(Guest Commentary by Rick Konrad June 25, 2009)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is a regular guest commentator and usually writes for us every third Wednesday of the month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will focus again on what he discussed last month the state of our water infrastructure. Specifically, Rick will dig deeper into the business and the valuations of the individual companies that serve the water industry. Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog Value Discipline, founder of Value Architects Asset Management, and is a regular guest commentator of MarketThoughts (please see Water Water Everywhere for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
In our last Marketthoughts.com post, we spent some time going over our water utilities hypothesis. We spent some time going through our rationale for American Water Works (AWK) the largest of the public water utilities.
There have been a number of subsequent articles pertaining to water, water purification, and developing shortages of potable water. For example, Canada's Financial Post published a recent article that was highlighted in Seeking Alpha:
Global Water ETF: Investing in Rising Water Usage
Another good article in ETF trends reviewed a number of the water related ETFs that are currently available in this industry.
How Water Scarcity Can be Accessed Through ETFs
We continue to believe that interesting opportunities are available in some of the public water equipment and water filtration companies. Here are some of the companies that are frequently identified with this industry and we think are worthy of further investigation. As usual, we both pick and pan:
Calgon Carbon (CCC)
CCC is a global leader in services, products, and solutions for purifying water and air. The Company (per 10-K) has three reportable segments: Activated Carbon and Service, Equipment, and Consumer. These reportable segments are composed of global profit centers that make and sell different products and services.
The Activated Carbon and Service segment manufactures granular activated carbon for use in applications to remove organic compounds from water, air, and other liquids and gases. The service aspect of the segment consists of the leasing, monitoring and maintenance of carbon adsorption equipment (explained below). The Equipment segment provides solutions to customers' air and water purification problems through the design, fabrication and operation of systems that utilize a combination of the Company's enabling technologies: carbon adsorption, ultraviolet (UV) and advanced ion exchange separation (ISEP®) among others. The Consumer segment primarily consists of the manufacture and sale of carbon cloth and new consumer products based on the Company's technologies already proven in large-scale industrial applications.
Calgon finally seems to be coming into its own as far as its return on invested capital which is finally north of 12% but unfortunately, over the last decade it has earned barely 3% on its capital. Generally, the company has failed to generate much in the way of free cash flow over the last five years.
The balance sheet is impeccable with total debt of less than $10 million and cash of about $14 million.
However, a mixed history of returns below the cost of capital causes me pause.
Danaher is in my opinion, a well managed business whose growth has come primarily from acquisitions. Management has demonstrated decent ability to integrate these acquistions into their system and culture. Though about 40% of their businesses are water-related, most of their other businesses are also industrial or process related businesses. As the company describes:
We derive our sales from the design, manufacture and marketing of professional, medical, industrial and consumer products, which are typically characterized by strong brand names, proprietary technology and major market positions. Our business consists of four segments: Professional Instrumentation, Medical Technologies, Industrial Technologies, and Tools & Components.
We strive to create shareholder value through:
- delivering sales growth, excluding the impact of acquired businesses, in excess of the overall market growth for our products and services;
- upper quartile financial performance compared to our peer companies; and
- upper quartile cash flow generation from operations compared to our peer companies.
To accomplish these goals, we use a set of tools and processes, known as the DANAHER BUSINESS SYSTEM (DBS), which are designed to continuously improve business performance in critical areas of quality, delivery, cost and innovation. Within the DBS framework, we also pursue a number of ongoing strategic initiatives intended to improve our operational performance, including global sourcing of materials and services and innovative product development. We also acquire businesses that we believe can help us achieve the objectives described above, and believe that many acquisition opportunities remain available within our target markets. We will acquire businesses when they strategically fit with existing operations or when they are of such a nature and size as to establish a new strategic line of business. The extent to which appropriate acquisitions are made and effectively integrated can affect our overall growth and operating results. We also continually assesses the strategic fit of our existing businesses and may divest businesses that are not deemed to strategically fit with our ongoing operations or are not achieving the desired return on investment.
Our positive assessment of Danaher reflects the business' strong ability to generate free cash flow in excess of its needs with a current FCF yield of 8.7%. Historically, free cash flow has exceeded net income by about 30%.
Our valuation of $75 suggests that there is about a 25% discount to its intrinsic value from current levels.
ITT Corporation (ITT)
ITT, of Harold Geneen fame refers to itself as a multi-industry company, avoiding the C word conglomerate. The business is considerably more concentrated than its historical image and defines itself as:
Our three principal business segments are referred to as Fluid Technology, Defense Electronics & Services and Motion & Flow Control. The principal products and services of each business segment are as follows:
Fluid Technology pumps, water and wastewater treatment systems, mixers, heat exchangers, boiler controls and related products
Defense Electronics & Services high-technology electronic systems and components, communications systems and engineering and applied research
Motion & Flow Control interconnect solutions, friction technologies, flow control, energy absorption, aerospace controls, and other controls products
With total enterprise value of only 7.2 times EBITDA and net debt of about 0.9 times EBITDA, debt is only about 20% of total capital, lower than I believe most of us think.
Return on invested capital has also improved over the years , though falling to 9.3% last year, it has averaged 12.2% over the last five years, probably higher than most investors would guess.
Our estimate of intrinsic value is also around $75 here, again a substantial discount to its current market price.
After some history as a bit of an industrial mini-conglomerate, PNR has spent the last decade putting together what is essentially a pure water treatment company.
Pentair, Inc. is a focused diversified industrial manufacturing company comprised of two operating segments: Water and Technical Products. Our Water Group is a global leader in providing innovative products and systems used worldwide in the movement, storage, treatment, and enjoyment of water. Our Technical Products Group, formerly referred to as our Enclosures Group, is a leader in the global enclosures and thermal management markets, designing and manufacturing standard, modified and custom enclosures that house and protect sensitive electronics and electrical components; thermal management products; and accessories.
Our strategy is to achieve benchmark Return on Invested Capital (ROIC) performance for diversified industrial manufacturing companies by:
- building operational excellence through the Pentair Integrated Management System (PIMS) consisting of strategy deployment, lean enterprise, and IGNITE, which is our process to drive organic growth;
- driving long-term growth in sales, income and cash flows, through internal growth initiatives and acquisitions;
- developing new products and enhancing existing products;
- penetrating attractive growth markets, particularly international;
- expanding multi-channel distribution; and
- proactively managing our business portfolio, including consideration of new business platforms.
The company has become a very goals-oriented company that portrays itself as being run by the numbers, its objectives have been well above its actual achievements. For example, though it has a 15% goal for ROIC, it has averaged only 6.7% for the last five years.
The company has been successful in converting 100% of its net income into free cash flow. With debt to total cap of about 29% and net debt EBITDA coverage of 3.4 times, the balance sheet reflects its acquisition bent.
Though recent ROIC performance has been less than inspiring at only 3.5%, I believe that PNR can, at least over time, exceed its cost of capital by probably a 2% spread. Our intrinsic value here of $29 reflects my faith in getting ROIC up to about 10 or 11% rather than management's much higher target.
For years, Nalco and its major competitor Betz Labs were almost a Pavlovian choice for a portfolio manager with an interest in the water treatment business.
Following an LBO, Nalco has come back to the public arena with a much more leveraged version with debt at 60% of capital. Return on invested capital of about 7% is below where I anticipate this highly regarded business will achieve. Buffett owns 9 million shares and perhaps that's all we really need to know!
The company describes itself:
We are the world's leading water treatment and process improvement company, delivering significant environmental, social and economic performance benefits to a variety of industrial and institutional customers. Our products and services are used in water treatment applications to prevent corrosion, contamination and the buildup of harmful deposits, in production processes to enhance process efficiency, extend asset life and improve our customers' end products, and in air emission control programs to reduce harmful releases. We help our customers reduce energy, water and other natural resource consumption while minimizing their environmental releases and improving their bottom line.
Through our sales, service, research and marketing team of more than 7,000 technically trained professionals, we serve more than 70,000 customer locations. We focus on providing our customers with technologically advanced engineered solutions and services. These technologically advanced engineered solutions and services enable our customers to improve their business by increasing production yields, lowering manufacturing costs, extending asset lives and maintaining environmental standards. The cost of our technologically advanced engineered solutions and services represents a small share of our customers' overall production expense.
We derive our strength and stability from the quality of the products and services we provide and the diversity of our revenues. We serve a broad range of end markets, including aerospace, paper, chemical, pharmaceutical, petroleum, steel, power, food and beverage, medium and light manufacturing, marine, metalworking and institutions such as hospitals, universities and hotels. We believe we offer the broadest product portfolio in our industry, including more than 10,000 products and 5,500 unique formulations.
Our view of intrinsic value ($23.50) suggests that the current market is undervaluing this business by about 16%.
Roper Industries (ROP)
With about 54% of its revenues relating to water, Roper deserves consideration in this industry. The company has demonstrated strong ability to convert net income into free cash flow, on average at about 140%.
The company does view itself as a growth company:
We are a diversified growth company that designs, manufactures and distributes energy systems and controls, scientific and industrial imaging products and software, industrial technology products and radio frequency (RF) products and services. We market these products and services to selected segments of a broad range of markets including RF applications, water, energy, research and medical, security and other niche markets.
We pursue consistent and sustainable growth in sales and earnings by emphasizing continuous improvement in the operating performance of our existing businesses and by acquiring other carefully selected businesses that offer high value-added services, engineered products and solutions and are capable of achieving growth and maintaining high margins. We compete in many niche markets and believe that we are the market leader or a competitive alternative to the market leader in the majority of these markets.
Return on capital has been somewhat undistinguished ranging between 7 and 9%. With about 80% of its revenues recurring, the company's products enjoy a great deal of loyalty. Debt to cap has become quite respectable (and achieved investment grade status after years of junk status) at about 24%. In EBITDA terms, net debt is 2.3 times EBITDA. FCF yield is about 10%.
The track record of successful acquisitions has placed significant goodwill on the balance sheet representing about two thirds of assets.
Our $54 intrinsic valuation suggests that the company is about 22% undervalued. The company's strong history of acquiring great free cash flow generators builds our confidence in this name.
Historically, I have viewed the pumps and valves or flow-control industry as wimp cyclicals. Though in the case of FLS, only about 6% of the business relates directly to water treatment, and significantly more relates to the chemical or refining business, flow control is an attractive business where, despite the consolidation of many public companies, only some 30% of the business is held by the largest ten players.
FLS has achieved ROIC of over 20% in the most recent year, way above its 9% average for the last five. FCF conversion recently is however, not as good as its history. Currently, the company offers a 6% FCF yield.
The balance sheet remains sold at only 12% debt to cap and net debt to EBITDA is very low at about 0.6 times.
Over the last five years, the company has generally sold above our esstimation of intrinsic value, but given its march to higher profitability on its capital, we view the business as being worth about $100 per share.
As the company describes itself:
Flowserve Corporation is a world leading manufacturer and aftermarket service provider of comprehensive flow control systems. We were incorporated in the State of New York on May 1, 1912. We develop and manufacture precision-engineered flow control equipment, such as pumps, valves and seals, for critical service applications that require high reliability.
With about a 35% discount to our estimate of intrinsic value, and high 20s ROEs on a relatively under-leveraged balance sheet, FLS has a lot of appeal.
Hawkins is an unusual combination of decent profitability, good growth, and small cap that you probably have not heard of.
As the company describes itself in its 10-K:
The Company's business is conducted in three segments, Water Treatment, Industrial and Pharmaceutical, which are more fully described below:
(A) WATER TREATMENT. The Water Treatment segment specializes in providing equipment, chemicals and solutions to problems for potable water, municipal and industrial wastewater, industrial process water and non-residential swimming pool water. The Water Treatment Group has warehouses in 14 cities supplying products and service to customers in Minnesota, Wisconsin, Iowa, North Dakota, South Dakota, Nebraska, Illinois, Michigan, Montana, Missouri, Kansas and Wyoming. The Water Treatment Group utilizes delivery routes operated by individuals that serve as route driver, salesperson and highly trained technician to deliver the Company's products and diagnose the customers' water treatment needs.
The Company supplies products and the necessary feed equipment to provide safe drinking water, and has the resources to treat potable water systems from a very small single well up to a multi-million gallon per day treatment facility. The Company's products and feed equipment also (1) allow industrial and municipal wastewater treatment facilities to produce discharge water that is safe for the environment, (2) enable process water within industrial plants to work effectively and efficiently, and (3) make non-residential swimming pool water safe.
(B) INDUSTRIAL. The Industrial segment specializes in providing industrial chemicals and services to the energy, electronics, chemical processing, pulp and paper, medical device and plating industries. In addition, the Industrial segment provides products and services to food manufacturers and processing plants. The Industrial segment also manufactures and sells certain food grade products, including the Cheese-Phos® liquid phosphate product and other blended products, none of which are individually material to the Company. This segment conducts its business primarily through distribution centers and terminal operations.
The Industrial segment receives, stores and distributes various chemicals in bulk, including liquid caustic soda, phosphoric acid, potassium hydroxide and aqua ammonia; manufactures sodium hypochlorite (bleach) and agricultural products; repackages water treatment chemicals; and performs custom blending of certain chemicals for customers according to customer formulas. The Industrial segment operates liquid caustic soda barge terminals to receive shipments during the period the Mississippi River is open to barge traffic (approximately April 1 through November 15). During the remainder of the year, the Company relies on stockpiles, as well as supplies shipped in by railroad tank car. Pursuant to operating agreements it has with other chemical companies, the Company receives and stores liquid caustic soda and other chemicals at its three terminal sites, Hawkins Terminal 1, Terminal 2, and Red Rock. The sites are located on the Mississippi River in St. Paul, Minnesota.
Bulk industrial chemicals are generally repackaged and sold in smaller quantities to the Company's customers. Sales are concentrated primarily in Wisconsin, Minnesota, northern Iowa, and North and South Dakota with food grade products sold nationally. The principal products are acids and alkalis and industrial and food grade salts. The Industrial segment also specializes in sales to the plating and electronic industries, relying on a specially trained sales staff that works directly with customers on their surface finishing needs.
(C) PHARMACEUTICAL. The Pharmaceutical segment specializes in providing pharmaceutical chemicals to retail pharmacies and small-scale pharmaceutical manufacturers. This segment conducts the majority of its business through one warehouse located at our principal executive site in Minneapolis, Minnesota. The Pharmaceutical segment's sales are primarily focused in the United States.
HWKN has achieved ROIC of 20% in its most recent year, more than twice its five year average. At only 5.2 times EBITDA and carrying no debt, there is about $30 million of cash on the balance sheet (about 13% of market cap.)
The water treatment business represents about 30% of revenues. Insiders hold about 20% of the business and there is but one analyst who follows the company.
With about 47% of its revenues relating to pumps and filtration IEX also deserves consideration in this industry. As it describes its operations here:
DEX Fluid & Metering Technologies are precision engineered pumps, meters and systems that move, measure and dispense high value liquids, gases and solids. Within the pump and flow metering world, we are recognized for our expertise in the precise handling of corrosive, abrasive, viscous, extreme temperature, fine particle and many other challenging applications. Our core capabilities support worldwide growth in the process industries, particularly the infrastructure-related markets like alternative fuels, chemical processing, and water treatment, as well as a growing range of highly precise sanitary applications within the pharmaceutical and food & beverage industries. With operations on six continents, we work continuously with our customers to develop the right applied solution to meet their specifications, anywhere in the world.
Idex has been very capable in converting earnings into free cash flow with a conversion ratio of 164% recently. FCF yield is very attractive at 10%.
Net debt to EBITDA is comfortable at 2.1 times.ROIC has ranged between 7.5% recently and about 10% for the last five years.
We calculate an intrinsic value of about $33, which offers considerable value relative to its current $23 market price.
Itron views itself as a provider of technology to the global energy and water industries. Its products include electricity, gas, water and heat meters, data collection and communication systems, including automated meter reading (AMR) and advanced metering infrastructure (AMI); meter data management and related software applications; as well as project management, installation, and consulting services. As the company indicates:
We estimate there are approximately 2.6 billion meters worldwide. In the United States and Canada we estimate there are 150 million electric meters, 70 million gas meters and 80 million water meters. In the rest of the world we estimate there are approximately 1.3 billion electric meters, 300 million gas meters and 700 million water meters. We also estimate that approximately 30% of all water points are not metered.
Water conservation continues to be a worldwide concern. There are many efforts underway to stimulate more efficient use of water and heat. Water utilities are focused on increasing the efficiency of water production and minimizing waste in consumption. Demand for water metering and heating and cooling metering (the measurement of energy consumed in district heating and cooling distribution systems and in heat cost allocations) are constantly growing. Actaris supplies a complete range of water and heat meters and associated AMR systems for residential and C&I markets including mechanical detection (turbine and piston) and ultrasonic technology. All water and heat meters are pre-equipped for remote data reading needs. Benefiting from almost 25 years of AMR experience, we provide a range of modules (wireless and wired technology), advanced leak detection systems and a variety of software for managing the collection and transmission of data from our AMR systems, including meter data for billing systems and our knowledge applications.
Debt is almost 5 times EBITDA with debt to cap of about 33%. The return on invested capital is only about 1.5% on a trailing twelve month basis. Free cash flow conversion has been unbelievably strong recently but inconsistent.
We calculate an intrinsic value of about $48 which is below its current market value. Sales growth has been spectacular at about 50% CAGR for the last five years but ROA and ROIC have yet to show much profitability. A little rich for our blood.
Badger Meter (BMI)
This is the market leader in water meters with 100% of its revenues in this biz. Unfortunately, a recent addition of BMI into the S&P 600 has lifted the stock.
Badger Meter is a leading manufacturer and marketer of products incorporating liquid flow measurement and control technologies serving markets worldwide.
This has been a very profitable business with ROIC of about 18% recently up from a five year average of 12% and a decade of 7%.
Unfortunately, the firm is not currently generating FCF and its record of FCF conversion has also been erratic.
We calculate an intrinsic value of about $29 for this very conservatively financed company. Debt to cap is less than 3% currently.
At about 23 times forward earnings, this stock reflects a lot of good expectations in my opinion.
As you can see, there are many companies looking for their niche in the water equipment and water treatment industries. There are many others that we could add and may address in future posts. This is an international industry with significant participants in all parts of the globe.
We have included as part of this post a spreadsheet with important fundamental parameters and ratios for each of these companies (courtesy of Reuters Knowledge.)
This spreadsheet can be downloaded using the following link: http://tinyurl.com/kwhha6
Disclaimer: I, my family, and clients may have a long position in securities relating to some of the names mentioned in this post.