Investors in Pentair (NYSE:PNR), which have not paid too much attention to recent developments, came in for a shock when seeing the stock dive. The lower price of Pentair is artificial as the company has spun-off the electrical business which is now called nVent.
Like in many cases where a company is being spun off from the “mother” business, its valuation looks relatively appealing, as this is the case with Pentair麓s spin-off nVent as well, at least in my opinion. While the pro-forma earnings power is still not 100% clear to me, nVent looks to be valued at rather attractive multiples, making me a buyer if shares dip toward the $20 mark.
The Spin-Off Details
A while ago Pentair decided to spin-off the electrical business in a one-for-one exchange ratio. The reason behind the separation is very clear and comes straight out of the textbook as both individual businesses have greater strategic focus and can control their own capital allocation.
nVent is the former electrical business of Pentair which focuses on connection and protection while it generates $2.1 billion in annual sales. Roughly two-thirds of these sales are generated in the US and Canadian market, complemented by a sizeable presence in Europe and a more modest presence in developing countries.
The company is comprised out of three segments of whichmakes up nearly half of total sales. This is complemented by a 30% revenue contribution from the thermal management business and little over 25% contribution from electrical and fastening solutions segment. By far the most important end market is the industrial segment which is seeing real momentum, complemented by commercial and residential, energy and infrastructure markets.
Within each of these segments, the company has strong brands and market positioning, translating into appealing margins. The company posted segment earnings (under the ownership of Pentair) of $410 million in 2017. Management of the new business sees sales growth of 3%-5% in 2018 and segment earnings of $430 million this year.
With 181 million shares outstanding and an interest bill of $43 million, as well as a 18% tax rate, the company is projecting adjusted earnings of $1.70-$1.80 per share this year. That works out to roughly $317 million in absolute terms. With shares trading at $22 following separation from Pentair shares look (optically) cheap.
Based on expected reported earnings (based on GAAP accounting) of $1.38-$1.48 per share, the multiples still look pretty reasonable at 15-16 times. It should be stressed that the vast majority of the discrepancy between GAAP and non-GAAP earnings relates to non-cash amortisation charges.
The company is furthermore looking to pursue bolt-on deals in order to accelerate growth, while targeting a leverage ratio of 2.0-2.5 times, as current pro-forma leverage of 2.2 times fits right within this range. The 篓freed篓 management team could really boost value creation, although it should be said that margins of the business are quite high already at 19.5% of sales, coming in at the high end of the peer range.
Based on the quality of the underlying business, steady organic growth, reasonable leverage profile following the separation, and the solid earnings power (with adjusted earnings approaching cash flows of the business), I do find appeal at the valuation at which nVent trades today.
There’s a big caveat, however. In the deal presentation, management of nVent bases its earning power for 2018 on the segment earnings reported, as this number needs to be reconciled with real operating earnings of the new company, no longer part of a larger conglomerate.
To put the numbers into perspective: Pentair麓s water business posted segment earnings of $546 million in 2017 as the electrical business posted earnings of $447 million, for combined segment earnings of $993 million. At the same time, reported operating earnings of Pentair only came in at $680 million, suggesting a corporate cost allocation of $313 million. With the electrical activities making up 42% of total sales, the corporate cost allocation suggests that $131 million might be attributable to nVent.
If we use the $447 million segment earnings reported by the electrical business and allocate $131 million of the corporate cost allocation to this segment, as well as factor in $43 million in interest and apply a 18% tax rate, earnings come in closer to $224 million, for an earnings number of just $1.24 per share.
Depending on your preference for GAAP or non-GAAP accounting metrics, as well as the allocation of corporate costs, realistic earnings are seen anywhere between $1.25 per share and $1.75 per share, as this remains a “show me first” story to me. Trading at $22, multiples look very appealing if earnings are achieved at the higher end of the range, although the valuation is much more in line with the market in case corporate cost allocations really hurt earnings of nVent, much more than “suggested” by management in the spin-off presentation.
While I’m quite upbeat on the prospects for nVent and the non-demanding multiple, I’m not pulling the buy trigger yet as I’m anxious to learn more about the pro-forma profitability of the business going forward, fearing that corporate cost allocation might leave investors with a small negative surprise compared to the communicated pro-forma numbers, although valuations would remain very reasonable if that were to be the case.
Nonetheless the valuations are not that demanding as its parent company Pentair. With communicated non-GAAP earnings power of $1.70-$1.80 per share, the multiples are very reasonable as shares trade around the $22 mark while its parent company trades around $44 per share with adjusted earnings seen at just $2.30-$2.35 per share.
Traditional literature dictates that these businesses (which are spun off) are typically great investments as shareholders in the 篓past篓 parent company are looking to sell their holdings as they are not as familiar with that investment, the valuation of that company does often not meet certain minimum capitalisation requirements, and a 篓freed篓 management team often has many levers to pull in order to create value, although it cannot be reasonably argued that nVent is mismanaged given its fat margins.
For now I’m looking for more information on the real earnings power before buying at these levels.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NVT over 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.