.  By the time FY09 rolls around the business will be poised for significant growth on all fronts – top line, bottom line, and free cash flow.  The upside relative to current trends comes mostly from gross margin, which is set to expand some 300+ bps on an annualized basis beginning now.   

The driver of this margin expansion is quite simple.  As noted earlier, WMCO has recently opened a second manufacturing facility in China to (1) save money and (2) have a local presence to serve what mgmt views as a significant long-term revenue opportunity in the Chinese and Indian truck markets as emissions standards (and ETC pedal demand) take hold in those countries.  The facility is staffed, running live, and producing pedals for truck manufacturers all over the world.  Over the past year, mgmt has kept much of its duplicate operation in Portland, OR staffed with high-cost labor to ensure seamless execution for customers.  Management is now satisfied that the China operation is running smoothly and, as a result, completed that majority of (and last of) its layoffs in September, or the last month of its FY07.  The company has also recently outsourced its die-casting operating to a provider in China.  Overall, WMCO estimates the die casting accounted for 10-15% of rev but consumed 50%+ of the labor cost.  This information is fully disclosed in the FY07 10-K, but the company hasn’t said much about it on its recent conference calls.  Further, since mgmt doesn’t give guidance I don’t believe these factors are even close to fully reflected in the stock price today.  They key point, though, is that these actions should equate to at least ~$2M in annual cost savings ($40K in salary + costs per worker x 50 workers = $2 million).  That total doesn’t include the recent shift to in-house sensor technology, additional growth from higher-margin off-road customers (margins are higher because the orders are smaller but still customized) or the potential for commodities such as zinc and aluminum to decline, all of which could/should boost gross margin further. 

What’s more, WMCO – despite absorbing a massive downturn in the heavy truck business over the past few quarters and duplicate overhead costs in China and Portland during most of FY07 – has still been holding its gross margins fairly steady.  Despite the aforementioned factors, gross margin was down only 87 bps in FY07 to 34.5% vs. 35.4% in FY06.  This highlights the strength of the product offering and the highly variable nature of the company’s operating costs, which is rare for a “manufacturer.” 

The table below shows how I see gross margins and, in turn, net income and EPS improving by at least 16% relative to FY07 levels just from these labor savings alone.  Note that the impact will start to trickle in during the coming quarters as all layoffs and related expenses are now complete.  Note also that I haven’t really given the company any margin benefits from improved sensor technology and/or other factors that could/should help gross margin going forward:

WMCO: Margin Impact from Labor Savings
	Sep	Sep	Sep	Sep
	2006A	2007A	2008E	2009E
Revenue	$74.6	$68.9	$66.6	$77.9
Gross Profit	$26.4	$23.8	$23.0
% Margin	35.4%	34.5%	34.5%
Savings from Layoffs			$2.0
% of Rev			3.0%
Adjusted Gross Profit			$25.0	$30.0
			37.5%	38.5%
EBITDA	$16.4	$13.8	$15.7	$18.4
% Margin	22.0%	20.1%	23.6%	23.6%
Net Income	$9.5	$7.9	$9.1	$12.4
% Margin	12.8%	11.5%	13.7%	15.9%
EPS	$1.25	$1.03	$1.17	$1.58
Diluted Shares	7.6	7.7	7.8	7.8
Pre-Tax Savings as % of '07 EBITDA		28.9%
After-Tax Savings as % of '07 NI		16.4%
After-Tax Savings as % of '07 EPS		16.3%

So, the key point here is that a compelling case can be made for significant improvements in EBITDA and EPS over the next couple of years with very little in the way of topline growth.  Once growth begins to accelerate again in late 2008 and into 2009 (as another round of new emissions standards kick in to boost demand) there could be room for even more margin expansion relative to what is shown in the assumptions above.  

 Valuation

Below is a summary of the valuation under my Base Case Assumptions.  Note that the stock is trading 12.9x FY08 ULFCF, 7.9x FY08 EBITDA, and 14x.3 FY08 EPS and 9.0x FY09 ULFCF, 5.4x FY09 EBITDA, and 10.6x FY09 EPS.  Again, those multiples seem way too low for a dominant, growing business with 55%+ ROICs.  Note also that that valuation on ULFCF gets about a 1x multiple turn benefit from working capital.  This is perfectly explainable.  Working capital was a big use of cash in FY06 and a modest source of cash in FY07 as the company maintained unnaturally high inventory levels while optimizing its dual manufacturing facilities in Portland and China.  As mgmt becomes more comfortable with the operations of the dual facilities it will allow inventory to bleed down to a more natural level of maybe $8 million (vs. ~$9 million today). 

WMCO: Valuation Profile
		2005A	2006A	2007A	2008E	2009E
Current Price	$16.72
Upside	0.0%
Upside Price	$16.72	$16.72	$16.72	$16.72	$16.72	$16.72
Shares		8.0	7.6	7.7	7.8	7.8
Market Cap		$133	$128	$129	$130	$131
Less: Cash		($5.1)	($2.5)	($1.6)	($9.8)	($22.7)
Less: Minority Interest		0.0	0.0	0.0	0.0	0.0
Plus: Debt		22.0	15.2	6.1	5.1	5.1
EV		$150	$140	$134	$125	$113
EBITDA		$14	$16	$14	$16	$21
EV/EBITDA		10.9x	8.6x	9.7x	7.9x	5.4x
ULFCF		$10	$6	$7	$10	$13
EV/ULFCF		15.1x	21.8x	20.1x	12.9x	9.0x
% Yield		6.6%	4.6%	5.0%	7.8%	11.1%
EPS		$0.94	$1.25	$1.03	$1.17	$1.58
P/E		17.7x	13.4x	16.3x	14.3x	10.6x

 Finally, I’d note that my DCF models yield valuations ranging from $17 (Bear Case) to $36 (Bull Case).

 Capital Allocation

A quick look at the historical financials will reveal the company has gone from a position of heavy indebtedness ($20.4 million at the end of FY05) to virtually debt-free ($1 million at the end of FY07).  The company is probably now debt free as we close on its fiscal first quarter.  Thus, given the business’s robust free cash flow production cash should begin to accumulate on the balance sheet.

Management has said it has no intention of building a massive cash balance and/or pursuing major acquisitions (any acquisition pursued would likely be of a small operator with a solid customer relationship which WMCO could buy for under 10x earnings and then move the manufacturing to its low-cost facility in China, thus providing instant savings).  Thus, it seems logical that the company will consider share buybacks and/or dividends sometime in the near-to-intermediate future.  

Management / Governance

CEO Patrick Cavanagh joined in 2004 and is leading the operational improvements and expansion into China & India.  He has 10+ years of operating experience in China and came to WMCO from Woodward Controls, the leading manufacturer of engine control systems for industrial engines and turbines (highly relevant experience).  

The CFO is Dennis Bunday.  He joined in ’00 for the turnaround but has decided to stay on board because he sees significant growth potential and profitability improvements ahead.

The board is actually decent for a small company like WMCO.  It has two senior executives with experience relevant to the trucking/auto industry (former COO of Mack Trucks and current CEO of Southwall Technologies (maker of auto parts)) 

Governance is good; annual elections for all directors, reasonable compensation for management, and minimal annual dilution from options (~1%).

Also, former CEO who oversaw the turnaround is suing the company for $500K in comp he says is owed to him via a verbal agreement.  Board denies it and is refusing to pay.  In my view, this speaks well of the board, which is essentially saying they see no reason to use their shareholders’ money to pay for past work (and good work at that) that they don’t believe they have any contractual commitment to pay for.   

Risks

-          Customer concentration: Top 5 customers = 56% of FY07 rev (although this isn’t rare for a  parts supplier; further, the company believes its customers are very satisfied, is working to make them even more satisfied, and hasn’t lost a major customer in recent memory)

-          Major economic downturn that could depress demand for trucks in the NAFTA region
 

-          Lack of traction from investments in emerging market growth opportunities

 

 

 

 

 

Catalyst

Rebound in NAFTA truck cycle
Realization of labor cost savings
Growth in new markets