One Company Going with the Flow

09/07/2011 8:30 am EST

Focus: STOCKS

Marc Gerstein

Editor, Forbes Low-Priced Stock Report

While lasers may be the cool 21st Century tools that have transformed the industrial age, that doesn’t mean Old School technology doesn’t have its own tale to tell, writes Marc Gerstein of Forbes Low-Priced Stock Report.

At first glance, machine tools sounds like a quaint industry, something from which we’ve long since progressed as our economy shifted from an emphasis on basic manufacturing, to services, to innovation-oriented areas such as wireless or biotech.

First impressions can, however, be deceiving. Flow International (FLOW), makes industrial waterjet cutting tools, and is quite innovative in its own right.

It produces equipment that enables manufacturers to cut surfaces more quickly, efficiently, and cleanly than they could with conventional blade-based cutting tools. This may not seem glamorous to the average investor, but to manufacturers, such considerations translate to lower cost—and that, in turn, translates to attracting business.

And by the way, it is true that a lot of this nowadays takes place outside the US. That’s fine for Flow: in the latest fiscal year, 57% of its revenue came from abroad.

The idea behind Flow’s equipment is to force 40,000 to 94,000 pounds per square inch (psi) of water through a tiny orifice, resulting in a stream of water traveling at supersonic speed. That’s a pretty powerful force: the stream actually can function as a cutting instrument, and can be used on just about any metallic or hard surface.

The appeal of waterjets relative to lasers, saw blades, or plasma comes from its versatility—it can cut a wide variety of surfaces because it does not involve heat or mechanical stress, and because it minimizes needs for special tooling or fixturing. The edges are smooth and accurate, allowing for tight nesting and minimal scrap.

As with many other kinds of equipment, there are varying levels of sophistication, with the most advanced versions offering automated approaches to tilting the head in ways that eliminate taper, as well as customization. In fiscal 2010 (ended January 2011), 54% of Flow’s sales came from standard systems, 13% from advanced systems, and 33% from spare parts.

Waterjets were invented in the 1970s, and achieved modest levels of awareness and adoption through the 1980s and early 1990s. In the late ’90s, awareness started to grow as higher-speed equipment was introduced, and it really took off in the 2000s, as still higher flow speeds were achieved and as dynamic cutting-head positioning was introduced.

Flow’s sales started to gain traction during this period, but progress was impeded by the late-decade recession. So, as things stand now, Flow is the dominant player with more than 30% of the waterjet market and revenues four times that of the runner-up.

But the category dominated by flow is small: waterjet has 5% of the cutting market, versus 65% for laser, 13% for electronic discharge, 9% for plasma, and 8% for other protocols. The investment opportunity in Flow stock depends on waterjet to make progress in narrowing the now-considerable gap between awareness and adoption.

It’s certainly not necessary that waterjet supplant, or even come anywhere near, laser’s dominant position. All we, as low-priced stock investors, need is for this now-nominally-profitable company to make enough progress to justify the stock’s currently-lean valuation metrics: a price/sales ratio of 0.57, compared with an industry median of 1.03 and the 1.00-plus levels achieved by FLOW prior to the recession.

Given the efficiency advantages of waterjet coupled with increasing use of outside distributors to reach more customers than can be addressed by the internal sales force, I think that’s very much doable. Flow International is a Buy.

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