Friday, June 16, 2006

Sun Hydraulics-Earnings Power in Fluid Power

Sun Hydraulics (SNHY) designs and manufactures screw-in hydraulic cartridge valves, manifolds and packaged systems. The business, formed in 1970, has been profitable every year since 1972, quite an accomplishment for a business in what is perceived to be a cyclical business.

SNHY products go into manufacturing capital equipment (historically about 34% of sales) such as metal cutting, injection molding, and metal forming machinery. Other users of hydraulic equipment include bulldozers and construction equipment and oil drilling and mining equipment.

In a recent Wall Street Transcript interview with the CEO,Allen Carlsen, he described the hydraulics industry as a $20 billion industry of which screw-in hydraulic valves represents about a $1 billion market.

Specifically, screw-in hydraulic cartridge valves is a newer hydraulic technology that is taking market share from conventional hydraulic valves. They can be product specific and help to differentiate and improve the end product and as well, represent a more cost-effective solution as they are faster and more reliable. Another technological trend is the integration of electronics into hydraulic applications and SNHY also has products which allow being driven by electronic controls. Screw-in cartridge valves represent a miniaturization of hydraulic valves.

The company generates about 50% of its net sales outside the US and has design and manufacturing facilities in Florida, Kansas, Coventry, England, Erkelenz, Germany, Seoul, Korea, and Shanghai, China.

The company has a clear product driven as well as customer service strategy. As Carlsen points out, " We really are focused on investors who are going to be with us five or ten years, and spend very little time on investors who are speculating on a very short-term horizon." Music to my ears!

This is a $200 million market cap company with long term debt of just $3.7 million which is offset by cash of $5.4 million giving an enterprise value of $197.

Only about 68% of the shares represent free float. Some 30.5% of the company is held by Robert Koski, the co-founder of the company and its former President and CEO.

From a valuation standpoint, the company trades on an EV/EBIT multiple of only 9.8 times. Return on invested capital on a TTM basis is 21%

The returns on capital have improved over time, and as you can see, were positive, even if only slightly, during recession periods:


Earnings quality has been decent with CFFO cxceeding net income for each of the last seven years.Free cash flow has been generated every year since 2000.The company has treated shareholders well with a dividend growth rate over the last five years of 23%. There have been some share buybacks, In December of 2005, the Board authorized the repurchase of up to $2 million in stock to be completed by Jan 15th 2007. They have worked quickly with $1.8 million of stock already completed and retired.

The company also has an intelligent attitude about equity based compensation. As the proxy indicates, "The Compensation Committee determined that the use of restricted stock under the long-term compensation program implemented in 2003 better satisfied the purposes for which such awards were intended than stock options." In other words, the board is more interested in having management own stock rather than placing a side bet on the market!

The company has a very interesting culture with a flat management structure that "encourages communication, creativity, entrepreneurial spirit, and responsibility among employees." As management describes it, "A workplace without walls: both in its offices and its shop floors provides employees at all levels to interface. Few 10-K's openly discuss an objective to avoid unnecessary bureaucracy!

Overall, I like the candid nature of their disclosures, the team spirit that they endorse, and the corporate governance that demonstrates that these are not empty words. The economics are attractive, though obviously subject to the risks of weakening of the economy. I also like the fact that this relatively small business has such a significant global footprint.

Disclosure: Neither I, my family, nor clients have a current position in Sun Hydraulics.


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