To The Moon

Summary

• Despite impressive Q2 results, Powell Industries shows signs of overvaluation, with a high P/E ratio and anticipated share price decrease.

• The company's debt levels and declining profit margins are worrisome indicators for long-term financial health and sustainability.

• A mixed and mostly bearish outlook from the options market underscores the importance of thorough research and informed decision-making when considering investment in Powell Industries.

Brown bear (Ursus arctos) roaring, side view

An astute investor must recognize the potential strengths and weaknesses of a varied selection of stocks, such as those offered by Powell Industries (NASDAQ:POWL), a Houston-based supplier of electricity that has demonstrated strong growth. Nevertheless, upon further investigation, a less promising picture emerges, characterized by a decline in profitability, unfavorable cash flow, rising debts, and overvalued equity prices that amplify my negative perspective. Since it is rare for me to issue such decisive "sell" advice, you can be assured this is a high-conviction idea!

Company overview

Powell Industries operates in the electrical power industry. It offers solutions designed to control and manage electrical energy and other processes. Powell also operates in a number of other industries too, such as oil and gas, petrochemical, and utilities.

Powell Industries generates earnings through three main segments: Electrical Power Products, Process Control Systems, and Professional Services. These segments cater to a diverse set of industries, forming a significant part of the company's comprehensive offerings.

Powell Industries primarily deals in electrical power products, catering to industrial applications. Their offerings include switchgears, circuit breakers, and bus duct systems designed for a diverse customer base across several sectors including utilities, oil and gas, and transportation.

Strong Q2 results

The Q2 financial performance of Powell surpassed expectations with a 34% increase in net revenue to $171 million. The net income rose remarkably from last year's net loss of $1.2 million to $8.5 million. Orders booked reached a substantial figure of $508 million, indicating a strong order backlog with a book-to-bill ratio of 2.4x.

The company has a record backlog of slightly over $1 billion and a healthy financial position with $163 million in cash and short-term investments and no long-term debt. Besides, it increased its credit facility to $125 million.

Financial woes

So on the surface, things seem to be going well for Powell Industries, yet beneath the surface, things look ugly.

For one, while the company might have recently shown some signs of profitability on an accounting basis, for the last two years it has lost a considerable amount of money when one examines its free cash flow.

The company reported a negative FCF of $33.35 million in FY21, while in FY22 that figure was a negative $6 million.

This financial performance might be somewhat excusable since the trend suggests the company is on the way up in terms of FCF. But when one examines the change in their margins, this suggests there may be some systemic issues it needs to address in its operations.

Notably, the company's operating and net profit margins have struggled to make any progress for the last three years. Also, its gross profit margins are struggling equally.

Author supplied

When compared with its peers, it's obviously underperforming. Also, although the company notes it has not taken out any long-term debt, its total debt has inflated considerably over the last three years, growing from $400,000 in 2020 to $2,232,000 in 2022.

The company is also churning through a high amount of cash.

Author supplied

Judging by its losses on a FCF basis and the instability of revenue and its cost basis over the last three years, the company is in an uncertain financial position.

The problem is that if the company manages to clear its backlog, is it efficient enough at controlling its costs to turn its cash flow positive in the near future? There are no clear indications that suggest this is possible from its recent performance, despite management's positive outlook for the future.

Overvaluation

Based on the company's financials, I believe its valuation is illogical and cannot be justified. But to put its overvaluation into context, here are a couple of charts.

TradingView

On the weekly time frame, the company has shot up on an incredible rally. It's in the overbought territory on the RSI, Bollinger Bands, and is more than a couple of standard deviations above the 200-week SMA.

On the monthly charts, it may be even more clear how overvalued the company is on a technical basis.

TradingView

More evidence that a major move is about to take place (which I surmise to be to the downside) can be found in the options chain for the stock. The options market is pricing in a movement between 51.37% and 99.56% for calls, and around 53.22% and 59.28% for puts. This is a huge amount of implied volatility.

The options market is weighted towards bearish, with the most open interest around the $50 level. When the market opens on Monday, things look very ugly!

Yahoo finance

Now let's examine some ratios and do a bit of forecasting. The company is significantly overvalued on a P/E and P/FCF basis.

Author supplied

Judging by the long-term charts, we can assume that it's due for a downside correction based on its momentum indicators. Another catalyst for the company's downward correction is that it is due to pay its quarterly dividend of $0.2625 per share on June 14. After a company pays its dividend, a corresponding correction in its share price occurs, by the amount that was paid to shareholders in cash, all else being equal. The company has around 11.86 million shares outstanding.

So in summary, we have a company with troubled financial performance, a somewhat misleading and optimistic earnings report, overvalued technicals, overvalued comparables, and an upcoming dividend with a strong possibility of knocking its share price back down to earth again. The options market is also slanted heavily towards the bear case.

I think the question to ask is how much would it fall? In this case, I think technical analysis has the answer. I give it a price target of $43, which is around the mean of its 20-week performance. This would imply a P/E of approximately 18.61, which would still be twice as expensive as its peers. Note that this price target is quite optimistic on the bullish side. In reality, I believe it could fall much lower than this, but for a strong sell recommendation, I'd rather underestimate a prediction like this.

I honestly don't see any logical reason for why its shares should continue to rise further. Even if I am incorrect on the fundamental side, the upcoming dividend and technicals are strong independent reasons to sell.

Risks

Going short or buying puts is very risky. Traders expose themselves to unlimited risk when going short (since stock prices can keep going up, in theory), making it a calculated gamble.

Also, just because the stock is overvalued based on momentum indicators, it can still rise in price regardless.

The company could also be in the process of improving its margins and operations, which would defeat my long-term sell thesis.

Overall, timing the market is inadvisable for most investors due to it often behaving in irrational and explainable ways, no matter how well-reasoned one's thesis is.

Conclusion

I think the market is wrong about Powell Industry's recent earnings report, and there's strong evidence to suggest that a correction in its share price is a high conviction idea. The company's margins are deteriorating and suffers from operational bottlenecks, as evidenced by its enormous backlog. Although the business is making money on paper, for the last two years it has lost millions in free cash flow. The stock is overvalued on its technicals, comparables, and has a likely catalyst in the form of its dividend on the horizon that will send its share price lower. The options market has made a bet that it will come down violently soon, and I am in agreement for the aforementioned reasons. I am buying puts here.

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