Colfax Corporation (CFX) is an industrial company with negative organic growth, at risk of missing analyst estimates, trading at 26x forward non-GAAP EPS. The stock is at 40x trailing free cash flow, a better measure of its true valuation. The company and its largest shareholder recently sold stock considerably below the current market price. The level of short interest is low, providing limited support if the stock were to collapse. At a reasonable multiple of likely earnings, the stock is worth $30 for more than 60% downside from the current level above $53. While this much downside may seem dramatic, the stock was at this level a year ago before going down to $25 and then starting a remarkable ascent that is unsupported by its financial results.
The company has two lines of business - Gas & Fluid Handling and Fabrication Technology. The Gas & Fluid Handling segment manufactures pumps, fluid handling systems, valves, fans and compressors. The Fabrication Technology segment makes welding consumables like electrodes, wires and fluxes. There is nothing remarkable about the products it sells, and they are run of the mill industrial products that garner a slim single digit % operating margin.
The company's revenue is steady at $4 billion a year, bolstered a bit by acquisitions, with organic revenue declining a little YoY in the latest quarter. It has a $5 billion market cap. Adding $1.5 billion of debt, $0.2 billion of minority interest and $0.3 billion of preferred stock results in an Enterprise Value of $7 billion. The company should generate operating income of approximately $300 million this year, so it trades at a stunning 23x EV/EBIT ratio (35x if the EBIT is taxed). EV/EBITDA is 16x and Price/Book Value is 2.8x. Tangible book value is negative. The company has a pre-tax Return on Invested Capital of a meager 9%. While the forward PE ratio is 26x, earnings estimates are inflated, and the true PE is closer to 35x.
In the last four quarters, the company has generated $260 million of operating cash flow and spent $83 million on capex for traditionally calculated free cash flow of $177 million. However, to get a true sense of the free cash flow to equity investors, one needs to deduct $10 million of stock comp, $20 million of minority interest and $20 million of preferred dividends, resulting in free cash flow of $127 million or $1.34 for each of the 95 million shares.
The Charter acquisition and BDT's investment
Most of the company's business is derived from the acquisition of Charter International plc in January 2012 for $2.6 billion in cash and stock. At that time, BDT (a private equity fund) invested $680 million, split evenly between common stock bought at $23 and 6% preferred stock with a liquidation preference of $24.50 and convertible at $28. Mitchell Rales, the Chairman of Colfax, and his brother also bought shares at $23. Together, they own close to a quarter of the company's shares.
BDT was founded by Byron D. Trott, formerly an investment banker at Goldman Sachs (GS), where he had a client relationship with Warren Buffett. There is perhaps some lingering hope that Berkshire Hathaway (BRK.A) (BRK.B) will buy Colfax, but given its poor GAAP results, liberal use of pro-forma accounting, and sky-high valuation on fundamental metrics, this seems unlikely. Besides, if BDT had any hope of a sale of the company, they would not be selling down their stock, which they did in May 2013.
Mediocre financial results and share sales
The company missed revenue estimates in Q1 2013, and the stock dropped as a result. However, it has since reclaimed that lost ground and more. In fact, it is up 25% since the company last reported results. Insiders and the company can scarcely believe the market's reaction as they were quick to sell 10 million shares in May 2013 at $44.25. (The company sold 7 million shares and BDT sold 3 million shares). The company previously sold shares to the public at $34 per share in February 2012.
The company generated $0.21 of GAAP EPS in Q1 2013, and declared $0.26 in pro-forma EPS by excluding restructuring and other charges. A quirk in GAAP regarding the treatment of the convertible preferred artificially depressed reported earnings, so the $0.26 is a good indicator of economic earnings. Somewhat puzzlingly, the mean analyst estimate is for EPS in the next few quarters to be more than double this figure. While the company is likely to derive some leverage from increased sales and a lower interest expense, it is hard to get to these figures. It is likely that the company will have pro-forma EPS of approximately $0.40 in the next few quarters, for FY 2013 EPS of $1.50, considerably below the mean analyst estimate of $2.00. The company reported pro-forma EPS of $1.34 last year, so $1.50 would represent 12% EPS growth - certainly not shabby, but not deserving of a 30+ multiple.
Given that the conversion price of the preferred is $28, significantly below the current market price, treating it as converted to common stock would add 12 million shares and save $20 million a year in dividend expense. This does not change the calculated EPS by much. Also, assuming proceeds from the recent share sale by the company are used to repay debt, the effect on EPS is minimal.
Other checks bring up a few minor red flags
Pension underfunding. The company's pension plan was under-funded by $377 million at year-end as per the latest 10-K filing.
Culture of pro-forma reporting. The company presents pro-forma results excluding recurring restructuring charges and asbestos litigation expenses. While the magnitude of these charges may vary from quarter to quarter, they should be treated as regular operating expenses.
Vulnerable to increase in interest rates. The company has $1.5 billion in debt and does not have the ability to de-lever quickly given its limited free cash flow.
Valuation: Fair value of $30 per share
Putting an aggressive 20x multiple on EPS of $1.50 for the year would get you a $30 fair value for CFX. The company's closest comparable, Flowserve (FLS), sells for 16x EPS. Applying this multiple on the (inflated) mean analyst estimate of $2.00 for forward earnings would get you $32. Any way you look at it, the stock is worth considerably less than the current market price of $53 and change.