Colfax: Getting Warmer?

I wrote about CFX in October 2016 (“Some Cold Facts about Colfax“). At the time, the stock had bounced back from a low of about $20 earlier that year to about $30. In the wake of Trump’s election, it continued to rise above $40, before dropping to the mid-upper $30’s again.

Screenshot from 2017-08-20 10-54-35

Some company-level developments:

  • Top-line growth returning?: Revenue decline stalled. FY2017 sales are expected to tick up marginally to $3.7B from $3.65B in 2016. For a company exposed to cycles, this might be an important datapoint.
  • Effect of leaner operations?: EBIT is expected to grow more than 10% to ~$360M from ~$320M. This growth is significantly greater than sales growth, which suggests better cost-management.
  • EBIT margins have increased from 6.5% (FY2016) to about 7.5% (TTM). This is still much lower than the targeted mid-teen operating margins.
  • ROIC even without goodwill and intangibles is still around 10%.

To summarize, fundamentals have improved modestly (10% EBIT growth). But the stock price has jumped much more (30%+), since last reckoning.

Valuation

To hold the stock at $37-38, where it is trading today, one has to believe that a serious transformation and acceleration is underway. That is, the forward-looking view from the windshield is much better than the rear-view mirror. Some level of faith in the management is important, because no matter what I do with a conservative DCF (which still relies on extrapolation of the recent past), I cannot justify a price much above $32-$35.

So let’s do something simple, but dangerous. Let’s try to visualize how CFX might look like in 5 years from now. Suppose sales grow at 4-5% to yield a revenue of $4.6B in 2022. Suppose management manages to hit mid-teen margins: EBIT = 0.15 * 4.6B = $690M. Factor in a reasonable interest expense (10% EBIT = ~$70M), and tax rate (35%), we get after-tax operating earnings to equity of about $400M. Dividing by shares (124M), we get an EPS ~ $3.20. Since CFX is expected to grow 1-2% faster than GDP, and become more profitable, it might deserve a premium valuation of 18x. This gives us a target share price in 2022 of 18*3.20 = $57.

Of course, I can guarantee things won’t go smoothly from where we are now to $57. There will be plenty of bumps. An acquisition or two can certainly be expected. They will be unexpected tailwinds. Nevertheless, this $57 gives us something to anchor to, if things play out well.

Given today’s price of $37, this implies a CAGR of about 9%, which would be respectable in today’s environment. However, don’t forget that lots of things have to go right for CFX for that to happen.

Strategy

I am a little conflicted on CFX.

I like the management. Incentives of the insiders are aligned with long-term shareholders. They have been trying to do the right things in a trying environment.

Over a long enough holding period, I expect intrinsic value to compound at a decent clip. Things are turning around. Even if they don’t transform immediately, CFX is no melting ice-cube. Time is on its side.

Optically, the performance doesn’t look great. But look at its sister, Danaher. It has never looked cheap to me. But you would have done very well buying that stock just about anywhere, and going to sleep for a long long time.

Okay, so why am I conflicted?

The current operating performance is shit. Operating margins and ROIC are meh. And that is a charitable reading. My cost basis is higher than the current stock price, and given how much stuff I’ve been forced to sell this year, I wouldn’t mind racking up some offsetting losses to ease the tax bill.

So what I’ve ended up doing is something that reflects my indecision. Since March of this year, I have been writing covered calls for $40 and $42.50, and rolling them over. The price action has been very cooperative, and I have collected over $4/share in premiums.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s