Global Power Equipment Is Either A Big Value Or A Trap

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By and large, investors do well for themselves if they assume that something that looks too cheap to be believed shouldn't be believed. Of course, carry that philosophy too far and you miss most of the really impressive turnarounds and long-term growth stories.

That brings me to Global Power Equipment (NASDAQ:GLPW). This company has been suffering lately from lower service demand and delayed orders, but nevertheless offers an intriguing mix of sustainable recurring revenue and leverage to natural gas-fired electricity generation expansion. A discounted cash flow suggests significant potential undervaluation, but investors would do well to remember that many power/utility-focused companies have ultimately disappointed relative to their long-range forecasts.

A Rare Combination In The Power Space

I suspect that many investors dismiss Global Power as a components/products company like SPX (SPW), and one that is vulnerable to severe competition from global energy giants like General Electric (NYSE:GE) and Siemens (SI). In point of fact, though, product revenue has shrunk to about 35-40% of total revenue, and turbine manufacturers like GE, Siemens, Alstom, and Mitsubishi look at Global Power as a valued supplier for their natural gas turbine businesses.

It's worth noting as well that Global Power is a relatively highly-focused company on the product side. Global Power has focused on components critical to ongoing operation like filter houses, inlet systems, and exhaust systems, and it holds the #1 or #2 share in most of its markets. What's more, many of Global Power's competitors are relatively small companies or diversified businesses like GE (which is both customer and competitor), Donaldson (NYSE:DCI), and Bilfinger.

On the other side of the business, Global Power gets close to two-thirds of its revenue from maintenance/modification contracts with power plants (nuclear plants in particular). Not only does maintenance work at nuclear plants demand a pristine safety record, but Global Power boasts customer relationships that go back decades with the likes of Southern Company (NYSE:SO) and the TVA. Better still, the service business is 100% North America-focused and the large majority of the contracts are "cost-plus" arrangements.

This Can Be A Difficult Business

While Global Power's basic business model looks fundamentally attractive, there are several issues that complicate the situation.

For starters, the products business is highly sensitive to global electrical capacity growth, and natural gas-fired generation growth in particular. While the arguments for natural gas generation are compelling (less than half as much carbon dioxide per Mwh, and far less sulfur dioxide and nitrogen oxides), there aren't that many new plants being built or proposed in the U.S., and natural gas generation isn't as economical in most of the world.

Consequently, a lot of the demand on the product side has been coming from gas-rich areas like the Mideast. Even so, the major turbine makers (again, GE, Siemens, Alstom, and Mitsubishi) haven't been too excited lately about order trends, and Global Power has seen that result in meaningful order delays and low book-to-bill ratios (0.8x in the third quarter).

While investors might think that the service business would be an isle of calm during the ups and downs of the order cycle, that's not really the case. Utilities can, and do, defer service and maintenance when power demand declines (maintenance schedules are often tied to generation volumes), and that has been happening for several of Global Power's customers lately.

Moreover, energy/utility service is a tricky business. Many of Global Power's rivals are larger - including companies like Babcock and Wilcox (BWC), Shaw Group (now owned by CB&I (NYSE:CBI)), and URS (NYSE:URS) - and even they struggle to produce solid sustainable margins, returns, or free cash flow. That would seem to run counter to idea that there are substantial barriers to entry (like the pristine safety record). Although some may argue that those comps aren't really comps because of their large, highly cyclical construction operations, the more detailed breakouts that these companies periodically provide don't suggest any particular bonanza in the service business.

Growth Will Come From Focus And Expansion

While Global Power has walked carefully since emerging from bankruptcy in 2008, the company has recently started to take advantage of opportunities to grow through adjacent markets. The company did two deals in 2012 (TOG Holdings and Koontz-Wagner) and both brought in additional product opportunities - fasteners/valves, and control house solutions, respectively - while Koontz-Wagner also added exposure to the pipeline industry.

Looking ahead, management has talked about building its exposure to the $20 billion utility and industrial separation/cleaning market (a market growing in the mid-single digits) and the $12 billion industrial heat exchanger market. Now that latter idea may spook investors - it was the large losses from the company's large-scale heat recovery steam generator product line that pushed it into bankruptcy in 2006 - but it doesn't sound like the company is looking to compete in the utility-scale sub-sector.

At the same time, management wants to broaden its service offerings. If successful, this could be a key driver in improving the margins/returns from services - if the company already performs certain services for a plant/client, adding additional services should offer an incremental margin and return leverage opportunity.

As it stands today, I see Global Power growing its top line at a long-term rate of between 6% and 7%. Global electricity generation capacity should grow at a mid-single digit rate, and while there's a risk that renewable sources will capture much of that growth, I think Global Power's commitment to natural gas and developing ancillary markets will help counterbalance it.

On the margin/cash flow side, one of the real keys is avoiding self-inflicted wounds on the product side (as investors saw in 2012) and improving the fundamental underlying profitability of the service business. Generally speaking, Global Power's peers on the products side produce free cash flow margins in the range of 6% to 10%, while the service peers come in at around 2% to 5%. I do expect Global Power to essentially "split the difference" and generate long-term margins in the area of 6%. Should they do so, the free cash flow growth potential is significant at 13%, though that number is inflated a bit by the low starting point created by weak margins and cash generation in 2012/13.

The Bottom Line

Using a 13% cash flow growth assumption results in a cash flow-based fair value of about $25; significantly higher than today's stock price. If I substantially lower my assumptions - taking revenue growth down to something closer to global GDP growth (4%) and free cash flow margin down to 4.5% - the resulting target price ($16.50) pretty much matches today's price.

I like "heads I win, tails I barely lose" opportunities, though I'm certainly aware of the risk that order delays/cancellations, switches to renewable power, and execution errors could drive numbers even lower than my bear-case scenario. On balance, then, I think Global Power is a name that aggressive-but-patient investors might want to consider. While 2013 likely won't be a banner year, I think there's more potential to this business than Wall Street currently credits in the stock.

Disclosure: I 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.