Policy Jitters Creating An Opportunity With Techtronic

| About: Techtronic Industries (TTNDY)
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Summary

Techtronic continues to gain share in power tools, with double-digit growth overall and 20% growth in its Milwaukee line, while floor care remains a laggard.

Greater use of automation at its main manufacturing center could drive some meaningful margin improvements, while a global footprint gives it options if trade protectionism becomes a real issue.

Between revenue growth and margin improvement, high single-digit to low double-digit FCF growth can support a fair value about 5% to 10% above today's price.

(Editor's Note: Investors should be mindful of the risks of transacting in securities with limited liquidity, such as TTNDY. Techtronic's listing in Hong Kong, 0669.HK, offers stronger liquidity.)

Although I don't write on it often, Hong Kong's Techtronic (OTCPK:TTNDY) is a company that I've enjoyed following for a long time. The company behind well-known brands like Ryobi and Milwaukee are tools and Hoover and Dirt Devil in floor care, Techtronic has done a good job over the years of growing revenue and improving margins and ROIC (its performance on free cash flow has been less impressive). What's more, there's still room for the company to gain share in established markets like the U.S., add to its assortment of product offerings, expand into other markets, and drive more operating efficiencies.

The "but" is that investors have been frustrated lately by slower progress on margin improvements and worried about the potential ramifications of the new administration in Washington, D.C. As I don't believe Techtronic has outsized vulnerability to potential trade restrictions, and does have options for dealing with them, I think this could be an opportunity.

The Power Tools Business Keeps Powering On...

There's really not much to dislike out how Techtronic's power tools business has improved over the last few years. The company's expansion into hand tools has gone well, and the company has continued to gain share in power towels, with the company outgrowing primary rivals Stanley Black & Decker (NYSE:SWK) and Makita (NASDAQ:MKTAY) with a growth rate of around 14% since 2011. Even after many years of above-average growth, the company's brand for professionals (Milwaukee) continues to show exceptional growth, with sales up about 20% in the first half of 2016 (the last reported financial period).

Product innovation continues to be an important part of the story. The Milwaukee Fuel series offered meaningful performance advantages over competing tools from Stanley Black & Decker, Makita, and Bosch, and while those companies were starting to somewhat close the gap, Techtronic jumped ahead again with its Fuel 2 line. The company also introduced its One Key platform back in 2015 - a smartphone-based tool that allows users to customize performance features like speed range, torque, and clutch settings and toggle between saved profiles quickly and easily. It's not a feature that's going to mean much to the casual user, but it is another point of differentiation for at least some professional users.

One area that hasn't gone quite to plan (so far) has been the expansion into outdoor tools. The company has certainly added to its assortment of HomeLite outdoor tools over the past few years, but the product reviews suggest the company still has a ways to go to improve this segment.

And The Floor Care Business Still Basically Sucks...

In contrast to the power tools business, which has grown steadily and seen margins improve into the high single-digits, Techtronic's floor care business remains a weak link. Brand perception has been a problem for some time now, and the company has responded by exiting the low end of the business and focuses more on professional and cordless products, including new Hoover robotic vacuums. Unfortunately, the reviews have been pretty lackluster (if not outright poor), and it looks as though iRobot (NASDAQ:IRBT) is probably going to clean the company's clock in this market segment.

Adding injury to insult, the margins in this business remain feeble, with low single-digit operating margins more the norm than not.

I suppose I should give some benefit of the doubt to management and let more time pass to see if culling out the lower-end products can make a meaningful difference. Still, I think that unless Techtronic builds a quality brand with quality products, this is going to continue to be a lagging business that cannot earn its cost of capital.

Opportunities To Do Better, Amid A Potentially Challenging Environment

I believe Techtronic still has opportunities to drive organic outperformance. The company has shown a strong commitment to new product development (particularly in the tools business); not only can the company go from design to launch in six months, it has doubled its R&D staff since 2008. I look for more product innovation in the power and outdoor tool businesses, and I think the company may also start taking more chances with new market entries. The company has started building a portable lighting business and there are other segments within tools and work site equipment that could make sense to address.

I also think market expansion remains a viable opportunity. Unlike Stanley Black & Decker and Makita, Techtronic has largely avoided the major emerging markets (Brazil, China, and Russia); a decision that has looked better given the recent challenges in those countries. Instead, Techtronic is more interested in growing within Western Europe and select emerging markets like Poland, the Czech Republic, and South Korea.

Improved operational performance is also a potential driver to consider. About 80% of the company's products (by sales) are manufactured in a mammoth facility in Dongguan, China, but the company has been very slow to adopt and introduce automation. As the company makes more/better use of factory automation (even if it's just on the level of replacing push carts with automated component delivery options), I would expect COGS to improve. I also wonder if the company could do better by insourcing its floor care production; the majority of the production in this business is outsourced and since they have excess capacity in Dongguan, it could make some sense to consider it.

The elephant in the room for Techtronic now is the new administration in the White House and the prospect of more combative relations with respect to trade policy. While the threat of tariffs on imports from China is real, most of the major U.S. tool companies (including Stanley and Bosch) import the majority of their products from China and so the impact across the industry should be broadly similar - Techtronic's tools wouldn't suddenly become more expensive than its peers unless or more rivals choose not to pass along the tariffs.

What's more, Techtronic's manufacturing footprint would allow them to shift at least some of their production - whether to Europe (if Chinese products were to be taxed more) and/or the United States as needed, as the company has actually been adding jobs in the U.S. in recent years. It's also worth noting that if the administration goes through with infrastructure spending stimulus, that would likely be a net positive for the company's power tool business (and maybe its nascent lighting business as well).

The Opportunity

I'm not looking for Techtronic to grow at the same rate as I was a few years ago, but that's largely because the company has continued to grow the business ("trees don't grow to the sky..."). While I think double-digit growth may still be possible, my base-case assumption is for high single-digit growth over the next five years and mid single-digit growth over the next 10 years. I do expect free cash flow margins to hang around in the mid single-digit range for a little while longer, but I do see opportunities for margins to improve as the company adopts more automation, introduces more high-end products, and drives better economies of scale. With that, I think FCF growth in the high single-digits to just into the double-digits is possible.

The Bottom Line

Discounting those cash flows back, I believe Techtronic ADRs are about 5% to 10% undervalued today. That's not huge undervaluation, but it does make the cut as a relative bargain in an expensive market. I do acknowledge that saber-rattling about trade is a risk (though likely more to sentiment/perception than the financials), as is ongoing underperformance in floor care. On the other hand, I think Techtronic has under-appreciated opportunities to automate and improve margins, and more flexibility with its manufacturing footprint than some may realize. With that, I think Techtronic is worth a closer look today.

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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.

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