On July 9th, Actuant (NYSE:ATU) announced the sale of the Engineered Components & Systems ("EC&S") segment. This business consists of their lower quality assets (more cyclical, more capital intensive, lower margin, etc.). A company electing to divest over 40% of its revenue doesn't happen often, so investors should take note and learn about the company when such an announcement is made. As a result of this portfolio move, Actuant has characteristics similar to many other special situation investment opportunities
History of Poor Acquisitions
Actuant has a track record of poorly allocating capital ever since they went through a corporate reorganization in 2000 when they spun-off the Electronics business as APW Ltd. and renamed the company Actuant (formerly called Applied Power). Over the years, the former Chairman and CEO used the cash flow generated from the industrial tools business to make expensive, ill-timed, and low-quality acquisitions. For instance, they spent around a billion dollars acquiring various electrical, engineered components, and energy services businesses throughout the 2000s and 2010s. These large, speculative acquisitions included Key Components ($317 million), Cortland ($231 million), Mastervolt ($158 million), Weasler ($153 million), and Viking SeaTech ($235 million). In each case, they took significant write-downs while they owned the assets as well as further impairments when the businesses were divested.
A new CEO and CFO were hired in 2016 and the long-time Chairman & CEO stepped away from the company in 2017. Then, in 2018, Southeastern Asset Management filed a 13D and got a few well-qualified individuals appointed to the board. Since the new management team and board members joined, M&A activity has been minimal, but very focused when executed.
So just to clarify, we won't focus any attention in the energy area for M&A. 100% of our activity for M&A is directed towards tool companies. As I mentioned before to a lot of our investors, we look at several distinct categories of tools and ones that bring either a technology that we need for Enerpac or opens up a brand-new market or a region that helps us grow as a tool company. So you can rest assured that our capital investment relative to M&A will be focused on developing a world-class tool company and we will not deviate out of that. And as I mentioned in my commentary, it will follow very strict guidelines on the quality of the company, the returns, how well can we own and operate it and we will always compare with the value of a share buyback rather than an investment in M&A. All those hurdles meeting the criteria, then we proceed. [emphasis added]
Randal Baker - President, CEO & Director - Actuant Corporation FY Q3 2019 Earnings Call
The Engineered Components & Systems Divestment
On July 9, 2019, Actuant announced the divestiture of the EC&S segment for $214.5 million to the private equity firm One Rock Capital Partners. The EC&S segment is a hodgepodge of various industrial businesses acquired over the years by the former management team. They manufacture a wide range of products for various cyclical markets, such as agriculture, trucking, and off-highway vehicles. Generally speaking, these products are more commoditized and lower margin than the businesses in the remaining Industrial Tool & Services segment.
It is difficult to determine the valuation Actuant received for the EC&S businesses because there are a lot of moving parts. They recently divested a few of the underlying businesses (Precision Hayes and Cortland Fibron) and plan on retaining a couple of others as well (Cortland's industrial rope and medical component businesses). As a result, it is challenging for outsiders to see the revenue and profits generated by the pro forma EC&S business sold to One Rock Capital Partners.
The table below displays the EC&S segment's financial profile during fiscal year 2018 and over the first nine months of FY 2018 and FY 2019. While revenue is down over the past year from the aforementioned divestitures, profits are actually up due to the benefit of price realization, savings from earlier restructuring activities, operating efficiencies, and lower incentive compensation.
It is impossible to determine with complete certainty the revenue and profits from the pro forma EC&S business, but investors can make an educated guess by removing the Rope & Cable subsegment and estimating profits based on the year-to-date performance. This implies that Actuant sold the EC&S segment for somewhere around 5.0-7.0x EBITDA. Overall, this is a relatively low valuation considering the currently robust private equity market but is consistent with the segment being rather cyclical and generating very average business economics.
The Remaining IT&S Business
The Industrial Tools & Services ("IT&S") business designs and manufactures branded hydraulic and mechanical tools as well as provides services and tool rentals. Their key end markets are general industrial, construction, oil & gas, and other energy markets. The business generates an attractive margin, ROIC, and free cash flow profile as a result of their premium, well-known niche brands (Enerpac, Hydratight, Larzep, Simplex, etc.) used in high stress, can't fail applications. You can see this dynamic in the table below where they generate attractive EBITDA margins and require very little capital expenditures to maintain the business.
These are not tools you would normally find in your local hardware store. They operate at extremely high pressure and are designed for professional workers. Overall, these tools increase productivity, reduce labor costs, and make work easier to perform.
Management is aggressively reinvesting in the business. During fiscal year 2018, they introduced 30 new tools which exceeded the total number of introductions released over the past several years combined. They have continued this pace of introductions in 2019 which has helped bolster revenue growth (over 6% so far this fiscal year - which is on top of 7% revenue growth in FY 2018).
Pro forma for the transaction, the remaining industrial tools business does not seem to be materially mispriced. It appears to be trading at over 14x EBITDA and 21x free cash flow (based on the mid-point of management's FY 2019 guidance). While the industrial tools business has some unique characteristics, investors need to underwrite above-average growth and margin improvement in order to earn an attractive return at today's price. Investors might have been expecting a higher valuation for the EC&S business which would have implied a lower valuation for the remaining IT&S business.
With the announced divestiture of the segment comprising over 40% of their consolidated revenue, Actuant has many of the characteristics found in special situation opportunities, such as spin-offs, carve-outs, and split-offs (click here to find the list of recent spin-offs). As a pure play Industrial Tools & Services company, Actuant's future business economics will be much better than in the past. The company should generate much higher returns on invested capital and robust free cash flow. Just as importantly, management has reiterated that they will not pursue acquisitions outside of the core industrial tools market. Instead, they will focus capital allocation priorities on reducing debt, complementary tools acquisitions, and returning excess capital to shareholders through opportunistic buybacks.
Given the dynamics of an improving business profile and focused capital allocation priorities, Actuant looks like an interesting opportunity for investors. However, it appears that they didn't receive as high of a valuation for the EC&S business as some were maybe expecting so the implied valuation on the remaining IT&S business appears rather full at this time.
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.