The Unwarranted Conglomerate Discount And Potential For Significant Value Extraction At Nortek

• Nortek is undervalued based on a sum of the parts analysis due to the conglomerate structure and relatively little analyst following for a stock of its size.
• Higher projected top-line growth along with ongoing efficiency initiatives should drive significant gains in EBITDA, currently depressed by restructuring charges and colder than normal weather.
• The tech and display mount solutions segments are a source of hidden and potentially significant value, especially the former given the interest in home automation.

Company overview

Nortek ( NTK) is a conglomerate focusing primarily on the remodeling and replacement (R&R), residential/commercial new construction and personal/enterprise computer markets. Below are the five operating segments:

The residential ventilation (RESV) segment manufactures room and whole-house ventilation products such as range hoods and exhaust fans.

The technology solutions ( TECH) segment manufactures residential security/access control systems, home automation solutions and professional video signal management solutions.

The display mount solutions (DMS) segment manufactures wall/desk mounts, carts, arms, workstations and stands.

The residential heating and cooling (RHC) segment manufactures air conditioners, heat pumps, air handlers and furnaces.

The custom and engineered solutions (CES) segment manufactures HVAC products used in non-residential applications such as data centers.

Industry tailwinds + internal growth and efficiency initiatives = Better than implied results

The conglomerate Deal News is magnified as the market is ignoring the consistent top line growth and focusing instead on the recent modest decline in the EBITDA margin shown in the chart below.

Even though cash flow is temporarily depressed due to elevated spending as a result of the ongoing restructuring, NTK still managed to generate a 7.8% FCF yield despite an 82% increase in capex.

As these restructuring charges gradually dissipate over the next two years, the high operating leverage and accelerating top line should drive significant EBITDA growth on a dollar and margin basis due to the following four factors.

First, NTK is positioned to benefit from the strong industry tailwinds with its broad product offerings and leading market position in many of its markets, which was largely responsible for the broad-based growth in the mrq. Moreover, R&R and construction activity should resume as spring approaches and the words "polar vortex" become a distant memory.

Second, the inter/intra segment diversity provides greater overall revenue stability. For example, the RESV and RHC segments (dependent on residential construction and R&R) are offset to some extent by the CES segment, which focuses primarily on the non-residential market projected to grow at 2x GDP. Within the DMS segment, lower demand for flat-panel TVs and PCs is being offset by tablet products, sit-stand workstations and stronger demand from the fast-growing telemedicine area with the Ergotron StyleView Telepresence carts.

Third, NTK can leverage its leading market share and multiple distribution channels to introduce new products to more customers with higher profit margins (e.g. exiting lower margin range hood and display mount products).

For example, the RESV segment is winning new business in the large and growing Chinese market with six new product families aimed at improving indoor air quality while the CES segment has one of its highest backlogs ever due to the growing demand for its data-center offerings that increase energy efficiency and reduce total cost of ownership. While the sales cycle is longer compared to the other segments, this is more than offset by the higher margin revenue stream. Overall NTK is just beginning to leverage the significant cross-selling opportunities, which should drive incremental growth (especially internationally).

Fourth, currently NTK is mostly experiencing only the costs rather than the benefits of initiatives to rationalize sourcing, manufacturing, distribution and logistics operations. For example, NTK reduced its warehouse and distribution footprint by ~40%, reduced the number of suppliers providing greater pricing power (e.g. reduced the number of hardware and fastener suppliers from 150 to 6), reduced the number of operations in the TECH segment by six and consolidated a portion of its manufacturing capacity into lower cost locations such as Mexico. The net result of these initiatives is annual cost savings of ~$15-20 million this year and ~$45-55 million going forward.

How the high debt can be a catalyst

The high debt load is only a negative when viewed in isolation and without considering the following three mitigating factors. First, NTK has excess capacity of ~$249 million given the low level of borrowing under its ABL facility. Second, there is little interest rate risk as ~92% of long-term debt is at fixed interest rates with no significant near-term maturities (closest is 2017). Third, the current level of EBITDA (even assuming no growth) is more than sufficient to service the debt as the leverage ratio has decreased from 6.2x in 2010 to 4.2x currently.

Management is aware of the need to continue to de-lever and mentioned on the most recent conference call (PDF alert) the possibility of refinancing in December, which should not be difficult given the constructive relationship with its lenders. For example, an amendment to its ABL facility in June 2012 resulted in a maturity extension to 2017, a lower interest rate and less restrictive covenants.

This refinancing would provide two key benefits in addition to the obvious meaningful interest savings. First, NTK should take advantage of the extremely favorable cov-lite financing conditions so it could sell assets and use the proceeds for shareholder-friendly measures such as a buyback or special dividend (see below). This would be difficult (at best) currently given that the term loan facility requires directing 100% of the proceeds of asset sales to debt repayment.

Second, this may be the catalyst for a ratings upgrade from Moody's, which appears to be behind the curve (what a surprise) in recognizing the previously mentioned significant financial and operational improvements. This could be a near-term event as management said it expects to meet with them by the end of March or early April

Leaving the nest: The case for selling the TECH segment

The January 2013 acquisition of Nest by Google resulted in investors looking for the "next Nest" and drove a 41% and 58% increase in Echelon and Control4, respectively. However, NTK received no such benefit given that its TECH segment is hidden in a larger corporate structure. The low amount of analyst coverage (for a $1 billion + market cap stock) further "suppresses" the story, especially the increasing contribution of security/home automation, which now accounts for ~66% of the business from 54% in 2011.

Given the increased interest in the industry, the February 2013 acquisition of 2GIG Technologies (a designer of residential security/home automation systems) for only 6.8x EBITDA appears cheaper by the day. Unfortunately for NTK, the significant consumer, investor and media interest in Nest products (which is deserved) is not extending to the similar 2GIG offerings (e.g. Go!Control touch-screen panel and all-in-one home security/automation solution). Moreover, the whole is greater than the sum of the parts given the engineering/supply chain synergies and cross-selling opportunities.

The large size of the domestic market and the fact that less than 2% of consumers use systems to remotely monitor or control home smoke/fire alarms, air-conditioning settings or doors provides the potential for significant and sustainable growth.

However, the optimal time to sell may not be when revenue is closer to the peak for two reasons. First, valuations are already attractive (for sellers) given that Google paid 10.7x revenue for Nest. Even assuming only a 2x multiple for the TECH segment, this would generate proceeds of ~$1 billion, which is almost as much as the current market cap.

Second, selling now for a high multiple is more attractive than holding out for a larger multiple years later. For example, for every time this strategy worked out (e.g. Facebook), there are probably 10x as many where it did not.

The list of potential acquirers is larger than just companies named Google. For example, this segment would be attractive to cable/satellite/telecom companies looking to strengthen their home security offerings.

Valuation

Given the conglomerate structure, a sum of the parts analysis better highlights the undervaluation. While there is inherent subjectivity in choosing a peer group and respective segment multiples, the primary focus should be on the fact that NTK is undervalued, especially as this assumes no takeover premiums, no EBITDA growth and no cost savings.

Although NEST is clearly the single-greatest value extraction opportunity, the DMS segment is a close second with its well-known Ergotron brand, which is also effectively hidden from investors. For example, although the annual revenue is only about half of the TECH segment, this is more than offset by the >2x higher EBITDA margin. A natural acquirer would be Pritzker Group Private Capital given that it acquired Milestone AV Technologies in December 2013 and would be able to generate significant operational synergies.

The purpose of calling for these asset sales is not due to mismanagement or poor execution - in fact the opposite. Management and the board have done (and continue to do) an excellent job in positioning the company for higher and more profitable growth. However, the market does not seem to care.

There is one caveat: Ares Management owns ~39%, which effectively eliminates the possibility of any activist involvement. Any divestment strategy would require their explicit approval, although given the potential gains they should at a minimum be willing to listen to new ideas.

Risks

The following are the primary risks to the investment thesis, in order of importance:

• NTK is largely levered to cyclical and seasonal R&R/new construction activity with ~65-69% of overall revenue related to the residential housing market.
• There is a high amount of debt although this risk is mitigated by the previously mentioned factors.
• Rising raw material prices (e.g. steel, copper, aluminum, plastic) would reduce gross margins.

Conclusion

The target price is based on a 10x multiple, which is more than supported by the higher aggregate peer multiple and potential for value extraction.

A tight stop loss should be placed below the 50 DMA slightly below the current price. The time frame is 12-24 months.