Cyclical industries have the economy as their definitive performance measure. When the economy is doing well, these industries show impressive growth and returns and when the economy is down. These industries make the headlines with news such as losses, bankruptcies and layoffs. The companies involved in producing Diversified Machines are part of the cyclical industries.
Colfax Corp (CFX) is considered a world leader in the manufacturing of fluid handling machines. Its products are sold to companies engaged in the defense, industrial, oil and gas, power generation and commercial marine sectors. Colfax has primarily three business segments. The fluid handling segment produces machines such as advanced pumps for industries in different sectors, the ESAB segment produces products for fabrication purposes and the HOWDEN segment produces products for gas handling in various industries.
Source: Y Charts
The above graph shows change in the price of Colfax with an increase in the major indices. This proves that a surge in the economic activities is reflected in the performance of companies engaged in the manufacturing of diversified machinery.
Historical Performance - CFX
Although the core competency of Colfax has always been the products of its fluid handling segmen. But the expansion into the gas handling and fabrication segments has diversified the business to some extent, therefore reducing some risks that are associated with focusing on a narrow line of products.
Source: Company Financial Statements
The diversification has been largely in favor of Colfax as in the 1Q13. The main business of Colfax reported a decline in its revenue by a very minute amount. This change is interesting as the U.S. economy has been slowly improving. Colfax, therefore, underperformed in its main business. The fabrication segment, however, saw an increase in its revenue by a hefty amount of 13%. This has resulted in Colfax reducing its risks and reporting earnings per share of $0.21 against a loss per share of $1.33 in 1Q12.
Comparative Financial Performance
Colfax's true competition is not with the industry giants such as General Electric (GE) because of the fact that such companies have a large portfolio of products and the advantage of significant economies of scale. Colfax's true competition is ideally:
- With companies that have market capitalization closer to its own
- With companies that have limited business segments
- \With companies that serve the needs of companies in limited sectors of the economy
- With companies that produce almost a similar type of products as Colfax does
The table above shows the breakdown of the Return on Equity (ROE) of the four companies in line with the requirements of the DuPont methodology. The results of the analysis are interesting to note. The net margin of CFX is much lower than its competitors. This means that other companies are managing to exploit the positive growth in the U.S. economy, managing to post solid margins up to 9.49%. This also means CFX's competitors have been successful in managing their costs. The asset turnover of CFX is lower than that of its competitors but it is closer to the average figure. The financial leverage of CFX signifies that the company is operating at a debt level higher than that of its competitors pointing towards the undertaking of higher risk by CFX. The above analysis is an eye opener. We can easily see that CFX's performance is worse than that of its competitors.
To complement the comparative performance measures, we can perform the comparative valuation of CFX.
The above chart uses three measures to gauge possible movements in the company's stock price. The P/E ratio of CFX is much higher than the industrial average and the average calculated with its main competitors. This indicates the possible overvaluation of the stock. The P/B ratio of CFX, although close to the industrial average, again points to the overvaluation of the stock. The P/S ratio of CFX is the only metric that indicated the possible undervaluation of the stock as it is a little lower than the industrial average. The overall result of the comparative valuation points toward an impending fall in the value of the company's stock.
Cyclical companies, because of their sensitive demand, need to keep track of the economic variables that influence them. This would allow them to take timely action that would result in the efficient utilization of their resources and greater profitability. As noted in the beginning of the analysis, companies involved in producing machinery for various sectors have the economic performance of the country as their number one performance variable. Almost half of CFX's sales are to companies inside the United States and therefore the economic performance of this country is of utmost importance to the company.
Source: BVR Resources
The above graph forecasts growth for some of the key economic variables of Unites States. In the years to come, the real GDP growth is expected to remain around 3%. CFX's strategy should be in line with this forecast if it wants to exploit this opportunity to the fullest.
Another opportunity for CFX is increasing its global footprint. At present, around half of CFX's sales are to customers outside the U.S. but more and more economies around the world are showing impressive growth and the company can benefit by tapping into these markets.
Cyclical industries suffered the most during the financial meltdown of 2008. The sensitive nature of these industries can translate into large gains and losses due to their risky nature. CFX, however, has not been able to exploit the recovery in the U.S. economy for a longer period. At present, it is performing much worse than its close competitors. The relative valuation shows possible overvaluation with chances of a drop in its share price. The future outlook for the whole industry is promising but it is doubtful whether CFX will be exploiting the positive economic variables. The future outlook for CFX seems bleak. I would therefore recommend a sell stance to investors.