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Hillenbrand Inc: Rising from the Grave
Posted by: ryzamora (IP Logged)
Date: June 20, 2012 02:22PM
Country: United States
Ticker Symbol: NYSE -- HI
Industry: Manufacturer -- Death and Industrial Machines
Current Price**: $22.78 a share (represents $1.42 billion in market cap)
NOPAT*: $100.2 / $99.9 / $113.4
Net Income*: $102.3 / $91.7 / $106.4
Adj. EBITDA*: $188.9 / $185.7 / $215.8
Analysis Duration: 28 Dec 2011 to 29 Feb 2012 (two months)
Report finished by: 1 Mar 2012
* for fiscal years 2009 to 2011, all in millions of USD.
** finalized and updated on 9 Jun 2012. Market price of HI then was $19.09 on the most recent trading day -- $1.2 billion market cap.
Hillenbrand Inc. (HI) is the parent company consisting primarily of three companies: Batesville Services Inc., K-Tron International Inc. and Rotex Global LLC. HI proclaims itself in its 2011 10-K as a “global, diversified industrial enterprise with two platforms that manufacture and sell premium business-to-business products and services for a wide variety of industries.”
For Hillenbrand, stability is the name of the game. Its presence is felt in the deaths of thousands of Americans and Canadians alike, the funeral products it manufactures (e.g. caskets, urns) contributing about 80% of sales from year to year. Two years ago it has begun diversifying from the scythes of death, expanding through M&A transactions into machines aimed at automating and maximizing the efficiency of manufacturing processes (e.g. feeders, crushers, and screeners).
The business of death rests mostly in Canada and the United States, with the company holding about 25% of the $2.6B industry on 2011 year-end. Process equipment, on the other hand, has a larger geographical and customer distribution, with sales across both the globe and multiple businesses, catering to the likes of General Mills, DuPont, Dow Chemical, MasterFoods (Mars), Merck, Pfizer, and Nestlé (Zack O’Malley Greenburg, “Counted, Weighed, and Divided”, Forbes.com, 29 Oct 2007).
Hillenbrand seemed like an excellent target...
First brought to my attention by Anand Chokkavelu, an analyst of the Motley Fool who mentioned it in an article he wrote five months ago, Hillenbrand seemed to have everything I looked for in a lucrative investment: high margins, high returns on equity, a dividend yield no less than 3% and a vise-like grip on its market share.
The company’s stock, on further investigation, looks fraught with inefficiency. No more than three analysts covered this stock in the past three years (S&P’s Quantitative Services, Quantitative Stock Report, Standard & Poor’s, Feb. 24, 2012, accessed via E*Trade). No articles about it exist on GuruFocus or SeekingAlpha. How can a business as great as Chokkavelu claimed escape the scrutiny of multiple, intelligent eyes? The answer to this lies in its special situation (more info in “Disclaimers” under Section III).
…but the company proved resilient to analysis.
Much time was spent and wasted on planning my attack strategy for this monster of a project. Industry-related information relevant to the analysis was scarce. Opacity and obscurity veiled the company reports, shielding it from investors and talented analysts alike. The footnote for “Segment Information” was more an obstacle than a tool of illumination. Standard procedures employed in appraising a business’s long-term value floundered in the face of Hillenbrand’s complexity, requiring much creativity and mental fortitude from the analyst. By the time I have begun diving into the business, a month has already passed.
Hillenbrand represented the most difficult project I have ever undertaken in my entire history as an analyst (as of writing). Writing this research report filled me with as much pride...
… as I wound up with agonizing disappointment in this company.
Perseverance and determination uncovered damaged credit
The company’s creditworthiness are troubling, but still enough to keep Hillenbrand out of trouble, provided it acts with caution and prudence, especially in its M&A dealings.
Debt ratios stand in the 60s, and solvency ratios saw less profit metrics meeting the safety marks. Asset liquidity may be adequate, but earnings coverage has worsened considerably, which will certainly result in refinancing of debt in the near future should HI permit the permanent expiry of its $400 million revolving credit facility in 2013.
…obfuscation of operating efficiency…
Opacity impedes understanding of the company. Management has consistently provided zero transparency on the nature of its operations in any of its filings. Even the investor-oriented presentations provide little help, tailored to a gross exhibition of pie charts stripped free of the numbers. Backlogs of the Process Equipment business aside, operational efficiency was analyzed using the financial statements alone.
The computed information suggest improving efficiency across the board, with discrepancies between LIFO and FIFO inventory accounting indicating both rising costs and an ineptitude in anticipating future demand.
Asset turnovers, an overused ratio for efficiency, are distorted further by the K-Tron and Rotex acquisitions, for the massive levels of goodwill added to the balance sheet would certainly exude the illusion of drastically falling turnovers, when in fact the plunge is not as dramatic as it seems.
…and a struggle to defend profitability.
Hillenbrand deserves a round of applause for keeping its gross margins consistent for the past eight years, despite the pressure exerted on it by cremations and their steady rise since the 1960’s. However, operating profits have gone defensive, squeezed by unidentifiable operating costs, depreciation and amortization, and pension liabilities.
Restructuring and acquisition costs chip away at the profits retained by Hillenbrand, as do the litigation costs that hound its cases against the unrelenting plaintiffs of the 2005 antitrust case and the more recent lawsuit involving its fellow competitor, Matthews. Whatever is left behind is eaten away by a growing base of interest-bearing debt — leverage employed to fuel HI’s acquisitional expansion.
Considering the amount HI has paid and must pay towards debt principals, it is clear the attractive dividend yield of no less than 3% is illusory, being purely debt-financed, limited by the separation agreement between HI and its parent, Hill-Rom (NYSE: HRC), and under threat by unseen catalysts.
Although the company is stable, immune to death…
Any idiot can easily figure out Hillenbrand’s product lines are enduring, if not everlasting. Caskets, cremation urns and vaults are facts of life as is the scythe of mortality. Machinery such as crushers, screeners and conveyors are critical components in large-scale processing, with no alternatives available save for manual labor: tedious, expensive and error-prone.
Roughly 75% of the Process EQT segment’s revenues are driven by six industries: plastics, food, chemicals, coal mining/power, pulp/paper/biomass and pharmaceuticals. Certainly it wouldn’t be hard to imagine how large are the demand for these products when aggregated.
…it is undermined by both management…
For all the stability and invulnerability dominating Hillenbrand’s lines of work, I harbor heavy distrust for the management. An analysis of internal accounting and the variances between cash and accrual bases imply moderate consistency, a neutral observation had “C” and “F” scorecards convinced me Hillenbrand’s leadership isn’t likely to screw its owners.
The management clearly doesn’t want serious investors and analysts from fully understanding their business, a desire deduced from the nondisclosure of KPI’s in their public reports, conference calls and presentations tailored to selling their story and “double-digit growth” instead of apprising the shareholders on more important matters with far-reaching ramifications on Hillenbrand’s future value.
Trouble encountered in catching a knowledgeable person from investor relations and a leadership willing to overpay for M&A transactions and partially finance them with debt to boot have both eroded my faith in the leadership.
…and uncertain prospects for the future…
There is little growth awaiting Batesville. With the market pool pinned to approximately 2.7 million Americans and Canadians on average, year after year, it is clearly in a zero-sum game poised for shrinkage as healthcare, biotechnology and lifestyle quality advance. Lawsuits battering Hillenbrand and Hill-Rom portend serious damage should their defenses flounder. On top of it all, gross margins are still under threat from the evolving preferences of their weeping, grieving consumers.
...which are hazy at best.
The process group’s upside potential, furthermore, is uncertain, tied not only to the economic cycle but also to the growth catalysts of so many industries they are too broad to specify and too many to factor in quantitative models. But whatever potential this business segment may hold is nonetheless exposed to the high possibility of Hillenbrand being ripped off by its M&A targets.
Thus Hillenbrand’s margins of safety are clearly insufficient.
Hillenbrand’s passable credit, generally improving efficiency, a preservative state of profitability, and strong competitive advantages all point to a “low to moderate” (Level 2) risk rating at best and a “moderate” (Level 3) risk rating at worst. However, the frustrating efforts it took to contact management, their acquisitional conquest in a different market combined with the likelihood of accepting overpriced deals, opacity in their public documents, negative catalysts for Batesville, and the diversified but uncertain growth outlook for the Process Equipment segment have all led me to conclude, after much review and reflection, Hillenbrand Inc. represents a MODERATE TO HIGH RISK (Level 4) to the investor.
This risk rating produced a WACC of 9.65%. HI’s market price of $22.78 contains an 18% premium for growth and implies a yearly revenue growth rate of negative 0.7% for the next seven years and a 2.4% rate of growth for the terminal period thereafter.
DCF models assuming maintained gross margins and the eventual payment of 50% of known potential litigation damages during the terminal period point to 48% overvaluation on a pessimistic scenario, and an inadequate 10.4% margin of safety for the neutral scenario. Should the company escape the lawsuits unscathed, HI would be undervalued by 20% on a neutral outlook and overvalued by 18.5% on pessimistic.
I do not recommend HI for short or long operations. However, its beta of 0.74 (according to Google Finance), Europe’s continuing problems, America’s struggling recovery, the uncertainty of Batesville’s litigation outlook, and the excellent stability of the company’s manufacturing businesses are compelling enough for continued observation.
June 9, 2012 UPDATE:
With the current price of Hillenbrand now at $19.09 a share, owing to developments during the ongoing euro crisis and its May 7, 2012 guidance (when its fiscal year 2012 expectations were revised downward). This is definitely a potential entry point, as this represents:
ü A 2.5% discount to stagnation value
ü 22% overvaluation to pessimistic growth and 25.6% margin of safety for neutral growth, taking into account the impact of litigation. (In its absence, 2% MOS for pessimistic growth!)
ü A dividend payout ratio of about 4%, whereas the price three months ago represented a DPR of 3.2%
However, I will not be editing the majority of this research report since it will not be necessary.
Disclosures: I do not own any shares of HI and do not have any plans to take in any positions in the next 72 hours as of posting. However, I'd buy shares in this company had I possessed the free capital to deploy it.
Before beginning with the risk assessment, I would like to point out several things the reader must be aware of. This is rather important as it has a direct impact on my analysis of Hillenbrand’s long-term viability as an investment, and those who have misgivings for my chosen methodology are free to peruse HI as well.
Hillenbrand mixes two different accounting methods...
Thanks to the wonders of GAAP, Batesville makes full use of the option to report inventory under the LIFO method, ensuring that inventory balances typed on the balance sheet represent trailing costs, and costs of sales, recent prices. However, this comes into direct conflict with K-Tron International’s custom of reporting both COGS and Inventory under the FIFO mentality.
Hillenbrand makes no effort to pursue uniformity and merely admits to saying a certain percentage of inventory is reported under LIFO. This becomes relevant as two different outcomes result from the use of LIFO and FIFO in computing inventory ratios. LIFO to FIFO adjustments have very little effect on profitability ratios.
...and this analysis is no different.
While the discrepancies between LIFO ratios and FIFO ratios are enough to pique curiosity (and are in fact, an aspect of my analysis of HI’s efficiency), my study on Hillenbrand’s creditworthiness and profitability admittedly mixes the two concepts together.
I am aware this practice distorts, to some extent, the reliability of my work in this aspect, but I believe the impact is not as bad as one would expect.
Industry information is fraught with estimates…
Publicly available industry information for the industry is scarce, stashed underneath the blanket of paid services. Attempts to scout the online landscape for reliable, free information are met with incomplete data, forcing me to rely on estimates and intrapolations, particularly with population demographics.
The death industry is a crucial element, as Hillenbrand’s spot in this stable, morbid yet lucrative sector contributes an average of 80% to consolidated revenues. (This statement assumes Batesville and K-Tron were retroactively married. More on this later.)
Three major industry associations are key sources of sector-relevant data, yet the information they hold within – many of which are relevant to a precise understanding of the business – are locked behind closed doors.
Government agencies certainly helped, but this aid was not enough to fully grasp the essence of the business.
…and the company’s reports are no help.
Opacity is paramount in Hillenbrand’s, and indeed, even K-Tron’s, company disclosures. Presentations and management’s discussion of past performance are clearly tailored only to the financial results, with references to the operations behind them minimal. Perhaps, even none at all. Investor-oriented presentations were more concerned with presenting the growth story of the Process equipment group. Save for growth rates, backlogs and other financial numbers, there was nothing accompanying the pie charts for viewers to absorb. Neither were there anything related to key performance indicators such as defect rates, figures for unit production and sales and customer mix. Annual, quarterly and current reports are just the same.
Even if Hillenbrand grew confident enough to disclose this information, it wouldn’t really matter — one year’s worth of information is not worth much to the value investor.
Hillenbrand’s complex history dissuades and intimidates attempts to descry value…
Obscurity compounds the difficulty of analyzing Hillenbrand’s investment worth. The company was once a subsidiary of Hill-Rom (HRC), spun off on 2008. Then, two years later, this standalone enterprise bought a public company as engaged in manufacturing as Batesville, which wouldn’t have been surprising had it not been catering to a wholly different market.
Everything that was purely, 100% Batesville was tucked away underneath “Segment Information” as it had been before the separation on 2008. Analysts and investors relying on public filings are forced to work with only four years of Batesville and two of Batesville plus process equipment.
Hardly the ideal situation.
…unless one employs drastic measures.
In order to combat the complexity and opacity Hillenbrand hides behind, unconventional methods were thus utilized in the analysis and appraisal of this complex business.
Mr. Chokkavelu gave me Capital IQ’s report of Hillenbrand Inc. containing numbers that were purely Batesville’s from ’04 to ’10. The figures are not as precise (i.e. adjusted) as I would want, but nonetheless enough to wring out meaningful information from within.
To assess Batesville and K-Tron’s synergy going forward, I brought in every single year K-Tron was public and merged them with the information I have on Batesville. This decision is further justified by that HI’s management elected to retain K-Tron International’s management and appointed its former CEO, Edward Cloues II, to its board of directors (2010 Annual Report, 8).
Finally, all three businesses were analyzed – Batesville, K-Tron, and the “married company” – to determine how individual traits coalesced into the collective.
Needless to say, the results were surprising and also clear enough as to pierce the intimidating darkness.
Before K-Tron came in, solvency was solid…
Indeed, before Hillenbrand — or before Batesville, to be more precise, decided to buy out K-Tron International, any idiot could see the company’s credit was as stellar as the sky on a clear night, glittering and beautiful. Pre-acquisition, less than 50% of assets were funded by liabilities, and certainly nearly half of these were current. Post-acquisition, the debt ratios increased by almost 50%. Noncurrent liabilities dominated the fore.
As one can easily see, all six were above 30% of total liabilities prior to the acquisition of K-Tron International. …and asset liquidity, despite separation efforts, was robust.
Liquidity ratios were decent in this time, even when no less than half of Hillenbrand’s debt was current, comprised primarily of trade payables and accrued expenses. Current ratios averaged at 2.0, and the quick ratio stayed above 1.0, indicating a high quality of current assets.
Pay no attention to the blip in 2008. That was a direct consequence of the separation efforts, which added $96 million in ST debt. Without it, both current and quick ratios for 2008 would’ve been at 2.26 and 1.55. Earnings coverage was unparalleled…
Earnings coverage above required payments — debt principal, interest expenses, and rent for its operating leases — were, as a whole, quite robust, leaving a sizable margin of safety against declines in profitability. The numbers on 2009 year-end averaged 1.43, with all but OCF being above one multiple of required payments.
Anyone who would’ve gawked at the cash flow statements of 2008 would realize that the earnings coverage ratios were less than a 1.0 multiple of required payments for all profit metrics except Adjusted EBITDA (due to high availment and repayment of debt, which likely came from Hillenbrand’s separation from Hill-Rom).
…only to fall.
Compare 2009 versus both 2010 and 2011. As seen in the bar graph above, earnings coverage ratios, indeed, have fallen from their highs in 2009. Figures derived from any earnings metrics aside from Net OCF were shadows of what they were two years ago. Not too long ago, I presented the pre-acquisition solvency ratios. The post-acquisition figures shown next to the earnings coverage indicators highlight the damage Hillenbrand’s credit endured when it assimilated K-Tron International into its fold.
Note the 2010 figures for residual free cash flows and owner earnings. These are actually deceptive, and the fact that they struck 60% of total liabilities on 2010 should not be taken as an indicator of safety. The reason can be found already in the cash flow statements: On 2010, Hillenbrand issued debt equivalent to $611 million, paying back only $277 million in the same year.
A thorough analysis of the company’s long-term debt showed that the company must pay at least $680 million in principal, interest, rent and retirement payments over the next ten years through 2021.
Should Hillenbrand opt to forgo the renewal of its $400 million credit card and pay off both principal and any accrued interest in 2012 and 2013, a little over half of the more than $680 million payments are required in these two years.
But Hillenbrand can still meet its obligations…
However, the yearly average of these required payments falls at $70 million. Considering that both the means and medians of six different profitability metrics are, at a minimum, 72% above this number, it is clear that Hillenbrand is solvent, possessing the capability to pay off these obligations.
…provided it perpetuates outstanding debt.
As it was pointed out earlier, Hillenbrand’s total required payments are skewed to the near term because of the revolving credit facility and its expiration. If the company does nothing, we’re looking at very high payoffs in the next two years. Payoffs that are more or less equal to the average values of the six profit metrics mentioned above.
Considering these numbers do not include acquisition costs, dividend distributions, share repurchases, growth CAPEX, and the small but treacherous possibility of incurring damages from its two lawsuits, to avoid critical damage Hillenbrand is most likely going to perpetuate its outstanding debt.
An abominable opacity bars proper operations analysis.
With operational efficiency being a crucial element in both understanding the business model and appraising the executives’ ability to control the parts that make the whole, one of my biggest disappointments with Hillenbrand Inc. is the complete, utter and absolute nondisclosure of key performance indicators.
No true operating metrics can be found in ANY of Hillenbrand’s reports and filings. The same goes for K-Tron! Not even units sold or units held in inventory are disclosed — which is a key difference between Hillenbrand and its competitor, Matthews.
Although investor-targeted presentations contain several pieces of information not found in any of the public filings, the fact remains they are not that reliable for research analysts hurling their laptops at the company’s business.
Take, for example, these pie charts taken straight from HI’s presentations.
The former merely discloses that about 75% of revenues are derived from pharmaceuticals, pulp/paper/biomass, coal mining/power, chemicals, food and plastics. The latter just points out replacement parts constitute 40% of the company’s business, with the remainder taken up by one-time big-time sales in machinery and other system solutions. How is such information helpful?
The former reveals the pointlessness in identifying growth catalysts precisely because they are so broad to the point it is almost impossible to pinpoint and quantify future growth.
The latter confirms that the life cycle of its products is crucial in determining 40% of the company’s revenues. Does this say how long the lead times of projects are? Does it tell the analyst-investor how long the useful lives of its equipment are? Is this 40% even representative of the long run?
Annual reports do not even bother mentioning the gross margins in selling either machinery or replacement parts, so no one would have an idea if they share a similar cost structure. Public filings and presentations are completely useless in supplying this information. The only way to get them is from the management, but my quest for this left a bitter impression on me…
Batesville enjoyed a high sales rate of its inventory…
With inventory as a crucial element of Hillenbrand’s businesses, whether it be related to the demise of thousands of North Americans or to the consumption of millions, it is imperative to begin the analysis of efficiency from here.
The sales rate of inventory, on the Batesville side, is actually robust. Strong and impressive. No less than 89% of inventory had been sold in the years between 2005 and 2011, with little variation around the number. Under FIFO Accounting, the sales rate averages higher than 90%, but for the most recent years, it fell below that mark. Production is also quite high, taking up almost 88% of goods available for sale. Although it just about matches the sales rate of inventory, production is still lower, whittling down excess inventory from past periods. Under FIFO accounting, however, production exceeds the sales rate.
...but the discrepancy between LIFO and FIFO portends dropping reliability.
To interpret the discrepancy, recall that LIFO tracks recent prices in COGS and trailing prices in inventory balances, while FIFO monitors it in the opposite manner (i.e. trailing prices in COGS and recent prices in inventory). As I have observed previously, the LIFO data suggest maintenance of sales rate and declining excess inventory, whereas the FIFO data indicate declines in sales rates and excess production.
With the exception of 2010, FIFO COGS has been lower than LIFO COGS in all four years (2008 to 2011) these numbers could have been computed. This simply indicates that, despite the overall decrease in Batesville’s reported COGS (0.968% five-year rate of decline from 2006 to 2011), prices per unit have actually been rising — meaning, the problem is not the cost structure, but the market. The market of grieving and mourning North Americans. Total variable costs went down because of unit sales, not because of the components of variable costs. The FIFO data doesn’t just indicate a decline in Batesville’s forecasting efficiency. It also indicates ongoing changes in the marketplace. Considering the research I’ve done in the funeral products industry, this is an ominous foreshadowing (refer to Future Prospects).
Turnover ratios portray a state of drastic decline…
I don’t have to point out the fact turnover ratios are looking pretty bleak.
Despite the incongruity caused by accounting changes, the fact remains that total asset turnovers are decreasing. The conventions of both traditional analysis and academic theorem hold that this is a result of declining operating efficiencies, as the business is producing less for every amount invested in assets.
…but in reality, the numbers indicate barely-maintained efficiency at worst.
When adjusted to exclude goodwill, all three still show decline, yet neither is as dramatic or appalling as the table shown earlier.
While ‘10 is a notable year for dealing a critical strike on the turnover ratios, this is a direct result of the operating intangibles added to the balance sheet, specifically “customer relationships”, which added a net of $150.6 million to total assets after the K-Tron acquisition. The ‘11 Rotex acquisition brought it up by an additional $76.5 million. Additions to customer relationships was worth 30% of the change in total assets from ’09 to ’10, and 58% of the change in the next fiscal year.
As intangible assets reside in a realm that would never exist objectively, it becomes clear that the turnover ratios shown in the first table are misleading. The numbers seem to indicating barely maintained efficiency, and we know neither the economic reality presented by “customer relationships” (because of subjectivity) nor the true quality of operations (because of management opacity).
Net profits represent a small fraction of sales.
As anyone can easily see, margins have been falling. For all the hype HI’s management stirred for its expansion into Process Equipment via acquisitions, in the long run there has been very little improvement at all in the business. Married revenues averaged $827 million with a 0.08 coefficient of variation from ’04 to ’11, and K-Tron has contributed roughly 20% of the total (currently 28%).
As anyone can easily see, margins have been falling. For all the hype HI’s management stirred for its expansion into Process Equipment via acquisitions, on the long run, there has been very little improvement at all in the business. Married revenues averaged $827 mil with a 0.08 coefficient of variation from ’04 to ’11, and K-Tron has contributed roughly 20% of the total (currently 28%).
Hillenbrand’s married revenues did not impress me. Think of the pre-acquisition era as the blue segment of the columns for all years prior to ‘10. Is it any wonder that the management will spin into a salivating tale that $880 million of revenues in ‘11 as a significant growth over the $600 million in ’09? One would think so until the bigger picture comes into light. The ‘11 performance almost matches ’07, and it remains to be seen how much the companies acquired by Batesville can organically grow. Process EQT’s yearly contribution weakened to 15% in ’09, but that was due to “significantly lower sales to customers of our process business line....” Studying the numbers reveals this decline came straight from America, Canada, “other” U.S. territories, Germany, Italy and undisclosed nations.
Above is a line graph dedicated to the profit margins of the married entity. Profit margins have been falling since 2004, with only Adjusted GAAP EBITDA as the lone exception — a ramification of bifurcating R&D and operating expenses into growth and maintenance components. Costs of goods sold were mitigated.
Interested in why profits have largely been in decline? The first place to look is in costs of goods sold. The couple that we now know as HI is inherently a manufacturing company. Like any other manufacturer, production and distribution is both the game and the source of its competitive advantages.
Apparently, despite the looming possibility of gross margins’ permanent dilution — a natural result of increasing consumer preference for cremations (refer to Future Prospects), Batesville has very steady figures. Cost of sales were mitigated enough to keep the Reaper above the 40% mark.
Even the married figures stand above it. However, considering the fact that Death has continually provided the majority of sales, it is clearly understandable why the consolidated gross profits closely track that of this segment. With the exception of ’10 (which is explained by high step-up costs during the year), K-Tron has also sustained consistent profit margins.
Costs of sales are not really the problem here.
…but operating expenses are voracious...
Because the table indicates high efficiency over production processes, the next step to look at are operating expenses, as these take out an astounding proportion of gross income — 32% of Batesville’s and 67% of K-Tron’s gross margins are lost to them. This is an observation of much concern when expense growth typically exceeds sales.
…especially unidentifiable expenses.
Operating expenses’ control over gross profits has gradually moved up from 40% in ’04 to over 50% after only seven years. Unidentifiable expenses underneath the SG&A item have grown at a wonderful 6.25% seven-year CAGR, overwhelming both consolidated sales (2.3%) and consolidated costs of goods sold (also 2.3%) by over 400 bps.
The significance of unidentifiable opex cannot be ignored. It has deducted no less than 27% of gross profits over the past eight years. Expressed in terms of sales, just divide the GP-based figures by two — the quotients derived overstate the exact figures by no more than 3 percentage points. Unfortunately, the components of unidentifiable expenses are beyond my reach.
When adjusted, returns actually rise.
With profit margins a fraction of sales, one should expect the company to compensate for this with sales volume. Especially now when profitability is gradually falling. With turnover ratios also dropping simultaneously, without a doubt ROA figures are also going to fall. Being the basis for ROE, it becomes clear the company isn’t that much of a big deal anymore.
Recall the graph at the beginning of this section on profitability, the one showing the married entity’s profit margins. Remember how net profit margins appear to keep on going down. With turnover ratios steadily dropping to a point lower than one (as discussed in the section on efficiency), doubtless one will think that returns on assets are going to fall — and simultaneously, returns on common equity.
However, the reality of it is, the numbers for 2010 and 2011 are illusory. As I’ve mentioned under Efficiency, intangibles have done considerable damage to balance sheets and instantly caused turnover ratios to plummet. This is by no means a direct indicator of real, operating efficiency, a perception derived solely from the analysis of figures crucial to the performance and health of the underlying business.
Since management is acting like a stuck-up snob towards its more scrutinizing shareholders and analysts, the recourse I opted for is the removal of goodwill from the computation of turnover ratios, as I’ve presented earlier. Using these adjusted turnovers will result in the following:
My analysis of inherent stability stems from two fronts: trustworthiness of the leadership and business fundamentals. Without stability, one cannot have faith in the future. Neither can one possess confidence in any forecasting models employed in valuation.
Efficiency and reliability go hand in hand.
Efficient companies speak volumes about the management’s ability to control costs and processes, but trustworthiness governs their reliability in being a shareholder-oriented party and aligns their interests with that of the lawful owners.
Balanced scoring does not work.
Scoring systems propagated by Joseph Piotroski and James Montier were employed to appraise the likelihood of Hillenbrand being a value trap and an accounting fraud, respectively. This is especially important for Hillenbrand as the Process Equipment Group can easily screw with its investors.
An excerpt of Hillenbrand’s 2011 SEC 10-K shows how. All emphases are mine.
Quote:Reading K-Tron’s past filings reveals this leeway has been around for as long as it has been public. While this seems to indicate there’s nothing wrong with the historical values, this nonetheless gives rise to the opportunity for Hillenbrand to manipulate sales revenues as they see fit.
Utilizing Montier’s C-score for Hillenbrand does not work. K-Tron merely averaged “3” during the pre-acquisition era – which can be interpreted to mean it can go either way as the highest score’s a six – while Batesville literally counted one to four in those same years (not in ascending order). The married company had C-Scores that did not leave “3” for the period of ’08 to ’11 except ’10 when it got a “5” due to the marriage of the two companies in that year.
Piotroski’s “F” score is as puzzling. Before the acquisition, K-Tron was clearly a company with value (averages “7” in a test with highest value of “9”). Batesville had a mediocre score of “5,” and the married company got something slightly lower.
…and accounting variances imply consistency…
With the scorecards producing conflicting results, one would think diving into the discrepancies between cash and accrual basis might suggest something about consistency.
The table above shows the historical averages of the differences between profitability metrics, along with their coefficients of variation. As one can easily see, while discrepancies exist when comparing operating cash flows before working capital changes to EBITDA and NIDA, the fact that their variation is implied to be low to begin with (CV’s of 0.07) suggests the three companies involved don’t seem to be engaged in anything that would’ve indicated earnings management.
The power of adjustments other than changes in working capital is apparently negligible, which further adds to the picture of consistency.
…but their opacity and inaccessibility speak otherwise…
With scoring systems neutral and accounting investigation shedding positive light on the three companies involved, it seems logical to conclude my fears are unwarranted and out of line. Unfortunately, Hillenbrand isn't as transparent as I'd want it.
…which undermines Hillenbrand’s unparalleled position.
Regardless of my misgivings for its management, Hillenbrand’s industry landscape is impeccably stable.
First, the death business has zero substitutions. The only alternative to having a funeral is the lack of it. Such a thing is highly unlikely given human nature — the newly deceased’s desire to be immortalized across generations, and the grieving family’s desire to remember their loved ones as who they were, and at their very best.
In death, a position of weakness…
In the death business, buyers consist of funeral homes and funeral service providers/directors, whose purchasing decisions ultimately consider the end users’ concerns with price, their personal beliefs and their own creativity towards the design and execution of the funeral service.
Because there is very little differentiation between the major manufacturers, along with importers such as Amazon and Wal-Mart, the funeral industry has much clout over companies such as Batesville.
…and in manufacturing, a position of strength.
For the feeder, crusher, and separator industries, an ever-growing switching cost pervades the business. This is because every machine is built-to-order and unique to both the client and the manufacturer’s expertise. These machines, sold to manufacturers operating for the food, plastics, chemicals, pharmaceuticals, and paper/lumber businesses, are depreciable — they must be maintained regularly.
It is almost similar to a trap. Herd unsuspecting victims into imaginary barns like cattle, blinding them with well-delivered solutions, and then milking them thereafter through maintenance, using the passage of time to reinforce this dependency.
People have to go to THEM for the upkeep of THEIR machines. This essentially embeds a switching cost that grows higher as the company client to approach Hillenbrand.
“Substantial capital is required to purchase existing manufacturers or to become a new manufacturer in the industry,” says the CFSAA. The funeral product business is capital-intensive, requiring production facilities dedicated to wholesale production. A new entrant vying to enter the game and compete with a business as large as either Batesville or Matthews should be ready to spend over $300 million (assuming it gets state-of-the art equipment), a number computed from gross values of land, buildings, machinery, software, and other technology.
In addition to high capital requirements, a learning curve repels new players from entering the game. Hillenbrand operate on a “lean business,” employing “strategy management” and “internal talent development.”
Setting such systems up will take time and money, and no doubt a good portion of operating expenses will be first spent establishing and developing the processes. To see just how sophisticated and meticulously designed such processes are, read Ben Austen’s article in The Atlantic: Bringing the Coffin Industry Back from the Dead (December 2010).
Customer relationships are important in the death business, especially when the manufacturer’s products aren’t that differentiated from their competitors. Genesis Casket, a smaller competitor in Indiana (so small neither Matthews nor Batesville even mentions it), outlines in its website the requirements funeral professionals dictate while establishing business relationships.
Production systems, logistics, and customer-friendly policies are especially needed to foster good, long-lasting relationships and maintain clients on book.
The process equipment group is even more reliant on business relationships than the death business — a corollary to the high switching costs it imposes on its customers. These relationships add to their marketing clout, and maintenance is critical to keeping the cows in the barn.
Parts are worth 40% of the Process Equipment Group’s revenues. These “parts” come from the after-sales service, which provides constant, recurrent income after “one-time, big-time” shots at selling the industrial machinery. Despite these high switching costs, the fact that is is so crucial to a significant chunk of total sales means new entrants must be prepared to expend resources on developing and fine-tuning both the manufacturing and after-sales services.
…economies of scale…
Furthermore, the death business is a zero-sum game. After all, only one death care product is available to one person. On average, 42% of revenues are preserved as gross profits, applying to both Batesville and the Married Company. Even to K-Tron itself. Yet operating expenses aside from R&D and D&A have been taking more and more from gross profits as the years pass, signifying the danger of fixed costs.
Pre-acquisition, both Batesville and Hillenbrand have operated at over 100% margins above breakeven revenues (computations assume operating and interest expenses are fixed). Post-acquisition, this has fallen to lower, but still high, margins thanks to the increased expenses as discussed earlier.
This highlights two things: (1) Hillenbrand is operating at robust levels despite environmental pressures; and (2) the scale economy it is operating from is certainly minimizing costs, absorbing enough to perpetuate R&D and growth initiatives. The married company, in fact, has spent no less than $4 million in R&D every year.
Much like its parent manufacturer, K-Tron International’s business is also plagued with high fixed costs. As stated three paragraphs earlier, 42% of K-Tron’s revenues have been preserved as gross profits with very little variation (CV = 0.01). Despite this, over 50% of gross profits are eliminated in a flash by operating expenses excluding R&D and D&A.
…and ruthless competition bar new entrants.
Last but not least, ongoing competition between incumbents bar new entrants. With the entire death care industry generating no less than $15.1 billion in sales since 2004 (according to US Census estimates), Batesville has controlled 4.3% of this amount on average with variation three times that of K-Tron’s gross margins. Matthews, a fellow competitor whose Bronzes, Caskets and Cremations segments allow it to maintain control of over 3% of this value.
Sourcing information from the US Census Estimates — a source I chose over the National Center for Health Statistics for the sole reason that the NCHS doesn’t have updated information for free) and Statistics Canada, I have observed that the total population in North America — net of births and migrations — has risen from 327.7 million to 348.6 million — a 1% 7-year CAGR.
In an almost linear but volatile fashion, deaths have risen 10 times slower, from 2.68 million to 2.7 million. This reflects an increasing longevity arising from advances in technology and research in health. That definitely sounds good for us… but not for the companies raking in the money.
Consequently, expressing deaths as a percentage of net population reveals this noticeable decline. The table in the next page shows that deaths have declined from 0.82% of the net population in 2004, down five basis points to 0.77% seven years later. While insignificant compared to the 0.8% average, it shows the available market pool for the death industry is just not growing.
With operating expenses growing multiple times faster than revenues, it isn’t any wonder that competition can only become more intense and ruthless going forward.
As for K-Tron International, Rotex, and any poor soul Batesville decides to swallow, competition is diluted by the nature of manufacturing processes, which vary across industries. This allows such businesses to attack niche markets — markets too small for the big boys.
According to OldSchoolValue’s 2008 valuation of K-Tron, direct competitors include the likes of Badger Meter, Heat and Control and Key Technology. Of these three, Badger Meter and Key Technology are publicly listed.
Overlap clearly exists, especially with Key Technologies. However, if Hillenbrand’s acquisitional strategy is of any indication, chances are likely this behemoth could have enough financial clout and organizational will to rip them out of the playing field.
Batesville has bleak prospects for growth…
Anyone who’s into death will realize quickly that Batesville’s core business has bleak prospects for growth. As mentioned earlier, its market pool is not growing, thanks to lengthening lifespans. Brian Burkhardt, a licensed funeral professional in the industry for 11 years, has provided in his blog on January 2011 a 25-item list of potential trends pervading the death industry, and many of them don’t bode well for Batesville. (Some of them, in fact, have already been recognized, which only serves to entrench Burkhardt’s credibility!) I’ve noted the nine that grabbed my attention:
1. Decline of traditional funeral industry (recognized by Batesville)
2. Lesser profits for funeral homes
3. Increase in discount funeral homes
4. Rising preference for cremations (recognized by Batesville and Matthews)
5. Funeral preneed scandals
6. More consumer contact by aggressive funeral vendors through social media and the Internet
7. Rise of green funerals and burials (also noted by the National Funeral Directors Association)
8. Persistence of alliances between funeral companies, vendors, and funeral homes
9. Attempts by funeral cartels to protect themselves from the free markets
Pay very close attention to the fourth item in this truncated list. This is a big problem for manufacturers, for the sole reason that margins are significantly lower for cremation urns. Batesville is significantly exposed to this considering burials brought in 90% of revenues from ’06 to ’09 with little variation.
Nonetheless, this trend is frightening for the casket investor. Cremation Info provides a historical record up until the year 2000 from as early as 1958. The record shows a glaring rise in cremation, which has risen from 3.5% of North American deaths in the 1960s to 28% by the year 2000. With recent data unavailable for public viewing, I can only imagine how much higher this value actually is.
…and darker prospects for decline.
Thus it is the biggest irony that the Death industry is clearly deteriorating. This clearly shows why the industry manufacturers are diversifying into unrelated businesses like Industrial Processing (Batesville) and Graphics Imagine and Packaging Solutions (Matthews).
However, larger dangers for Hillenbrand are two potential catalysts waiting in the lawsuits attacking the company’s Batesville segment. One is an antitrust lawsuit, while the other is a more recent one commenced by Matthews.
The damages being sought in the former range from $947 million to $1.46 billion, and despite being dismissed in HI's favor two years ago, the plaintiffs are are vigorously appealing against the judgment. As for the latter, this one comes from the use of a common marketing consultant and the piracy of two former employees of Matthews. Compensatory and punitive damages being sought for are largely unknown, even in Hillenbrand’s first quarterly report for 2012.
[quote][/quote]The Process Group’s prospects are well-diversified…
Putting aside my biased opinion — based solely on the K-Tron deal — that Hillenbrand’s future takeovers will be done at value-destroying prices, growth prospects for the Process Group are well-diversified to the point that the only real source of growth is through acquisitions. Edward Cloues, prior to his company’s merger with Hillenbrand, had admitted to Forbes that “the companies [K-Tron has] are limited in organic growth. The growth comes from combining.”
They are diversified precisely because their sources of revenue growth stem from catalysts covering the industries they are serving and the amount of market share they command in the materials handling niche for each one. Sixty percent of the Process Group’s business comes from plastics, food, chemicals and power generation. Minerals mining and potash looks like another significant source of business.
…to the point they overload financial models.
The worst part of it all is, these catalysts are so broad and generalized, financial models would be overloaded by the information. It certainly doesn’t help that K-Tron International has never provided industry demographics of its customer base in all the years it has been public, giving me no historical base to draw projections from.
One consolation, however, is that all these sectors are linked to the economy as a whole. An image from Hillenbrand’s December 2011 presentation supplies a list of key growth drivers for the Process EQT Group.
At first glance, this company places on the high-end of cheapness. At $22.78, I’m looking at a company trading at 13.4 times ’11 net income, 12.8 times NOPAT (three-year average), and negative tangible book multiples. For a company that trades at no less than 20% return on equity for the past five years and provides a consistent dividend yield higher than 3% for the past three years, it seemed like a good deal.
The market-implied growth rates seem unrealistic as well, assuming a 0.7% yearly decline for the next seven years, when the married company has grown 2.3% a year since ’04, with much of the growth attributable to K-Tron and the Process EQT Group (even so, Batesville itself fell at 0.1% — seven times less than assumed).
With final adjustments for my estimates of whatever the company cumulatively extracted from R&D, its customer relationships, and the impact of its dilutive securities, the net reproduction costs for Hillenbrand Inc. totaled to $8.8 per share after discounting at the specified risk rate. (See Executive Summary.) First impressions said it was a buy from the get-go. A shame I stood corrected two months later.
Net Asset Value
There is no point in evaluating Hillenbrand from a liquidation standpoint. Batesville has been in business for decades, and until the day people gain immortality, start dying by vaporization or are whisked to the heavens by the Rapture as prophesied in the book of Revelations, there is no reason to think Batesville will ever run out of business. (Being forced out of it is a different breed altogether.)
The same line of thinking goes for the Process EQT group. In this regard, approaching Hillenbrand from Greenwald’s Net Reproduction Cost approach is a sensible choice.
Adjustments for the NRC were mostly focused on fixed assets, although FIFO inventory, investment assets and net retirement liabilities were adjusted to reflect: (1) higher costs of manufacturing, (2) lower discount rates and (3) lower market values — in light of the ongoing volatility in the capital markets as the European crisis continues to unfold.
With final adjustments for my estimates of whatever the company cumulatively extracted from R&D, its customer relationships, and the impact of its dilutive securities, the net reproduction costs for Hillenbrand Inc. totaled to $8.8 per share after discounting at the specified risk rate. (See Executive Summary.)
Value of Stagnation
The value of stagnation is essentially the result of a DCF valuation model assuming zero growth. Instead of going for the business’ most recent performance as its designer initially conceived, I went and applied multiple conservative assumptions (which are available on request).
These resulted in operating margins of 20.3%, versus the median OPM’s of 22.3%. The valuation model also produced a NOPAT margin of 13%, roughly 120 bps below the long-run average. My estimate of maintenance owner earnings was pinned at $155.4 million — the current market cap of $1.4 billion is about 9.2 times this amount. Capitalized at a discount rate of 9.65%, the unadjusted value of stagnation stands at $1.6 billion. Adjusting this computation for excess cash, dilutive securities, and long-term debt including its defined benefit plan, the final estimate of stagnation value was calculated at $1.21 billion — $19.32 a share.
This value suggests the current market price of $22.78 represents an 18% overvaluation above stagnation value. In other words, investors are paying almost 20% for Hillenbrand’s future growth! Is this premium worth it? Looking back at the company’s future prospects… not really.
Value of Future Growth
Every investor is always looking towards the future. In painting the estimate of Hillenbrand’s future, one must be aware of four things: First, HI’s primary business (death) is in decline; second, the Process EQT Group’s future tied to the industries integral to the economies; third, acquisitions will make the brunt of Process EQT’s growth; and fourth, HI’s potential for litigation-related, extraordinary expenses in the future can have a detrimental effect on the company’s value in the long run.
The market-implied growth rate is almost misleading, as it fails to include the price Hillenbrand must pay to exceed this hurdle.
My financial models aimed at appraising Hillenbrand’s future growth forecast owner earnings, employing over 20 variables including but not limited to North America’s population and its historical growth rate, the backlogs in the Process EQT Group’s pipeline, the married company’s cost controls and litigation damages. The net present values of these models are 66% dependent on the terminal period, highlighting Hillenbrand as a long-term value play.
Since the other scenarios employed clearly more conservative presumptions in Hillenbrand’s growth drivers, I can approach their results with significantly more confidence than the optimistic outlook. My worst case scenario presents a $15.4 per share outlook, suggesting a fair chance at losing money if Hillenbrand’s growth prospects and cost controls don’t play out well, even after taking account for strong hits to nonoperating items by the company’s acquisitional strategy and its pending litigation.
With its current price at $22.78, Hillenbrand is a pretty big gamble. The margin of safety at neutral growth — 10% — is not enough to justify not only the embedded growth premium of almost 20%, but also the substantial risk of permanent loss should the company encounter setbacks in the near future. This MOS rises to a more decent 21% when litigation’s shadow is completely eliminated from the equation. It’s nice to know Hillenbrand has been successful so far in defending itself from the 2005 antitrust case, but the company isn’t out of the woods yet, thanks to the Matthews case
Personal Choice of Action
That investors should avoid Hillenbrand at this current point is clear. VERY clear. As much as the market-implied growth rate does not reflect reality, the disjunction is not glaring, and the growth premium priced into the current market value is not worth the 21% margin of safety at neutral growth, not when this large gap in value could easily contract by half.
Unfortunately, this company’s prospects are not so dire that someone in my position should step into a short side. As a consequence, the best option is to wait it out and return to the stock once it plummets to a price that can justify the growth premium, even after considering the potential litigation damage. Those who are already locked in are better off hedging, either to offset the average costs or to use as an insurance policy in the short run — which is more likely given this year’s volatility.
Stocks Discussed: HI, MATW,