Twin Disc: Reiterating ‘Hold’ As We Approach Fiscal Q3 Earnings

Intro

We wrote about Twin Disc, Incorporated (NASDAQ:TWIN) in December of 2023 when we looked at the stock’s continuous uptrending rally and whether this momentum could continue in earnest. Shares had rallied a very impressive 40%+ over the previous 6 months, leading to the reinstatement of the company’s quarterly dividend. The reinstatement demonstrated management’s growing confidence in the company’s respective end markets & forward-looking financials.

Shares though since that December commentary have only managed to break even, demonstrating that the momentum the stock enjoyed up until that point now seems to have eased off.

If we pull up initially an intermediate 5-year chart, we now see shares of TWIN attempting to break through long-term overhead resistance (2022 highs). Although this long-term pattern depicts buyer accumulation (higher lows depicting an ascending triangle), we would first need to confirm an upside technical breakout before changing our ‘Hold’ rating in the stock. What attracts us here with this triangle formation is the height of the pattern (greater than $10 a share). This demonstrates significant upside potential in TWIN only if as stated, an upside technical breakout is forthcoming.

On the long-term monthly chart, we see that if shares managed to break out above their 2022 highs, they would not reach the multi-year downcycling trend line until the $23 level approx. Suffice it to say, given that shares are trading under the $17 level at present, a $6+ minimum gain (35%+ capital gain) would be something that interests us if indeed the above-mentioned intermediate breakout was forthcoming.

Fiscal 2024 Q2 Profitability Trends

TWIN reported its second-quarter earnings on the 7th of February this year. Technicals aside, in an earnings report, we aim to size up the relationship between the trends of the company’s key profitability metrics along with the valuation. To this point, Twin Disc was able to report strong sequential top-line growth (14.8%) and rolling quarter top-line growth in Q2 (15%+). With top-line sales hitting $73 million in the quarter, the company’s profitability also benefited from an increase in gross margin (28.3%). The ‘Marine & Propulsion’ business powered the quarter forward, reporting strong double-digit top-line growth (Almost 30%) whilst Twin Disc’s ‘Land-Based-Transmission’ business reported 8% respective top-line growth.

Furthermore, forward-looking trends in both of the above-named businesses look encouraging. We state this because ongoing geopolitical tensions continue to ramp up defense budgets, which in turn should keep patrol-boat demand elevated for some time to come. Furthermore, concerning the ‘Land Based Transmission’ segment, there is plenty of runway for growth in the North American oil & gas market given demand for the company’s products only now seems to be ramping up in earnest.

The industrial business witnessed a 13% decline in Q2, with OEM-related sales continuing to struggle. Suffice it to say, one would feel here that better initiatives are needed (such as stronger OEM partnerships) to bring more value to this market over time.

However, all things remaining equal, Twin’s operating profit increased significantly in Q2 ($3.8 million) as key pricing changes and supply-chain improvements aided the company overall. To this point, investors should not go off the GAAP earnings number in Q2 ($900k) for valuation purposes due to a $4+ million sale of a facility in the same period of 12 months prior. Generated operating cash flow in Q2 came in well above $6 million, which enabled the company to bring down its leverage ratio (and corresponding interest expense) & increase its cash position. All the while, book value ($145.9 million) continues to grow, increasing by almost $6 million in value in the second quarter alone.

Valuation Remains The Wildcard

Therefore, when we subtract Twin’s trailing 12-month capex spend ($8.6 million) from the trailing operating cash flow of $38.9 million, we get a trailing free cash-flow figure of $30.3 million. Following on, by dividing Twin Disc’s trailing free cash flow into the present market cap of the company ($230.93 million), we get a trailing free cash flow multiple of 7.62. Suffice it to say, from a valuation standpoint, this is an excellent start as we see right away how much each dollar of free cash flow costs Twin Disc to generate. Ample free cash flow provided the fuel to keep on investing in the company, either organically or inorganically.

However, valuing a company can be difficult as investors tend to study a myriad of metrics when doing their due diligence. Another attractive multiple closely aligned with the company’s cash flow is from an operating profit perspective. If we return to Twin Disc’s operating profit, we see that the company has generated $21.3 million of EBIT over the past 12 months. Dividing this into the company’s enterprise value, we get an attractive trailing EV/EBIT multiple of 11.53.

Nevertheless, it is Twin Disc’s assets & sales that essentially make earnings & cash-flow growth possible, and here is where we see some discrepancies. As we see below, despite the above-mentioned sales & book-value growth currently taking place in Twin Disc, the company’s trailing book multiple as well as sales multiple continue to trail their respective 5-year averages by some distance. We do see a narrower gap between the company’s respective trailing EV/Sales multiples, but it remains evident that Twin Disc’s sales & assets both look a tad overvalued at this stage.

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Buying a stock at the right valuation is crucial as it is linked to investor psychology. What we mean by this is that investor sentiment in the main does not change which means that Twin Disc will need to report forward-looking above-average profitability to justify an overhanging valuation. For this to happen, we need to see strong working capital trends (inventory increased in Q2) where the supply-chain environment will need to continue to oblige to ensure the backlog can be sifted through at an accelerated clip.

Conclusion

To sum up, we are reiterating our ‘Hold’ rating in Twin Disc despite the company’s growing profitability & improving balance sheet. Although the company’s technicals look promising, shares (taking the company’s valuation into account) may not be able to overcome overhead resistance at this present moment in time. We look forward to continued coverage.