Baldor Electric (BEZ) is an overleveraged, low-end industrial parts manufacturer that is facing a steep drop in demand that management and the investment community has yet to fully acknowledge. The company produces and sells motors ranging from 1-5 horse power motors for [miscellaneous industrial applications] to  horse power motors for heavy duty oil and gas operations. BEZ's products are sold entirely into industrial end markets, and the sales mix is roughly 50% OEM and 50% distributor. We believe the company has about 40% market share in motor manufacturing in the U.S. and Canada. In an unwise, but seemingly common maneuver in recent years, Baldor made a large, mostly debt-financed acquisition near the top of the bubble in early 2007, acquiring Rockwell Automation's motor manufacturing operations. While this transaction roughly doubled the company's sales, BEZ's debt load jumped to well over 4x debt-to-EBITDA. That level of indebtedness is fine for boom times, but Baldor's business is cyclical and is now enduring collapsing demand. Despite numerous industry data points that point to sales falling off a cliff, Baldor management (and the sell-side) has been slow to acknowledge the unfolding pain. We believe this is chiefly because the company desperately needs to amend its credit agreement before it violates leverage covenants (possibly as soon as Q2-09 without an amendment), so management needs to maintain a show of strength to its lenders. The sharp deterioration in the company's results also undermines management's credibility, as it has projected an "everything is just fine" message (at least relative to similar industrial companies) throughout the downturn. Late last week the company filed an 8-K announcing that it had begun preliminary talks with its creditors for covenant relief as a "precautionary" move. We believe this will prove more costly than management expects. We also think it confirms that management's relatively optimistic assessment of business conditions is unraveling.
The sell-side seems reluctant to slash estimates to realistic levels - in no small part, we believe, because management itself has not really confessed to the depth of the current downturn. (We note that they also still remain in love with the stock: of 9 analysts, 8 have buy ratings on it.) Current revenue estimates are down about 9% y/y. EBITDA is projected to fall only 12%, and EPS are projected to decline from $2.15 in the peak year of 2008 to $1.58 in 2009, before rebounding to $1.81 in 2010. We think these estimates are far too optimistic. Our work suggests that sales are currently running down 20-30% y/y in the industry, which will have a devastating impact on profitability as the company de-levers operationally. Moreover, as we discuss below, Baldor is running at profit margins that are substantially above historic levels, implying a high likelihood of a painful reversion to the mean. We think the combination of an increasingly scary balance sheet (think debt-to-EBITDA over 5x), collapsing sales and a potentially huge contraction in profitability will cause investors to dump the stock. A share price in the $5-7 range seems possible. This would equate to about 7x our EBITDA estimates and about 10x earnings.
- Rapidly Deteriorating Sales. In Q4-08, BEZ reported 4% revenue growth, though management acknowledged that sales had been running +10% for the quarter until the last two weeks of December, implying a dramatic downturn at quarter-end. Even worse in terms of underlying demand, pricing contributed ~6-8% to revenue growth, while and an acquisition in Q3-08 added another ~2%. In January, management noted that sales dropped about 9% y/y, inclusive of the aforementioned benefits which anniversary later in the year. Despite abundant red flags, management recently outlined a scenario for investors that had a "worst case" 2009 revenue decline of 15% and predicted a sales recovery in H2-09. As mentioned above, the Street apparently finds this far too conservative, and has sales down a mere 9% in 2009. Our work suggests that both these figures will prove quite optimistic. After studying Baldor's publicly traded peers and chatting with numerous private players in the industry, we believe that conditions are actually much worse than BEZ management describes. Most industry participants are seeing sales down 20-30% y/y in Q1-09 (several data points were even worse), with comps only becoming tougher as the year progresses. We think management's move to amend its debt covenants strongly suggests a growing realization that 2009 is shaping up much worse than expected.
- Exposure to Weakening End Markets. We believe that Baldor has fared a bit better than some folks recently because 50% of the business is sales to OEMs of generally longer lead-time motors (2-7 months). These motors go into new construction of vehicles, buildings or infrastructure. Baldor's biggest customers by industry tend to be those that are slashing capital spending the fastest at the moment: (note: % is % of total company sales) oil and gas 6-7%, mining ~5%, commercial HVAC ~4%, farm equipment ~3%. Another way of evaluating end market exposure is by application. About 25-30% of BEZ's sales go to pumping applications, e.g. oil, water, rock, etc. Another 15-20% is "air moving", e.g. HVAC, furnaces, etc. The third largest bucket is air compression at ~10%, which is mostly related to factory equipment. We don't believe that any of these end markets are in good shape from a demand perspective.
- Pricing Could Be at Risk. Healthy industry conditions until Q4-08 enabled Baldor to raise prices consistently over the last few years. Benefiting the company in this respect is Baldor's strong brand name, significant size and scope and, by all accounts, good local distribution. But our diligence suggests that the company might have been too aggressive. The private competitors and distributors with whom we spoke suggested that Baldor's annual price increases were perhaps double what the industry took (i.e. high single digit vs. low single digit). While it's possible to get away with this in a period of strong demand and rising input prices, many of the experts with whom we spoke thought that Baldor was most at risk of push-back given its premium pricing for what is, for the most part, an undifferentiated, commodity industrial part. Furthermore, while higher horse power motors are less commoditized and more expensive, these products tend to be sold directly to larger OEMs who are more sophisticated and cost conscious buyers.
- Fairly Low Quality, Over-Earning Business. Motor manufacturing is not the world's best business. The product is one of the lowest value components in the industrial supply chain. Lower horse power motors are mostly commoditized, and foreign competition from China and Eastern Europe is closing the quality and perception gap. Higher end (i.e. higher horse power) motors cater to heavy industry and non-residential construction, both of which are notoriously volatile industries. In general, visibility is quite poor. More than half of Baldor's sales are out of existing inventory, meaning orders ship the same day as they're received. As such, it's not surprising that management was so surprised by the sudden Q4-08 sales collapse and why we believe its optimism for the rest of 2009 is not well-founded. Despite these conditions, during periods of strong industrial demand, Baldor does well. In 2007 and 2008, Baldor's saw strong sales and high incremental profitability. Unfortunately, we believe these margins are not sustainable. Since 1990, Baldor's average EBITDA margin was a little over 13%, with a recessionary low of 10.5% in 2003. Given that BEZ's EBITDA margins were 17.8% and 16.2% in 2007 and 2008, respectively, there is considerable room to fall, even to mid-cycle levels, much less recessionary lows. We note that the sell side thinks that margin declines are about as unlikely as large revenue declines. The Street has EBITDA margins down a mere 70 basis points in 2009 and up 120 basis points in 2010.
- Balance Sheet Leverage Trouble. Baldor has a debt-to-EBITDA leverage covenant of 4.25x in 2009 and 3.75x in 2010 to which the company has no hope of adhering. Leverage was 3.81x in Q4-08, but we expect this figure to be about [4.20x] in Q1-09 and worsening. The current rumor is that management is seeking a waiver to boost this to 5.25x through 2010. This level might be enough, but it will be close and highly dependent on how much working capital management can suck out of the business. Frankly, given the lack of visibility in the business and management's penchant for optimism, we think it's likely that the company obtains an insufficient amendment. In any event, we expect the waiver to be costly. At this stage in the downturn, creditors are well acquainted with overleveraged industrials and the terms they can extract. The revolving portion of Baldor's term loan facility currently pays LIBOR+175 with no floor. We expect the company will have to pay something more like L+400 with a LIBOR floor and a fee of 50 basis points. All things considered, this would probably be a good outcome for BEZ. It's entirely possible, however, that the lenders are more aggressive and restrict the company's dividend (~$32m/year) or even force an equity offering to reduce debt, both nice outcomes for our short position. Regardless of the amendment outcome, we think that investors will increasingly focus on the health of Baldor's balance sheet, about which there has been too much complacency up to this point.
We show our financial estimates alongside the Street's consensus estimates below:
FY: Dec 2007 2008 2009 2010
Revenue (us) 1,825 1,955 1,538 1,461
% Change NM 7% -21% -5%
Revenue (street) 1,780 1,780
% Change -9% 0%
EBITDA (us) 325 330 213 201
% Margin 17.8% 16.9% 13.9% 13.7%
EBITDA (street) 289 310
% Margin 16.2% 17.4%
EPS (us) 2.08 2.15 0.64 0.57
% Change -70% -13%
EPS (street) 1.58 1.81
% Change -26% -15%
Net Debt 1,339 1,314 1,230 1,200
Net Debt / EBITDA* 3.8x 5.6x 5.7x
*Note: there are some small add-backs to EBITDA for purposes of the leverage calculation.
We believe that rapidly declining sales, slimmer margins and heightened balance sheet risk will prompt investors to dump BEZ shares. A valuation of $5-7 per share, or roughly 7x estimated EBITDA and 10x estimated earnings seems reasonable.
- A good portion of business (we think around half) is replacement, which should partly insulate the company from declining sales.
- Given recent consolidation in the motor manufacturing industry in North America, a more favorable industry structure exists than in years past. Offsetting this to some extent is the rise of foreign-manufactured motors, especially at the low-end.
- Regulations are in place that mandate more energy efficient motors by December 2010. These motors have higher selling prices, but are also costlier to build. Sales of higher efficiency motors will cannibalize existing sales. Our conversations with industry experts suggested that Baldor has nothing unique on this front, i.e. everyone in the industry is already selling "green" motors.
- Baldor has a big chunk of high cost inventory from raw materials it purchased at much higher levels in 2008. As this inventory cycles through later in 2009, we expect a one-time improvement in COGS. We think that operational deleverage from lower sales and customer pressure on prices (given that this was an excuse used by management to raise prices in the first place) will negate much of this benefit.
- The biggest risk, of course, is a sudden upturn in industrial demand which rejuvenates motor sales. We're not too worried about this in the short-to-medium term and take some comfort in the fact that regardless of where sales are, the company still seems to be over-earning from a margin perspective.
In addition to the BEZ equity short, another mis-priced security is the company's junior bond issuance ($550 million at face value with an 8.625% coupon), which currently trade for about 80 (implied YTM of around 12.5%). These bonds will likely pay the price for management having to accommodate the company's senior lenders. We think a best case scenario is a 400-500 bps widening after the amendment is finalized. A more pessimistic scenario driven by a loss of confidence in management could involve the bonds' yield jumping to 20-25%, implying 45-55 levels, or 30-40% downside. Baldor's 8.625% bonds are liquid and have ample borrow.
- Amendment to credit facility, probably on worse terms that management expects.
- Potential dividend cut mandated by creditors.
- Potential equity raise to reduce debt, also mandated by creditors.
- Management confesses to the poor state of the business - a big turnaround from the last time they briefed investors.
- Analysts will need to reduce their forecasts materially.
|Subject||Rockwell Power Systems|
|Entry||03/24/2009 02:32 PM|
Thanks for the write-up
Have you normalized margins for the Rockwell Power Systems acquisition and associated synergies?
In 2006, it seems as if Rockwell Power earned about 14% operating margins vs. about 10% for BEZ (pre-acquisition). Given that Rockwell Power represents over 50% of consolidated sales, this would boost post acquisition margins by over 200 bps. If we were to add another 150 bps for the $30M of expected synergies, a shareholder could make the argument that the normalized margins after the Jan 2007 acquisition should be 350 bps higher then before the acquisition.
Therefore, one could make the argument that 30 year average EBITDA margins of 13% should be adjusted upward above 16%. This seems way too high to me, but I would be really interested to hear your thoughts on this. The implication is that normal earnings could be closer to $1.30-$1.40.
|Entry||03/25/2009 04:56 PM|
tks for the idea. is EPS really the right measure for valuation here? i ask this because it appears, partly due to the amortization running through the income statement, that FCF is signficantly higher (perhaps around 80 cents / shr / year?). if earnings estimates way too high / debt levels unmanageable may work anyhow but curious to here your thoughts.
|Entry||04/02/2009 01:28 PM|
The amended credit agreement did not look particularly punitative. Any thoughts on how this affects your thesis. Thanks
|Entry||04/29/2009 07:13 PM|
Looks like the Q1 sales miss and Q2 guidance play into your thesis. Any thoughts/update given the strong move up over the last month? Thanks
|Entry||05/03/2009 05:37 PM|
First off, apologies to all for not being more forthcoming with responses. Having said that, I must admit that Q1 earnings were better, esp on the top line, than I forecasted. Q2 is def more in-line with what we thought sales-wise. In fairness, mgmt seems to be doing a better than expected job on the cost side though, which doesn't help the short case. A little mea culpa is probably in order here. If people are (increasingly) willing to look thru tough interim performance (and frankly BEZ's performance wasn't even that bad), this probably isn't a short that works.