Colfax Corporation (CFX) is a serial acquirer with impeccable pedigree. It was founded by the Rales brothers of Danaher (DHR) fame, and seeks to replay the same playbook, starting from a much smaller capital base (CFX is about 10x smaller than DHR).
M&A is in their DNA.
Currently it has two segments:
- Gas and Fluid Handling (GFH)
- Fabrication Technology (FT)
It is #1 or #2 in most product categories it operates in.
On a revenue basis both the segments are roughly equal contributing about $2B each. CFX’s products serve a number of industries. I snipped the following picture from the Q2 investor presentation from their IR site.
Geographically, CFX is spread all over the world. It’s emerging market exposure is about 40-50% of revenue.
In 2012, CFX acquired Charter, which had a revenue base that was 5x larger. You can see this in the following table (all figures in millions) where revenue jumped from $693M in FY 2011 to nearly $4B in FY 2012.
Notice that the FCF has consistently outpaced net income.
Revenue and operating income peaked in FY 2014 at $4.6B and $410M, respectively. Since then, both sales and EBIT have declined to $3.8B, and $232M.
For one, many of the industries that rely on CFX products like oil and gas went into a tailspin. Several power projects got delayed. Sentiment around emerging markets and roll-ups turned 180 degrees.
From most analyst projections, the short-term pain is not over; the consensus view expects some muddling around to persist for 1-3 years.
Nevertheless, there are several redeeming features. The management is competent. They have used the recent past to digest recent acquisitions, and streamline the cost-structure. The down cycle seems like it is in its last innings (to mix metaphors); when it turns, business come booming back.
Insiders have signaled as much for some time now. In Feb 2015, Mitch Rales bought about $20M of stock in the high $40s. In Oct. 2015, CFX announced a $100M buyback program, and bought about $50M worth, when the stock was in the $20s.
Before I put up my own numbers, here are some sources that I found very useful. In chronological order:
- In May 2013, Vertical Research Partners put out their note “The Real McCoy“, which argued that CFX was a good long term bet, but suggested that the valuation was full. They did a bunch of valuations, all of which pointed to a value of approximately $50/share.
- Brooklyn Investor took a look in October 2013, when CFX was trading at $57. Using rough numbers he reckoned CFX was trading at nearly 15x FCF, which was a tad rich. But with the prospect of smart capital allocation and growth, perhaps the premium valuation was deserved.
- In March 2015, the stock price was still near $50, when this VIC writeup which recommended a hold/buy was reported, saying that the headwinds were short term in nature. Remember that FY 2014 had just marked the best year in CFX history.
- Earlier in Jan 2016, as the stock was reeling at $20/share, Barron’s put out an optimistic, and superbly timed report.
- Weitz Investment management wrote a Colfax 101 in June 2016.
Remarkably, most of these valuations have been spot on, in predicting the intermediate term price-swing in CFX price.
CFX’s end markets are currently suffering. It is not hard to argue that the past year or two has been a temporary setback, and that CFX will bounce back once things normalize.
This makes valuing CFX somewhat tricky since once cannot escape making at least some projections (which will likely be proved wrong). However, management are good stewards, and are generally regarded as opportunistic capital allocators. Thus, once can afford to be slightly wrong on price, and still not lose money in the long run.
In this blog, I will do some simple analysis. In principle, the management gives us targets (revenue growth = GDP + 1-2%, EBIT margin = mid to high teens, Debt/EBITDA target = 2, etc.), which could be used to build a DCF. But I’ll save that for a later date.
The book value as of June 2016 was $2,965M. Dividing by the number of shares outstanding (124M), we get a BVPS of nearly $24. Historically, CFX has traded at a premium to book value, and buying it below book has been a great short-term move, since the stock has almost always bounced back strong.
For example, earlier this year the stock price dipped to 0.9 BVPS. Since then shares have rallied nearly 50%. Thus, we can perhaps think of $24 as a low end for the valuation.
I should point out that, CFX carries a lot of goodwill and intangibles on its balance sheet. They account for about half of the total assets. This extra fat is the norm for serial acquirers. At Danaher for instance, goodwill and intangibles currently account for 75% of the total assets.
PTI or FCF Multiple
The TTM pre-tax income (PTI) and FCF have been $1.56, and $1.74/share, respectively. One could slap a 10x multiple and still come up with only $16-$18.
Current earnings do not support the current stock price.
If you don’t think CFX is under-earning, and that it can profitably grow in the future, you shouldn’t buy the stock, based on current earnings.
Peers of GFH currently sport average ROIC and EBIT margins of 15% and 13%, compared to CFX’s 6.3%, and 10%, respectively. Similarly, FabTech peers sport ROIC and EBIT margins of 20%, and 17%, compared to CFX’s tepid 6.5%, and 10%, respectively. Management has telegraphed several times that they want to achieve mid to high teens operating margins.
Three Year Projection
Let me just toss some plausible numbers, just to get a rough back-of-the-envelope sense.
Suppose CFX sales hit $4.5B in three years. Remember that revenues were greater than this in 2014; so this guess is just a bet on some form of reversion to normalcy.
Management has signaled higher (say 15%) operating margins. On sales of $4.5 billion, this yields an EBIT of $675M.
Let’s suppose interest expense of 10% of EBIT ($67.5M, which is a plausible number given recent history), and a 35% tax rate, for a net income just shy of $395M.
Dividing by the number of shares (124M), this is an EPS of $3.18. If we slap a market multiple of roughly 15x, we get a target price of about $48.
Given the current price of about $30, this can yield a CAGR of 15%, if the thesis plays out.
If earnings take longer (say 5 years) to bounce back to this level, the return will be lower, but still respectable (~10%).
One can just look at peers (listed in the Vertical Research Partners report linked above) in the two segments. The fact that the numbers used here are nearly the same for comparables in the two segments makes this simple analysis even simpler.
The EV/EBITDA ratio is about 9-10. Based on Yahoo Finance numbers, the EV/EBITDA of CFX is 11.1, so it is overvalued on this metric. But remember, our underlying thesis is that CFX is under-earning, so this is okay.
The average EV/Sales ratio for the comparable peer group is about 1.65. Taking TTM revenue of $3865M, slapping a 1.65 multiple, gives us a per-share EV of $51. Subtracting the net debt (about 1/3 of total capital), gives a fair value of $34/share.
CFX is under-earning; current earnings can only support a valuation of $16-$18.
CFX usually trades above book. The current BVPS of $24 probably provides a floor for the price.
On a relative valuation basis, CFX is worth $27-$34/share.
If things normalize in three years, one could be looking at 15% returns. If they take 5 years, then the CAGR will drop to 10%. In the current low-growth environment, either scenario doesn’t look too bad.