Blount International (NYSE:BLT) manufactures equipment, accessories and replacement parts sold in two primary end-markets.
The Forestry, Lawn and Garden (FLAG) segment sells saw chain, guide bars, rims/sprockets, log splitters, cordless tools, lawnmower/edger blades, trimmer heads/line and related accessories.
The Farm, Ranch and Agriculture (FRAG) segment sells tractor attachments (used for mowing, cutting, clearing, material handling, landscaping and grounds maintenance), log splitters, post-hole diggers, lawn mowers and attachments for off-highway construction equipment.
The Concrete Cutting and Finishing (CCF) segment sells gas/hydraulic chain saws, diamond cutting chain, parts and accessories used in the construction and utility markets.
Pullback overdiscounts negative catalysts and ignores the positives
BLT is down 24% YTD after management reduced 2013 guidance in February as weakness in FLAG more than offset strength in FRAG.
To add insult to injury, BLT announced in March that it was unable to file its 10-K in the prescribed time period due to the identification of internal control weaknesses. As a result, its auditor (PricewaterhouseCoopers) announced that it would not stand for re-election and BLT incurred significant accounting-related expenses ($1.5 million more than the previously assumed amount) in connection with remediation efforts.
However, there are three mitigating factors that support the thesis that BLT should regain a meaningful portion of the recent stock price decrease. First, there were no disagreements between BLT and PricewaterhouseCoopers in the past three years relating to accounting practices nor was there any material misstatement of the financial statements. Second, management has taken multiple steps to correct the problem including appointing KPMG as its new auditor. Third, EBITDA should increase as professional service costs (comprised largely of audit fees) return to a lower, normal run rate.
This lingering and unwarranted discount (even after these concerns have gradually shifted into the rearview) ignores the following positive fundamental drivers that remain intact.
Leading market position. BLT is a clear market leader in both of its primary segments, although more so in FLAG with a ~60% market share in saw chain (forestry accounts for ~80% of FLAG revenue). Moreover, there is only meaningful competition from one chain saw OEM as smaller competitors offer low-end products. This moat is protected by the high technical expertise involved in manufacturing, a global distribution network (OEMs, retailers, aftermarket), the high upfront required capex investment and strong customer loyalty to existing products. Furthermore, BLT is able to efficiently manufacture high quality chain as a result of its significant experience and economies of scale.
Attractive business model. BLT employs a "razor and blades" model as the initial sale typically drives replacements with FLAG generating 75-80% of revenue from replacements, which results in a recurring, higher margin revenue stream. Not only is this business largely non-cyclical but there is reduced revenue volatility given the diverse end-user base (consumers and professionals) and geography split (~70% of FLAG revenue is generated outside of North America while 94% of FRAG revenue is generated in North America).
Growth opportunities. The growth outlook remains bullish for each of its segments. For FLAG, saw chain sales grew at a 7.4% CAGR from 2002-2012 and should continue as a result of the continuing shift from hand cutting to chain saw cutting. Although BLT already has a dominant market share, there is still the potential for incremental gains (especially in emerging markets with lower penetration) given its strong reputation and relatively low level of competition.
For FRAG, BLT should be able to take advantage of the significant cross-selling opportunity (e.g. ~70% of FRAG end users own chain saws), ramp up of international sales and constructive macro outlook as shown in the chart below.
In August 2013, Woods Equipment (a division of FRAG) announced a partnership with Cabela's in which it will supply implements in the new Wildlife and Land Management category. Growth should ramp up as a result of expansion into additional states following an initial test in a single store in Nebraska. This is an excellent low-cost opportunity to expand its target market and strengthen its brand name. Given that Woods was Cabela's first choice with its expansion efforts, the former gains instant credibility with one of the largest and most valuable demographics in the U.S. This partnership with Cabela's provides a similar endorsement to the one received by vendors chosen by Costco, another company known for only selling best of breed products in order to "protect" its customers.
Although the revenue contribution from CCF is currently not meaningful, this should gradually change as BLT leverages its experience in saw chain manufacturing to expand into new product areas (e.g. sewage and utility pipe cutting) and markets (e.g. Europe and China) with its competitive specialized saws that provide tangible benefits compared to cut-off saws (e.g. deeper cuts and more time efficient).
Restructuring. Management has been proactive in addressing the steady decline in capacity utilization in FLAG from 93% in 2011 to 74% in 2013 through facility consolidations and workforce reductions. The consolidation of two manufacturing facilities in Oregon in 2013 was recently completed and is expected to provide annual savings of $6-8 million. In January 2014, BLT began consolidating its North American lawn/garden blade manufacturing into its Kansas City plant (expected to be complete by 2Q14) and closing a small facility in Mexico, which should provide annual savings of ~$2 million.
Deleveraging. In 2013, BLT used the significant FCF to reduce net debt by $71 million, which brought the net leverage ratio down to 3.2x (see "Risk-limiting factors" section for a more in-depth discussion regarding debt).
In 2013, overall revenue decreased 2.9% to $900.6 million as weaker international sales (down 5.8%) and a stronger USD more than offset a modest 4% increase from FRAG and a 3.2% increase in CCF (their combined weight is only about half of FLAG).
The gross margin decreased 70 basis points to 26.9% due to lower, higher margin FLAG sales (and the reverse in FRAG) and lower production volumes that reduced manufacturing efficiency. However, management expects a 100-150 basis point increase in FLAG and FRAG gross margins in 2014, which would reverse the steady downtrend since 2011.
SG&A as a percentage of revenue increased 90 basis points to 19.3% driven in part by the higher audit fees that should decrease to <$2 million from ~$6 million in 2013. A continued focus on cost control should result in SG&A remaining relatively stable going forward.
EBITDA decreased 10% to $123.5 million due to the previously mentioned weak FLAG results and increased audit fees. However, not only should both of these negative factors reverse but management provided 2014 EBITDA guidance of $130-135 million (on revenue of $925-950 million) driven by a 2-4% increase in FLAG sales and a 6-8% increase in FRAG sales.
Investors appear to have allowed the weakness in FLAG to overshadow the more than doubling of EBITDA to $20.9 million in FRAG. The primary factors responsible for this increase (lower cost structure, higher volumes/prices) are the same ones that should continue to drive overall EBITDA growth beyond 2014.
BLT generated $67.6 million of free cash flow (12% above guidance) compared to none in 2012 due to lower capex spending (following significant previous investment in its China plant) and a $46.5 million improvement in working capital, which was driven primarily by lower accounts receivable and inventories. In 2014, FCF is expected to be $35 million net of ~$45 million of capex.
While BLT may appear to deserve the ~2x lower multiple given the recent challenges, this is unwarranted given that it is nonsensical for the discount to remain even after the two primary negative factors have been resolved and due to the fact that this discount implies zero value for the strong recurring cash flow driven by replacements.
There are two primary catalysts that should play out over the next year, both of which should be even more powerful considering the low expectations (similar to LMOS). First, given the recent steady downtrend in revenue and EBITDA as shown in the chart below, BLT is currently in a "show me" state where the re-pricing of the stock should only occur concurrent with reported results (rather than ahead of them as is typical). The 2018 EBITDA goal of ~$175 million (on $1.1 billion of revenue) appears conservative given the recent operational and financial improvements alone, much less the potential for further improvements over the next several years.
Second, current plans to use FCF primarily for debt repayment and funding strategic initiatives are the best use of cash flow as deleveraging can act as a significant catalyst. However, management said on the most recent conference call that once the leverage ratio falls to 2-2.5x that it may consider a dividend or buyback.
Although a low relative valuation, stable cash flow, strong market position and overall bullish outlook may appear to result in BLT being an LBO candidate, this is unlikely at least in the near term given the high leverage. However, investors can still benefit from PE expertise as three of the nine board members work for PE firms (including TPG).
- Its customers may decide to self-manufacture components rather than purchase from BLT. In 2013, its largest customer (The Husqvarna Group) announced that it would begin manufacturing certain cutting chain beginning in 2015. As a result, management expects to lose about half of this business by the end of 2018.
- BLT has $438 million of debt with $406 million coming due in 2016.
- There is increasing competition and pricing pressure in North America due to capacity expansion from suppliers in low-cost manufacturing locations such as China.
- Although acquisitions are responsible for a large portion on the growth since inception (most notably in 2010-2011 to establish FRAG), this also resulted in higher leverage as net debt increased from $269 million in 2010 to $468 million in 2011. Moreover, typically the acquired businesses have lower gross margins although this spread should narrow as the acquisition accounting effects gradually drop off. As a result, at this point any more sizeable acquisitions would be viewed negatively, especially following a $24.9 million impairment charge in 2013 due to reduced expected performance of several of the acquired businesses.
- BLT is exposed to foreign exchange (primarily in BRL, CAD, EUR, CNY, JPY) and commodity price risk (e.g. cold-rolled steel and fuel for freight expenses) as a result of its global manufacturing and distribution footprint. Unlike with FX, BLT does not hedge against commodity price risk.
- Sales are dependent to some extent on the weather. A drought would typically result in lower demand for agricultural and yard care products, which occurred in 2013 and negatively affected the FRAG segment. A lack of natural disasters* such as hurricanes and ice/wind storms that knock down trees would typically result in lower demand for forestry products. Higher temperatures and/or lower heating oil costs would typically result in lower demand for firewood (and in turn log splitters).
- See the previous discussion for the risk related to the material weaknesses in internal controls.
Below is a discussion regarding specific mitigating factors for the previously mentioned risks.
The lost business from The Husqvarna Group is offset to some extent by a new long-term and exclusive supply agreement announced in February 2014 that extends the expiration to the end of 2017 from 2015. Even though The Husqvarna Group is the largest customer, it still only accounted for less than 10% of 2013 revenue while the top three customers only accounted for 15.1%.
The high leverage is less concerning for the following reasons:
- BLT has a history of refinancing so the 2016 maturity should not be viewed as a "fiscal cliff."
- The 3.2x leverage ratio should come down to the target of 2-2.5x as FCF is used to repay debt. Going forward, management should be focusing more on execution and integration (or at the most smaller tuck-in acquisitions) rather than large acquisitions that would result in higher leverage and interest costs. For example, BLT currently pays the lowest rate (LIBOR + 2.50%) as the leverage ratio is below 4x. However, there is a sliding scale that would increase the spread to as high as 3.5% if the leverage ratio is 4.5x. Also, the maximum leverage ratio steadily decreases from 4.6x at year end 2013 to 3.25x at year end 2015, which would be difficult to meet if there were further acquisitions.
- The credit agreements are not as restrictive as would be assumed given the high leverage. There is no provision requiring early repayment in the event of a downgrade and in March 2014 an amendment extended the due date to provide audited financial statements by an additional 60 days (with no fees or transaction costs).
- BLT can dial back a large portion of capex if necessary in order to increase cash flow as only about a third is for required maintenance while the remainder is for capacity and productivity improvements.
- The weighted average interest rate on its debt is only 2.68%, again extremely low for a company with such high leverage.
- BLT can postpone its expected $7 million 2014 pension plan contribution as previous voluntary contributions resulted in there being no required minimum contribution for 2014.
The pricing pressure from Chinese suppliers is offset by the fact that BLT also has a significant presence in China after a recent facility expansion. Moreover, the superior quality of its products helps offset any pricing pressure as the switching costs are much higher than implied.
The FX risk is significantly less than it appears as only ~24% of 2013 revenue was in foreign currencies as a result of ~55% of foreign sales being conducted in USD. Residual risk is reduced through cost-effective hedging (e.g. zero-cost collar option contracts).
BLT has a certain degree of pricing power in terms of passing along higher raw material costs, which should not automatically translate into a lower gross margin (e.g. although sales decreased in FLAG there was a positive contribution from pricing).
While there is the risk of unfavorable weather for BLT in the short term, this risk eventually evens out for two reasons. First, BLT by virtue of its global footprint is less at risk of a perfect storm (in reverse) marked by a drought and no natural disasters in a single geographic area. Second, and fairly obviously, the weather fluctuates so the run rate for any unfavorable weather should not be expected to continue while any "excess" revenue earned can offset a shortfall in subsequent periods.
From a more overall standpoint, If the stock falls below the primary stop loss level at 10.84, the secondary downside target would be the 9-10 support area. The two primary metrics to watch are EBITDA and debt, especially as a decrease in the former would result in less ability to service the latter, although this risk is mitigated by the previously mentioned recurring revenue stream. However, there is effectively no tangible book value support as the numerous acquisitions resulted in a high level of intangibles/goodwill.
*Obviously I am not saying there should be more natural disasters for the sole purpose of selling more forestry products.
The target price of ~15 (for a return of 37%) is based on an 8.75x multiple, which is a slight discount to the peer group median. A stop loss should be placed below the recent low of 10.84. The time frame is 12-18 months.
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.