Transcat Inc. (NASDAQ:TRNS) is a distributor of test and measurement instruments. From their website, it's clearly very much a B2B market. The company is also an accredited provider of calibration, inspection, engineering and repair services of test & measurement instruments.
The company has split its distribution and service businesses into two segments. Their differing characteristics are central to this investment thesis. The first segment is larger today but under pressure. The latter is displaying promising growth in combination with significant operating leverage. Management indicates the services segment recently passed an inflection point.
Recent Performance
The most recent fiscal year - 2014 - has been pretty good to Transcat. The focus of my story, the Service segment gross margin increased 130 bps to 26.6% from 25.3%, the prior fiscal year. Service segment revenue increased 18.5%, or $7.5 million, to $48.2 million and 40.7% of total revenue. The increase in revenue was driven by a combination of organic growth. The improvement is the result of operating leverage coming into play after higher revenues were achieved. It's important to note that these results were achieved on the back of both organic growth and a recent acquisition of Cal-Matrix.
The pressured Distribution segment sales decreased to $70.3 million in fiscal 2014, a decrease of 1.8% from $71.6 million in fiscal 2013. Gross margin increased modestly to 24.1% in fiscal 2014 compared with 23.9% in the prior fiscal year.
As reasons for the improvement in gross margin, management cites more co-op advertising income - cooperative advertising with manufacturers - and vendor rebates - basically discounts from vendors but these can be structured in complicated ways. Unfortunately, price discounts to customers were also increased.
This goes to show the company has some leverage with its vendors but unfortunately also shows that it has no pricing power with its customers. This indicates the company doesn't benefit from any competitive advantages in this segment and it will be very hard to beat the market on the back of this business.
Net cash provided by the entire operation, performed even better, growing 45.2% to $7.6 million for fiscal 2014, compared with $5.2 million over the same period last year. CAPEX came out to be $2.0 million compared to $2.7 million in 2013. The money was used to update labs and develop software on the Service Segment side of the business.
Outlook
Management communicates clearly about the disparity on the outlooks regarding their different segments. A few important remarks concerning its service segment in the Q3 2014 quarterly report:
We continue to expect our Service segment revenue to grow at a double-digit rate and to realize the inherent leverage in our business model as Service segment operating income grows at a faster rate than our revenue. We expect Service segment growth to be fueled by a combination of organic and acquisitive activities.
I wish management expectations would be a little more specific than a double-digit rate but it does help to support confidence it's going to be at least 11%+. This number is in line with my baseline estimate that use in my DCF in the valuation paragraph.
The distribution segment is clearly struggling and the company lays out the problems and its intentions as follows:
Taking into consideration the challenges faced in the wind energy industry and the overall competitive nature of the Distribution market, our Distribution segment has actually done quite well through the year. As we have stated in the past, we intend to defend our Distribution market share.
Notably, management intends to defend its market share.
Lee Rudow, CEO and President, also indicated he is actively looking for strategic acquisitions to build out Transcat's competitive position. This is one of the few legitimate reasons for acquisitions and could help Transcat capitalize on its operating leverage more quickly. I'll discuss Transcat's competitive position later in the article. In addition to possible acquisitions management also expects to spend between $3.0 million and $3.5 million on CAPEX in fiscal 2015 to support online projects and on lab equipment and capacity.
"Importantly, having surpassed the inflection point in our Service segment, we expect to further demonstrate the inherent leverage of our business model. We expect Service segment operating income to grow at a faster rate than Service revenue. In general, we expect our Service segment to become a much larger contributor to our financial performance.
"The Distribution business will continue to face challenges in the year ahead, including likely reductions in rebate incentives, but we expect a rebound in alternative energy markets in fiscal 2015."
source: investor relations presentation
Investment Thesis
Transcat's competitive position is important to assess the opportunity that it represents. I don't think Transcat has a wide economic moat but it likely does have a narrow one. For a company of its size that's pretty unusual, but made possible by the specifics of the calibration industry.
The company competes with other 3rd party calibration providers, in-house calibration and OEM-calibration providers. In house calibration struggles with the problem of having to deal with so many different measurement disciplines that it is inefficient to invest the capital for labs, equipment and trained personnel to do it themselves. In addition it is possible insurance and or customers of the firm want to see 3rd party calibration for safety insurance by a party that isn't financially incentivized to skimp on this.
OEM-calibration doesn't struggle so much with the investments into equipment, labs and trained personnel but doesn't exactly present a objective party. This gives 3rd party providers an advantage over OEM-providers in some cases. OEM-providers do not focus on calibration and thus may not be as efficient as 3rd party providers.
That leaves competition among 3rd party providers and Transcat is well positioned by occupying the number 2 spot, behind Tektronix which is part of Danaher (DHR), in terms of market share:
source: investor relations presentation
The advantage Transcat derives from its scale doesn't lie so much in being able to deliver calibration at lower prices, but in the ability to offer an all-in-one-place calibration service.
Customers don't need to shop around to get all their equipment taken care off but can deal with just the one party. Transcat has all the expertise in one place and in the rare case it doesn't, it outsources that business. That's feasible because this only happens with a small slice of the total business.
The competitive advantage develops further after a customer has Transcat take care of all its business and, going forward, is faced with the choice between accepting Transcat's prices or having to take all their business away and shop it around. Although this is not a relationship Transcat can abuse with no regard for the other party, it does provide it with significant negotiating leverage.
Another reason Transcat is well positioned to charge a premium is that its services are must have in nature while the cost of the service is relatively insignificant to the revenues from operating the serviced equipment.
This also means that when Transcat buys up smaller competitors and acquires its customer portfolio, these customers are on average of slightly greater value to the combined party than they were to the acquired company.
Risk
Probably one of the most interesting aspects of an investment into Transcat is also its greatest Achilles heel. Operating leverage is a double edged sword. With a large part of expenses for the service segment including facility expenses, equipment expenses and personnel training being fixed, they weigh very heavily when Transcat doesn't achieve the growth its management expects. When revenue growth of the service segment stalls or reverses, this will result in a large negative effect on Transcat's stock price.
I do think demand for its services is not as cyclical as that of the industries the company serves. Its calibration services are must-have services.
Valuation
Although its likely Transcat will be able to increase the pace at which it grows revenue, I've taken its 5 year average revenue growth rate to build a DCF model around. This is somewhat conservative because the Service segment has been growing faster but has been held back by the slow growth distribution business. With Services now making up ~40% of revenues its growth rate will be a strong driver to total operations revenue going forward.
Having reached an inflection point in the Services segment, the company can also achieve considerable wider operating margins. To give you an idea, current operating margins at Transcat are 5,6%. Meanwhile the Test & Measurement segment at Danaher Corporation achieves operating margins of ~20%.
A problem with this comparison is that Tectronix is only a part of Danaher's business within this Test & Measurement segment. The segment also represents the acquired businesses Fluke Corp and Keithley Instruments. Total revenue for the segment is also 30 times that of Transcat's total revenue.
Still this is a strong hint, with growth Transcat will be able to achieve much stronger margins and supports the thesis that there is operating leverage to be capitalized on. On this basis, I estimate over the next 7 years Transcat will be able to grow operating margins to 8%.
I model its current FCF 7 years into the future because the company benefits from a narrow competitive advantage. For the calculation I'm relying on a CAGR of FCF by 11.8% (because both operating margins and revenues expand).
These fairly conservative assumptions, management's guidance could be used to justify more rosy projections, get me to a net present value of $11.90 per share. This conservative case is getting me to a stock price 9% higher than Transcat's current market price.
I couldn't fault anyone for assigning a high probability to a significantly improved scenario from the above.
On the downside there is significant risk. If cash flow of the company becomes impaired, its value becomes impaired. There isn't really a way around that. In the aggregate, this is an investment opportunity that offers positive expected value above and beyond that of the market and possibly with less volatility because of the must-have nature of its services.
On a side note: The company bought back 800K shares for $6.4 million in private transactions over the past fiscal year.
Conclusion
A very modest and conservative discounted cash flow model based on the expected growth of Transcat values the company 9% over its current share price. I made the model wanting to present you with a baseline valuation. The greater your conviction in the company's competitive advantage and the faster you estimate it will be able to grow its operating margins, the higher the company should be valued.
Because both margins and revenue are growing, FCF or earnings are expected to grow not in a linear, but in an exponential fashion. If you think my estimates are just a little too conservative you can quickly arrive at the conclusion the shares are deeply undervalued.
Sources:
In addition to the sources linked to directly I've consulted TRNS 10-K, Donaher 10-K, TRNS 10-Q and Morningstar TRNS data.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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