I know it’s a corporate-speak cliché, but there really is something to notions like “under-promise and over-deliver” and “plan the work, work the plan”, and I think you see some of the benefits already at GEA Group (OTCPK:GEAGY) (G1AG.XE). Although I saw relatively modest near-term upside before if management “only” hit the initial targets, execution on the turnaround plan has been better than expected, and the more ambitious targets that I mentioned in that piece are now relevant to the conversation.

There’s still a lot of work to be done. While management has already largely decentralized the operations, the divestitures haven’t really even started, and certain projects, like the turnaround of the Liquid & Powder Technology segment, are going to take years as new management works through bad projects on the books. Still, there is a credible plan here, and I like management’s decision to focus on food, beverages, and pharmaceuticals as future growth drivers (not unlike SPX FLOW (FLOW)). With low single-digit revenue growth, mid-single-digit FCF growth, and high single-digit adjusted operating margins supporting a fair value more than 20% above today’s price, I still think this is a name worth considering.

F&B Isn’t Cyclical … But It’s Also Not Fully Immunized

As a provider of capital equipment to primarily food & beverage markets (including dairy producers and processors), it’s tempting to think of GEA Group as more or less acyclical, and it is true that companies like Alfa Laval (OTCPK:ALFVY), SPX FLOW, and others do see less cyclicality than, say, welding or machine tool companies, but they’re not immune to economic cycles. To that end, food and beverage companies are still sensitive to consumers trading up/down in good/bad times, and likewise have their own balance sheet concerns, and sectors can go through their own boom/bust cycles (like dairy).

So, it wasn’t a total surprise that GEA Group’s orders declined by about 8% in the second quarter, and that was about 2% worse than analysts expected. Separation and Flow (down 10%) was hurt by weakness in oil/gas and marine (about 6% of total company revenue exposure), but only Farm Tech saw order growth (up 2%), with Liquid & Powder down about 7%, Food & Health down about 13%, and Refrigeration down 28%.

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Dairy capex investment remains low, and I believe the cycle is bottoming out, particularly with recent bankruptcies like Dean Foods (well, if within the last twelve months is “recent”) and Borden. As I’ve discussed in prior pieces on GEA Group, there was a boom cycle in dairy processing, largely driven by Chinese demand for products like infant formula. While liquid milk consumption will likely continue to decline, dairy byproduct demand growth should continue to grow, and this should be a low-to-mid single-digit growth business for GEA Group – although I do see management looking to exit certain parts of the dairy business, including the Farm Tech segments.

As for other food/beverage categories, brewery capex spending is currently quite weak, but that will need to reverse if the companies are going to continue to satisfy demand growth, particularly in emerging economies. One of the more exciting growth areas over the mid-term is in what I’d call “plant-based alternatives” – meat and dairy substitutes made from plants – and GEA Group has top-three share across the equipment range, competing with companies like John Bean (JBT) and Marel in some categories.

I’m also intrigued by what GEA Group could do over the longer term in pharmaceuticals. This is around 5% to 10% of the business today, with GEA Group providing equipment for functions like granulation and tablet-forming, lyophilization, liquid/powder processing, and liquid handling. I don’t believe GEA Group wants to get into bio-production (where companies like Danaher (DHR) and Thermo Fisher (TMO) compete), but there are a lot of opportunities to automate pharma production processes and acquire into important equipment categories for a range of drug categories.

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Lots Of Work Still To Do

New management has only been on the job at GEA Group for a little over 18 months, and turning around a company with GEA’s issues is a multiyear project. The decision by former management to centralize the company created a bloated white collar infrastructure with very little responsibility for financial performance. They also made a series of poor deals, let product development and quality slip, and chased big-ticket revenue projects without much discipline, leading to a loss-making order book.

The centralization/decentralization issue is already being addressed, and there will probably need to be more headcount reductions at the mid-executive level. Project selection criteria have already improved, though, and managers now have a great deal more personal responsibility, which helps guard against booking deals with poor return prospects.

GEA Group management has yet to really start getting out of low-return businesses, and I expect that will be the next phase. Management has already identified businesses amounting to about EUR 200M-300M to be divested, and believes they can sell at least EUR 100M’s worth this year (calendar 2020). That may prove to be ambitious given challenges created by COVID-19, but I also believe the longer-term divestiture opportunity is larger than what management has initially identified. As they work toward their 11.5%-13.5% 2022 overall EBITDA margin target, I believe additional businesses with poor margin / long-term return prospects will be sold.

Management is also willing to start buying, and the balance sheet is pretty clean. Food, beverage, and pharmaceuticals are the target markets, and management would like to do larger deals (triple-digit millions of euros in revenue). I believe the former management’s strategy of small tuck-in deals led to a lot of “clutter” in the business; small tuck-ins are fine, but they don’t work well in structures with weaker segment-level executive accountability.

The Outlook

I do still see some risks in the dairy cycle, and with various parts of the dairy chain making up around 30% of the business, that’s not a trivial concern. I’m less concerned about capex spending in the food/beverage or pharmaceutical space, there will always be areas of year-to-year weakness, but I don’t see any structural issues.

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I haven’t really upgraded my revenue growth expectations for GEA Group, and I’m still looking for long-term revenue growth of around 3% to 4%, excluding acquisitions and divestitures. I’m also still expecting FCF margins to eventually get into the low double-digits, but it will likely take a while, and I think FCF margins will likely average out in the mid-to-high single-digits over the next decade. Given that this would still represent below-peer performance, this is likely the area/source of greatest upside if management can drive even greater cost reductions and business restructurings.

FCF growth on the high end of the mid-single-digits can support an annualized return in the double-digits, and the shares likewise look undervalued even with sub-10% operating margins. Again, there’s a lot of upside here if management can drive even better margin leverage, and exiting Farm Tech and Refrigeration would probably help.

The Bottom Line

I’ve said it in the past and I’ll say it again – successful turnarounds usually exceed analyst and investor expectations in the early parts of the turnaround, and with GEA Group about 12-18 months into a turnaround that will take at least 36 months, I think that still applies. With over 20% upside to my base-case numbers and over 40% upside to my bull-case numbers, I think this is a name still worth considering.

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.



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