Although 2012 has been a tough year for industrial names, hydraulic component players like Eaton (ETN), Parker-Hannifin (PH), and Sauer-Danfoss (SHS) still post quite solid 12-month returns relative to the S&P 500; about 40% higher on average. That makes Sun Hydraulics (SNHY) a notable and surprising laggard, with the trailing year's return about 40% lower than the market. Sun stands out as a high-quality and differentiated industrial small cap, but producing an appealing fair value target takes some effort and above-average optimism.
Different Is Better… For The Most Part
Sun Hydraulics stands out from the aforementioned hydraulic manifold, valve, and cartridge makers (as well as lesser-known players like Moog (MOG.A), HydraForce, and Bosch Rexroth) in terms of margins, returns, and its product line.
As is often the case, a difference in returns can be tied to a difference in products. While many hydraulics companies build standard cartridges that fit into a common cavity size, Sun uses unique (smaller) cavity specifications and a floating end cartridge design. At the end of the day, those design differences lead to better reliability, the ability to build more compact machines, and the ability to design in five axes, as opposed to more standardized products that accommodate three axes.
That has let Sun penetrate a wide range of markets, including mobile applications like construction, agriculture, mining, and utility vehicles, as well as fixed applications like factory automation and machine tools. While larger players like Parker-Hannifin and Eaton also serve a wide range of markets with their hydraulics products, smaller players like Moog and Sauer-Danfoss tend to focus more on particular markets (aerospace and agriculture, respectively).
Of course, "different" can come at a cost. Because Sun's cartridges have unique specifications, that basically commits a company to Sun if they design a product around it. That's not much of a problem for a large company like Parker-Hannifin or Eaton, but I do wonder if large customers may hesitate to design in a non-standard component from a smaller player (that may have less staying power).
A Good Base To Build From, But Emerging Markets Need To Emerge
Sun Hydraulics presently gets about half of its sales from customers in the U.S. (while revenue sourced from the U.S. is more than 60% of the total), with sales to Asia less than 20% of the total and Europe close to 30%. Sun has a manufacturing footprint not only in the U.S., but also in Germany, the U.K., and South Korea, and has done a good job of establishing a highly vertically integrated manufacturing process.
Now the company needs to leverage the heck out of that. Between company-run sales offices in major markets like the U.S., Germany, China, and India, the company also relies on a network of distributors. That said, the company needs to sell more of its products into markets like Brazil, China, India, and Indonesia to really maximize its long-term opportunities.
In the meantime, though, exposure to the U.S. and Western European industrial economies carries some well-known and well-reported risks. Sun's performance ties in fairly closely to PMI numbers, and the recent PMI readings for the U.S., Germany, France, and China have not been encouraging of late. In fact, they've been pointing to shrinkage, with the numbers below 50. Even if Sun's differentiated products give it some insulation, it's just not a good operating environment out there right now.
Can Sun Maintain Superior Performance?
It doesn't take much time before a new investor will see that Sun's financial performance is unusual for an industrial company. Apart from a terrible year in 2009, Sun has posted operating margins above 15% since 2005 and returns on invested capital in the high teens to high 20's. While Sauer-Danfoss has done pretty well of late itself, and Parker-Hannifin too has delivered mid-teens and higher margins in its hydraulics business, Sun Hydraulics is very nearly in a class of one when it comes to these metrics.
So one of the biggest questions I have is whether the company can maintain that level of performance. Sauer-Danfoss and Parker-Hannifin already sit in the upper range of industrials when it comes to converting revenue to free cash flow, but Sun Hydraulics goes a step further… and I just don't know if it's sustainable or expendable. Then again, it wouldn't surprise me in the slightest if a larger player scooped this company up - making the long-term margin potential perhaps a moot point.
The Bottom Line
If I model a free cash flow margin that grows into the very high teens by 2016 and into the very low 20s by 2022, and ten-year compound revenue growth of about 7%, fair value seems to fall around $28 to $30. Bump up the revenue growth rate to 10% and the fair value jumps into the mid-$30's. Keep in mind, too, that a larger acquirer could reap synergies out of the manufacturing, marketing, and general corporate overhead - all of which would support a healthy M&A-based price.
Can Sun Hydraulics grow that quickly? It's a demanding target, but Sun is tiny compared to Eaton and Parker-Hannifin, to say nothing of the hydraulic cartridge valve and manifold market as a whole. Moreover, investors I respect like Royce and Brown Capital Management have put their money to work here. Consequently, while I do think valuation may be a little stretched right now, it looks like a first-rate small cap to me, and one I'd seriously consider on a pullback.