By: Scott Davis
When we downgraded CFX to UW back in September, we were concerned about a structurally challenged portfolio, deteriorating earnings quality/FCF and a stock valuation that didn’t seem to reflect this reality. Today’s announced acquisition of orthopedic device maker has spooked the market (pro forma leverage approaching 5x, plus equity dilution of ~20%, stock off 15%), but will reduce cyclicality and improve the margin/FCF profile of the pro forma entity. It’s a playbook pursued by the other Rales brothers’ companies Danaher and Fortive to great effect. Though DHR/FTV never stretched this much on financing to do a deal. Importantly for CFX however…it helps buy time to divest the Howden fans/compressors business, which has been the problem child in the portfolio. With the stock underperforming the XLI sharply since our downgrade, and a less cyclical/higher cash generating pro forma business, we are upgrading to Neutral from UW. And we could make an argument for further upgrades if management execution improves.
As for the early read on the DJO acquisition…the business seems to have had some challenges under Blackstone’s ownership. The headline sub-12x EBITDA multiple (and lower if backing out the $800M tax loss carryforwards) also strikes us as unusual for a business with gross margins north of 55% and a FCF margin (% of sales) in the low to mid-teens. Hard to know why this business went to CFX and not another strategic (could have fit at Danaher or 3M, for example). But if CFX management can improve growth and margins, it could create outsized value. If nothing else, the business will materially change CFX’s cyclicality and return profile. Skeptics will view the pro forma 4.7-4.9x leverage as too much if we enter a downturn, and we can understand the concerns. However, we see a welding business that’s just coming out of recession, a coal power business that’s already in one, and the new orthopedic business should not carry any real cyclicality.
Post today’s stock drop, shares now trade at only 8x pro forma EV. That’s 5 turns of debt and 3 turns of equity. If CFX can de-lever quickly, there’s a lot of upside for the stock. And industrial de-levering stories overall typically work. Accretion from debt to equity holders is a big opportunity though, as noted above. Monetization of the Howden asset could accelerate this de-levering process, though we aren’t giving CFX any credit here in our model. It’s hard to know if Howden has much of a market value here. Our guess is that Colfax holds it through the other side of the cycle – the Charter deal has been a failure and hurt the firms credibility – however there seems to be no reason to “fire sale” the asset. Longer term disposition seems likely and if CFX can rotate out of “crap” and into good stuff – much like Fortive and Danaher have done over time, the net result should be favorable.
In any event, we close out our negative call on CFX today. We see limited downside for longs, limited upside for shorts. We move to the sidelines with a bias towards being more positive if valuation remains this depressed.