Portfolio Review- October 31, 2011

Summary

Despite a sour windup to the month, free cash flow multiples expanded from the cruel levels in September. The portfolio is showing out-performance against both the Russell 1000 value and Russell Midcap since inception of the account this year.  That said, investors would be prudent to expect a prolonged period of slow worldwide growth, the kind of environment which is beneficial to our invested firms-those with sound financial structure and ability to earn superior returns on capital.

Devoting lots of time reviewing our firms almost weekly acquisitions, it was nice to have it go the other way with Healthspring receiving an offer close to fair value, and as a result the position was sold. Other portfolio firms have, by and large, reported free cash flows and either return on capital or economic profit, and financial structures, in line with model requirements.

I am devoting this month’s letter to one position (Regal-Beloit-RBC) which in many ways, epitomizes the portfolio—an industrial manufacturer which has seen its stock decline resulting from the current and likely to continue,  economic malaise, typical following deep credit crisis.

In the following example, our models, which include the alteration to RBC’s financial structure as a result of its most recent, and large acquisition[1], indicate an undervalued cash flow stream available to the equity holders. This is also evident on a historical basis by the chart at the end of the report, showing RBC’s historical three-year average free cash flows and market values. The chart shows investors have always responded favorably, although it often took an ensuing economic expansion, to respond to the firm’s improvement in operations resulting from its operating and financial decision-making.

Regal-Beloit Corporation (RBC, market capitalization $1.7 billion)

A firm with a normalized consistency of metrics for a cyclical business, a history of value-adding acquisitions, and a free cash flow yield which over the cycle is safely above its cost of capital, Regal Beloit shares, despite above-market volatility, should continue to provide above normal return to shareholders.  The firm’s shares, since inception of the account, have been underperforming the benchmark. Over the long-term, its superior metrics have resulted in outperformance, and in fact, was a position I owned for clients over 20 years ago. Management has continued to employ and promote executives who believe in the time-tested and economically proven philosophy of acquiring firms which exceed its cost of capital within one year. Smaller acquisitions, it appears, have taken longer to become value-adding, although financial details are sketchy at best with such deals.

As organizations strive to improve energy efficiency, and with RBC enjoying a pre-eminent position in motors, generators, and electrical manufacturing, benefits should accrue continue to both equity and credit holders.  Prospective results should also be bolstered by the recent AO Smith electrical products division acquisition, which has a stronger presence in faster growing markets.  RBC has leading positions in Asia and North America and is attempting to be 50% non-US in total sales.

Management has kept to its knitting in their “bolt-on” acquisitions (14 in the past 36 months) in which the firm has a knowledge base whereby it can be a better owner than the seller, meaning, it can improve upon the financial metrics at the time of acquisition. It also has a history of making good fits, culture wise, always and an important yet somehow underappreciated consideration in merger analysis. Their larger acquisitions tend to be those which RBC has a long history of competing and has deep familiarity in both product and people.

RBC funded the AO Smith purchase with cash, equity, borrowings under their credit facility and additional debt. The size of the acquisition (41% of its market value, amounting to $700MM in cash and 2.8MM shares of stock) and the impact to the financial structure caused us to raise cost of equity by half a percentage point. Of the $700MM, $500MM of long-term debt is at 4.74% with a $100MM revolver at 2%. RBC expects large cross selling opportunities, which is often overlooked in these type of mergers, as analysts prefer to concentrate on cost synergies, which RBC estimates at over $35MM over 4 years.  I believe RBC will be able to pay down the added leverage rather quickly given data from the seller’s 10-K’s and RBC’s ability to improve upon existing, as well as internal, cash flows.

Total debt as a percentage of total capital, due to the acquisition, is at the company’s historic high range, even when bringing the debt to present value.

RBC claims they will, despite the current economic climate, continue to be active acquirers; I view this as a positive as most well financed companies shy away from acquisitions during slowdowns. If however, any upcoming deal is not immediately value-adding or brings the financial structure out of line with normalized free cash flows, or brings its cost of capital above acceptable levels, our positive position will be re-accessed.

RBC is comfortably within all loan covenants. Capital spending, despite its acquisitions, is higher than normalized, in part due to the requirement of the Chinese Government to relocate 2 of its plants while funding a manufacturing facility that was previously leased. Our worksheets (see table-excess capital spending) reflect these expenditures. Litigation is normal and derivatives within fair hedges. Pension liability adds 16% to total debt, and operating leases about 8%. Purchase and other commitments, including outstanding letters of credit are normal. Although the tax effective rate has remained in a 30%-35% band the past 7 years, its cash rate has been more erratic, owing to credits and other normal factors. NOL benefits are minimal. Unremitted US earnings are $131 MM.

The free cash flow worksheet shown below (and attached for larger print reading) is for the six months ended June, as the current quarter results are not to be released until November 2. One would expect a below average performance given the macroeconomic factors, results from other cyclical firms, and acquisition related expenses. As you have seen, yearly worksheets are more detailed and reliable, given firms’ estimation procedures and the incorporation of additional data.

As the half year worksheet illustrates, RBC has been able to continue to show the ability to produce superior free cash flows, resulting in a cash yield above that for the median S&P industrial entity, a fact being currently overlooked by investors focusing on the general economic slowdown and the European debt crisis, rather than the gathering of the firm’s operating leverage, which I believe will become quite evident as those problems unwind. RBC, as with other firms doing business in Asia, is seeing a noticeable slowdown in China; they are not overly exposed in Europe.

Included in free cash flows is part of last quarter’s $28MM charge from the addition to their warranty cost provision due to a defect, shown in cost of goods sold, and with the total charge to be paid over upcoming current quarters.

The models also added minor free cash flows due to higher than normalized input costs reflected in COGS, which grew to 77.8%, due to higher commodity and other expense. The models added other free cash flows to operating expenses (SG&A) which were high relative to historic levels. As sales grow, new acquisitions absorbed, the supply chain continuing to be squeezed, and acquisition related improvements placed, I expect these expenses to normalize. Given general economic weakness, however,   it might take a while longer than management currently believes. Regardless, employment cuts should be expected which could free up cash not fully reflected in our models which partially pick up a percentage (between 15%-20%) of the excess expenditures. Other discretionary expenses are within normal limits.

Half of RBC’s employees are covered by defined benefits plans which were frozen in 2009; foreign employees are covered by government sponsored plans.  As stated, we added 16% to total debt to account for current market rates based on RBC’s somewhat high 8.25% investment assumption (72% in equities) and 6% discount rate assumption. We have also penalized cash flow from operations based on the announced $2.2MM contribution this fiscal year and cash payments running slightly under $5MM. Most US employees participate in their savings plan.

The following chart shows the relationship between Regal Beloit’s three year average free cash flows, as defined, and its corresponding market values. We also show trend lines for each series. As is not unexpected for cyclical manufacturers, the lines are somewhat jagged; the trends however are unmistakably close and positive, which has resulted in strong performance for the patient investor.

The free cash flow worksheet shows higher free cash flows than the company has, in its presentation slides, been reporting to shareholders.  The reasons are twofold. First, we adjust for normalized expenditures, including commodity costs, which have impaired the results of RBC. The model also picks up and includes as overspending, excess expenditures, and since RBC has been an active acquirer, the model accounts for some reductions in labor and other cost redundancies. In fact, during its most recent conference calls the company admitted it is diligently working to reduce expenses from acquisitions.

We recognize firms like RBC will always be impacted by economic forces, as will be seen again this coming week. However, once an expansion takes hold, however slight, and as energy becomes costlier, and the benefits of its most recent acquisitions return cash to reduce leverage (and cost of capital), investors will begin to appreciate the superior normalized yield.

Please call me with your investment questions.

Ken

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