Altra Industrial Motion Corp (NASDAQ:AIMC) is a global designer, producer, and marketer of machine components that transmit torque and control motion in a diverse array of industrial machines. Though the company's products and brand names may not be immediately recognizable to the average consumer, their components are used in broad variety of machines, such as elevators, forklifts, baggage handling conveyors, lawn tractors and mowers, hoists and cranes, oil and gas drilling platforms, wind turbines, movable solar panels, and numerous other specialized machines. Over the last decade the company has grown revenues at a compound annual rate of 9.5% while holding the number 1 or number 2 spot in market share in categories (primarily mechanical power transmission) accounting for over 50% of revenues. Although no unmarried industry accounts for more than 20% of Altra's sales, metals, mining, energy, and agricultural industries combined account for roughly one-third of revenues. Difficulties in those industries along with the general economic malaise across the globe have caused AIMC shares to fall almost 30% over the last year.
With metals, mining, energy, and agricultural end markets all in different stages of bear markets, it is easy to dismiss the idea of investing in a company that derives 35%-45% of sales from those industries. However, in the face of those difficulties, Altra management has implemented several initiatives to increase returns going forward. Starting with an organizational restructuring (aka the Business Simplification Plan), AIMC has simplified its corporate structure, increased the use of shared services, and has begun to improve provide chain management and logistical operations. In addition, the company has worked to further decrease development and production time and put through a strategic pricing initiative. While some of these changes are still in their early phases, they have resulted in an EBIT margin that has remained above 9% (before restructuring charges) in spite of end market weakness for a significant portion of the company's portfolio. Should end markets stabilize or begin to recover, these improvements should provide an possibility to arrive management's goal of 15% operating margins. Though I do not believe that this goal is sustainable in the long run, the optimizations should create improved operating leverage over the long term. Implications for valuation: higher normalized operating margins and return on invested capital.
One of the benefits of Altra's business mannequin of serving highly engineered, but somewhat niche markets is that once AIMC's particular solutions/products are utilized by customers it is likely that the customer will continue to purchase replacement components from Altra. The high measure of specificity and engineering inherent in the company's products also creates increased barriers to entry and some measure of pricing power. In addition, because the company's products are highly movable and transfer high amounts of mechanical power they inevitably wear out over time, creating consistent and less discretionary replacement cycles. All of these characteristics are demonstrated by the company's aftermarket revenue hovering near or above 40% of consolidated sales for the last decade. As long as the company maintains high quality production, long term consistent returns should continue to be the norm. Implications for valuation: consistent, though not spectacular growth over long time periods and ability to maintain returns in excess of capital costs over a long time period.
Finally, Altra has plans to continue its expansion into a wider geographical area and new and adjacent product segments. As management has articulated, a key to this expansion strategy is further consolidation of the highly fragmented mechanical power transmission industry. The company plans to maintain a stable stream of acquisitions in the $10-$100 million revenue range, which implies mostly lower risk tack-on type acquisitions. Indeed, this fits the historical pattern of Altra, which has consequently demonstrated an ability to extract value from previous acquisitions. Along with organic growth, AIMC management believes this strategy will result in a doubling of revenues to $1.5 billion within 5 years. In addition, if AIMC is able to consolidate enough of the industry, pricing power should improve and allow the company to increase operating margins and return metrics. Implications for valuation: increased growth through reinvestment.
Unfortunately, and all too often, risks are not carefully examined by those who listen to management projections of doubling revenues. Likewise, those who think a inventory is cheap already simply because of a selloff tend to ignore the remaining risks. Clearly, any company and its supporters can tell stories about opportunities and potential, but real world constraints and pitfalls are always present. Further, just because risks are ignored or glazed over, does not intend they do not exist. Altra Industrial Motion is no different in that regard.
Though one could list numerous more, there are three primary risks that investors need to carefully examine before investing in the company. First and foremost is the aforementioned cyclicality inherent in most of AIMC's end markets. It is no secret that metals, mining, oil & natural gas, and parts of ag, paper, and printing are currently in decline. What is more uncertain is how long the current declines in those industries will last. As these industries stay subdued, time increases the probability that other end markets may fall as well. Even without other industries contributing to macro declines, a lengthy depression of over one-third of revenue sources will continue to hurt AIMC's earnings. Beyond that, cyclicality is a permanent part of Altra's risk profile. Implications for valuation: slow or declining growth in the near term, higher risk/cost of capital over the long term.
While the specificity and high level engineering required by end users of mechanical power transmission products can create high barriers to entry and give some companies competitive advantages, it also makes gaining market share difficult to accomplish by organic means. That being the case, growth is likely to remain slow without taking risks on new product categories, production methods, or acquisitions. Currently, the company is taking all three risks. For example, Altra is more and more involved in renewable energy, robotics, and additive manufacturing. While these may turn out to be high growth areas, there will, no doubt, be OEMs that fail and force Altra to "eat" the cost of produced components and inventory. In addition, there is the possibility that the company's attempt to shrink the development and production cycle may lead to a slippage in quality. Because of the high specification demands of customers, any deterioration in quality would likely create a ripple effect across customers and future orders. As unlikely as these scenarios may seem, they must still be considered. After all, few companies (or shareholders) actually plan to let quality slip. Implications for valuation: higher risk and cost of capital.
Finally, management has consistently articulated a "growth-through-acquisition" strategy. Inherent in that strategy is integration risk and the risk of overpayment. The larger the acquisition, the larger the risk. This is an especially applicable risk with the company's lofty 5 year revenue growth projections. In order to double revenues over that time period (particularly with the declines this year), it is very likely Altra will have to make at least one big acquisition, if not multiple large acquisitions. If/when this occurs, risk to cash flows will necessarily increase. Implications for valuation: higher reinvestment rate, but also higher overall risk and cost of capital over the mid-term.
When a company is currently facing a tough market or talking about doubling revenues, it is easy to get carried away in either a positive or negative direction. However, story alone does not dictate what a company is worth. In order to form a justifiable opinion, I used a perpetual growth discounted free cash flow model and two relative pricing methods to transform Altra Industrial Motion's story into numbers and derive a reasonable market price for shares. Here, I will elaborate on my methods, primary assumptions, and what influenced my judgments on each.
For the intrinsic valuation of AIMC, I used a three-stage (growth, transition, and growing perpetuity) discounted free cash flow to the firm model. The company's operating cash flows were valued as a going concern and discounted back at an estimated cost of capital. Cash was added back, and debt, capitalized operating leases, and current pension obligations were subtracted out to arrive at a complete value of equity. Total equity value was then divided by the current complete number of shares outstanding to arrive at a value per share.
Though Altra's end markets are quite diverse, the company's revenues and earnings are clearly cyclical. However, for the base valuation I did not normalize operating income or capex/acquisitions as I will include that as a second valuation. This decision was made in light of what may be a lengthy downturn in the commodities related industries. I did, however, remove restructuring charges from operating earnings as the company has not shown a tendency to use these charges on a steady basis to cope earnings. Operating leases were capitalized, as they are, after all, interest bearing contractual obligations with corresponding long term assets. And finally, I converted the company's research and development expenses into capital expenses and intangible assets (amortized over 10 years). The reasoning here is that this spending is designed to benefit the company over a period longer than the next 12 months and is therefore a capital investment with corresponding intangible assets. This conversion is necessary to receive an estimate of the quality of these investments and assets in order to more accurately calculate reinvestment and return characteristics. In AIMC's case, this conversion added over 33% to the overall value.
For many practitioners, deriving the cost of capital, or discount rate, is a menial task requiring only the use of a generic, intuitive, historical, or outsourced number. However, as the discount rate can have a substantial impact on valuation, I prefer to spend a reasonable amount of time on this component in order to add forward-looking granularity and specificity to the process. That said, I use a modified, forward-looking CAPM, which is far from perfect and is not to be taken as an exact science or precise number. It is, after all, only one potential tool in this process. With that disclaimer in mind, I used the following process to find the market-neutral cost of capital: First, for the cost of equity, I derived a market-implied risk premium based on normalized existing cash flows (market dividends and buybacks), current risk-free rate, and current top-down projected growth of market earnings. In addition, I added a country risk spread for the revenues derived from outside of the U.S. Next, I used a bottom-up business beta from comparable companies within the machinery industry and levered the beta to AIMC's own adjusted debt-to-equity ratio. The reason for the business beta is twofold: 1) standard regression betas contain large standard errors rendering them near to useless on a standalone basis, and 2) ABCO's business mix has continually evolved and diversified through acquisitions over the regression period. Multiplying the equity risk premium by the computed beta and adding it to the risk-free rate sums to a total cost of equity.
Because AIMC is not currently rated by any of the major ratings agencies, I had to estimate a synthetic rating for the cost of debt. I based the synthetic rating on the interest coverage ratio and S&P's Credit Scenario Builder. I then used this synthetic rating (A-) to find an average option-adjusted risk spread over the risk-free rate. Although this is obviously an imperfect solution, I believe it is better to make an educated, data-based estimation than to simply make up a rating or cost of debt. Cost of equity and cost of debt are then weighted according to the market values of each, resulting in a total cost of capital of 7.57%. Shown below are the calculations.
By definition, sustainable growth of operating income can come from one of two places (or both): efficiency gains, and income from new investments (including capex, acquisitions, and new products). Higher margins and the ability to create more revenues from existing assets are both efficiency gains reflected in return on capital improvements. Investments in new products, services, or other assets using internal or outside capital are reflected in a company's reinvestment rate. Mathematically, this means growth is a function of return on investment and reinvestment rate. Growth cannot be obtained without affecting these two variables.
Altra's operating margins have been remarkably stable over the past 5 years, especially considering the negativity in many of their end markets. While sales/invested capital has declined somewhat, it has also demonstrated healthy capital efficiency in a difficult market. These factors combined have led to a fairly robust adjusted return on invested capital of 10.33% over the last 12 months. After converting R&D to capex, capitalizing operating leases, and adding acquisitions to capex, Altra reinvested just under 60% of adjusted after tax operating income back into the business. Again, it should be noted that I did not normalize this reinvestment for the base case valuation. Mathematically this leads to a smoothed growth rate of 6.09%. While this may seem aggressive given the current state of Altra's end markets, it is far lower than what will be required to arrive $1.5 billion in revenue within 5 years.
In traditional DCF valuations, the terminal value carries much of the weight. However, if discipline is maintained, there are substantial caps that keep the terminal value from getting out of control and over-inflating (or deflating) the valuation. Mathematically, for instance, a perpetual growth rate for any individual company cannot exceed the growth rate of the overall economy. Empirically, the 10-year U.S. Treasury bond is a more accurate proxy for the long-term nominal growth rate than economists' projections. Though it's still not perfect, it's better than simply making up a number. Because AIMC's growth rate is closely tied to U.S. GDP over long periods, I decided not to deviate from that pattern. Therefore, I used a perpetual growth rate matching the GDP growth rate projected by the U.S 10-year bond.
Far more important than the perpetual growth rate are the perpetual cost of capital and return on capital assumptions. For cost of capital, I assumed a partial reversion to the mean, moved the equity risk premium toward the long-term, adjusted geometric average (U.S.) of 4.61%, and maintained the existing country risk spread. I slightly lowered the current beta of 1.36 to 1.18 as old companies tend to become less volatile over time. For the cost of debt, I improved the current debt rating by one notch, reflecting that alike improved stability and subsequent ability to cover interest payments. Therefore, I applied the current A rated debt risk spread to the halfway point between the current risk-free rate and the long-term median interest rate of the U.S. 10 year government bond (3.87%). Based on a capital charter analysis, I also increased the debt ratio slightly to 40% as that is closer to the optimal structure but maintains some conservatism. Additionally, I used a long-term marginal tax rate of 35%, based on the company's geographical diversification and reinvestment into overseas subsidiaries. This resulted in a total, after-tax cost of capital in perpetuity of 6.76%.
Due to high level engineering, necessity of the company's products, and embedded replacement cycles, I expect Altra to maintain a slight excess return on capital versus their cost of capital in perpetuity. Therefore, I assumed a return on capital just above (+5%) the cost of capital at 7.09%, over 300bps below the current ROIC.
My last based-case intrinsic value for Altra Industrial Motion's equity after adding back cash and subtracting debt, capitalized lease obligations, and pension obligation is $752 million, or $28.61/share.
In order to differentiate between AIMC as it stands now and how the company looks when normalized across economic cycles, I separated the two scenarios into two valuations. For the normalized valuation I changed only the initial operating margin and capital spending. All other inputs remained the alike as the base case. For operating margins, I moved the trailing twelve months number upward by roughly 90bps 10%. This was just slightly above the decade mean, but still well below the group intend of 10.4% and management's goal of 15%. For capex, I moved the spending up to the decade intend as a percentage of revenue to account for somewhat lumpy acquisitions for the time period. The resultant intrinsic valuation in the normalized case is $934.6 million, or $35.56/share.
Relative pricing (aka pricing multiples) is different than valuation in the sense that pricing is based on similar assets or something else external to the company, while valuation is based on the risk-adjusted cash flows of the company itself. Both methods are useful, depending on the perspective that you take. For example, if you take the perspective of buying shares to later "flip" to some other buyer, pricing is more relevant. Conversely, if you take the perspective of ownership in the company, valuation is more relevant.
For relative pricing, I used two methods. In the first, I used the company's own historical high and low PE ranges over the past 10 years, and multiplied the median values of each range by a weighted average forward EPS estimate for AIMC. The estimate is based on the current analysts' ranges in order to reduce my own bias and to introduce current market expectations into the process.
The second pricing method was necessarily more rigorous than the historical PE. In this method, I used a multiple regression analysis designed to control for differences across comparable companies (as opposed to the opinion-based multiple applications you are likely to see elsewhere). In this method, I compared various price ratios (P/E, P/S, EV/EBITDA, etc.) and inputs (growth, operating margins, return on equity, etc.), and was able to identify which factors were most important to the overall market in pricing the comparable companies. For AIMC, I used a fairly narrow scope comp group made up of industrial machinery firms. The data showed that the price/book ratio was primarily tied to returns, margins, growth, volatility, and debt characteristics. In addition, the price/sales ratio was primarily dependent on growth, returns, and debt characteristics. PE was also predicted by many of the alike characteristics, but with far less statistical power.
In the weighting of the different pricing methods, I gave the regression-based methods a higher weight than the historical PE, because the regressions partially control for current, real differences across firms. Further, because of the price volatility inherent in cyclical companies, there is high standard error in the historical PE data.
Altra Industrial Motion is not a glamorous company, nor does it make products that most people get excited about. It does, however, make components that are necessary for many industrial applications. If you want exposure to renewable energy, Altra has it. If you want exposure to robotics, automation, and 3D printing, Altra has it. If you want exposure to water and wastewater treatment, Altra has it. The problem is, Altra also has exposure to industries that are currently out of favor and may remain out of favor for some time. That being the case, based on the available information and my own assumptions, AIMC appears to be both undervalued and underpriced.
Ultimately, the key questions on if or not to invest in AIMC are 1) Will end markets normalize over long periods of time or will they stay subdued indefinitely? And 2) Will the current restructuring actions create substantial operating leverage and cash flows if end markets do normalize? Based on history and current evidence, I believe commodity markets will come back over time and that Altra has made necessary long term improvements to take advantage. However, both will take time and that is where possibility cost comes into play. For traders who need a defined catalyst to drive the inventory up in the near future, AIMC is not a great target. In addition, downside risk to $20/share is a legitimate concern should the market sell off more aggressively. With those caveats in mind, I think Altra Industrial Motion is compelling enough to warrant consideration as part of larger, long term portfolio.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AIMC over the next 72 hours. (More...)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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