ENERSYS INC ENS S
June 30, 2015 - 3:10pm EST by
mtbattie
2015 2016
Price: 70.59 EPS 0 0
Shares Out. (in M): 44 P/E 0 0
Market Cap (in $M): 3,140 P/FCF 0 0
Net Debt (in $M): 260 EBIT 0 0
TEV ($): 3,400 TEV/EBIT 0 0
Borrow Cost: General Collateral

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  • Cyclical
  • China

Description

Thesis

ENS is a cyclical lead acid battery business trading at an 8.5x EV/NTM EBITDA multiple – despite “over earning” in recent years due to favorable cycles in telecom capex and forklift truck production.

Also, consensus estimates for ENS’s earnings power are overstated, because they are an extrapolation of the company’s recent growth in “non-GAAP” earnings. We believe ENS’s non-GAAP metrics greatly overstate their true earnings power, as this metric includes increasing amounts of serial, “big bath” restructuring charges, and other aggressive tactics.  

 

Background

ENS’s core business is producing lead acid batteries that go mostly into industrial forklift trucks (those things you see in the aisles of Costco for example) and into back-up power solutions for telecom companies (Verizon, AT&T, Sprint, etc.) and other customers.

 

 

The motive business has both an OEM (Hyster Yale, German OEMs, etc.) and aftermarket component – and is the more cyclical business of the two. The timing of forklift battery sales (some 90% of motive sales at ENS) naturally lag new forklift truck sales (which also tend to lag on-road trailer sales). Sales of all three are all heavily tied to economic activity.

As consumer activity picks up, and people more regularly shop at the Home Depots of the world, forklift truck sales follow suit (see Motive section below for more detail). To give you a sense of the cyclicality of this business, motive sales declined ~34% from fiscal 2008-2010.

The reserve business is cyclical as well – having declined ~12% in fiscal 2010. But the reserve business in the U.S. has benefitted from a “mega cycle” of capex spend related to the 3G and 4G rollouts, which has muted the cyclical aspects of this business to a degree. As new cell towers are built, each of these new towers needs their own backup power solution. In comes ENS.

Below is a scatter plot of cell site deployment in the U.S. versus ENS sales in their reserve segment from 2004-13. There is a high positive correlation between the two:

 

 

Source: http://www.ctia.org/docs/default-source/Facts-Stats/ctia_survey_ye_2013_graphics-final.pdf?sfvrsn=2

With the steepest part of the 4G-led growth curve in the U.S. for large cell site deployment now in the past, ENS is currently waiting, or hoping, for a similar wave of capex to take place in Europe in the coming years as that region embarks on its own 4G rollout. But the prospect for this is yet years away according to ENS management.

ENS sales are currently almost perfectly split 50/50 between the motive and reserve end markets. The company does not provide margins by product line, only by region. Americas is by far ENS’s most profitable geographic segment, given the high market share and operating leverage they enjoy in this region – with EBIT margins nearly 2x on average of both that of EMEA and Asia:

 

 

The company has ~40% market share in the Americas and ~30% in EMEA. The company has only ~5% share of Asia, where they have experienced continual struggles in China in particular (more below).

ENS’s primary competitors in the U.S. include Exide Technologies, East Penn Manufacturing and New Power in both the reserve and motive products markets; and also C&D Technologies Inc., NorthStar Battery, SAFT and EaglePicher (OM Group) in the reserve products market.

In EMEA, competitors include: Exide Technologies, Hoppecke, FIAMM, SAFT as well as Chinese producers in the reserve products market; and Exide Technologies, Hoppecke and Midac in the motive products market.

In Asia, ENS has small share, but competes with GS-Yuasa, Shin-Kobe and Zibo Torch in the motive products market; and Coslight, Amara Raja, Narada, Leoch, Exide Industries and China Shoto in the reserve products market among others.

Exide recently emerged from Chapter 11 bankruptcy. The uncertainty of Exide’s future in recent years has likely benefitted ENS. On the flip side, Exide’s emergence from bankruptcy should remove this tailwind for ENS. Note that Exide’s problems related primarily to their “automotive business” – not their Industrial business (network and motive), which competes directly with ENS, and comprises about $1 bln of Exide’s sales.

 

Source: Factset

 

Finally, fiscal 2013-15 marked peak “Adjusted” EBIT margins of 11%+ for ENS, with this strength buoyed most recently by their performance in Europe.

It’s all about Europe

The climb in ENS’s overall operating margin as reported from 7% at the start of the most recent cycle in fiscal 2010 to almost 11% currently has largely been on the heels of a dramatic improvement in the margins of ENS’s EMEA segment:

 

 

The jump in margins in Europe has been impressive indeed – but we believe it is unsustainable. Why? As highlighted below, ENS is a “serial restructurer” - that has been conveniently adding recurring “non-recurring” expenses back to their Adjusted EPS metric every year for almost a decade now.

Where have the majority of these restructuring charges been taken? You guessed it, Europe. All of them in fact – until ENS took a recent, small restructuring charge in Asia too.

The reasons this is important are really twofold:

  1. We believe ENS’s non-GAAP EPS number is NOT representative of the company’s long-term earnings power, because ENS has been adding back (at an increasing pace) to their earnings number “recurring non-recurring” items to arrive at their non-GAAP metric.

  2. More specific to EMEA operations – we believe ENS’s exclusion of its massive restructuring charges in recent years (which include the write-downs of inventory) have possibly served to juice up EBIT margins in this segment in future years. Consequently, we do not believe EMEA’s recent performance is indicative of its long-run earnings power.

The massive ~$30mm restructuring charge that ENS took in Fiscal 2014 included an $11mm write-down of inventory. Perhaps not coincidentally, in Fiscal 2015, ENS enjoyed record EBIT margins in the EMEA segment, despite noted FX headwinds, and flat top line growth.

Some of this is surely the benefit of layoffs that took place as part of the Fiscal 2014 restructuring. But what about the $11mm inventory write-down?

A classic shenanigan used by management teams is the “big bath” write-down – whereby a company takes a restructuring charge (in the hopes the Street will overlook this “one-time” charge, and focus on the company’s non-GAAP metric instead). But additionally that write-down of inventory does not also necessarily involve the inventory being removed from the company’s shelves. So they can then in turn sell that inventory in subsequent periods at 100% margin flow-through.

For example, ENS could have sold that written-off inventory for ~$14.67mm in Fiscal 2015, given $11mm of COGS written-off would equate to $14.6mm at 25% GM’s. If so, then this would have provided some ~140 bps boost to their Fiscal 2015 EMEA EBIT margin (from 10.2% to 11.6 %) in that year.

While 10% is still a record EBIT margin as reported for this segment, where there is smoke, there is usually a gun. This is likely not the full extent to which ENS has strategically used restructuring charges to boost future income.

Importantly, the absence of this potential benefit would have also taken ENS’s firm-wide EBIT margins as reported below 10%. This is significant because a 10%+ EBIT margin is a key component of management’s goals, and a key focus of investors.

 

Management’s Lofty 2018 Goal

One way to get comfortable with the risk to the short thesis is to assess the likelihood of ENS achieving management’s stated long-term goals, which are for $4 billion in sales and 10% EBIT margin by 2018. Judging by ENS’s forward multiples, investors are assigning a high probability to management’s ability to execute this plan.

FY 2015 sales for ENS were just over $2.5 bln with EBIT margins above their 10% goal. ENS operates, as mentioned above, in cyclical businesses that over time should grow with GDP. So the only way for ENS to achieve this sales goal is through serial acquisitions.

Now this is precisely how ENS has grown largely to-date. Here is a timeline of all the acquisitions ENS has made since their initial acquisition of Yuasa pre their IPO in 2004:

 

One way to consider the likelihood of management’s goal is contemplate the liquidity it might require to achieve the necessary inorganic growth – and whether or not that liquidity would likely be available to ENS.

First, historically, what has been the organic growth of the ENS business?

If we assume the $400mm sales added over 2002-12 (see timeline above) was added evenly at $40mm per year, and we calculate the growth in the business, outside of the above $1.575 bln in acquired revenue, ENS has grown at about a 4% CAGR organically from 2000-14, so a little north of GDP.

If anything, we believe this calculation slightly overstates ENS’s long-run, organic growth potential, given their higher saturation at present in their key end markets, and because the Fiscal 2015 snapshot is closer to “peakish” sales level, given where ENS is in the cycle in each of their key end markets.

Next – what market share would ENS have to achieve, given they operate in a GDP-grower market – to reach their 2018 sales goal?

First, let’s look at the total addressable market (TAM) for ENS in each of its segments, as provided by management.

Management believes the reserve and motive markets are $9.2bln in size (as of 2013). At that time, they believed their market share to be 16% in reserve and 35% in motive. Judging by the share %’s they provided, these market share numbers are before the impact of the Purcell, UTS, and Quallion acquisitions. If I adjust for those, then market share would have been 19% in reserve, and 35% in motive, if we assign all those sales to reserve.

But their market share ex-Asia, is in the upper 30’s. So they are much more saturated in motive now – and more saturated too in reserve - if Asia is not up for grabs.

We question ENS’s ability to ever grow meaningfully or profitably in China over time (and China is a big part of Asia TAM). Consequently, we think ENS’s growth potential is much more limited in their key end market than investors appreciate.

 

 

Also, ENS believes the Aerospace & Defense and Cabinets end markets (which recent acquisitions moved them into) worldwide are each ~$1.5bln markets. They currently have single digit market share in these markets. What is clear is that growth in Asia and adjacent markets are crucial to ENS’s growth plans.

So next question - how much revenue and EBIT would they need to acquire, if they continue to grow 4% organically between now and the end of Fiscal 2018, all other things constant in order to reach $4 bln in sales by fiscal 2018?

Organically, they would get to about $2.8 bln in sales by end of fiscal 2018, barring no cyclical slowdown, and continued 4% organic growth – which if anything is generous, given the reasons mentioned elsewhere.

This means ENS would need to acquire $1.2 bln in revenue, and $120mm in EBIT, to reach their stated goal. An additional $1.2 bln, if it were to come from Americas and Europe, would mean ~60% market share in these markets. We do not view this as a realistic possibility, outside a major merger with the likes of Exide, C&D, or East Penn, as nearly 80% market share is tied up among the industry’s major players.

Therefore growth will most likely have to come from China and/or markets adjacent to reserve and motive. But so far ENS’s forays into these new frontiers have been wrought with failure. In the most recent quarter, they took an almost $18mm impairment on their Quallion and Purcell acquisitions – their first forays into adjacent end markets.

Also, Asia is operating at margins well below 10%, as fixed investments weigh down margins – given they have not yet resulted in higher volumes.

Finally - $1.2 bln in sales would likely equate to $150mm in EBITDA, if they achieved their 10% EBIT margin target on these additional sales.

Management said they would never pay 10-14x EV/EBITDA for companies (perhaps not coincidentally, they are active sellers of their own stock at ~10x EV/EBITDA). But let’s assume they could acquire this $150mm EBITDA at 8x EV/EBITDA multiples on average. That would mean they need $1.2 bln of liquidity to get where they want to be by 2018.

Currently, they have $260mm in net debt (this includes $270mm in cash that is predominantly held overseas – and therefore would preclude use of this cash for the acquisition of an U.S. based company without significant tax consequences). ENS recently issued $300mm in debt that will be used to buy back shares and offset dilution associated with $173mm convertible. So as of next reporting period, we would anticipate net debt to increase to $390mm.

ENS did $340mm in EBITDA during fiscal 2015. So net debt/EBITDA is only 1.15x currently. They did $190mm in FCF (more on this later) in  fiscal 2015. They started paying a dividend this year, of ~$30mm last year. So they will have about $150mm in FCF per year (assuming some div growth), or $450mm over next three fiscal years, to go towards acquisitions – if they continue to execute as they have been lately, and if the topline grows 4%.

So this would mean ENS would need $750mm in liquidity to reach their stated sales goal, given our assumptions. Organically, EBITDA could grow to $380mm over that time, assuming 4% sales growth, which would be added to the $150mm in acquired EBITDA. So the $750mm in additional debt on $390mm net debt currently, on top of $530mm in EBITDA, equates to an estimated net debt/EBITDA of ~2x turns. This is the bull case. Given $1 bln in revolver availability currently – it does not appear ENS’s balance sheet would be a constraint to their growth plans.

But while two turns does not seem like a lot of leverage – the above all assumes ENS executes flawlessly, and could find available targets at 8x multiples. Also, you will be hard pressed to find a lead acid battery company with 2x turns net debt/EBITDA. Exide had 2.6x turns in 2011 – but fell into bankruptcy. Perhaps their industrial business (i.e. ex-Automotive battery) could have sustained that kind of leverage. Another public comp, Saft, has < 1x net debt/EBITDA.

The point here is that the lead acid battery business is commoditized, competitive, and cyclical. Lenders are going to be weary of slapping 2x+ net debt/EBITDA onto ENS’s balance sheet anywhere near the top of the cycle. Also, ENS’s current 2011 Credit Facility does not permit a net debt/EBITDA ratio greater than 3.25x. Given ENS’s EBITDA declined ~40% in their last down cycle – anything more than 2x net debt to peak cycle EBITDA would risk potential breach of that covenant in a downturn.

So outside of flawless execution – and continually favorable end markets – ENS’s balance sheet could yet become a constraint to their growth plan.

Also, this analysis only looks at EBIT – and so, it ignores FCF (which would surely be lower, given ENS would have to take on the $750mm in additional debt, and most likely in a higher interest rate environment).

Given ENS’s problems in Asia, market share saturation in Americas, serial restructuring in Europe, exposure to cyclical downturn in motive, the temporary boost they got in Americas reserves from 3G and 4G rollouts, the benefit they have received over recent years from Exide’s distress, lack of available M&A targets in their core business, and recent M&A foibles in adjacent markets – this bull case is more myth than reality. And management presumably agrees, given the precipitous rate at which they are selling stock.

 

Troubles in China

Through the years, Asia – and China more specifically - has been a cruel mistress for ENS. Sales in the region still only comprise < 10% of firm-wide sales, even despite their presence there for over a decade. Here are sales and EBIT margins in the region by fiscal year:  

 

 

Management has a long-run stated EBIT margin goal for all their regions, including Asia, of 10%. As you can see in the above chart, that goal has become increasingly elusive in Asia over the last 3 years.

ENS problems in Asia predominantly relate to:

  • Overcapacity in China and concordant price competition - The recent weakening of the EUR – and recent law changes - have both made it more difficult for those Chinese manufacturers to ship batteries into the European market. Europe has benefited very recently from less China supply/product now flooding their market, and therefore less price competition, than in the recent past. The flipside of this is that there is now massive overcapacity in China – which is leading to further price competition in that market. ENS refuses (sensibly) to compromise on price – but this is resulting in lower sales in China, right as they have more fixed assets coming on line, resulting in lower and lower operating margins in the region. From the most recent earnings call:

The China market is actually a good news-bad news story…The good news is to export of battery out of China has become much, much more expensive, because of the export taxes associated with it…we don't see the Chinese in the Americas in our business hardly at all, and in Europe, it's really been cut back, because of what I just referred to and also the FX effect…The bad news is with that excess capacity they have…what they're doing is, to keep their factories loaded, they've lowered their pricing on it. So, it's made it a tougher market for us to do business in China.

And:

Now what's the problem with reserve power? The problem with reserve power in China is the telecommunications industry are deploying 4G right now and the price they're willing to pay for batteries is very low. And we walked away from a lot of that business…If you compare battery to their battery, our battery will outperform their battery, but the reality is the market is not willing to pay for that. So we need to come out with the products that perform more like what the market will buy and put that product in place to go after that telecom in China. –November 2014

 

  • China plants are both currently underutilized – Management had this to say recently:

Same thing in China, where you've got [a plant] that's now running at about 50% capacity utilization, state-of-the-art world class factory and I'm very pleased and very proud of the people that put that in that place. But we're also building a new factory in China also for the motive power group [Yangzhou]. So we're having a lot of expenses that's taking place right now that are investments for the future. Short run is going to hurt the earnings, it's going to take it down below 10%. I'm okay with that, because in the long run it's a good payback.

So right now, ENS is operating with high fixed costs, and low volumes (and prices), in China. Their plants are underutilized there, as they are unwilling to concede on price or quality. The Chinese telecom companies do not want to pay a higher price. Given the level of competition in these markets, and current pricing dynamics, we believe questionable at best is the premise that over the longer-term the payback in recent fixed asset investment in China will be favorable for ENS.  

ENS does believe they are starting to get traction on the telecommunications side in Asia (“we have been focused on increasing our sales in China telecommunications markets with new product offerings and successfully winning additional business in this important market. We anticipate in the second half of fiscal 2016, we will experience higher telecommunications volumes based on these efforts).”

ENS also believes they have the opportunity to sell more thin-plate pure lead product in (which is their premium product) in Japan going forward, but not in China (“The China market, which is telecommunications, where we're not selling thin plate pure lead into that market yet and the reason is the market doesn't want to pay for it”).

Despite these bullish sentiments, we believe that continued price competition in Asia is likely, however, given the noted overcapacity in China in particular.

 

Motive Cycle

Anyone who has followed companies like Hyster-Yale (HY), Crown Equipment, or just the sales numbers for forklift trucks in general, know that forklift sales have grown rapidly from a nadir in 2009:

Source: World Industrial Truck Statistics

 

With regards to how ENS motive sales track forklift truck orders – according to management, declines in forklift battery sales tend to not be as pronounced as declines in forklift production, because of their aftermarket sales.

But just looking at the WIT data - forklift production declined ~40% in 2009, whereas ENS motive sales fell 34% from fiscal 2008-10. We look at the more drawn-out fiscal 2008-10 period for ENS – because forklift battery sales numbers lag forklift production numbers. For example, the recovery in forklift production began in 2010. The recovery in motive sales at ENS lagged that by about six months to one year.

Management has addressed recent investor concerns about the motive cycle by saying that their motive aftermarket business will mean their sales will not decline in that segment by as much as a decline in forklift truck production. But history should be our guide here. This was not the case in the last down cycle – and it is very possible it will not be the case in the next one either.

Finally, it is very possible that Exide’s recent distress (namely from 2011 to present) has benefited ENS in their motive business (in Europe). With Exide emerging from bankruptcy, this recent tailwind will be gone.  

 

Purcell and Quallion Acquisitions

Given the limits to ENS’s TAM, as noted above, management had to start wandering into adjacent hunting grounds for prey – and this is precisely what they did in October 2013, when they acquired Purcell, Quallion, and UTS.

Purcell is a manufacturer of reserve battery enclosures or cabinets. These are literally the cases that the reserve batteries go into. Quallion is a maker of lithium ion cells and batteries that go into aerospace and defense applications. UTS is a distributor of motive and reserve power battery products and services in Malaysia.

Purcell sales are included in the company’s Reserve segment.

When ENS purchased Purcell, Purcell’s growth in the United States, with the 4G rollout complete, had largely reached saturation. Sure, there may be 5G someday, or the like. But that is yet a long way off. ENS management purchased Purcell for what they saw as an eventual 4G roll out opportunity in Europe. When asked on a recent call, management said they feel Europe is in the “first or second inning” of their transition from 3G to 4G, and that it is years off. But the promise of this potential cap ex cycle eventually in Europe is largely what made the Purcell acquisition attractive in the eyes of ENS’s management team.

But already – not even two years into the transaction – the deal is not going well. AT&T, one of Purcell’s key U.S. telecom customers, suspended cap ex plans, as they related to reserve battery cabinets. This was due to the completion of their multi-year “Project VIP” initiative (“Due to our completion of Project VIP, we anticipate lower capital spending in our Wireless and Wireline segments in 2015”). This forced ENS to take a large asset impairment charge of $18.7mm on this transaction in MRQ. The Street has eagerly been anticipating a return to spending on cell deployment by this crucial customer, but as of now there is not a line of sight on when this may happen.  Now that AT&T reached an important milestone of 300mm POPs, they are focused more on network improvement than tower buildout (“what we're seeing is, as we finish the build-out of LTE and we just announced this week 300 million POPs, so we essentially are complete. And so we'll continue to have augmentations in the network to improve the density in certain areas, to provide for growth. All these cars and all these things is growth, but it's at a much lesser pace than what we have seen during the build-out of LTE”).

Also, given AT&T has referred to 2014 as its “peak investment year” for Project VIP – it is unlikely telecom cap ex spending – as it relates to tower buildout and back-up power solutions for those towers - will reach its 2014 heights in the U.S. anytime soon.

Some people believe there was a quid-pro-quo government lobbying aspect to AT&T’s suspension in Cap Ex – i.e. if you let us buy Direct TV, we will pick spending back up. If this were the case, a completion of the Direct TV deal, and resumption of cap ex, could be a tailwind to ENS’s stock price. While this theory may be true of AT&T’s broadband investment in rural areas – since the company has said that it “essentially completed the expansion of its 4G LTE” network, we do not believe the potential Direct TV dynamic is relevant to the parts of AT&T’s budget that matter to ENS.

 

 

The Quallion acquisition was an attempt to move into Lithium Ion, which is a technology that some believe presents a long-term threat to lead acid batteries (i.e. if the “total cost of ownership” of Lithium Ion batteries ever comes down to be more in line with that of lead acid). The reason ENS is moving into these adjacent market becomes clear, when considering both the company’s limited TAM is in their key end markets (as highlighted above), and also their lofty 2018 sales and EBIT margin goals.

Put simply – they cannot get to their 2018 goal simply through organic growth, or even through roll-up acquisitions in reserve and motive with Europe and the Americas alone, outside a possible, large tie up with Exide, East Penn, or C&D. But the hiccups related to recent acquisitions in adjacent areas should give investors pause about ENS’s ability to grow in non-core areas, and management’s capital allocation ability in general.

Given the company’s challenges in both Asia – and their hiccups related to their first forays into adjacent markets – we believe their 2018 target goals are more myth than reality. And perhaps management does too, given the pace at which they are selling stock.

 

CEO and CFO recently shed 30-50% of holdings

CEO John Craig has been selling ENS stock like it’s a hot potato. He sold ~133k shares in May 2015. In April and May 2014, he sold a combined ~189k shares. He owns only 318k shares currently. So in the last year, Craig has shed ~50% of his shares.

Perhaps not coincidentally, as part of the 2016 Long Term Incentive Plan (LTIP), ENS’s compensation committee instituted a new 1-year holding period on vested shares, “Starting with the fiscal 2016 grant, performance market share unit grants are subject to an additional one-year mandatory holding period after vesting.”

CFO Schmidtlein has been getting in on the action too, as he recently sold ~32k shares in May 2015. He currently only owns 91k shares. So he shed ~26% of his holdings – all at a stock price below where ENS is trading today.

This inside selling married with the fundamental business headwinds ENS’s growth plans are up against, and further reinforced by the poor earnings quality underlying ENS’s recent performance, all comes together to paint a bleak outlook for ENS’s likely future performance.

 

Earnings Quality a Concern

CFFO vs. NIDA – ENS’s cash flow generation is trailing their reported income, a telltale sign of poor earnings equality and aggressive accounting practices.

Specifically, ENS’s LTM CFFO was $194mm. This compares to LTM Net Income plus D&A plus Stock Based Compensation of $254mm. So there is a $90mm gap in “other” non-traditional working capital items.

Now two-thirds of that unexplained gap between LTM CFFO and reported income is due to the settlement of a legal matter that resulted in a non-recurring cash outflow. But the other gap is due to Accrued Expenses – namely payroll and wages, which we consider benign – and Prepaid and Other Current Assets (a hotbed for improper capitalization or deferral of expense), ~$20mm use.

This shows that ENS is possibly attempting to inflate earnings through the capitalization/prepayment of expenses. $20mm is ~8% of LTM EBIT.  

Non-GAAP vs. GAAP EPS - ENS has reported record Non-GAAP Adjusted Net Earnings over the last couple years ($3.03 in fiscal 2011 growing to $4.32 in fiscal 2015, or $149mm growing to $208mm).

Over the same time, LTM CFFO has declined slightly from $204mm in Fiscal 2012 to $194mm in Fiscal 2015 as reported (but increased to $243mm if you take out the legal settlement outflow, but subtract out SBC growth).

So ENS’s non-GAAP earnings metric has grown ~43% vs. only ~19% growth in their CFFO over this time.

Note: Only $5.3mm “Accelerated SBC” was added back to their adjusted net earnings number in fiscal 2015, and no other SBC outside of that.

Going back to Fiscal 2010, Adjusted Net Earnings have almost tripled to $208mm from $70mm, while CFFO has not even doubled from $137mm to $243m (adjusted for legal settlement and SBC).

Since cash is king, this growth in “Adjusted Earnings” gives us pause.

Here is a breakdown of the non-GAAP metrics management has utilized over an extended period of time:

 

Our adjusted number takes out what we believe are recurring, non-recurring items – and as you will see in the above graph: management’s use of non-GAAP adjustments has become more pronounced over the last two years. This is due to increased restructuring charges (and including SBC for the first time in their non-GAAP metric this past year) among other charges. The stock currently trades for over 20x P/E of our  TTM recurring earnings number.

Why might management be accelerating this gamesmanship?

For possible motivation, look no further than the company’s institution of a new 3-year LTIP plan, beginning in Fiscal 2015, which grants management shares based on the 3-year share performance of ENS stock. The payout factor (i.e. percentage applied to this grant amount) is determined by total shareholder return over the three-year period, where 100% return gets 200% payout factor, 25% return gets 100%, 0% return gets 75%, -25% gets 50%, and < -25% gets 0%.  

Note: if the stock declines 25% across Fiscal 2015-17, management still gets 50% of their grant amount! How is this an alignment of interests?

But regardless, the 4x greater payout ratio on a 100% vs. -25% return over that time period is certainly ample motive to manage earnings as much as humanly possible.

OCA – Other Current Assets as a % of sales for ENS have gone from ~13% in fiscal 2011-12 to 17% more recently, raising concerns that perhaps ENS is pre-paying and capitalizing expenses – which is partly contributing to the margin improvement (and can be witnessed in the deteriorating cash flow relative to reported earnings).

The buildup in OCA is evenly split between “prepaid income taxes” - which would not impact EBIT margins but could be helping to inflate management’s adjusted earnings number by capitalizing future expenses. The rest of the balance is “other”.

It is not clear from the disclosures what this “other” constitutes – but if it includes operating expenses, then ENS could be using these prepaid expense to inflate margins.

DSO  - Over the LTM period ENS’s ‘Days sales outstanding’ has been elevated relative to longer historical averages.

 

 

The spike was most pronounced in Q2-Q314, when ENS’s DSO eclipsed levels not seen since Dec. ’09. This also predated by a quarter – perhaps not coincidentally – AT&T’s announced slowdown in their 4G LTE related cap ex spending. DSO’s have since come down, but are in each of the last four quarters still 1-10% above their 3-year quarterly averages (i.e. in fiscal ‘15 vs. fiscal 2012-14 comparable quarters). This raises concern that ENS is pulling forward revenue through either offering more lax payment terms to customers, or stuffing distribution channels. Also, as the Alcatel’s of the world come under the strain of lower telecom capex spending – perhaps they are pressing for more lax payment terms from their suppliers, which would ultimately flow down to ENS.

 

Valuation

ENS is currently valued at ~9x FY15/EBITDA, and trading at a ~6% FCF yield. Also, ENS’s stock-based comp is growing (and was $25mm in fiscal 2015). ENS will have to buy back shares to offset the dilution that will result from this growing SBC. Doing so would tie up $75mm+ in liquidity over the next three years – capital that cannot go towards acquisitions – as they look to achieve their 2018 goals.

The last time that ENS traded at such a lofty EV/NTM EBITDA multiple was 2008. A trough multiple for ENS is ~4x (Sep. 2011). A “mid-cycle” multiple is more like 7x.

We believe the market is assigning far too high a multiple to a cyclical business that has been overearning in recent years due to: aggressive accounting practices, a mega capex cycle in their reserve business, and a strong upcycle in their motive business.

To justify anywhere near that multiple, you would need to believe in the acquisition potential for ENS, think that recent earnings are indicative of their recurring earnings power, that the motive business will not slow down, and that the top line will continue to grow in the 4% range organically.

We believe a 7x multiple is more appropriate. Assigning this multiple to an EBITDA estimate for fiscal 2016 of $300mm (10% EBIT margins on $2.4 bln in sales plus $60mm in D&A), and assuming $390mm in net debt, we see ~45% upside to the short at current stock price of around $71. Further note that ENS’s cash balance is almost entirely held abroad – and would be subject to tax penalties if invested in U.S.

At our target price, ENS would trade closer to a 11% FCF yield, which we think is appropriate, given the cyclicality of the motive business, the challenges in Asia, the competitive nature of the business, etc.

 

Risks

European 4G rollout – If capex by Europe telecom companies begins to pick up and grow at levels similar to those levels experienced in the U.S. over the last decade, ENS’s reserve business would be well positioned to continue growing at a rate faster than GDP.

Underlevered balance sheet – At less than one turn net debt/EBITDA currently, ENS does have the dry powder to make further acquisitions. To the extent they can find viable candidates at reasonable prices, ENS could use further acquisitions to “scramble the egg”, and obscure their deteriorating organic growth performance. A mitigating factor is the lack of appropriately priced takeout candidates in EMEA and Americas reserve and motive business – as evident by the cadence of recent acquisitions into areas further afield of ENS’s core markets. Also, given the consolidation of market share among the industry’s top four players – there is a limited population to monitor in assessing this risk.

Continued industry consolidation – ENS has likely benefitted in recent years from financial distress of competitor Exide, who declared bankruptcy in 2013 due to environmental litigation and deteriorating business performance. Should ENS’s competitors continue to struggle, ENS may be able to claim some of these competitors lost share through the promise of more reliable service.

Improvement in Asia – Some capacity in Asia gets taken off line, causing price competition there to abate somewhat. Heightened government and environmental regulation would be one way in which some capacity could get taken offline in China.

Lead Prices – ENS has to pass through lower lead prices to their end customers – but there is a lag to this pass-through mechanism. Therefore a sharp decline in LME Lead price could lead to a temporary boost in ENS’s GM%.

Potential Exide Merger As Exide emerges from bankruptcy, there is certainly the potential that Exide and Enersys could merge. This would consolidate supplier power for ENS – and present significant cost synergies potential. This is only a possibility, likely, if Exide sheds its “bad” automotive business, or spins out its “good” Industrials (network and motive) businesses, as ENS would likely not want the two businesses as a package deal, given the historical problems with the former.


This report (this “Report”) on Enersys (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold short positions tied to the securities of the Company described herein and stand to benefit from a decline in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their short exposure to the Company’s securities or establish long positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Next Earnings – ENS’s earnings estimates have been declining lately – but this has been met with uninterrupted investor optimism in the form of multiple expansion. Signs of further disappointment will likely be met at some point with a sharp correction in ENS’s forward multiples.

Continued pricing competition in Asia – Should price competition continue in Asia, ENS’s recent investments there will likely underperform – and result in further restructuring in this region.

Further impairments Should U.S. telecom companies continue to suspend capex plans, the Purcell acquisition in particular could result in further asset write downs, causing investors to grow weary of management’s capital allocation abilities.  

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    Description

    Thesis

    ENS is a cyclical lead acid battery business trading at an 8.5x EV/NTM EBITDA multiple – despite “over earning” in recent years due to favorable cycles in telecom capex and forklift truck production.

    Also, consensus estimates for ENS’s earnings power are overstated, because they are an extrapolation of the company’s recent growth in “non-GAAP” earnings. We believe ENS’s non-GAAP metrics greatly overstate their true earnings power, as this metric includes increasing amounts of serial, “big bath” restructuring charges, and other aggressive tactics.  

     

    Background

    ENS’s core business is producing lead acid batteries that go mostly into industrial forklift trucks (those things you see in the aisles of Costco for example) and into back-up power solutions for telecom companies (Verizon, AT&T, Sprint, etc.) and other customers.

     

     

    The motive business has both an OEM (Hyster Yale, German OEMs, etc.) and aftermarket component – and is the more cyclical business of the two. The timing of forklift battery sales (some 90% of motive sales at ENS) naturally lag new forklift truck sales (which also tend to lag on-road trailer sales). Sales of all three are all heavily tied to economic activity.

    As consumer activity picks up, and people more regularly shop at the Home Depots of the world, forklift truck sales follow suit (see Motive section below for more detail). To give you a sense of the cyclicality of this business, motive sales declined ~34% from fiscal 2008-2010.

    The reserve business is cyclical as well – having declined ~12% in fiscal 2010. But the reserve business in the U.S. has benefitted from a “mega cycle” of capex spend related to the 3G and 4G rollouts, which has muted the cyclical aspects of this business to a degree. As new cell towers are built, each of these new towers needs their own backup power solution. In comes ENS.

    Below is a scatter plot of cell site deployment in the U.S. versus ENS sales in their reserve segment from 2004-13. There is a high positive correlation between the two:

     

     

    Source: http://www.ctia.org/docs/default-source/Facts-Stats/ctia_survey_ye_2013_graphics-final.pdf?sfvrsn=2

    With the steepest part of the 4G-led growth curve in the U.S. for large cell site deployment now in the past, ENS is currently waiting, or hoping, for a similar wave of capex to take place in Europe in the coming years as that region embarks on its own 4G rollout. But the prospect for this is yet years away according to ENS management.

    ENS sales are currently almost perfectly split 50/50 between the motive and reserve end markets. The company does not provide margins by product line, only by region. Americas is by far ENS’s most profitable geographic segment, given the high market share and operating leverage they enjoy in this region – with EBIT margins nearly 2x on average of both that of EMEA and Asia: