B - Barnes: A Partial Recovery

2024-01-13 09:25:51 ET

Summary

• Barnes Group experienced a rally in its stock over the past two months, driven by lower interest rates and the announcement of a bolt-on sale in 2024.
• The company's history dates back to 1857, and it has consistently paid dividends for nearly 90 years.
• Barnes recently sold its Associated Spring and Hanggi business for $175 million, aiming to reduce leverage and improve financials.

In October, I believed that Barnes Group (B) was facing heavy turbulence as it announced a very soft set of third quarter earnings results, with the softer operating performance being made worse due to significant leverage incurred with the recently acquired MB aerospace business.

Over the past two months, shares of Barnes have seen a huge rally, aided by interest rates aggressively moving lower, and now a bolt-on sale being announced early in 2024. This creates some early green shoots, which are actively being priced in here.

On Barnes

Barnes has a history which goes back to 1857, having paid out nearly 90 years of uninterrupted dividends. The business has long relied on transformation of its business in order to remain relevant, but quite some events have taken place over the past year.

In February 2023, the company posted 2022 results with sales reported at $1.26 billion, unchanged compared to 2021. After adding back an impairment charge, operating profits fell from $150 million in 2021 to $125 million in 2022, with earnings reported around $2 per share.

These sales and earnings were mostly derived from industrial markets, notably molding solutions, motion control solutions and automation. The other third of the business was generated from the aerospace market, mostly from OEMs and after market services.

A $40 stock looked fairly valued with earnings power reported around $2 per share, as no growth was reported, while net debt of $500 million translated into a low 2 times leverage ratio. Even a solid 2023 outlook, calling for sales to grow by 6-8%, with earnings seen at a midpoint of $2.20 per share, could not alter my neutral stance.

A Big Deal, Raising Questions

In June of last year, Barnes announced a $740 million deal to acquire MB Aerospace, an aero-engine component manufacturing and repair services. The UK-based business was set to add $300 million in sales and $65 million in EBITDA, with synergies having the potential to increase the latter number by twenty million over time. With the deal, the aerospace business would become roughly equally large compared to (what used to be) the core industrial business.

The pro forma net debt leverage ratio would increase to 3.8 times EBITDA, enough of a reason to get cautious in a higher interest rate environment, certainly as the organic business was underperforming a bit. Moreover, while significant leverage was added, the same could not be said for near term earnings per share accretion.

Given this backdrop, I found it very easy to avoid the shares on the announcement date. Darker clouds surfaced in July as the company reported a mere 4% increase in second quarter earnings, reported at $0.58 per share. Moreover, the MB deal closed in August, when interest rates were higher, with higher borrowing costs making the deal dilutive in the first year, with dilution expected to the tune of $0.25 per share.

Third quarter sales were reported in October, and while revenues were up 15% on the year before (aided by the deal for MB) organic sales growth of 4% was softer again. The real issue was that even adjusted earnings fell sharply, down to just $0.19 per share, prompting a big cut in the full year earnings guidance, now seen around $1.62 per share. Moreover, no quick avail was in sight, with book-to-bill ratios coming in far below 1 times.

The issue was a $1.22 billion net debt load. In fact, the 51 million shares traded at just $20 at the time, combined being valued at less than net debt. While shares were not expensive from an earnings point of view, the issue was that of leverage concerns.

With a run rate of $1.5-$1.6 billion in sales, I pegged EBIT margins around 12% of sales, equal to $180-$200 million in dollar terms, as I estimated EBITDA to come in around a quarter of a billion. This would translate into sky-high leverage ratios of 5 times, although this number was surrounded by great uncertainty.

With the concerns from June have manifested themselves in a shorter period than expected, I was hesitant to buy the dip, given the rapid and big shortfall in the results.

Recovering

The dip by the end of October has proven to be an excellent buying opportunity as it turns out, as shares have risen more than 50% in the same span of just about ten weeks, now trading at $31 per share.

Quite frankly, most of these gains have been driven by a rapid decline in interest rates, as these likely alleviated most of the concerns given the leverage incurred in the light of the softer operating performance. Other than that, it has been quiet on the corporate front, with exception to an investment presentation in November in which Barnes highlighted the potential if it executes to its plans. On top of this news, some insider buying activity has been reported as well, always as comforting sign.

In the second week of 2024, Barnes announced the sale of its Associated Spring and Hanggi business to One Equity Partners. The two activities are valued at $175 million, which includes a promissory note of $15 million due in 24 months, with net cash proceeds pegged at around $150 million, as the company reiterated its goal to reduce leverage to 3.0 times, or less, by year-end 2024.

The two activities were part of Barnes' industrial motion control industries and generate about $200 million in annual sales with some 800 workers. The exact pro forma implications are not yet known, but with these activities valued at 0.9 times sales, it is clear that valuations are quite a bit lower.

Trading at $31, the enterprise value of Barnes has recovered to $2.8 billion, implying that the entire business trades just shy of 2 times sales here. To call the divestment too cheap is shortsighted as well, as the industrial segment posts margins while trailing the aerospace business is a great deal, but the exact margin details of these activities were not announced.

And Now?

The easy work seems to have been done, as the real buying opportunity has been seen already. Nonetheless, Barnes remains an interesting business to keep an eye on, as further deleveraging of the business might create a runway for earnings to come in around $2 per share not too far from now.

Combined with more moderate leverage and a mid-teens earnings multiple, this might reveal upside. For now, I am patiently awaiting the implications of this deal and the outlook for 2024 before reconsidering a neutral stance.

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