It's bad enough to be wrong about a stock and miss the opportunity to log significant capital gains. It's even worse to try to over-correct for the mistake, buy too late, and rack up capital losses because you chased a good company with a hot stock.
That's the conundrum before me with Colfax (CFX). I not only like the company's exposure to the industrial and energy pump and valve markets, but also happen to think that the acquisition of Charter (and its ESAB welding/cutting business) will be very successful. The key questions, though, revolve around how quickly Colfax management can drive opportunity improvements at ESAB, how far those improvements can go, and how much of that is already captured by today's stock price.
A Messy Quarter With Generally Weaker Results
Based on the very early market reaction to Colfax earnings, it looked as though investors might get a shot at a real pullback in these shares. The market ultimately decided things weren't so bad, though, and that opportunity vanished fairly quickly.
That said, it was a somewhat soft quarter. Revenue was up 7% as reported, but organic revenue fell 2% on a 2% decline in volume. Companies with broadly similar exposure to markets like energy and process industries (a group that would include names like Dover (DOV), Emerson (EMR), and Tyco (TYC)) have reported fairly healthy operating conditions, but Colfax did have a very difficult year-ago comp to surmount.
Adjusted profitability was likewise a little disappointing, but far from disastrous. Gross margin slid about a point, while operating income rose about 1%.
The Charter Opportunity
In buying Charter for $2.4 billion, Colfax is reconfiguring its business in a fairly dramatic way, as the ESAB welding/cutting business will comprise more than half of company sales. It's also very much a fixer-upper opportunity, as ESAB had been losing share in the European welding business and reporting generally unimpressive margins and cash flow conversion. In fact, margins have slid from the low mid-teens in 2007 to almost 5% in 2011.
Colfax is now competing with two rather well-run competitors in Lincoln Electric (LECO) and Illinois Tool Works (ITW), but as these top three companies comprise only about one-third of the welding market, there's plenty of market share to be had. Keep in mind, too, that while ESAB may have lost share, it's still the #1 player in Europe (Lincoln Electric is #1 in North America).
Given that Colfax's corporate DNA ties in with well-known acquirer and cost-cutter Danaher (DHR), I don't think there's much risk that Colfax will fail in driving costs out of ESAB and improving the operating performance. The question is whether management will push too far too fast and cede more share in the process.
The Base Business Should Support Growth
While Colfax management works on repairing the ESAB business, conditions in the legacy Colfax business and the acquired Howden operations (the other part of Charter) should be relatively solid. Colfax reported organic order growth of nearly 9% and core markets like energy and process industries are continuing to spend on upgrades and expansion.
In fact, given the shift away from natural gas towards liquids and oil in North American energy production in 2012, conditions may be getting stronger in some markets. At the same time, the Howden business will expand the company's exposure to power generation (especially coal-fired power) and that too is an industry that looks primed to resume long-delayed capital spending.
The Bottom Line
The real driving questions with Colfax are "how much?" and "how soon?" I don't see any reason why Colfax can't ultimately drive free cash flow conversion to a rate in the high single digits. The problem is that that kind of assumption drives the sort of free cash flow growth that makes you do a double-take. I would also point out that the odds are very good that early success in turning around ESAB (say in the 2013-2014 timeframe) would likely incentivize management to do even more potentially additive deals.
As it stands today, I think fair value for Colfax lies in the high $30s, but I would not argue strenuously with those who'd bump it higher still and into the low $40s. Certainly that looks like an ambitious target relative to today's P/E or EV/EBITDA ratio, but those ratios don't account for the considerable operating leverage that could come from fixing ESAB. Colfax isn't quite cheap enough for me to buy today (based on that high $30s target), but I wouldn't sell these shares if I owned them and I would be more than happy to reconsider after a pullback.