Sauer-Danfoss (SHS) produces parts for leading OEMs for off-road mobile vehicles. They operate in four main divisions, which are as follows: propel products, which includes hydrostatic transmissions and open circuit piston pumps; work function, which includes steering units low speed high torque engines and propeller motors; controls, which includes electro-hydraulic controls and microprocessors; and stand-alone businesses, which includes hydraulic integrated circuits and gear pumps. To simplify things, these parts are integral in making machinery such as agricultural vehicles, construction vehicles, material handling, and other specialty vehicles.
I found this company by conducting a pseudo-Ben Graham search: looking for companies with Earnings to Price Yields double the risk free rate, total debt less than book value (I took this one step further and used tangible book value), a P/E ratio less than 40% the max P/E over the past five years, and a current ratio greater than 2. These concepts relate to minimizing risk, especially on the downside, while finding companies with proven earnings power.
I then zeroed in on this company upon seeing that the company had a free cash flow yield of nearly 20% and a significant net cash position of over 100MM funded created by 300+MM of cash and short term equivalents. These numbers are no aberration: the company has been actively deleveraging from 2008, when it had almost $500MM of long term debt (now it has around $200MM). This is quite important in a cyclical industry where boom/bust cycles can exacerbate losses and put companies with poor capital structures out of business.
Additionally, SHS has consistently increased its free cash flow over the past 3 years. This has continued into this most recent quarter. This incredible cash flow has been used to reduce the company's debt, but now that debt levels are quite low, the company has reinstated a cash dividend, which is currently yielding 4%.
From a valuation perspective, this company appears quite undervalued. It is currently trading at an EV/EBITDA ratio of a little more than 3X and a P/E ratio of 7.62 (ex cash 5.41). When one examines net income, it appears the company did not grow earnings much since 2010; however this occurred because SHS used a NOL of $50MM in 2010, and did not even pay taxes. Their operating income grew almost 50% yoy.
Now expecting the company to continue its high growth in the coming years would be unreasonable. The company has stated growth expectations of up to 10% for the coming year. However, this could easily be on the low side, as companies such as John Deere (DE) and Caterpillar (CAT), two of SHS's biggest customers, are forecasting growth of around 15%. Inventories have declined slightly over the years, and thus the company should not have to slash price to clear inventories. Additionally, much of their inventory is raw materials, which can be easily sold.
On a longer-term perspective, the company anticipates 16% CAGR revenue through 2015. I believe that is sustainable due to the characteristics of the markets in which SHS operates and the strength of its products. The fact that major suppliers, such as Caterpillar, have chosen SHS speaks to this. Additionally, many markets in which SHS operates are fragmented, with many local suppliers of niche products. This provides a great opportunity for a larger company such SHS to consolidate. I believe this is possible, because the industry depends upon technological innovation which SHS will be better at than smaller companies. Additionally, these markets benefit from economies of scale, and are not dependent upon transportation costs, which is where very local niche companies can succeed.
In markets where they have larger competitors such as Eaton or Bosch Rexforth, SHS still has quite strong products. And since Eaton is public, it can be easily seen that SHS has much higher returns on capital and investment. Further, this growth is sustainable market wide. People will need more construction of roads as America's infrastructure is quite poor. Infrastructure world-wide deteriorates. Agriculture will always be necessary. SHS was still able to grow construction and road building 18% in America despite huge drops in federal spending.
SHS is also well-positioned to grow globally as it generates 38% of revenue in Europe and 18% in Asia. One may worry about European sovereign debt instability may hinder sales in the region; however, SHS only does an appreciable amount of business in Italy out of all the unstable countries and does the remaining business in countries such as Germany.
Another major risk for the company is its cyclicality. There is no denying that the success of the company depends upon larger macroeconomic drivers. However, its capital structure and strong balance sheet limit the downside. Further, further economic difficulties may put some of the smaller competitors out of business, allowing SHS to gain market share. Additionally, it does not appear we are entering a bust phase, judging from inventory levels.
The company is also highly dependent upon material costs and currency effects. Currency affects all companies operating globally, so this is merely a marketing risk. SHS is highly dependent upon hard assets for its products. However, commodity prices are quite low right now allowing the company to lock in sustainable resources for a large period of time. The company is also somewhat dependent upon patents and a key number of buyers. However, the company does not depend upon one patent heavily in case it were to expire, and has a critical mass of customers so that it is not at the mercy of its clients.
This company has strong fundamentals and is well positioned in its industry, and yet its price has not appreciated. This may partially be due to the lack of institutional ownership (22%) compared with larger stocks that hover in the 70%. This gives the opportunity for a large influx of capital to increase the price of the stock, once again creating an asymmetrical bet.