These Two Industrial Standouts Merit a Closer Look
(Bloomberg Opinion) -- Some companies are known for being good operators, others for being good at M&A; the one that can do both is uncommon indeed, but it just so happens that we heard from two such rare birds this week in TransDigm Group Inc. and Fortive Corp. Amid warnings of a slowdown and plenty of results that were only "better-than-feared," these companies reported earning that stood out for organic growth and profitability gains that were genuinely strong, making their rich valuations look justified. It’s as good an opportunity as any to dive deeper into their business models.
TransDigm gets most of its revenue from proprietary aerospace parts, meaning it controls the patents and intellectual property behind the components and is often the sole provider of them. That gives it significant pricing power, as evidenced by its 49 percent adjusted Ebitda margin in fiscal 2018. TransDigm’s private equity mentality and capital structure has led to at least 30 publicly disclosed acquisitions over the past decade, the biggest of which was its October agreement to acquire Esterline Technologies Corp. for about $4 billion. Fortive, meanwhile, is aggressively transitioning away from the cyclical, mediocre-growth industrial assets that Danaher Corp. put into the business when it spun it off in 2016. In its short lifetime, Fortive has announced a reverse Morris trust combination for some of its automation businesses with Altra Industrial Motion Corp., as well as more than $6 billion in takeovers in the medical-sterilization, gas and radiation-detection equipment and software markets. The upheaval has made its recent quarterly reports messy, but the Danaher heritage of steady margin gains and strong cash-flow generation has remained intact.
This growth by M&A strategy comes with risks. Fortive paid dearly for its recent acquisitions, even going so far as to extend its return horizon to support its September purchase of facilities and asset management software provider Accruent for $2 billion. TransDigm’s Esterline acquisition is likely to be a drag on margins, as the target company gets a lower share of its revenue from the more profitable after-market. But both M&A strategies seem geared toward building a more defensible revenue stream. In Fortive’s case, that means sales that are less likely to dip precipitously in a recession; in TransDigm’s, that means building a stronger base of intellectual property that can resist Boeing Co. and Airbus SE’s efforts to squeeze costs out of suppliers. If anyone can pull off a good takeover, it’s these two companies.
Arconic Inc. on Friday said it would spin off either its engineered products unit or global rolled products division. I had predicted such a split may be in the works earlier this week after the company abruptly rejiggered its leadership team just two days before it was scheduled to release earnings. It’s still unclear whether former CEO Chip Blankenship had simply had enough after Arconic’s buyout negotiations with Apollo Global Management collapsed at the one-yard line, or if he was a sacrificial lamb. Not even a takeover premium could put Arconic shares at the $33 level that Elliott Management Corp. said was achievable with only “modest improvement” as it launched a proxy fight in 2017. A breakup is the most logical path at this point, but it’s also a sign that the company is out of better ideas. The units Arconic will split apart rely on different manufacturing processes and have different margin profiles, but both make variations of aluminum parts, so this feels like financial engineering taken to an extreme. Recall that Arconic is itself the product of a breakup of Alcoa. Elliott could still prove out its thesis with margin gains at whatever remains of Arconic. But it’s hard not to think companies will be skeptical the next time it comes knocking with talk of an operational-focused turnaround.
SLAP ON THE WRIST
General Electric Co. will have to pay a $57 million fine to France after falling short of a hiring pledge it made to obtain regulatory approval for its doomed purchase of Alstom SA’s energy assets. GE’s vow to create 1,000 net jobs is just one example of the ill-advised concessions former CEO Jeff Immelt made as he doggedly pursued the takeover. The fine is a drop in the bucket relative to the $22 billion writedown GE booked in its power unit last year, mostly because of that deal. But it underscores the challenges GE faces in reducing the bloat in its power unit as it grapples with government and union forces. The deterioration in the power division’s cash flow amid a heavy restructuring lift magnifies the “execution risks” for GE’s deleveraging plan, Fitch Ratings said this week as it revised its credit outlook on the company to negative. Fitch expects GE's free cash flow “will be well below industrial peers for the next two to three years before restructuring is fully effective.” I agree, and I remain puzzled as to why CEO Larry Culp’s forecast for substantial free cash flow growth in 2020 and 2021 was taken at face value despite the lack of 2019 guidance.
DEALS, ACTIVISTS AND CORPORATE GOVERNANCE UPDATE
Eaton Corp. agreed to pay $214 million for an 82.3 percent stake in Turkish switchgear maker Ulusoy Elektrik Imalat Taahhut ve Ticaret A.S. (say that ten times fast). The price works out to just under 6 times Ulusoy’s trailing 12-month Ebit, a discount to the median multiple paid for electrical-equipment deals over the past decade. Asked about its attitude toward M&A on its earnings call last week before the Ulusoy deal was announced, Eaton CEO Craig Arnold said he sees “more opportunities and more deals than ever,” but pricing can be challenging. The priority is bolt-on acquisitions that compliment Eaton’s existing business (the Ulusoy deal will expand its access to the medium-voltage market in Europe, the Middle East and Africa). After the Ulusoy deal, Eaton will still have $800 million in M&A firepower to put to use.
Siemens AG ‘s bid to merge its train operations with Alstom SA was blocked by European Union antitrust regulators who defied calls from Germany and France for the creation of a national rail champion in the face of growing Chinese competition. My Bloomberg Opinion colleague David Fickling points out that for all the hand-wringing, revenue for China’s CRRC Corp. is mostly domestic at this point and Alstom and Siemens’s rail businesses having been performing quite well. But if growing competition from the Chinese in Europe does come to pass, Siemens and Alstom will have only themselves to blame. Both agreed to technology transfers as part of China supply contracts they were only too happy to tout at the time they were announced, David writes. EU antitrust chief Margrethe Vestager said she would be willing to reconsider a combination if Siemens and Alstom proposed a new format that addressed regulators’ concerns about overlap in very high-speed train technology and signaling.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.
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