In theory, it’s great to talk about emulating the legendary Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), of Berkshire Hathaway (BRK.A) (BRK.B, Financial) fame. But, how do you do that in practice?
Many of Buffett and Munger’s top companies are 100% owned by Berkshire Hathaway, and we can’t always find appealing values when looking at the companies in which they have minority positions.
Enter the Buffett Munger screener at GuruFocus; it gets us at least started along the same road as the investors from Omaha. The screener shows us companies with consistent revenue and earnings growth, as well as objective valuations based on the P/E divided by the growth of EBITDA: PEPG.
MTS Systems Corporation (MTSC, Financial) came to our attention by making its way through the Buffett Munger screener. Notably, it’s a small cap (just under $1 billion) that boasts predictable earnings and a PEPG of less than 1.0 (undervalued).
History
1966: Company founded, incorporates the following year
1970: Becomes the first company to use the principle of magnetostriction for position sensors and liquid level gauges
1973: Opens its first international office, in Berlin, Germany
1984: Acquires Temposonics, which leads to creation of the Sensors Division
1987: Created first tuned mass dampers, for Citigroup Center in New York City and John Hancock Tower in Boston
2008: Fined $400,000 after pleading guilty to submitting incorrect export license applications for shipments to India in 2003
2011: Temporarily suspended from U.S. Government contracting for failing to to disclose, in its Online Representations and Certifications Application (ORCA) relating to U.S. Government contracting, that it pled guilty to two misdemeanors in 2008
2012: Jeffrey A. Graves, Ph.D. named Chief Executive Officer
2013: Opens regional office in Moscow, Russia; with Shanghai Jiaotong University, agree to establish an Aerospace Structural Strength Testing Demo Site in Shanghai; recognized in the April 2013 issue of Kiplinger’s Personal Finance as one of six smaller-sized companies that "pay generous dividends and have bright prospects for shareholder appreciation."
2014: Acquires Roehrig Engineering, Inc.; opens first joint laboratory with a domestic Chinese automotive OEM, Chery Automobile Co. Ltd. in Wuhu, China.
History based on information from the company website and Wikipedia.org.
Takeaways: A company with nearly 50 years of history in a couple of defined niches; note as well the company’s inclinations to acquisitions and international expansion.
The MTSC Business
According to its 10-K for 2013, MTS Systems Corporation is an engineering technology company, specializing in test systems and position sensors.
The company’s Test segment involves hardware, software, and services that customers use during product development, to simulate the forces and motions expected from a new product. Simulation is quicker and less expensive than ‘real-world’ testing during development.
Typically, a test system will include a frame which holds the prototype, a power source (hydraulic pump or electro-mechanical source), piston actuators that create the force or action, and a computer controller that directs the actuator and collects the results.
MTS divides its Test customers into three groups:
- Ground vehicles: such as cars, trains, and construction equipment; typical usage might include tire performance and rolling resistance, and moving-plane road systems within wind tunnels
- Materials: a diverse group of end users including aerospace and bio-medical products; one example would be to test the durability and performance of prosthetics (artificial limbs)
- Structures takes in end users such as wind turbine manufacturers and construction companies; one example is testing the design of bridges and buildings.
Products from the Sensors segment are used by industrial machinery and mobile equipment manufacturers; for example, some products measure liquid displacement, liquid levels, in the process industries.
The company says its customers include: "...manufacturers of plastic injection molding machines, steel mills, fluid power, oil and gas, medical, wood product processing equipment, mobile equipment, and energy."
Test systems and sensors are mostly custom built or developed at various offices and manufacturing plants around the world. Order sizes range from a few hundred dollars to $11 million, with the average order size coming in at about $115,000.
The company had about 2,300 employees at the end of fiscal 2013. It is based in Eden Prairie, Minnesota.
Revenue
As the following excerpt from the 10-K report for fiscal 2013 shows, about 80% of revenue originates with Test and about 20% from Sensors:
Geographically, the sources of revenue look like this:
With a September year end, fiscal 2014 has recently finished; the company recently announced preliminary results for 2014 in a press release, "For its fiscal year ended September 27, 2014, the Company anticipates that revenue will be $564 million...." That’s below its previous guidance of $570 million to $580 million. For fiscal 2015, it offers guidance of $615 million to $645 million.
Competition
While MTSC designs and develops one-of-a-kind products for its customers, it still faces competition. As it notes in the 2013 10-K, "Competition is based on application knowledge, product features and design, brand recognition, reliability, technology, breadth of product offerings, price, delivery, customer relationships, and after-market support.
Morningstar names Keyence Corp (KYCCF, Financial) (market cap $28 billion) and Sensata Technologies Holding N.V. (ST, Financial) (market cap $8 billion) among the numerous competitors in the Scientific & Technical Instruments industry. MTSC also faces competition from internal sourcing, which happens when companies decide to the work inhouse, rather than contracting it out.
With a market cap of just under $1 billion, MTS Systems is much smaller than than these two and a number of other competitors.
Competitive Advantages
As a engineering technology company, MTSC has two main sources of competitive advantage: its intellectual property and its employees.
On the IP front, the company says in its 10-K, "We rely on a combination of patents, copyrights, trademarks and proprietary trade secrets to protect our proprietary technology, some of which are material to the Test and Sensors segments. We have obtained numerous patents and trademarks worldwide, and actively file and renew patents and trademarks on a global basis to establish and protect our proprietary technology. We are also party to exclusive and non-exclusive license and confidentiality agreements relating to our own and third-party technologies."
Employee incentives includes stock-based compensation. As of September 28, 2013, 1,776,238 shares were available for future grant. In addition to company-wide stock incentives, MTSC also issues restricted stock to directors and key employees. In fiscal 2013, the company issued 12,000 restricted shares initially valued at $677,280.
Takeaways: MTSC is an engineering company that operates in the competitive Computer Hardware/Scientific & Technical Instruments sector. Within its own niches, it has found operating segments and geographic opportunities to grow its revenues.
Growth
The following GuruFocus chart shows the growth of revenue (blue line) and Earnings Per Share (red line), alongside the share price (green line):
Looking forward, MTSC sees long-term growth drivers that will push it forward. They are:
- New classes of consumers in emerging markets, creating demand for new and better transportation
- Increasing energy pricesÂ
- Environmental concerns, fueling demand for fuel-efficient, low-emissions trains, planes, and automobiles
- A demographic shift which will see a new generation of young engineers, especially in emerging nations, need to add testing capacity as they develop new products. (Source: 2013 Annual Report)
Takeaways: MTS Systems has demonstrated its ability to grow both the top and bottom line over the past 20 years, and it has identified trends which it believes will propel it forward over the coming decade or decades.
Management
President, Chief Executive Officer, and Director: Dr. Jeffrey A. Graves, Ph.D. has held the CEO post since 2012; prior to that he held the same positions at C&D Technologies, Inc between 2005 and 2012. His Ph.D. Is in Metallurgical Engineering.
Chief Financial Officer: Jeff Oldenkamp, took up this position in mid-2014; previously Vice President of Finance for the MTS Test business, and before that CFO and Vice President Finance at Nilfisk-Advance, Inc.
Senior Vice President: Dr. William E. Bachrach, Ph.D. His doctorate is in theoretical and Applied Mechanics.
Chairman of the Board: David J. Anderson; previously President, CEO, and Director of Sauer-Danfoss Inc.
Board of Directors: 10 members, including Dr. Graves and Chairman Anderson; areas of expertise and experience include manufacturing and marketing, engineering, finance, electric motors and turbines, defense, auto manufacturing, fluid technologies, management consulting, and international marketing.
ISS Governance QuickScore: MTS Systems receives earns a good or very good (low governance risk) score of 2/10, on a scale where 1 is very good and 10 is very poor. It receives two red flags, for Related Party Transactions and Use of Equity, as well as one green flag for voting issues.
Takeaways: Strong management and board; should be capable of growing the company in at least the near- to mid-term future (source: company website).
Ownership
Gurus: Five gurus followed by GuruFocus have holdings in MTS Systems. The biggest holding belongs to Bill Frels (Trades, Portfolio), with 1,795,884 shares. Smaller holdings belong to John Rogers (Trades, Portfolio), Chuck Royce (Trades, Portfolio), Jim Simons (Trades, Portfolio), and John Keeley (Trades, Portfolio).
Institutions: Data from nasdaq.com shows MTSC with 164 institutional investors (includes pension funds, mutual funds, banks, insurance companies, hedge funds, and others) holding just under 92% of the outstanding shares. The biggest institutional holder is Bill Frels (Trades, Portfolio)’ Mairs & Power Inc.
Shorts: According to GuruFocus, short interest is currently 5.98% and this is how it looks historically:
Insiders: GuruFocus puts the insiders at 3%. Yahoo! Finance lists director Barb J. Samardzich as having the biggest holding, at 22,585 shares; Chairman David J. Anderson had 13,349 shares as of February 11, 2014 (according to GuruFocus, he bought 5,000 shares just a week earlier). CEO Graves does not make the top five list of insiders.
Takeaways: The big investment pools have lots of interest in this stock; shorts have a modest holding, and when it comes to insiders, we wonder only where the CEO stands.
MTSC By the Numbers
Taleaways: Market cap just under $1 billion, current stock price about mid-way between 52-week high and low, ROE strong at 20,7%, dividend yield of 1.8%, and no share buybacks recently.
Financial Strength
The GuruFocus automated rating system gives MTSC 9/10 for Financial Strength and 8/10 for Profitability & Growth; both very good scores:
The system flags our attention to the company’s long-term debt, both on the Financial Strength dashboard and in one of the warning signs. Looking further, though, we see the system telling us, "Over the past 3 years, it issued USD23.837 million of debt. But overall, its debt level is acceptable." (revenue for the trailing twelve months is $576-million).
The following chart shows that the long-term debt situation is quite good:
And here’s how the company’s cash flow looks, on a quarterly basis, for the past decade:
Takeaways: Good financial strength, with no concern about debt or free cash flow.
Valuation
MTS Systems makes through the Buffett Munger screener for two reasons: the ability to consistently grow revenue and earnings, and fair-valued or undervalued.
Consistency of results shows up in the Predictability rating at GuruFocus; MTSC rates four stars (on a scale of 1 to 5), which is very good. Backtesting by GuruFocus shows companies with four and five star ratings are highly likely to increase in value and very unlikely to drop in value if held for 10 years.
GuruFocus values Buffett Munger stocks with PEPG, Price/Earnings ratio divided by the average growth rate of EBITDA over the past 5 years. MTSC has a P/E ratio of 19.40 which we divide by the five-year EBITDA growth rate of 32.60% for a PEPG value of 0.60.
A stock scoring less than 1.0 is considered undervalued; a stock between 1.0 and 2.0 is considered fair valued; and a score of more than 2.0 is considered overvalued in the GuruFocus system.
With a PEPG of 0.60, MTS Systems is considered undervalued.
Takeaways: A solid company that might catch the attention of Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) because of its predictable flow of revenue and earnings, and because of its low PEPG score.
Opportunities & Risks
To paraphrase what the company points out in its most recent Annual Report, a huge middle class is emerging in countries like India and China. With those citizens increasingly able to afford newer and better transportation, testing and sensors will experience increased demand.
We also note the public’s low tolerance for safety-compromised products (as we’ve seen with automobiles in the past few years) driving new business to companies like MTSC.
The broad trend of intense pressure to produce more product at lower and lower prices should help MTSC generate new business from manufacturers.
While we’re not sure what might be involved, if driverless cars arrive we can surely expect an enormous new market for sensors to emerge.
Turning to risks, we note many of the company’s customers, in many countries, feel the effects of national economic conditions; economic slowdowns mean slow times throughout the vertical chain.
Similarly, the company notes in its 10-K for 2013 that many of its customers are in cyclical industries, which adds another layer of overall uncertainty.
As a tech company, it depends heavily on intellectual property, both its own and of not infringing the IP of competitors and other companies.
It also depends heavily on its employees, particularly its professional engineers and technical staff.
As an international company, and one that sees emerging markets playing an important role in its future, it is exposed to currency, political, and other risks.
Outlook
The opportunities and risks suggest the company’s optimism in its Annual Report for 2013 is warranted. It does face risks of various kinds, but it does have a solid management team with a good record.
In the shorter term, the company will announce its fiscal 2014 results on November 10, 2014. In its preliminary results, announced October 28, the company, it predicted revenue of $564 million and earnings per share, excluding any restructuring charges, of $3.01.
For fiscal 2015, it offered guidance of $615 million to $645 million and earnings per share in the range of $3.60 to $4.00. The average estimate of the three analysts followed by Yahoo! Finance puts fiscal 2015 earnings at $4.01, which is consistent with the upper range of the company’s guidance. That would mean earnings increase by 33% from 2014 to 2015.
Conclusions
With the exception of a couple of missteps over incorrect paperwork, MTS System Incorporated has a solid operations and financial history.
Indications are the company also has good prospects for future growth, for fiscal 2015 and beyond. And, it offers a forward dividend yield of 4.3% (4.5% trailing) as well.
Investors looking for both capital appreciation and income in a small cap stock should take a long look at MTS Systems.
