I have a habit of buying small stocks that are barely followed by sell-side analysts, as I think you can find the most inefficiently priced stocks where there are fewer people watching. The downside to that philosophy is above-average volatility, as Sauer-Danfoss (SHS) is ably demonstrating today. While investors were disappointed by the sharp reversal in momentum at this commercial vehicle supplier, the long-term growth picture still supports a substantially higher price.
Pretty Dismal Fourth Quarter Results
To management's credit, the results reported for this quarter were consistent with the lower end of the range they gave with third quarter results. Unfortunately, with no analysts following this stock (apart ValueLine), there really wasn't a consistent voice out there reminding investors of the potential slowdown this guidance implied.
Revenue rose 4% this quarter, as double-digit growth in the U.S. (up 19%) offset extremely weak results in China (Asia-Pacific sales down 30%). Sales in the Controls business were up 16%, Propel was up 4%, and Work Function was down 2%
These results were broadly consistent with what Eaton (ETN) and Parker-Hannifin (PH) reported for the similar period, though Sauer-Danfoss definitely saw far more weakness in China. Sauer-Danfoss reported considerably more weakness in Chinese construction and road-building markets and that relative difference in exposures can explain at least some of the divergence with the larger Eaton and Parker-Hannifin.
That said, neither Caterpillar (CAT), Deere (DE), nor Terex (TEX) talked about that much weakness in Chinese demand in the fourth quarter, so that leads to a couple of questions. Is Sauer-Danfoss ahead of the curve and a warning of what's to come? Or did Sauer-Danfoss see some of its smaller customers lose share to OEMs like Caterpillar and Deere that often produce their own competitive products in-house (especially in the area of Controls)? At this point, I'd go with option #2, but we'll all know more in a couple of months.
Profitability Hurt, But Still There
Sauer-Danfoss definitely took a hit to its margins this quarter. Gross margin slid about four points, while operating income dropped more than one-third from last year. Recall costs certainly hurt, as did a restructuring of the European sales operations, but Sauer-Danfoss also saw an impact from inefficiencies tied to less capacity absorption in China.
A Tough Year Ahead
Looking ahead, orders dropped 21% from last year and backlog fell 15%, but book-to-bill was still above one and the company has about half a year of sales in its backlog. Nevertheless, management is expecting the European market to get tougher and is fairly skeptical about credit policies loosening up enough in China to drive a big rebound.
The longer term is still relatively bright, though. The global agriculture equipment market may be in the later innings of its growth cycle, but Caterpillar, Deere, and Terex have sounded no such warnings in markets like construction, mining, or materials handling. Moreover, as has been echoed by competitors like Eaton, Parker-Hannifin, and Bosch Rexroth, the long-term growth opportunity in emerging markets like Brazil, China, India, and Indonesia can be measured in double-digits. Given that Sauer-Danfoss is in the midst of a 4-year $100 million expansion in China, they're playing for the long haul.
Considering The Value Picture
I am not in the habit of publishing my own models, but given that there are no sell-side analysts covering Sauer-Danfoss, maybe it will help support my thesis that the stock is undervalued.
As you can see, I'm expecting 4% sales growth in 2012 (below the midpoint of management guidance), a slight rebound to 6%, and then modest ongoing growth. I am expecting a pullback in margins, followed by a recovery in a couple of years, and my EPS estimate matches the bottom of Sauer-Danfoss management guidance. In cash flow terms, I expect the company to lose about five points of free cash flow conversion leverage, but to steadily improve up to about 13% before leveling off.
The Bottom Line
There's no doubt that low single-digit revenue growth, weaker margins, and declining orders is a bad way to end the fiscal year for Sauer-Danfoss. That said, the company has gone a long way towards fixing it most pressing problems and the macro results that pressured the fourth quarter (and will likely persist through the first half of 2012) are not going to last forever.
I do believe that Sauer-Danfoss is undervalued and can trade up into the $60s or low $70s. Certainly the stock has lost momentum and will drop from a variety of revenue/earnings growth screens, but the long-term value is still in place. Investors new to the name should arguably let the dust settle, but this volatile, risky, and un-followed industrial company is worth a look from risk-tolerant investors who believe there's room left in the construction, agriculture, mining, and other heavy equipment capital cycles.
Disclosure: I am long SHS.