Allied Motion Changing Mix And Refinancing Opportunity Set Up 60% Return Potential

Allied Motion: Changing Mix And Refinancing Opportunity Set Up 60% Return Potential|Must Read May 16, 2016 7:30 AM ET

by: Lester Goh

Summary• The market is overly concerned regarding Allied Motion's exposure to

commodity-sensitive end markets, which is not that large of an issue.• Allied's product mix is shifting to more solutions-oriented sales, which are

better, stickier, less volatile, and higher margin.• Refinancing of $30m subordinated notes should add an incremental ~$1.6m

to 2015 net income.• Fair value of roughly $36, implying ~60% upside.

Allied Motion: Changing Mix And Refinancing Opportunity Set Up 60% Return Potent… Page 1 of 12

http://seekingalpha.com/article/3974928-allied-motion-changing-mix-refinancing-opportun… 1/8/2016

Due to its exposure to commodity-sensitive markets, the market is pricing Allied Motion (NASDAQ:AMOT) ("Allied", "AMOT", or the "Company") as if a shoe is about to drop any quarter now. I disagree.The Market Is Overly Concerned About Allied's Exposure To Commodity-Sensitive MarketsAmong the markets Allied serves, electronics and medical are doing fine and have helped offset lower demand from the vehicle, industrial, aerospace, and defense markets in 2015.The reason for the weaker performance from said markets is quite clear. They are commodity sensitive, and anything commodity sensitive has not done too well in recent years. As 2015 progressed, management became more cautious regarding its outlook.This is also reflected in its quarterly results - the Company barely generated any sequential growth throughout the first three fiscal quarters. Predictably, shares declined over the course of the year. The bad news came in fiscal 4Q, where quarterly revenue declined from ~$62m to ~$51m, or ~18%. Management cited that this sequential decline was primarily due to orders being pushed out to later dates. On a full-year basis, revenue fell ~7%. Adjusted for currency fluctuations, this number falls to ~1%.Undoubtedly, the concern here is whether another shoe is about to drop any quarter now. With shares still heavily depressed, the market is clearly worried. In my view, this concern is not entirely warranted.I think Allied's product lineup will be sticker following changes to the mix. The Company does not explicitly disclose mix so investors may not be focusing on this. However, if one observes management's commentary over the years, he would be able to discern the shifting mix. Investors seem unaware that this changing mix would dampen the effect of end-market downturns on Allied's business.Let's rewind the clocks back to 2009. Allied did ~$86m in sales in the prior year. Then, the financial crisis hit and sales cratered, falling nearly 30% in 2009. In 2010, revenue rebounded to ~$81m. But that's not what caught my attention.



The ~700bps improvement in gross margins peaked my interest. The 2010 10-K mentioned that the improvement in gross margins was due to the sale of higher-margin products. Higher-margin products in the context of Allied and its peers refer to more solutions-oriented sales.

Allied Motion Gross MarginsYear 2011 2012 2013 2014 2015Gross margins 30.2% 29.1% 29.1% 29.4% 29.6%

Source: Company filingsSince 2010, progress on gross margin expansion has stalled, but that was due to lower fixed overhead absorption due to lower sales (2011-2012) and less sales on lower-margin products offsetting greater sales in higher-margin products (2014-2015). There is reason to believe that current gross margins are not "terminal" margins.According to the Allied 10-K, it competes with Ametek's (NYSE:AME) EMG segment, Danaher Motion (NYSE:DHR) - the automation business (part of the industrial technologies' division), and Parker Hannifin (NYSE:PH).From its low-20s gross margins, one can infer Parker Hannifin (NYSE:PH) sells fairly commodified stuff to countless markets (just look at its 10-K). But Parker can do well because its massive scale and decentralized operating structure keep costs down and learning curves stemming from its huge cumulative volume protect profitability. However, due to the commodity nature of its products, sales are highly volatile - just look at its numbers.Ametek's precision motor product line is probably the most similar to AMOT's, but it is slightly more nichey and thus it does 34-36% gross margins. Now, this is on a consolidated basis, and EMG does ~20% operating margins while EIG (the other Ametek segment) clocks ~25%. So EMG's gross margins are probably a bit lower than the consolidated number, assuming a similar amount allocated to SG&A. However, while Ametek and Allied attack similar sub-segments, AME goes after



relatively larger customers - the markets AMOT serves are likely too small to warrant any significant attention by Ametek. Sales are much less volatile as compared to PH.Danaher Motion does the super-nichey stuff in that it offers fully-integrated solutionsinstead of individual components, and that is why it can get 50%+ gross margins. This is also a consolidated number, but its industrial tech segment does ~25% operating margins, and with nearly ~30% of sales allocated to SG&A, it is not a stretch to say Danaher Motion has the highest gross margins amongst the bunch. Sales here are the least volatile. Note that industrial tech has other segments as well, so it is not a perfect comparison. But it does get the idea across.The point of this comparison is to illustrate that focusing on solutions is much better, stickier, less volatile and higher-margin. Allied used to focus a lot on individual products, but in recent years, it has shifted its strategy to a more solutions-orientedmodel, which carries higher margins.Selling individual components is not really that good - it tends to utilize just one of the Company's technologies and not only carry lower margins, but are also the stuff that gets skimped on first when times are rough.Selling an entire solution which utilizes multiple Allied technologies which is customized to individual customer requirements - thus less likely to cut during end-market downturns - is much better, stickier - and the margins reflect that. This is primarily because such solutions are purchased with a long-term view, and thus they do not tend to be cut when temporary downturns occur.So with gross margins approaching 30%, although we cannot know the exact mix of solutions-oriented sales, we know intuitively that they comprise of a significant percentage of the total. The Company also mentions that the majority of its new opportunities are solutions oriented, so we know that that part of the mix will grow and act as a gross margin tailwind. Its acquisitions also reflect this shifting focus - the recent Heidrive purchase was done to expand Allied's solutions capability, according to the CEO. Moreover, the Company now has three solutions centers which design this stuff - one in China, another in Sweden, and the last in New York.



How high can gross margins go? Well, Ametek's offerings of precision motors look pretty similar to Allied, and earlier we discussed that AME's EMG segment probably does slightly lower gross margins than the consolidated 34-36%, so 32% does not seem overly optimistic.Moreover, Allied discloses in its 10-K that most of manufacturing facilities are operating at less than full capacity. So there is also gross margin leverage that should help margins expand here. All in all, a gradual expansion to 32% gross margins seems like a fair assumption.Now, the market believes that a shoe is about to drop any quarter now - I clearly have the opposite view. But don't take it just from me. Market research firms such as Allied Market Research (no relation to AMOT) see the overall market as a ~5% long-term grower.Normally, I wouldn't place too much weight on these forecasts, but from Allied Market's commentary, it seems like most of the growth is driven by replacement demand, which tends to be more robust. It mentions that newer and more energy-efficient motors, while more expensive as compared to conventional motors, offer long-term environmental benefits and cost savings.So companies are looking to replace old motors with more energy-efficient ones. Some may certainly argue that with energy prices (oil, natural gas, etc.) at where they are right now, this argument is less valid. But this is quite beside the point.Companies are not expecting energy-efficient motors to provide them with short-term payback, but instead they are looking at medium- to longer-term payback periods. While Allied's larger peers (Ametek, Danaher, etc.) would likely be a beneficiary of large contracts, Allied would probably do fine with the relatively smaller (but still meaningful as Allied is fairly small itself) addressable market.A similar view is also reiterated by the Company itself. While AMOT does not issue guidance, its quarterly earnings presentation (specifically 4Q '15) mentions that "new program wins" will help "drive organic growth in 2016." Management does not offer such hints often, so it seems likely that it would not state this so explicitly unless it was very confident about its outlook.



Allied also amended its credit agreement in January this year to up the revolving credit facility limit from $15m to $30m and the foreign revolving sublimit from $10m to $25m. As Allied's FCF is solidly positive, it appears that the most likely reason for this change in credit terms would be to finance future growth.Getting Into The Numbers: 5% Top-Line Growth + Gross Margin Expansion + Overhead Leverage = 60% UpsideOn to overhead. SG&A has been relatively consistent in absolute terms, adjusted for acquisitions. As a percentage of sales, the figure has come down from ~17% at the start of the decade to ~13% at the current time, with ~3.5% allocated to selling and ~9.5% allocated to G&A. This can be largely attributed to the Company's lean improvement initiative, called Allied Systematic Tools by management. For those who are unfamiliar, AST is quite analogous to the Danaher/Colfax (NYSE:CFX) Business System at Danaher/Colfax, the 80/20 management process at ITW, and so on.Ametek's SG&A, as a percentage of sales, is ~11%. As for Allied, the Company has less scale as compared to Ametek, so its SG&A per unit will likely be higher. I assume it stays at 13% of sales.As for R&D, this is quite simple to project given that it has hovered around 6% of sales in recent years, and the Company has guided for it to stay at that range.So with gross margins expanding to 32%, SG&A staying at 13% of sales, R&D remaining at 6% of sales, and amortization staying flat (it seems depreciation is embedded in other line items), Allied should do ~12% operating margins in a couple of years.Ametek does ~23% operating margins on a consolidated basis, so the EMG segment is probably in the high-teens, assuming a similar amount of SG&A allocated to both segments, so these expectations are not exactly unreasonable.Below the operating income line, there is room for improvement as well. The Company has a $30m senior subordinated note outstanding at a 14.5% interest rate - 13% cash, 1.5% payment-in-kind. Looking at the rate relative to Allied's other sources of financing, this seems fairly high and could probably be brought down quite a bit with a refinancing.



The Company issued this note to fund the Globe acquisition in 2013. While this is clearly expensive financing, it seems well worth it. The acquisition doubled the top line, gave Allied a global reach, and allowed the combined firm to reap savings stemming from the consolidation of production facilities and raw material sourcing.Perhaps most importantly, the acquisition provided Allied with high-margin offerings such as integrated feedback devices and controls - again, focusing on solutions-oriented stuff, not individual components.Anyway, the interesting thing about this note is that the Company has an option to prepay the principal amount at any time after October 18, 2016. With the fiscal year ending in December, this date corresponds to 4Q '16. As the Company has just ~$6m in cash on hand as of 1Q '16, it is highly likely that Allied will refinance this note, instead of paying it off in full.The question then turns to - what kind of rates can Allied get on the refinancing? I believe that looking at the rates of the other debt obligations in its capital structure is instructive. Apart from the sub notes, the Company has a term loan at a 2.2% rate - the effective rate is actually closer to ~2.7% due to the impact of hedges.However, I doubt Allied can get a similar rate on its sub note because the term loan is secured by substantially all of the Company's assets, whereas the sub note is not - it is instead unconditionally guaranteed by some of the Company's subsidiaries.Allied also has a China credit facility, which it recently refinanced in 4Q '14 at a 6.4% rate. As the Company's net debt/EBITDA has not changed meaningfully - at 4Q '14 it was just south of 2x and now it is closer to ~2.1x, including the contribution from the Heidrive acquisition, which closed in January this year.(In response to an analyst question, management mentioned on the 4Q '15 call that the Heidrive acquisition has gross and EBITDA margins comparable to that of the Company. Heidrive did ~$32m in revenue in 2015. So at comparable EBITDA margins (~11%), the acquisition should contribute ~$3.5m in incremental EBITDA, assuming no growth from 2015 levels).The point I am getting at here is that the Company's financial leverage has not changed meaningfully since the 4Q '14 refinancing. Hence, it seems fair to assume that Allied would be able to get a similar rate in the upcoming refinancing of the sub



note. I assume a 7% rate, which reduces interest expense by ~$2.25m pre-tax, and adds an incremental ~$1.6m to net income at a 28% tax rate ((30*(0.145-0.07)*.72)).



Source: Company filings, author's estimates/calculationsKey assumptions are: 5% top-line growth, gradual expansion to 32% gross margins, 13% SG&A as a percentage of sales, 6% R&D, flat amortization expense, a ~$2.25m decrease in interest expense due to sub note refinancing, and a 20x P/E multiple. The rationale for these assumptions - excluding the P/E multiple assumption - has been articulated in prior paragraphs. Note that of the ~19.5% jump in revenue growth for 2016P, ~14.5% stems from the Heidrive acquisition. Also note that Heidrive grew sales by ~8% in 2015, so my 5% rate seems conservative.The reasoning for the 20x P/E multiple - a three-turn discount from the S&P 500 - is fairly simple. A firm with a multi-year earnings growth profile in excess of 20% should command a multiple that at least matches the S&P 500. As S&P 500 earnings will likely grow at 3-5% in the long run, one could plausibly argue for a multiple at a premium to the market - I do not. Instead, I assign a three-turn discount to account for customer concentration risks, among other risks.Furthermore, such a multiple is grounded in reality in that the market has historically assigned a much greater multiple to the stock when it had a similar net income growth profile. During the 2014-2015 period, Mr. Market awarded Allied a mid-twenties P/E multiple when its rolling three-year average annual net income growth was in excess of 20%.



While in absolute terms the multiple may appear aggressive, the Company has the advantage of a low starting point (i.e. its current margins are unlikely to be its "terminal" margins), thus making the multiple expansion story highly plausible. Bottom line, a 20x P/E multiple seems quite reasonable (and also matches the 2015 P/E multiple, excluding the Heidrive acquisition), and would imply ~60% upside from current levels. Even with much more modest multiple expansion (i.e. a 15x multiple), upside is still a decent amount at ~20%.

Source: Company filings, author's estimates/calculationsTo summarize: at ~12x 2016P P/E, you get a business that is slowly, but surely, improving its franchise through its continued focus on higher-margin, better, stickier offerings, with a long-term growth trajectory that seems fairly certain, as it is largely grounded in replacement demand, which again tends to be far more robust than "growth" demand.Catalysts

• Consecutive quarters of improving financials: Such a scenario should invalidate the bear case and assuage investor concerns of the Company's exposure to commodity-sensitive industries.

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• Sell-side initiations: The Company is scheduled to present at a Houlihan Lokey conference just a week from now, which could attract both sell-side coverage as well as investors. The Company has not presented at a conference for a number of years.

• Refinancing in 4Q '16: As discussed, if the Company manages to refinance at rates that are in line with my expectations, this should add ~$1.6m in incremental net income, or ~$0.17 per share.

• Continued debt pay-down: Note that the Company has been paying off $5m-7m in debt annually in recent years, reducing interest expense by ~$400k per annum, and adding ~$300k in net income at a 28% tax rate. Further debt paydown seems likely given that FCF is solidly positive and would serve as incremental upside to my earnings estimates.

Risks

• There is always the risk of losing major customer accounts. In my view, this is heavily mitigated by the increasing sales to larger customers in recent years, which signify greater commitments by customers. Customer concentration is a huge risk if the stuff you're selling is mostly discretionary and where the purchase decision is predicated largely on price and near-term outlooks, but as discussed, this is not the case for Allied.

• The long thesis depends heavily on the top-line growing and gross margins expanding due to changing mix and manufacturing leverage, so if there are persistent declines in sales, a major leg of the long thesis will be materially impaired.

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.



Additional disclosure: Disclaimer: The author's reports contain factual statements and opinions. He derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. His reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester") accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. Lester advises readers to conduct their own due diligence before investing in any companies covered by him. He does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.



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Allied Motion Changing Mix And Refinancing Opportunity Set Up 60% Return Potential