Seeking Small-Cap Moats: Sun Hydraulics

When I came up with the idea for this monthly series, one company stood out in my mind as embodying all the characteristics of a high-quality small cap that possesses an economic moat. It's also a company that I've followed and owned for a number of years now. At the risk of playing favorites and "talking up my book," then, I wanted to highlight a few other small caps in this series before I discussed this one.

Before we jump into this month's small cap, however, I want to clarify what I mean by a "quality" company--a term that's often used in equity research but is rarely defined. Depending on who is making the case, quality can be limited to just meaning a good balance sheet or consistent free cash flow generation, but there's more to it than any single factor. 

My favorite definition of quality comes from Montanaro Asset Management, a U.K.-based firm that incidentally specializes in small-cap investing.

For us, [quality] encapsulates the comprehensibility of a business, growth prospects, customer concentration, insider ownership, balance sheet strength, transparency and corporate governance, to name a few characteristics.
-- Cedric Durant des Aulnois

For my purposes, I add an economic moat and Exemplary stewardship to the list, but Montanaro's criteria is a much more complete definition of quality than you'll find elsewhere. 

By using this helpful framework, we can begin to see why this month's highlighted small cap should be considered a quality company.

Here Comes the Sun
The company is Sun Hydraulics (SNHY), a $1.1 billion manufacturer of high-performance screw-in cartridge valves and manifolds. For my fellow non-engineers out there, Sun's cartridge valves and manifolds control the force, speed, and motion in fluid power systems that are used in both mobile and fixed industrial equipment.  

Even if we don't completely grasp the science behind its products, Sun's niche business is comprehensible and straightforward. As capital goods orders come and go, so will demand for Sun's products. Indeed, the company's order patterns have largely tracked the U.S. Purchasing Managers Index (PMI), a leading economic indicator that measures manufacturing activity.

As you might imagine, demand from end markets like construction, energy, and mining is very cyclical. Nonetheless, Sun has been profitable every year since 1972. That's a remarkable achievement in itself considering the sharp pullback in industrial demand following the financial crisis.

One of the reasons Sun was able to stay profitable in those lean years was that the company didn't carry any debt going into the financial crisis (and still doesn't today). The firm's sterling balance sheet allowed the company to reinvest in the business, retain staff (it didn't lay anyone off), and prepare itself for the next demand cycle while some of its competitors were scrambling to survive.

Geographically, about half of the company's sales come from North America, 30% from Europe, and 20% from Asia. In the longer term, Sun expects the mix to be closer to a third in each region owing to increased Asian demand. This target could be a bit further off than the company expects, in my opinion, as China's economic growth rate slows relative to the torrid pace we've seen over the past decade.

Moat
Though Morningstar doesn't currently cover Sun Hydraulics, and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, I'm of the opinion that Sun possesses at least a narrow economic moat (that is, the company has an expected competitive-advantage period of at least 10 years).

Given the mission-critical nature of its products, Sun's primary economic moat source is likely a durable switching-cost advantage. Sun's products are highly customized and specific to a certain customer's specification to create an integrated solution, so swapping out a Sun valve for a competitor's valve, for example, doesn't work.

In fact, Sun's products have been known to outlast the equipment for which they were designed, thus reducing the customer's need to frequently shop around. Its highly efficient products also allow customers to save money on labor, energy, and downtime costs that peers may find difficult to match even at a lower price point.

I wouldn't say this about most companies, but Sun might benefit from an advantage related to its unique corporate culture and organizational structure. Since 1970, the firm has employed a "horizontal management" style that aims to eliminate rigid bureaucracies (there are no formal position titles and no levels of approval for decisions), maintain the right level of staffing, and quickly adapt to rapid changes in the marketplace.

This arrangement places an enormous amount of trust and responsibility on each employee and encourages a mentality of ownership and entrepreneurship across the company that has, to date, borne fruit. To illustrate, between 2004 and 2013, Sun's book value per share increased at an impressive compounded annual growth rate near 16%. 

SNHY Book Value (per share) data by YCharts

This cultural advantage would likely be attributed to the intangible-asset moat source, but it may also factor into a low-cost production advantage owing to its unique and lean manufacturing process.

When it comes to capital-allocation decisions, Sun has traditionally been conservative with mergers and acquisitions. This aversion to large M&A deals makes sense given Sun's strong corporate culture, as merging with a firm that possesses a markedly different culture could significantly increase the risk of integration failure.

Over the past 10 years, Sun hasn't actively repurchased shares, and it pays out a modest dividend that has nevertheless increased at a 22% compounded annual rate since 2004. It also pays a periodic shared distribution (that is, a special dividend) in particularly good years that benefits both shareholders and employees. The remaining cash is reinvested back into the business, and understandably so, given the firm's growth potential and returns on investment.

Sun's leadership team also has significant skin in the game, with directors and executive officers owning (as of the most recent proxy) 15.1% of shares outstanding. Most of this amount (about 12.4% of total) is held by members of the founding Koski family, one of which remains a board member.

Risks
Beyond the boilerplate risks outlined in the company's annual report, the three biggest long-term risks to Sun Hydraulics' business are potential adverse effects from 3-D printing technology, improving copycat manufacturing techniques from emerging-market competitors, and a large acquisition (however unlikely) that marks a departure from the company's core competency.

Valuation
Sun Hydraulics' operational strength and durable competitive advantages are reflected in its attractive profit margins and returns on equity over the past 10 years. 

SNHY EBITDA Margin (TTM) data by YCharts

This type of performance--particularly for a cyclical company--doesn't come cheap, however, particularly now that global industrial demand has rebounded following the latest recession.

SNHY Price to Book Value data by YCharts

From a historical perspective, the best time to buy Sun Hydraulics is when the market is concerned about future capital goods demand and manufacturing growth. Right now the market appears optimistic, but if it grows more concerned about a slowdown in capital goods demand in China, a better entry point may present itself. I'd look to add to my current Sun holding below $35 per share.

Bottom Line 
Sun Hydraulics is--by just about any definition--a high-quality company that has a profitable niche focus, a likely economic moat, and a strong management team. At the very least, it's one to keep on your watchlist.

Please share any questions or feedback that you have in the comments section below.

Other stocks highlighted in this series:

• John Bean Technologies
• Culp Inc.
• Badger Meter
• US Ecology

Todd owns shares of Sun Hydraulics. You can follow him on Twitter at @toddwenning.