Renk is well positioned in a number of niche markets offering a wide range of products. The market is not giving much credit to the good operating results valuing the company at just six times operating earnings. Apart from that, a potential corporate event could emerge as a catalyst.
Renk is a supplier of propulsion equipment and test systems for a wide variety of applications. The company is headquartered in Augsburg, Germany. 35% of sales come in Germany, 23% in Asia, 22% in the rest of Europe and 15% in North America. According to the company, in tracked vehicle transmissions, slide bearings for electrical machinery and naval gear units, Renk is undisputed world market leader.
A wide product range serving different niche markets
Renk divides its business into four divisions:
The vehicle transmissions division (20% of sales) is a manufacturer of automatic transmissions for tracked vehicles (tanks and armoured carriers). The sale of vehicle transmissions is characterized by a small number of long-term procurement programs, with small volumes and only a few annual shipments. The French subsidiary provides maintenance work on the tank transmissions of the French army. This has been a long term relationship generating recurring revenue. In 2013 the company received a follow-up order for logistical services in South Korea following the delivery of an order. Also included in this division is Renk Test System that supplies testing systems for development, production and quality assurance in the automotive, rail vehicle, aviation and defence industries.
Management sees further potential in growing the aftermarket revenue as clients (in most cases the land forces of the respective country) extend the life of implemented machines. This might increase the potential to generate more aftermarket revenue going further. Concerning the demand side for new transmissions there is a mixed picture. Defence budget cuts and the end of military operations in Afghanistan and Iraq have a negative effect on demand. At the same time significant growth is expected to come from Asia-Pacific and Middle East. Apart from that, there is also competition between tracked and wheeled vehicles. In particular smaller countries have to make a decision which type of propulsion they want to use.
The slide bearings division (21% of sales) supplies hydrodynamic lubricated slide bearings for applications such as electric motors, generators, pumps and marine propulsion. With an operating margin of more than 20% this is Renk’s most profitable segment.
In this segment the company is competing with one of my other portfolio holdings, Miba. Renk is observing an increase in competition, as competitors target this lucrative market segment. In addition, the company’s established customers from Europe and Japan are losing market share against competitors from emerging markets who are not Renk’s customers. As a consequence, margins are expected to decrease in the future. In May 2014 the company sold its affiliate ADMOS. Going forward, this will reduce revenue by roughly EUR 10 m.
Management still sees growth potential for the future. For instance, there is a trend toward local, flexible energy production and the general increase in demand for energy in emerging markets. In addition, accessing new natural gas deposits might further increase the demand for electrical and turbo machines for extraction, transport and energy conversion.
The special gear units division (35% of sales) produces gear units for fast ships and naval applications as well as stationary gear units for a variety of industrial applications as in the cement industry or power generation. Renk’s turbo gear units have capacities of up to 140 MW.
While the market for stationary industrial gear units (e.g. cement and power plants) is subject to fierce competitive pressure, Renk has a very solid position in the market for marine gear units within the special gear units division. Here Renk’s product range includes technical drive solutions for frigates, corvettes, patrol craft and mega yachts designed to run on a combination of propulsion options as required.
Comparable to the transmissions division, the marine segment is characterized by multiyear procurement programs. Turbo gear units are produced at Renk-Maag in Switzerland. The affiliate is currently suffering from the strong Swiss franc and low demand from China.
The Standard gear units division (24% of sales) includes the production of marine gear units for merchant and supply vessels, for liquid gas tankers and ferries. Also part of the division are gear systems for turbine, pump and compressor applications as well as gear units for the 5-MW offshore wind energy market and industrial couplings.
The segment is currently profiting from strong demand in the market for LNG tankers and specialty offshore vessels. Here orders are currently outnumbering the shortfall in the offshore wind energy sector, other ship projects, turbo gear units for energy production and couplings.
High margins and high return on capital can be maintained during economic downturns
The company showed strong top-line growth until 2008. After that the order book dropped from more than EUR 400 m to below EUR 300 m, but since then has recovered to EUR 650 m. Margins were not affected by the downturn. Over the last two years revenue also recovered to the pre-crisis level. Given my assessment of the company’s four divisions above, I believe a stable revenue development going further can at least be expected.
Margins grew until 2007 together with revenue and have been pretty stable since then. Return on capital looks very good. Management makes the following statement regarding the calculation of capital employed in the annual report:
“For capital management purposes, the company’s capital employed (CE) comprises total assets excluding financial funds and tax assets, less all accruals and liabilities other than financial debts, pension accruals and taxes. Additionally eliminated from CE are any material M&A-related effects produced by finite-lived tangible and intangible assets. Prepayments received are not deducted unless they have already been applied to contract work.”
There are two things I want to know. First, to what extent prepayments applied to contract work influence CE. Second, how much unrestricted cash Renk has available.
In Renk’s balance sheet prepayments make up a large contribution to current liabilities. Deferred revenue increased from EUR 63 m in 2004 to EUR 133 m in 2013. According to the annual report, CE at YE 2013 was EUR 167 m. All the components of the CE are available from the report except from M&A related effects (which I believe are not material) and prepayments applied to contract work. Assuming that M&A related effects are EUR 10 m, I estimate that prepayments applied to contract work come close to EUR 115 m or 86% of total prepayments at YE 2013. Hence, prepayments have a substantial effect on working capital and return on capital employed (ROCE).
Apart from that, I can also use my estimate of prepayments applied to contract work to come up with an estimate of unrestricted cash. Assuming that 14% (=100%-86%) of prepayments have not been applied to contract work yet, I can deduct them from the cash balance to receive an estimate for unrestricted cash.
Gross OCF is operating cash flow before changes in working capital. In Renk’s case I prefer this number as working capital fluctuates quite a lot (mostly due to prepayments). Overall, cash flow generation seems to be very healthy. In addition to that, the company grew book value at an annual CAGR of 16.4% from 2004 until 2013 (after dividend payments and without undertaking any share repurchases).
Renk has a market cap of EUR 530 m. The company has no outstanding debt financing on its balance sheet. Net cash is EUR 117 m after pension liabilities and prepayments not applied to contract work. This implies Renk is valued at just six times its operating profit.
Renk’s uncertain future as part of Volkswagen Group
Renk has been part of Munich based MAN since 1923. MAN owns a 76% stake in Renk’s capital stock. Renk is therefore fully consolidated in MAN’s financials. Over the years there were rumours coming and going that MAN could either sell Renk or fully integrate it. However, nothing happened.
Within the MAN Group, Renk is part of the “Power Engineering business area”. Apart from Renk, this includes MAN Diesel & Turbo which according to the company is one of the world’s leading developers and manufacturers of two-stroke diesel engines for propulsion systems in large ships, in the development and manufacture of four-stroke diesel engines built into smaller vessels and used as auxiliary engines, and in four-stroke engines for electricity generation at power plants. This business area generates 25% of MAN’s total revenue or EUR 3.9 bn.
In 2011, Volkswagen gained control of MAN. Two years later they reached the threshold of 75% of MAN’s capital stock, which enabled Volkswagen to sign a profit and loss transfer agreement (Beherrschungs-und Gewinnabführungsvertrag) with MAN. Together with MAN and Swedish Scania, Volkswagen is currently in the process of consolidating its commercial vehicle business segment.
Volkswagen has three segments: the passenger car segment with Volkswagen, Audi, Skoda, Seat, Bentley, Lamborghini and Ducati, the commercial vehicle segment with MAN and Scania and the financial services segment. It’s obvious that MAN’s power engineering business incl Renk does not fit into the Volkswagen Group. It generates only 2% of Volkswagen’s total revenue and is operating in a different industry. The only overlap exists between Volkswagen and Renk Test System, where Renk delivers test systems to Scania, Audi and Porsche.
What kind of options does Volkswagen have concerning Renk?
First, Volkswagen can do nothing, in which case cash distributions from Renk to MAN will stay at roughly EUR 11 m per annum. Minority investors would keep holding undervalued shares of a quality company which is growing book value at a double digit rate paying a stable dividend (current dividend yield 2.6%).
Second, Renk could make use of its net cash. I believe that between EUR 10 and EUR 15 per share (between 13% and 19% of the current share price) are not being used for operating activities. So either an acquisition or a special dividend/share repurchase might be adequate tools to enhance the capital structure. It is highly likely that the share price would appreciate under this scenario.
Third, Volkswagen can decide that Renk will become an independent public company by either selling their shares to the public or passing them on to Volkswagen shareholders. As a consequence, an increase in free float should enhance investor interest for Renk.
Fourth, Volkswagen could take Renk private first by entering into a profit and loss transfer agreement with Renk and thereafter squeezing out minority shareholders. They could then sell Renk (perhaps together with the rest of MAN’s power engineering unit) to a competitor or financial investor. Under this scenario, it seems to be highly likely that Volkswagen would have to pay a premium over the current share price to minority shareholders. However, for Volkswagen this might be negligible given that they are already holding the vast majority and that they should be able to sell the entity at an attractive price.
Renk’s share is trading at a low multiple. Combined with an extremely solid balance sheet the company presents a favourable investment. One could argue that the low valuation is just a result of a temporary expansion or upcycle in Renk’s markets. While that is correct for some of Renk’s markets the situation is rather bleak in other markets. So the company profits from different cycles in the respective niche markets. This has an offsetting effect with regard to total revenue generation. Apart from that, a potential corporate event offers additional return for the patient investor.
In one of my last posts, I announced that I will start to accumulate a position in Renk. Based on the assumption that I trade one third of the daily volume, I have accumulated a 1.2% position from October 16th, 2014 until October 27th 2014 at a VWAP of EUR 75.9. Going further I will increase the limit to EUR 82 and I will target a 3% position for the virtual portfolio.
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