Even after Gardner Denver's (GDI) 10% jump on Friday, I recommend buying the stock. Three events have coincided to make the stock a very attractive buyout candidate: a low stock price, an interim CEO and an activist shareholder publicly urging a sale. The stock seems attractive without a buyout, but it could rise 30% or more with a takeover.
Gardner Denver makes compressors, pumps, blowers and similar products used in industrial applications across many industries. GDI's Industrial Products Group (53% of 2011 revenues and 35% of EBIT) obtains half its sales from Europe. 47% of 2011's revenues and 65% of its EBIT came from GDI's Engineered Products Group. A large part of EPG's revenues are pumps used in oil & gas drilling, mainly in North America.
Historically, Wall Street has correlated GDI's revenues with increases in capacity for pressure pumping, a horsepower-intensive industry used while extracting natural gas from shale. Pressure pumpers had added lots of capacity, but as low natural gas prices have reduced natural gas drilling, pumping capacity growth has slowed dramatically.
Wall Street, as it often does, has oversimplified a business. Upstream energy, which is high-margin, was only 19% of revenues in 2011, with downstream another 8%. Industrial manufacturing was 28%, with transport, medical and food/beverage each between 5-8%.
At first glance, GDI's second quarter results seemed solid, with the company using cost efficiencies and fewer shares outstanding to turn flat revenues into 9% more EBIT and 19% higher EPS. But the report was actually negative, because GDI reduced its earnings guidance for 2012 by 30c, about 6%. Orders were flat year-over-year in IPG but fell by 36% in EPG, where the backlog was down 12% vs. prior-year.
GDI's weak results came as no surprise. Its exposure to pressure pumping, and to European manufacturing, has both concerned investors. Also concerning is management instability, with both division heads leaving early in 2012, one after just nine months. The stock, which fluctuated around $80 most of the second half of 2011, was hovering near $50 by early July, a level it stayed at after July 19's earnings release.
Three days earlier, GDI had stunningly announced that CEO Barry Pennypacker was leaving, effective immediately. Pennypacker joined in early 2008; he was highly regarded for his manufacturing background and focus on improving GDI's operational performance. CFO Michael Larson, who has been with GDI less than two years, immediately became interim CEO. Larson is retaining his CFO title while the board conducts a search for a permanent successor.
Into this situation stepped San Francisco hedge fund ValueAct, which historically has worked with managements to maximize shareholder value. ValueAct on July 6 reported owning a 5.0% stake in GDI, nearly tripling its holdings since March 31. On Friday, July 27, ValueAct publicly released a letter to GDI Chairwoman Diane Schumacher, calling for the company's sale; in the letter, ValueAct said it was the first time it had ever called for a company's sale publicly.
GDI's stock jumped 10% Friday, to $57.42, on three times its average daily volume. But even with the move, it is still attractively priced. Over the past four years, the firm has averaged annual free cash flow generation of $205 mn. With 49.0 mn shares outstanding, GDI's market value is $2.8 bn, giving it an average free cash yield of 7.3%.
GDI has guided to $4.90-$5.10 in EPS this year, which would put its PE under 12. At $3.1 bn of Enterprise Value, GDI trades at 7X consensus EBITDA of $450 mn. It also trades at 1.3X EV/trailing sales, its lowest EV/sales level since late 2009 and below its average EV/sales over the past 5 and 10 years.
If GDI goes up for auction, its stock could rise by 30% or more. ValueAct cited the sale, announced on July 25, of United Technologies' Hamilton Sundstrand division, for a reported 9X EBITDA. Two private equity firms bought Hamilton Sundstrand. Like Gardner Denver, Hamilton Sundstrand makes industrial pumps and compressors for industrial, infrastructure and energy markets. At 9X EBITDA, GDI would sell for $74, 30% above its current price. It's possible GDI would sell for more, given that $74 would be only 15X this year's EPS and well below its all-time high of $92.
With an interim CEO, a still-beaten-up stock price, and a well-respected activist shareholder publicly calling for a sale, Gardner Denver appears to be firmly in play. Investors can prosper by buying shares of this cheap stock, ahead of a potential buyout.