You know the old saying "his eyes were bigger than his stomach?" That was exactly the case when industrial conglomerate Eaton
You see, it's not so much that Argo-Tech is too big for Eaton. It's more that the price Eaton is paying makes me feel queasy. According to today's press release, Eaton intends to pay $695 million to acquire the aerospace business (it also has a few non-core activities such as cryogenics) of Argo-Tech parent company AT Holdings. While sizable, the acquisition isn't at all out of reach for Eaton, which sports an $11 billion-market cap. But a look at the relative valuations suggested by the deal hints that the aquiree is the one getting dinner and a movie here.
According to the Fool's data provider, Capital IQ, Argo-Tech as a whole booked $229 million in sales in the fiscal year just ended, $206 million of which came from the aerospace business that Eaton will be eatin'. Total earnings before interest, taxes, depreciation, and amortization (EBITDA) for the year were $50 million, which tells us that Eaton made at least one good call. The press release advises that the aerospace business produced EBITDA of $63 million, meaning that by refusing to swallow Argo-Tech's side businesses, Eaton is eschewing $13 million in unnecessary annual EBITDA losses.
Even so, the deal values Argo-Tech proper at approximately 3.4 times annual sales, and 11 times annual EBITDA. In contrast, Eaton itself sells for only 0.9 times sales, and 7.2 times EBITDA. Quite a difference.
Method behind the madness
Mind you, I understand the rationale for the deal. Eaton sees how the aerospace industry is booming these days, and wants to incorporate Argo-Tech's state-of-the-art fuel pumps into its own offerings, so as to be able to offer customers like Boeing
For my part, though, I focus not on EBITDA -- whether you want to count it or not, interest and taxes must be paid, and high depreciation of past capital spending promises high capex in the future. Looking past EBITDA, I see that in contrast to Eaton's $900 million-plus annual net earnings, and its even stronger $1.1 billion annual free cash flow, Argo-Tech booked a net loss under GAAP, and generated negative free cash flow over the last 12 months. In addition to being a money-loser, Argo-Tech isn't even a fast grower -- its 6% compounded revenue growth over the last five years just matches Eaton's own.
One final reservation before I close: According to Capital IQ, Argo-Tech carries roughly $275 million in debt, and the press release did not address whether Eaton will have to assume that debt, or whether it is perhaps incorporated into the announced purchase price. If it's the former, the deal will look less appetizing still.
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Fool contributor Rich Smith does not own shares of any company named above.
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