MTS Systems (NASDAQ:MTSC) is a company which surfaced on my radar a while ago. MTS is a stable business which has delivered on solid growth, although margins have been lagging somewhat in recent years. The company presents itself as a play to benefit from a recovery in margins, but surprised the market as it announced the acquisition of PCB in recent weeks.
Investors have been cautious given the higher sales multiple being paid, the incurred leverage and one-time transaction-related costs. That being said, I see real strategic and financial benefits in the long run, provided that the deal will not interfere with the goal to improve the stand-alone margins of the business.
Given some of the concerns, investors have been a bit disappointed with the shares in recent trading sessions. This has created a nice entry opportunity for those investors with a long term horizon and confidence in the recovery story.
MTS produces and distributes test and position measurements sensors to a wide range of industries and geographic areas. The company is quite diverse in terms of end markets and this stability has served the business well.
Over the past decade, MTS has grown sales by an average of 4% per annum, while it was able to buy back shares as well. This allowed MTS to report solid growth in terms of revenues on a per share basis. Despite the headwinds resulting from a strong dollar, MTS managed to post flattish sales at $564 million for 2015.
The main problem which the company is witnessing is the long term pressure on margins. Operating margins came in at around 11% of sales in 2015, quite a bit below the 13-15% margins being reported for most of the past decade.
This margin pressure has been a key focus point for management going forwards. Even as management does not anticipate to expand margins a great deal into 2016, it guided for earnings of >$3 per share for the current year. If the company delivers on 200-300 basis points margin improvements in the coming years, things look much better. This margin expansion, combined with sales growth could easily support earnings of $5 per share by 2018/2019. Given the current share price level, investors would most certainly see real upside if this could be achieved.
The Deal To Acquire PCB
In the midst of the margin recovery story, MTS somewhat surprised the investment community by announcing the large acquisition of PCB Group. PCB is a group of businesses which focuses on the development and manufacturing of sensor technologies, similar to MTS. The similarity in terms of history, culture and overall business has really been highlighted by executives on the conference call.
MTS stresses the strategic fit, improved diversification and growth in test products and sensors as rationale behind the $580 million deal. Few financial details were revealed in the press release other than that combined revenues come in at $785 million in 2016, at least on a pro-forma basis. What surprised me is the comment that the pro-forma business anticipates to be able to grow both sales and revenues by double digit percentages in the future. Given that the growth rates of MTS are currently seen in the single digits, it appears that PCB is growing at a much more rapid pace.
MTS is really keen to stress the strategic rationale as the new combination will gain scale in both sensors and test solutions, becoming large enough to effectively compete in the global market. While the deal looks good on paper, investors need some patience as the deal is only expected to close in October of this year.
What About The Price?
At the first quarter earnings release, MTS guided for annual sales of $570 to $600 million. Pro-forma revenues, including PCB, are now seen around $785 million. That suggests that the deal will add some $200 million in sales, translating into a 2.9 times sales multiple.
That multiple drops towards 2.6 times, if you take in to account anticipated revenue synergies of $20-$30 million per annum. The strong growth profile of PCB is somewhat confirmed in comments being made on the conference call. Based on the pro-forma outlook and previously issued outlook by MTS, PCB will add some $200 million in sales this year. This marks +10% growth from the $180 million in sales which the company reported in 2015.
The other valuation multiple being revealed was the 9.8 times adjusted EBITDA multiple being paid for PCB. That multiple does include anticipated cost synergies of $5-7 million per annum, seen roughly three years down the road. That suggests that adjusted EBITDA comes in at $52 million at the moment. Again, this compares very favorably to the $43 million in adjusted EBITDA being reported in 2015.
So how do these valuation multiples compare to the own valuation of MTS? The company ended the first quarter of 2016 with a very modest net cash position. The 15 million outstanding shares traded around the $60 mark ahead of the deal, for a $900 million valuation. That implies that the business was trading at little over 1.5 times projected sales for 2016. Based on EBITDA of roughly $80 million, MTS was trading at an EBITDA multiple of 11 times, being more or less in line with the multiple paid for PBC.
So while MTS is paying a higher sales multiple for PCB, the EBITDA multiples are fairly similar. This follows the fact that PCB´s EBITDA margins of 26% surpass those of MTS by more than 12%! It furthermore seems that PBC has a higher organic sales growth rate, being another key positive attribute of that business.
The Pro-Forma Business
Leverage is always a concern as this deal will entirely be paid for by the issuance of debt, at least for now. With MTS net holding $20 million in cash, and looking to spend $580 million on PCB, the net debt load is seen around $560 million going forwards.
The company indicates that this is equivalent to 3.5-4.0 times EBITDA. This suggests that EBITDA comes in at $140 to $160 million on a combined basis. This matches the $52 million contribution from PCB and the $80 million number from MTS, if you take into account the impact of synergies and forecasted growth into 2016. It should furthermore be noted that the leverage ratio is based on the anticipated closing date in October, giving MTS some time to improve the balance sheet ahead of that date.
It seems reasonable to assume that PCB will add $40 million in operating earnings based on the EBITDA numbers. If you take into account a 4% interest rate on a $580 million purchase price, interest expenses will increase by $22 million per annum gong forwards.
After applying a 25% tax rate, after-tax earnings could increase by roughly $16-$17 million, equivalent to roughly $1.00 per share. This accretion looks sizable given the fact that baseline earnings come in around $3 per share at the moment.
Short-Term Worries, Long-Term Optimism
I must say the deal seems to make sense, though I find the timing a bit odd given that MTS promised to focus heavily on margin expansion of its own business. It seems that other investors think alike, given the stock lost roughly 10% of its value after the announcement. This wiped out roughly $100 million in market value — on the back of a $580 million deal.
While the timing of the deal might be early, and leverage might be on the high side, I think the price is fair. At similar EBITDA multiples, MTS is buying a business with a much better margin profile and higher organic growth rates. This move has the potential to boost the growth profile of the entire business, and thereby the valuation multiple being attached to the new combination if the merger is consummated successfully.
In my previous article I saw potential for earnings per share of $5 by 2018/2019, on the back of operational and margin improvements. Given the anticipated accretion I think that an earnings per share number of $6 by 2020 might be within reach.
With quality test and measurement businesses typically being able to carry quite some debt, while trading at 20 times earnings multiples, a >$100 stock price might be within reach by 2020. That suggests that shares could double, if all goes correct, in the coming four years. This is certainly an attractive potential picture, although much work is required to attain these results.
The potential for the deal to work out, margin improvements and low valuation multiples make that I am upbeat, even as leverage is on the high side in the short to medium term.
Disclosure: I/we 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.