Investors will notice a name on the top gainers list today that they probably do not recognize. Hydraulic and electrical component maker Sauer-Danfoss (SHS) is getting its day in the sun on the back of a surprisingly strong fourth quarter and solid guidance for the next year. For better or worse, though, this company has virtually no coverage and no analyst support – perhaps explaining why it is one of the relatively few under-priced industrials with exposure to markets like mining, construction and agriculture.
Better Growth Across the Board
By almost every metric, Sauer-Danfoss posted solid results for the fourth quarter. Sales jumped 54% as reported, or 56% on a currency-neutral basis. Sales rose 53% in the Americas, 42% in Europe, and doubled in Asia. Looking at the results by market segment, “propel” saw growth of 71%, “work function” saw growth of 49%, and “controls” saw growth of 33%.
To put that in perspective, Caterpillar (CAT) reported 62% sales growth in its latest quarter, while Deere (DE) revenue rose 27%, while component companies like Eaton (ETN) and Parker Hannifin (PH) saw growth of 17% and 22%, respectively.
Going a step deeper, aerial work machines (like those sold by Terex (TEX) and Oshkosh (OSK)) were a big driver in the material handling space, as demand in Brazil and China continues to be strong. Construction, road-building and agriculture markets were all also strong contributors to the quarter, as well as secondary markets like mining.
Sauer-Danfoss also reported that orders jumped 81% from the year-ago level to $578 million, a number that also translates into 42% sequential order growth.
Stronger Profitability as Well
With stronger revenue came stronger profits. Gross margin jumped significantly from the year-ago level and added over 100 basis points from the third quarter to reach 31.4%. Operating profits were likewise much better as SG&A spending actually declined from last year. Adjusting for some items, the company added about 40 basis points of operating margin on a sequential basis and ended the quarter at 16.5%.
Not only was business stronger this year, but the company's efforts to reduce working capital needs and capital expenditures went ahead of plan. Consequently, free cash flow jumped to $235 million, or more than 14% of sales. The company's focus on paying down debt also succeeded, to the tune of $257 million.
The Road Ahead
When I write about Sauer-Danfoss I am clearly talking my book, as I do own shares of this company. I would suggest, though, that there is a lot to like in an under-followed industrial company that restructured itself just in time to take advantage of a big upswing in capital equipment markets. Moreover, with guidance of 10-20% revenue growth and a recent history of delivering at or above the high end of expectations, earnings momentum seems to be in place as well.
Beyond this, the company's management seems to have seriously reconfigured the company's operations. Not only did management sell some businesses, but it has attempted to make the manufacturing process more flexible and less capital intensive (by outsourcing more machine tool work, for instance).
Of course there are threats and risks to consider. Strong growth in China and Brazil underpins a lot of the company's recent growth and Brazil's recent rate hike is yet another sign that major emerging economies are still concerned about inflation. What's more, the sustainability of strength in road-building is an open question given the severe financial difficulties of many state budgets, to say nothing of other Western countries as well. It is also worth noting that Danfoss A/S owns more than 75% of the company.
The Bottom Line
All of that said, I cannot resist a bargain in a sector that is still seeing strong order flow. Sauer-Danfoss has not yet regained its peak sales level and I am only looking for 7% annual revenue growth over the next five years. Moreover, while I do believe the company will improve upon its historical free cash flow margins, I do not expect 2010 to be the norm and project only high single-digit free cash flow as a percentage of sales. With all of that in place, then, and a market-average discount rate I come up with a fair value of $49 – still not a bad target even after Thursday's big leap.
With names like Titan International (TWI), Cummins (CMI) and Gardner Denver (GDI) (a supplier to the energy industry, but industrial nevertheless) already having done so well and carrying double-digit EV/EBITDA ratios, Sauer-Danfoss seems cheap by comparison and poised for better days. It is still a cyclical industry and it has much to prove before belonging alongside Cummins in terms of quality, but this looks like a risk-reward set-up tilting toward “reward."
Disclosure: I am long SHS.
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