Circor International (CIR) announced a sizable deal in its goal to create a more diversified and industrial flow conglomerate. The $210 million purchase of Critical Flow looks reasonable but will add quite some leverage at a time when the core business is under continued profit pressure.
While the deal makes sense, I am not impressed by the performance of Circor, as recent operational improvements are offset by headwinds in the dominant energy segment. Continued disappointments in terms of the poor Q3 outlook and lack of structurally solid margins make me cautious, as I am not willing to give management the benefit of the doubt.
A Quick Overview
Circor develops and produces flow control products and solutions for energy as well as aerospace and defense markets. The company employs about 2,500 workers which generate annual revenues of roughly $650 million, accompanied by decent adjusted margins of 10%. The trouble is that these are adjusted margins, as actual GAAP margins have been disappointing for years.
Roughly three quarters of revenues are derived from energy markets and just a quarter from aerospace, with these revenues being split up pretty evenly between predominantly North America and Europe.
Energy products include valves, gates, instrumentation fittings and control instruments. Circor competes with the likes of Flowserve (NYSE:FLS) and Emerson Electric (NYSE:EMR), among others. Aerospace fluid controls being produced have to compete with products from Eaton (NYSE:ETN), GE (NYSE:GE) and Triumph Group (NYSE:TGI).
It goes without saying that the large exposure to energy markets is creating some headwinds at the moment, but the long-term track record is not very good either. The company has grown sales from $600 million in 2006 to a peak of $850 million in 2014, but sales have fallen back on the back of energy headwinds. The lack of growth has furthermore been accompanied by disappointing GAAP margins on the back of continued restructuring efforts and other one-time charges. Despite the "renaissance" of the US oil industry, GAAP margins have averaged just 5% of sales over the past decade.
Following dealmaking in most of the 2000s, the company laid out a transition strategy in 2013. The company has restructured the overall business, cutting back on the number of manufacturing facilities, business units, and suppliers, while it invested heavily into new ERP systems. While some benefits are seen from these initiatives, these gains are more than offset by challenging end markets.
By now the focus should return to growth, margins and acquisitions, at least according to management. For now the growth and margin gain plans have been derailed by challenging end-markets, although management has announced a sizable deal.
Initiatives Still Have To Pay Off
2015 was a difficult year as total revenues fell by 22% to $656 million. Revenues fell by 23% in the energy segment, in part driven by net divestments and a strong dollar, although organic revenue declines of 16% were pretty severe. The company posted earnings of merely $9.9 million on a GAAP basis for 2015, equivalent to just $0.58 per share. Adjusted earnings came in at $2.43 per share, but this profit number excludes a lot of items which can almost be regarded as structural with Circor.
So far, 2016 has been quite disappointing. Second-quarter revenues were down by 12% to $146 million, after revenues fell by "just" 9% in the first quarter. GAAP margins improved by 70 basis points to 3.7% of sales on the back of lower incidental costs. At the same time, sales deleveraging fueled a 90 basis point decline in adjusted margins, which fell towards 8.1% of sales.
The difference between both margin numbers predominantly relates to restructuring and acquisition amortization charges, which are quite structural in the case of Circor. The good news is that the gap between GAAP and non-GAAP earnings is narrowing, although it remains large by all means.
The balance sheet was in reasonable shape by the end of the second quarter, containing $73 million in cash. With debt standing at $98 million, net debt of $25 million is very modest.
While second-quarter revenues showed deceleration in terms of momentum, Circor had to disappoint investors again in October. After initially guiding for third-quarter revenues of $140-$150 million, which at the midpoint implied a 9% fall in sales, Circor has cut this guidance. Sales are now seen at $133-$135 million which indicates that sales are seen down by 16% at the midpoint of the range.
Third-quarter adjusted earnings are seen at $0.41-$0.45 per share, down from a previous guidance of $0.45-$0.55 per share. With adjusted earnings coming in at $1.09 per share in the first half of the year, adjusted profits are seen around $2 per share in 2016, as these remain adjusted metrics of course.
Strange Time To Pursue Deals
Given the deceleration in the operational momentum, the timing to pursue large deals at this point in time seems odd, even if the balance sheet tolerates the usage of additional debt.
Yet this is exactly what Circor has done. The company has agreed to acquire Critical Flow Solutions in a $210 million deal. This company manufactures critical severe equipment for refining companies. On a trailing basis, Critical Flow has generated revenues of $120 million and EBITDA north of $24 million.
Refining is surely one of the more stable segments within energy, and besides offering diversification, unspecified cost synergies are targeted as well. With a significant portion of revenues being derived from after-market sales, thereby not relying on new projects, the revenue streams are quite stable as well.
The deal values these operations at 1.7 times sales and 8.8 times EBITDA, excluding synergies. Circor itself has 16.6 million shares outstanding which trade around $52 per share, for a $865 million market valuation and $890 million enterprise valuation. This suggests that it trades around 1.5 times revenues which could fall below $600 million this year. EBITDA is likely to fall below $60 million on an adjusted basis on the back of the severely impaired profitability, for relatively high multiples of 15 times.
In all fairness, the deal does make sense from a financial and strategic point of view. One drawback is the significant increase in net debt, which is expected to rise from $25 million to $235 million.
Based on a combined EBITDA run rate of $80-$90 million, to account for the significant profit pressure on the core of Circor, leverage is seen around 2.7 times, which is quite elevated.
Interesting enough, the deal presentation talks about a 3.2 times leverage ratio on pro-forma EBITDA number of $97 million. That suggests that net debt would increase to levels above $300 million which either implies that Circor has bought back a lot of stock since the end of Q2, or it has used funds for other uses.
Not Appealing For Me
While it is to be applauded that Circor is making progress with margin initiatives, after a decade long period of stagnation, these gains are offset by headwinds in the energy segment, and the aerospace segment is seeing its fair share of struggles as well.
Shares fell from a high of $80 in 2014 towards a level in the low-thirties at the start of the year, before rebounding towards $52 at the moment. The recent recovery seems a bit preliminary, given the warning which the company released for the third-quarter results.
The core business is generating sales of just $550 million at this moment in time, and the Critical Flow deal will add some $120 million in sales, for a $670 million revenue run rate. The issue is that GAAP earnings are very modest at this point in time as leverage is seen at around 3 times EBITDA.
If the company could stabilize and recover margins towards 10% of sales, accompanied by some revenue gains, operating profits could come in at $75 million. After factoring in $10 million interest costs and a 30% tax rate, real GAAP earnings could hit $45 million, equivalent to $2.75 per share. Achieving these kind of results will be a real challenge, but still results in a fairly elevated earnings multiple at 18-19 times GAAP earnings.
Note that GAAP operating margins never surpassed 10% of sales in any year over the past decade. This is despite the large energy segment which enjoyed big tailwinds at a time when oil prices were rising and US oil production was expanding rapidly.
You get the point, improvements are needed to justify the current valuation and maintain leverage ratios, yet these are far from certain at this point. Poor execution, although it must be said that the company is facing severe headwinds, is disappointing nonetheless as the long-term track record is not great either.
The only real upside can be seen if margins structurally surpass 12% of sales, but that seems out of reach, at least for now. This makes me very cautious to jump aboard the current momentum run. I furthermore note that shares have risen 23% already so far in 2016, at a time when revenues are falling by double digits, creating sufficient reasons to hold off for now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.