|Shares Out. (in M):||12||P/E||27.9x||21.2x|
|Market Cap (in $M):||823||P/FCF||NA||NA|
|Net Debt (in $M):||-121||EBIT||43||64|
Powell Industries is a below average cyclical business that is +60% YTD, +130% over the last 2 years and recently hit an all-time high. The stock and consensus estimates continue rising while the cycle is turning down, leading to consensus estimates that are unachievable. As POWL is on the verge of missing consensus estimates, I recommend shorting the stock.
POWL Business Description
POWL manufactures capital equipment that manages and distributes electrical energy for the utility, industrial and municipal industries. Products are low and medium voltage customized equipment procured from competitive bid fixed price contracts. Revenue is 60% US, 25% Canada, and 15% in one-off projects in Europe. POWL competes against Eaton, ABB, Siemens, and Schneider Electric along with some small Korean companies.
Cyclicality is highlighted in SEC filings and management commentary on conference calls. Sales are at all-time highs with gross and operating margins significantly above normalized levels of 19.4% and 4.7%, respectively and approaching record levels.
The Company backlog is falling and book to bill is trending negative indicating the cycle may be turning.
Cycle is Weakening
17% revenue is from base load power generation and distribution projects. Market conditions are soft attributed to falling power consumption and an uncertain regulatory framework. In regards to the utility market and a potential pickup, Management stated on the May call for FY2013 Q2 “But right now, we’re still looking at that as generally flat through this year and probably into 2014, we’re not seeing it yet.” Furthermore, in June 2013 POWL initiated headcount reductions in the European utility business due to softness in market conditions.
13% revenue is from municipalities, which is government financed transit projects with some energy and environmental applications. Through 9m FY2013, revenue increased +19% from a few large transit projects in the backlog to start the year. Those projects are not being replaced as they roll off for 2014 however; POWL was awarded a $39m project in October scheduled for delivery in 2015 to 2017.
70% revenue is general industrial with oil & gas production the primary driver and also includes petrochemicals, refineries, and general manufacturing. This business is at record levels due to oil & gas. Backlog and book to bill was boosted in FY2013 Q1 as POWL landed a record $50m+ offshore oil & gas order that will be delivered over the next few years. Per Barclay’s June update, E&P spending in North American will increase +2% in 2013 and it appears this will be positive in 2014 (not quantified yet).
In July 2012, POWL began construction on two new facilities for $75m that are slated to be completed in September 2013. The net increase in capacity (POWL exiting some leases) is ~20%. The 20% increase corresponds with a backlog that is weakening and book to bill that is negative (and looks worse when adjusted for the large multi-year order in Q1).
Management indicated that FY2013 Q4 would include $0.25 of startup-costs. Notably, the consensus 2014 estimates assume both facilities seamlessly operate at optimal utilization levels one month after completion. On the FY2013 Q1 call Management indicated “Clearly, there will be bumps in the road as you start them up. But if the market is as strong as we envision for the next couple of years and we can get those facilities and can get rid of some of the inefficient cost that we currently have, we’re very positive on the impact of what these facilities will provide to both Powell and to our clients.”
The new facilities will not generate incremental revenue. On the FY2012 Q4 call Management indicated “The incremental revenue will come from the market, not the facilities. At this point in time, we are seeing strong investments in the oil & gas. We fully expect that will continue into 2014, but to sit here and say that the facilities are going to create revenue; we’ve got to keep things in perspective. The market will create the revenues.”
The facilities may positively impact margins long term but with no revenue benefit, a falling backlog, weakening market conditions, and lower utilization levels, consensus margin expansion of 200bps seems very unlikely in 2014. (As a side note, D&A expense will also be higher in FY2014, which actually decreased ~$2.5m in FY2013 benefitting margins by 25bps.)
2014 consensus is for +11% revenue growth (all-time high) and +32% EPS growth to $3.25 (18c shy of the all-time high).
The 2014 revenue forecast is optimistic. The 17% utility exposure is likely down in 2014. 13% municipal business is unlikely to see material growth (it grows in 2015 but likely down with no large transit projects in 2014). If we assume the net growth for both markets is flat, that indicates the oil & gas business needs to +16% to meet consensus. That would indicate that FY2014 must surpass the FY2012 segment performance, which was record performance due to several large projects and +23% above the prior peak (FY2013 is not matching those levels). If they meet that standard in FY2014, POWL must be awarded several $30m+ projects that would be announced in FY2013 Q4 (and by the latest April 2014) that call for delivery within a few months.
Furthermore, Management continues to comment that projects are being delayed, postponed indefinitely, and customers are taking more time to award contracts. POWL already reduced FY2013 revenue guidance in Q3 based on this excuse.
Assuming the 2014 revenue forecast is accurate, operating margins need to be above 8.5%, which is more than 200bps over FY2013 (and above the long term average of 4.7%). POWL has only produced margins at this level on three occasions, with the FY 2009 and 2010 margins boosted by unquantified cancellation fees and positive change orders on projects coming out of the recession (copper fell over 60% with orders booked at those higher copper prices), both of which aren’t available in this environment.
POWL discloses in their filings that raw material costs are 48% of revenue. Management has not publicly quantified or discussed the effects of raw materials on margins however, my belief is that recent margin improvements have nothing to do with POWL operational efficiencies but are due solely to falling copper prices. This is totally unnoticed in the market.
As copper fell in 2008, margins reached all-time high levels, then became negative when copper rose coming out of the recession, and most recently spiked again as copper fell from 2011 levels. With copper now in a flattish pattern since April, the current backlog of projects will not benefit from falling copper prices negatively impacting margins.
POWL reports Q4 FY2013 results in early December and will provide guidance for FY2014. It is quite possible guidance is in-line with consensus. It is very difficult to forecast the annual earnings power of a cyclical company particularly those deriving earnings from competitive bid project awards. However, the short is predicated on several prudent, downside possibilities available that will negatively impact both revenue and margins whereby performance will fall short of consensus in 2014.
It should be noted that this is not a good business. Margins are low, there is no secular growth, there is no R&D, return on capital is low, and the business model is poor with risk from contracts awarded on a low bid, fixed price basis. The net cash on the balance sheet is fantastic but cash flow is meager as POWL only generates cash when revenue declines.
I believe there is little buyout risk in shorting POWL. There is no strategic rationale for a competitor acquiring POWL, and the business has enough negative attributes to eliminate a financial buyer.
This market is extremely difficult to short. The only situations that seem to be working are hit pieces on exposed frauds (NQ, TTS), inflection points in business failures (VITC, DM), and momentum cyclicals with below expectations earnings and outlooks (AAWW, AEPI, AEGN, CAT, DAN, MSM). POWL clearly falls into that last category. The setup is more favorable given the significant increase in share price with no corresponding increase in fundamentals, the fact that POWL screens headline cheap, and there are several prudent, realistic downside assumptions that could lead to 2014 earnings 25%+ below consensus. The market is blinded by this “cheap industrial with a pristine balance sheet” and looking past the significant margin impact from raw materials, the effects of the new capacity expansion and the low quality nature of the business. These factors coupled with weakening market conditions off of an already strong 2013 indicate there is little risk that earnings suddenly accelerate more than the +32% forecasted by consensus. Risk is further reduced as POWL is not an acquisition candidate. POWL may not get style points but it is low risk, it has a catalyst, and the technicals are ideal (see chart, read Peter Lynch on trading cyclicals, reference Soros on reflexivity). I think they earn closer to $2.50, which is 25% below consensus, and with POWL trading @ 30% premium to the peers @ the same point of the cycle, the stock is setup to fall.