PSB Monthly Issue February 2011

The Financial Crisis of 2008, and the ensuing recession, took its toll on nearly every type of company.  Revenues and profits fell across the board.

But companies producing industrial equipment were hit even harder.

You see, capital expenditure spending slowed or was put on hold at many companies. It’s no surprise… as budgets are cut, big ticket items are the first to go.

Sales of products such as expensive machinery and industrial equipment took a major hit over the past several quarters.  Industries reliant on those kinds of products, like construction equipment manufacturers and renewable energy, witnessed significant declines.

But times are changing in 2011.

Capital expenditures are increasing for the first time in months.  Companies have built up their cash positions.  New equipment purchases are built back into budgets.  Old equipment is finally due to be replaced.

What’s more, with oil prices climbing, companies such as renewable energy providers are once again attracting the attention of investors.  These companies are ramping up their equipment purchases.

One industry is perfectly positioned to benefit from the new wave of capital equipment spending in 2011…

The industrial electrical equipment industry.

Industrial electrical equipment is a diverse industry.  It’s populated by both large and small companies specializing in a large variety of products.  One thing’s for sure… this is an enormous industry.

The public companies in this industry alone are worth over $130 billion.  And the industry’s revenues are even bigger.

Here’s the thing…

In this industry, the kind of company I want to invest in is one with a diverse product offering.  I want a company with high growth potential and a solid balance sheet.

Most importantly, I’m looking for a company which was oversold during the recession… and has yet to see its share price recover.

And my research has led me to that exact company.

Introducing Magnetek (NYSE: MAG).

THE INDUSTRIAL ELECTRICAL EQUIPMENT BUSINESS

MAG is a leading provider of motion control systems and digital power equipment.  The scope of their products varies considerably… but the products generally fall into three categories – material handling, energy delivery, and elevator.

Material handling products include drive systems for overhead cranes and hoists.  This is MAG’s biggest source of revenue, accounting for roughly 55% of sales.

Energy delivery products fall into two categories.  First, the company develops digital power inverters which connect renewable energy sources to the power grid. Second, the company produces drive systems used in underground mining. Combined, energy delivery products comprise about 25% of sales.

Finally, MAG provides motion control subsystems to many of the world’s major elevator producers.  These products make up approximately 20% of the company’s revenue.

There’s quite a bit of synergy between the three different product groups.  In fact, all the major product groups are contributing to the bottom line without hurting the company’s production efficiency.

But a diverse selection of products isn’t the only reason I really like this company.

MAG is perfectly positioned to benefit from several key developments in 2011.

First off, sales of material handling products should get a nice boost from improvement in the economy.  Keep in mind, these are 55% of the company’s revenue.

MAG is the country’s largest producer of digital drive systems for industrial overhead equipment such as cranes and hoists.  Of course, products like cranes and hoists are expensive capital equipment… They aren’t in big demand during a recession.

Now, with the recession fading, demand is back.

But that’s not all…

The company plans on adding new products to their menu.  For example, there’s room for growth into areas like radio remote control… a $150 million market.  With a loyal group of customers in place, any new products should help drive sales even higher.

And consider this…

MAG renewable energy products will thrive as the industry manages a turnaround this year.

You see, the recession caused oil prices to drop.  So there wasn’t a lot of pressure to replace expensive oil-based fuel with alternative energy sources.  But that’s changing now with oil approaching $100 a barrel.

Renewable energy is back in the spotlight.

Companies are going to be ramping up their production of wind turbines and solar panels.  And they’ll need MAG’s products to transfer the energy to the utility grid.

Renewable energy products are MAG’s fastest growing segment.  And it’s one of the hottest industries in the market right now.  MAG’s positioned for big growth in this industry too!

Finally, MAG has fairly significant pension costs which will decrease in 2011.

Here’s the deal…

Pensions have to be paid every year.  If a pension’s investments are underperforming, the company will need to put in larger amounts of money.

A bullish stock market and higher interest rates both increase a typical pension’s returns… and both are expected to occur in 2011.  Favorable conditions could cut MAG’s pension expense by 25% or more.

And a big reduction in pension costs will dramatically improve the bottom line.

Now let’s take a closer look at the company’s financials.

THE NUMBERS

MAG doesn’t just have a good story… they also have the financial numbers to back it up.

Fiscal year first quarter revenues jumped to $24.9 million… an impressive 40% year over year climb.  Even better, the revenue increase was across the board.  The company is seeing greater demand for all of their products… and that’s a very healthy sign.

What’s more, the company is net income positive.  It may not seem like a big deal at first glance.  However, after multiple quarters of posting a loss, MAG has turned the corner and is now in the black.

More than anything, it’s a great indication this company is headed in the right direction.

And here’s my favorite part… MAG has a rock solid balance sheet.

The company has nearly $10 million in cash… compared to essentially zero debt.  Big cash and little debt is always a great combination.  Plus, it gives them flexibility to expand operations or acquire a competitor.

Additionally, the company’s current assets are a stellar 2.5x current liabilities. Management is doing a fine job of looking after MAG’s financial health.

INVESTMENT RISKS

As you know, no investment is without risks.

First, there’s the risk of a prolonged slowdown of the US economy.  MAG sells a majority of its products to domestic customers, so revenues could decline if the US economy doesn’t grow in 2011.

The company’s growth depends in part on continuing to be a market leader.  If a major competitor takes business away from MAG, it will cut into future sales.

Finally, sustained lower interest rates could pose a minor risk.  If interest rates stay low for most of 2011, the company’s pension expense could be higher than expected.

POTENTIAL RETURNS OF 125% OR MORE

Although MAG is a healthy, growing company, the shares are badly mispriced.

At a recent price of $1.78, MAG shares are trading at just 9x projected earnings. Meanwhile, the industry average is at a far higher 22.2x earnings.  If MAG simply trades at the industry average, the share price would jump 147%.

There are plenty of reasons to believe MAG can trade closer to the industry average.  I talked earlier about several positive catalysts for this company.  Even better, the company’s expected to grow earnings by over 200% this year.

Take a look at the chart below.  Before the Financial Crisis in 2008, MAG shares regularly traded over $5.00.  With the economy improving and renewable energy making a comeback, the share price could realistically return to those levels.  And I think it could go even higher.

Based on our analysis, we see the stock trading up to at least $4.00.  Buy MAG now for potential gains of 125% or more.

ACTION RECOMMENDATION

BUY Magnetek (NYSE: MAG) up to $2.05 per share.