I enjoy finding stocks that fly under the radar. What does that mean? It typically means smaller companies that do not have good sell-side research coverage from large banks (e.g. Goldman, Morgan Stanley, JP Morgan, etc). Therefore, the large institutional money managers are not being pushed constant updates on the company, nor do they have in-depth “initiating coverage” reports on the company that are good for shortcutting the diligence process.
These companies can be very good businesses, yet sometimes are hidden gems (especially when they don’t show up well on equity screens too). In today’s data-driven environment, it is not hard to set up an easy screen to search for value (e.g. Find me companies that trade for a P/E of less than 7x; find me companies that have grown revenues 15% p.a. over the past 5 years). Therefore, if you do your homework and find companies before they are easily screened or picked up by a major bank, there is considerable alpha that can be generated. Today’s case, for example, is followed mainly by Keybank and Suntrust. No Goldman, Morgan Stanley, BAML, etc.
On to the company…
NN, Inc (ticker NNBR) is an industrial company that has undergone a significant portfolio transition. As background, NNBR was founded in 1980 and was mainly focused on the oil and gas industry. However, a recession in the 1980s drove the company into new markets, including automotive. The products the company sold to these markets were precision steel balls and rollers, which are critical moving parts of anti-friction bearings which, in turn, are integral parts of machinery with moving parts.
The company went public in 1994, and by 2000, the company had expanded into a variety of other industrial end markets. Through acquisitions, NN continued to expand into new products as well, including precision plastic products and bearings. The most significant acquisition was Autocam Precision Components in 2014, which created products for the fuel systems, engines and transmissions, and other products in the automotive industry as well as HVAC and fluid power industries.
We will come back to this segment and discuss the opportunity driven by more stringent CAFE requirements in cars that will be a tailwind for NN.
The company also made acquisitions that expanded the business into the medical industry, including surgical knives, surgical staples, orthopedic system tools, laparoscopic devices, drug delivery devices among others. It also expanded into the aerospace and defense industry.
Next, in 2017, the company divested its Precision Bearing Components Group for $375MM, or 9.6x EBITDA, which they have since re-deployed in other highly attractive business. Importantly, PBC was a highly cyclical business (highly related to commodity auto OEM products) and that exposure came down significantly, from ~25% of sales to 8% of sales (CAFE was still 39% of sales).
One thing I like about this management team is that they have an eye on the cycle, which is important for an industrial business. As such, they try to have a balanced portfolio of cyclical (benefiting from the business cycle going up) and counter-cyclical (benefits when we are in a recession, or at least doesn’t go down).
The management team re-deployed that PBC cash into buying Paragon for $375MM, or 9.3x 2018e EBITDA. This filled out NNBR’s medical portfolio and was higher margin than NNBR’s core business.
As the CEO said at their recent investor day (though I do think it was embellished a bit… the company will still be cyclical):
“…in 2013… the majority of our end market, our revenues came from an automotive largely cyclical end market. As you look at where we are today, some 70% of our revenue comes from a non-auto, non-cyclical revenue base. When you think about our EBITDA, it’s the same story, obviously, it was heavy auto. When you look at it now, it is well distributed. So we’re a balanced organization and it’s distributed, again, across those counter-cyclical pieces within the economic cycle. And when you look at cash flow, it’s the same story. It’s even larger on the cash flow side. So I would submit to you that we are no longer an automotive company, we are diversified industrial that happens to have a CAFE technology interest. We are no longer a cyclical company, because we have the counter-cyclicality built in, and we are getting our revenues, our EBITDA, our cash from a variety of places. We are a transformed organization.”
In sum, through lot of acquisitions and some divestitures, the NN business looks very little like the initial one started in the 1980s.
The key, long-term drivers going forward are:
- Life Sciences: NN is highly exposed to orthopedics, surgical tools, endoscopy, finished medical devices, among others. As the population ages and the baby boomers move into the next stage of life, this segment should benefit. NN expects this business to grow from $300MM to $750MM over the next 5 years, from organic growth as well as portfolio expansion (e.g. adjacent to their current platforms, such as expanding their cardiovascular business).
- Power Solutions: This business is broken down into electrical power management (which will grow due to higher efficiency standards and demands as well as automation) and aerospace & defense (fuel efficiency, light weighting, etc) and is targeted to growth from $195MM to $450MM over the next 5 years. Similar to life sciences, they expect to get there from some organic growth in the base business, as well as growth in new areas
- Mobile Solutions: The company is targeting transportation and general industrial products that are high precision and our core competencies. For context, the company said at its investor day that, “human hair, it’s about 88 microns in width. We’re manufacturing parts in the single-digit area, in some cases below 1 micron. We have a fuel system part, in China as an example that we manufacture, where the roundness requirement is 0.38 microns. We manufacturer that part in a climate-controlled room and each part is individually laser-gauged to make sure it meets our customers’ requirements.” The company is targeting a balanced portfolio with HVAC, off road, etc to also balance the portfolio.
- CAFE Technology: While CAFE is technically is in mobile solutions, I wanted to break it out, given its an important growth driver for the company. Auto companies are driving out power from engines with less fuel. And part of this is regulatory mandated (i.e. CAFE standards). As the content of these devices increases, so will NN’s earnings.
Put all this growth together and the company is targeting being a $1.6bn in sales company in 5 years, up from $860MM today. And importantly, they expect EBITDA margins to expand to 25%, which would be top-quartile.
As you can see, this business has some serious moving parts and that provides an opportunity for analysts willing to do their homework. I think NN, for those who know anything about it, relegate the company to just an Auto OEM supplier, when in reality, medical sales are a higher component of EBITDA and cash flow today. The company also has carried a higher leverage profile, which is risky on a more cyclical business, but medical tends to be more stable.
The company did recently issue equity to pay down some second lien debt. The stock sold off on the news, but I think it helps eliminate negative headlines.
Let’s move on to the price target…
I think NN has been beaten up too much in the context of the cash flow I expect the business to generate, not to mention the possibility of re-rating in the longer term if the business does reach its EBITDA margin targets.
At an 8% FCF yield (the average S&P500 company trades at less than 5%), I see over 35% upside on the stock over the next 12 months and much higher thereafter for long-term investors.