With a buyout agreement announced Friday, Gardner Denver's (GDI) stock has risen 30% since late July, when I suggested on Seeking Alpha that it was a takeover target. Despite that strong return for shareholders, sell-side analysts have criticized GDI's decision to sell itself to KKR (KKR) for $76/share, saying GDI is worth more. Evidence strongly favors those critics, and I think shareholders would do better by rejecting this agreement and voting to remain independent.
Gardner Denver makes compressors, pumps, blowers and similar products used in many industries. 37% each of 2012 revenues came from the U.S. and Europe/Middle East/Africa, with another 19% from Asia Pacific. End-markets are broadly diversified by industry. 28% of 2011 sales came from industrial manufacturing and 19% from very high-margin products sold to the upstream oil and gas industry; no other industry accounted for more than 10% of revenues.
By mid-2012, GDI's stock was slumping as investors expected a slowdown in orders for energy pumps; North American pressure pumping customers had rapidly grown capacity and were slowing that growth. On July 16, CEO Barry Pennypacker abruptly resigned. Eleven days later, San Francisco hedge fund ValueAct, which owned a 5% stake, publicly urged the company's sale. On Seeking Alpha, I calculated that GDI could command $74/share in a buyout.
My $74 estimate is just below the $76 private equity firm KKR agreed to pay GDI. $76 is 46% above GDI's closing price the day before ValueAct released its letter. ValueAct did well for its clients and understandably has publicly favored this deal. A hedge fund with $9 bn in assets has clearly made a lot of wise investments, and this is yet another one.
ValueAct still owns 5% of GDI. BlackRock and T. Rowe Price each own 10%, with Vanguard owning 5%. T. Rowe Price has voted against mergers in the past; about half of TROW's stake is in the $20 bn T. Rowe Price Mid Cap Growth Fund. TROW would probably have to oppose the merger for it not to proceed. With T. Rowe Price having sold one-third of its shares during January, that seems unlikely.
Which is too bad, since the case for the deal appears quite weak. The stock market and valuation multiples are both much higher than in July. GDI's 30% return since ValueAct's letter barely outpaces the 25% return of the S&P Mid Cap 400 industrial machinery industry. Peers Flowserve (FLS) (+43%) and Idex (IEX) (+35%) have risen even more, despite not being part of buyout speculation.
Acquirers typically have to pay above-peer valuation multiples when buying a company, for several reasons. There's a control premium for taking control of the business and its cash flows, which public shareholders cannot do. Acquirers are removing public shareholders' opportunity for future gains, and shareholders require compensation for that. There is often the ego of boards and CEOs. Before the financial crisis, a colleague and I marveled about the high percentage of takeouts which occurred almost exactly at a stock's all-time high price, allowing management to say that no one ever lost a cent investing in its stock.
KKR's purchase of GDI has none of those characteristics, leading analysts at KeyBanc and Robert W. Baird to term the purchase price "disappointing." Both oppose the deal, as does BB&T's analyst. $76 is 16% below GDI's all-time high of $91/share, set in July 2011. $76 is about 14.5X 2013 consensus EPS estimates and 9X EV/EBITDA. Those are 10% discounts to the valuation of a peer group of 18 mid-cap industrial companies, trading at a median of 16X 2013E PE and 10X EV/EBITDA. Of those 18 companies, GDI is the 4th cheapest on both PE and EV/EBITDA. No wonder BB&T analyst Kevin Maczka titled a report, "Did KKR just steal GDI?"
Maczka says management's guidance is conservative and points out opportunities for the company's business to improve, both from market conditions and its own actions to cut costs in Europe. He also cites GDI's underlevered balance sheet, and how adding some leverage can help shareholders. GDI generates strong free cash flow: $650 mn over the last three years combined, averaging $4.40 per share per year. So its balance sheet can handle more debt. Including retiree liabilities, GDI's net debt is $222 mn, about half the $437 mn in EBITDA GDI generated last year. If GDI were to issue $650 mn in debt, it could buy back 17% of shares at $76 each, which would add 10% to EPS. This would result in 2X debt/EBITDA and EBIT/interest coverage of more than 7 times, both very manageable figures.
While the full benefit of such a transaction would not occur in year 1, let's look at GDI's potential earnings run rate. 2013's consensus EPS estimate is $5.26; adding 10% to that would lead to EPS of $5.78. At $76, GDI's stock would trade at a 13X PE multiple - 20% discount to peers - with upside from industry conditions and self-help. If I were a shareholder, I would prefer those odds and vote to reject the buyout.