MTS (MTSC) has issued a troubled guidance for 2017, as this has rightfully caused investors to become cautious after it announced the large purchase of PCB last year.
As the company has resolved the ¨Chinese¨ issue and touts about 10% organic growth rates in Q1, the picture looks good. These headline results are overshadowed by the guidance for 2017, which calls for growth to slow down dramatically and even reverse into the remainder of the year. This will put a lot of pressure on adjusted earnings, let alone GAAP earnings of MTS.
The resulting sell-off following the news flow seems more than warranted, as the guidance essentially implies that 2017 will be a lost year. This warrants caution as leverage remains above average as well at a time when the core is not performing well in what can be considered to be a decent operating environment.
On the other hand, MTS still has great potential if management can deliver, but that remains a big if for now. For that reason, I see no triggers to send shares higher in the near to medium term. This makes me a very patient buyer, as I would only start to accumulate shares in the low forties on the back of the long-term potential of the business.
A Long-Term Growth Business
MTS has been around for over 50 years and operates in inherently attractive end markets, but it has seen some stagnation in the performance of the business in recent years. In the calendar year of 2015, the company posted sales of $564 million, which was generated across two segments.
The vast majority of sales was generated from production of test equipment (roughly 4/5 of sales) as the remainder was generated from measurement systems and sensors. The main test segment provides testing for both hardware and software and is quite a global business. In terms of end markets, the business is quite diversified as well, being tied to ground vehicles, materials and structures, among others. Notably, the exposure to ground vehicles is very interesting amidst continued developments surrounding self-driving cars, as the business has been held back by weakness in oil & gas.
The sensor segment is used in machinery and equipment and is typically employed to improve safety and productivity, and this too is quite a global business.
This core business of MTS has posted sales that ranged between $400 and $600 million over the past decade and have gradually trended upwards. Operating margins came in at around 15% with the exception of the crisis years.
Shares of MTS dropped from $40 in 2007 to $20 in 2009, amidst the harsh economic developments at the time. The company emerged stronger out of the crisis as both sales and shares peaked in 2014-2015, when shares peaked at $70. To rejuvenate the flattish sales trends, MTS announced a sizable deal in April of 2016 when it acquired PCB in a $580 million deal.
Revisiting Last Year's Deal
About a year ago, MTS announced the $580 million purchase of PCB. With the deal, MTS was hoping to achieve multiple goals in one time. The deal obviously boosted the scale of the business to sales of $785 million, allowing the company to reap scale advantages.
Another projected benefit would be improved diversification as the sensor business would get a big boost, reducing the reliance on test equipment. The complementary nature of the offerings should allow for both revenue and costs synergies as well. The company modeled $20-$30 million in revenue synergies some 3-4 years down the road, accompanied by costs synergies of another $6 million.
Based on the information provided at the time when the deal was announced, PCB would add some $200 million in sales, which implied that MTS paid a rather steep 2.9 times sales multiple. This was compensated for by the fact that PCB was growing at a faster rate, as its margin profile is more lucrative as well. Once costs synergies were taken into account, the EBITDA multiple being paid for the business drop to 9.8 times.
The deal did have a profound impact on the balance sheet, as MTS actually operated with a modest net cash position ahead of the transaction. Net debt would rise to $560 million following the deal, for a 3.5-4 times leverage ratio. The relative high (sales) multiples being paid, relative modest costs synergies being projected and increase in leverage triggered a 10% sell-off in the shares at the time. This corresponded to a roughly $100 million decline in valuation of the firm, although shares still traded in the mid-fifties.
On the other hand, the bull case could be made as well. The deal seems like a nice strategic fit, as the unleveraged balance sheet and projected synergies could boost pro-forma earnings from $3 per share to roughly $4 per share over time. As shares pulled back to a $40-$50 range in the summer of last year, I actually initiated a position in MTS as a play on a good outcome of the deal and revival of the core business.
Shares actually did recover and approached a high of $60 earlier this year, as I sold out of my position following late filings as a result of potential irregularities in China.
How Bad Is The News?
The issues in China resulted in the delay of the release of the full year results for 2016. In January, the company obtained approval to delay the publication of the annual results, as an investigation into the issues in China was still ongoing. At the time, the company reiterated the third quarter guidance that called for sales in 2016 to come in at $645-$650 million, accompanied by GAAP earnings of $1.65 to $1.70 per share.
The company finally released the results for 2016 halfway April, some five months after the third quarter results were published. Full year sales for the year ending in October of 2016 topped $650 million, coming in at the high end of the guided range, with reported earnings coming in strong as well at $1.72 per share.
The company has started 2017 on a strong note, as first quarter sales rose by 42% to $199 million, mainly as a result of the PCB deal as the 10% organic growth rate was pretty impressive as well. The other good news is that the investigation in China ¨only¨ revealed that some ex-employees have violated the code of conduct by starting a competing firm. As a result, the situation seems controlled, as it does not result in restatement of financial results.
While top line sales growth at the start of 2017 is very good, adjusted earnings are seen at just $0.55 per share for the first quarter. Worse, the solid growth momentum is not anticipated to last into the remainder of the year, amidst a somewhat softer order intake. For that reason, full year sales are now seen at $760-$790 million, as the second half of the year is anticipated to show weaker results.
Full year GAAP earnings are seen at $0.80-$1.20 per share. After adding back acquisition-related charges of $16-$18 million and $8-$9 million in costs related to the Chinese investigation, the pro-forma earnings number is quite disappointing. With roughly 19 million shares outstanding, adjusted earnings are expected to come in at roughly $1.90 per share this year.
With earnings power just shy of $2 per share on an adjusted basis, investors have to swallow a big decline from the $2.72 per share number being reported in 2016, as they forecasted earnings to come in flat. The company blames the fall in earnings on additional interest charges being equal to $0.73 per share and amortization charges of another $0.31 per share. Of course, these are real costs and could have been foreseen when PCB Group was bought, indicating that either the core or PCB is underperforming versus expectations.
The earnings guidance is rather disappointing, with adjusted EBITDA being seen at $115 to $130 million this year, including dilutive stock-based compensation charges of a hefty $33 million. Following a modest follow-on offering last year, MTS now operates with net debt of $366 million, for a relative steep 3 times leverage ratio.
What Does The Normal, Or Better Said Potential, Look Like?
With shares trading in the mid-forties, MTS looks optically cheap, but investors have to take into account that the company has taken on quite a bit of debt. On the back of simple sales metrics, the company trades at valuations that are in line with the average of the past decade. The issue is that margins are rather disappointing and are far removed from historical norms in the double digits.
You could even argue that shares look expensive in the mid-forties as adjusted earnings are seen at just $2 per share this year, with GAAP earnings being just half that number.
While the first quarter was good, the run rate of sales of $800 million seems pretty much the maximum for now, which could be combined with peak margins of 15% if the integration goes well. That could yield a $120 million operating profit number by 2018 if management finally delivers on its promises, which is a big if. Amidst improving earnings leverage comes down and interest expenses could be reduced towards $20 million a year. After applying a 28% tax rate, earnings could come in at roughly $70 million, for an earnings number anywhere between $3.50 and 4.00 per share.
Part of this ¨projected¨ earnings growth should be driven by a successful integration of PCB, for which the company does not assume any meaningful synergies yet this year. If that were to happen, the core would improve its operations and leverage would come down; such an outcome could be reasonable by 2018/2019. With earnings power of up to $4 per share, one could not rule out a $70-$90 valuation in that case in a year or two. That being said, confidence in management is very low following the 2017 guidance as this year is setting up to become a lost year.
With no immediate triggers in sight following the dismal guidance and the fact that a recovery of the core will probably take some time, I would be cautious for now. That said, I would become an opportunistic buyer in the low forties, as I like a margin of safety given today's challenges and still elevated leverage position. That said, the long-term positioning is sound and the potential is substantial as well, as it becomes time for management to deliver on its promises.
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.