No Changes to Our $171 Fair Value Estimate for Dover
No Changes to Our $171 Fair Value Estimate for Dover
Analyst Note| by Joshua AguilarUpdated Oct 20, 2022
Nothing in narrow-moat-rated Dover’s latest third-quarter results materially alters our long-term view of the firm. Top-line results were nearly line-ball accurate with our forecast. However, EPS of $2.26 easily cleared the $2.10 we earmarked for the quarter, thanks to 60 basis points of better-than-expected operating margins. That said, we brought down our fourth-quarter EPS expectations by about the same difference, based on management’s commentary and reduced top-line guidance (currency), so the effects mostly offset one another. Therefore, we maintain our $171 fair value estimate.
Revenue of $2.16 billion was a 7% year-on-year reported increase over last year’s third-quarter results. Organic results were even better at 9% year on year, which was offset by strong currency headwinds of about 5%. The two standouts during the quarter were the climate and engineered product segments, each growing organically over 19% and nearly 18%, respectively. Climate grew on strong volumes and price actions across all its businesses (food retail, HVAC, and consumer goods), with strength in all geographies, too. Dover is investing in capacity expansion programs, CO2 systems, and heat exchanges, which are fertile areas for secular growth. The firm had a similar story in engineered products with broad-based strength thanks to both robust volumes and pricing actions taking hold.
Dover also managed to increase third-quarter segment operating margins by 50 basis points—a very nice result. Unsurprisingly, climate once again led the way with an eye-popping 470 basis points of segment operating margin expansion. Engineered products and imaging followed closely behind, with segment operating margin improvements of 240 and 220 basis points, respectively.
Business Strategy and Outlook| by Joshua AguilarUpdated Oct 20, 2022
We view Dover as a collection of moaty businesses in niche markets. Since his installation in 2018, CEO Richard Tobin has focused on cost-reduction efforts that are still bearing fruit as evidenced by the firm's ability to hold decremental margins to below 20% during the pandemic. We expect average incrementals of about 33% over the long term as sales recover and believe the firm can eventually hit nearly 23% segment operating margins and free cash flow margins of over 16%.
Dover is a GDP-plus business, with subsidiaries that have leading and profitable market share, backed by an economic moat. Many of its businesses hold the first or second share position in consolidated niche markets. Customers in these markets demand highly technical, engineered solutions and trust Dover’s portfolio of brands to meet both safety and environmental regulatory standards. Dover also benefits from a large installed base, backed by highly recurring parts and service revenue that sells at higher margins than equipment sales.
Dover’s current portfolio benefits from myriad secular trends, including traceability and food label regulations, technological advancements in both printing and refrigeration techniques, customer demand for energy-efficient solutions, rising urbanization in the developing world, increasing volume of surgical procedures, CO2 refrigeration systems and heat pumps, and chip card regulations (EMV), which we believe will continue to propel Dover toward mid-single-digit top-line growth through the cycle. Other significant drivers include the use of single-use technology in biopharma applications, which we think will drive strong double-digit top-line growth through our explicit forecast.
We believe Dover can steadily increase each of its segment margins over the next five years, with the greatest upside evident in the firm's climate segment. Aside from improving mix, increasingly implementing automation should drive productivity and efficiency gains. While this segment is the laggard, we think it's capable of consistently generating midteen operating margins through the cycle. As with many peers, we also expect Dover to cut down on its quantity of IT vendors.
Economic Moat| by Joshua AguilarUpdated Oct 20, 2022
We believe Dover has a narrow economic moat based on intangible assets and switching costs. Dover's core competency is creating highly technical, engineered solutions that meet industry demands for performance, reliability, and safety. The firm boasts a portfolio of businesses with well-regarded brands in niche markets that benefit from sizable installed bases, leading to highly recurring revenue. Customers perceive these brands as vital because of the firm’s ability to meet customer demand, whether by creating value-additive products through innovative, proprietary technology, or by meeting safety and reliability standards in highly regulated industries. While we think the firm's returns have materially improved since the spin-off of Apergy and will never return to their 2016, industrial recession lows (total oil and gas exposure now remains only about 5% of sales), we still don't have enough confidence to assign a wide economic moat rating for our 20-year excess return horizon.
Both marking and coding and digital textile printing, which comprise the imaging and identification segment, are highly technical product categories that require continuous innovation and know-how to improve both output and quality. We think this is a narrow-moat business. Market codes include best-before dates, batch numbers, ingredients, logos, and barcodes. Digital textile printing serves customers who ultimately create images for fast-moving consumer goods, including fashion retailers like Zara and H&M. Dover’s operating companies are leaders in this space, particularly in marking and coding, where the firm’s brand Markem-Imaje has about 25% of the addressable market (behind industry leader Danaher). Furthermore, the firm has accelerated its patent filings as measured by its 30% increase in new patent filings from mid-2012 to the end of 2014. A survey of the U.S. Patent and Trademark Office reveals multiple utility patents ascribed to Markem-Imaje. To qualify for this designation, these inventions must be novel, new, and non-obvious. Given the comparably higher hurdle to obtain them, utility patents offer advantages over design patents given the intellectual property protection around an invention’s function. They can also protect many different variations of a product with a single approved filing. Examples of Markem-Imaje’s utility patents include inkjet chemicals that permit a drying time of less than 10 seconds while boasting a decap time--the time a printhead can be left uncapped and idle while still producing a high-quality image--of over a minute.
Customer relationships are also a key intangible asset in the imaging and identification segment, allowing Markem-Imaje to create superior products based on demand, including inkjet models that use ketone-free ink. These models translate to 15% less additive consumption, quicker drying time on non-porous materials, and less odor and fumes. Dover’s MS business’ digital printing solutions further reduce print lead times, improve print quality by 4 times that of analog (in the case of single-pass technology), and are a superior environmental solution as digital printers reduce water usage by 60%-plus. Even so, digital printing only accounts for about 5% of print and packaging volumes worldwide.
At its core, the firm’s imaging and identification segment is built on a razor-and-blade model. According to Dover, the firm’s marking and coding installed base generates over 60% recurring revenue (this is fairly close to the segment's overall aftermarket parts and components, as well as its recurring revenue bases from software and services). This recurring base includes a range of specifically designed coding products, specialty inks, as well as software that allows for remote diagnostics. Furthermore, government regulations placed on food safety and traceability reinforce these switching costs. A 2015 academic study found that the annual cost of medical treatment, lost productivity, and illness-related mortality due to food pathogens in the United States alone amounted to $55.5 billion. We believe food and beverage customers loathe switching providers, given the high cost of failure in the event of misprinted or unclear food labels.
As for the firm’s engineered systems segment, examples of its value-additive technology include loader dump trucks that reduce customers’ cost ownership by improving load time by 20%-30%, or tailgates that allow for customer conversion to compressed natural gas from diesel, while not running afoul of vehicle height and weight restrictions. Waste per capita has been growing, while governments are increasingly regulating the space to mitigate illegal dumping, and environmental regulation, in tandem with general infrastructure and other government spending should continue to drive value-accretive growth for years to come. We think this narrow-moat segment is Dover's highest-return business, despite equipment sales representing a majority of the firm's sales mix (aftermarket and software sales are generally higher margin). Peak to trough, we think returns on capital will move from midteens at the low end to the lower-20s on the high end, when baking in goodwill and corporate expenses (which the company excludes when making it calculations).
For Dover's clean energy and fueling solutions segment, these same competitively advantaged dynamics in other portions of the company are also at work. We think it's also a narrow-moat business. By our math, fueling solutions is Dover's most valuable business on an enterprise value basis. The segment focuses on the safe handling of critical fluids along with other retail fueling and car was solutions. Just over 60% of the segment's sales are either higher-margin aftermarket or service sales, which we believe is a resounding quantity. Many of these dynamics are also reinforced by regulations including and environmental and chip card security (commonly referred to as EMV for Europay, Mastercard, and Visa), the latter of which still has appreciable runway in the United States as the burden of liability shifts to gasoline operators in the latter portions of 2020. Dispenser-agnostic technology should help drive above-market growth as more gas stations implement capability to service passenger vehicles equipped with secure electronic wireless payment (part of an "infotainment system"). The segment’s brands, including OPW, boast both proprietary technology, such as a patented liquid level detection sensor, and clean energy products for compressed natural gas, liquefied natural gas, and liquefied petroleum gas. Other product innovations include a patented underground fueling system made from prefabricated, factory-assembled components, which results in reduced labor costs and increased leak prevention. Dover’s fluid brands collectively retain nearly 20% of the retail fueling addressable market. Each of these gases present their unique storage challenges. For example, liquefied natural gas is typically stored at extremely low temperatures (between negative 184 F and negative 274 F), while liquefied petroleum gas, given its heavier weight than air, can accumulate on the ground and create explosion hazards. The high cost of failure tends to create sticky relationships with the industry’s trusted brands.
Razor-and-blade dynamics are also evident in the narrow-moat pumps and processing solutions segment, and we especially like Dover's strong competitive position in the medical and biopharma connectors market. Strong switching costs are further evident in PPS' returns on invested capital, even when baking in goodwill. Peak to trough, we think this is a business that has appreciable upside. Current returns stand in the high-teens, but we think they could reach the lower-20s, strongly driven by the medical market. Aside from general healthcare trends like an aging population, rising procedures, and greater access to care, we think Dover stands to benefit through its CPC business with the rise of single-use technology, which represents half of all new capacity. Single-use technology is a lower cost alternative to conventional materials (for example steel), and reduces significant time in the biomanufacturing process. Aside from reducing the product development time, it's cheaper given reduced labor, materials, and utility costs. It's also safer given a reduced risk of cross-contamination. This portion of the market will grow at a double-digit CAGR (while overall biopharma connectors we think will grow revenue in the high-single digits through the cycle).
Finally, we think Dover’s climate and sustainability technologies segment benefits solely from intangible assets--including well-known brands like its flagship Hillphoenix, proprietary technology, and customer relationships with grocery store powerhouses like Kroger to faster-growing convenience stores--and not switching costs, given that its recurring revenue primarily relates to spare parts and represents a small portion of its product mix. According to Dover, its brands possess about 22% of the addressable refrigeration market. Other innovations include brazed plate heat exchangers used in both HVAC and heating and cooling applications, which provide Dover’s customers with lower total cost of ownership, take up less space, and improve energy efficiency. Last, the firm’s Advansor transcritical carbon dioxide systems used in refrigerators are 10%-15% more energy-efficient than their non-CO2 counterparts. While returns have struggled recently, we think this is a business generating returns on capital that are on the slimmer side of a narrow-moat business (currently high single digits).
Fair Value and Profit Drivers| by Joshua AguilarUpdated Oct 20, 2022
After reviewing Dover's third-quarter results, we maintain our $171 fair value estimate. EPS of $2.26 easily cleared the $2.10 we earmarked for the quarter, thanks to 60 basis points of better-than-expected operating margins. That said, we brought down our fourth-quarter EPS expectations by about the same difference, based on management’s commentary and reduced top-line guidance (currency), so the effects mostly offset one another. We value Dover about 20 times our adjusted EPS of $8.41.
The two standouts during the quarter were the climate and engineered product segments, each growing organically over 19% and nearly 18%, respectively. Climate grew on strong volumes and price actions across all its businesses (food retail, HVAC, and consumer goods), with strength in all geographies, too. Dover is investing in capacity expansion programs, CO2 systems, and heat exchanges, which are fertile areas for secular growth. The firm had a similar story in engineered products with broad-based strength thanks to both robust volumes and pricing actions taking hold.
The main negatives to call out results were a) flattish organic revenue growth, combined with a weaker book-to-bill rate of 0.93 in the fueling segment and b) a lower than historical cadence toward full-year free cash flow aspirations we’ve baked in for Dover. We're not concerned they portend long-term weakness, however. What we are somewhat concerned with are signs of weakness in fueling, particularly in above-ground. Management is framing this as a wait-and-see from customers into 2023, but we’ll be monitoring closely for any evidence of demand destruction.
Our long-term revenue assumptions consist of various secular trends. For the firm’s identity and identification segment, these include a growing emphasis on product traceability and stringent labeling regulations in marking and coding, and technological advancements in digital printing. As for its engineered systems segment, we think the market will be primarily driven by high component replacement rates, and expensive costs of labor and spare parts. Furthermore, convenient operation and growing prominence of workplace safety will continue to aid the growth of the automotive lifts market.
For fueling, growth drivers include increasing vehicular sales in emerging markets. For the pumps & process solutions segment, we think single-use technology is one of the big drivers in this space. Single-use technology is a lower cost alternative to conventional materials like steel, and reduces significant time in the biomanufacturing process. It's also cheaper given reduced labor, materials, and utility costs, with reduced risk of cross-contamination.
Lastly, within the firm’s climate segment, we believe refrigeration benefits from a growing demand for frozen and chilled products, energy efficiency, and other technological advancements in commercial refrigeration, like CO2 technology, as well as the need for ESG compliance.
Finally, automation and greater recurring revenue from software and services should drive 240 basis points in EBITDA margin expansion from 2021 levels, with additional runway in Dover's climate business.
Risk and Uncertainty| by Joshua AguilarUpdated Oct 20, 2022
We assign Dover a medium uncertainty.
Dover has several key risks that include adverse economic conditions, both in the United States and internationally, market acceptance of its products, particularly in its shorter product lifecycle printing and identification business, execution risk with merger, acquisition, and other event-driven transactions, as well as environmental and products liability risk. That said, after the spin-off of Apergy, Dover greatly reduced its commodity exposure risk inherent in the upstream business. We think that adverse economic conditions are the most realistic risk to Dover’s results, as the firm has fallen below its stated 3%-5% organic growth target in recent years, specifically because of softness in its refrigeration markets. COVID-19 could still pose some headwinds in the front half of 2022 sales, although we're less concerned with this now given sales secured in backlog. Of course, new variants of the virus could significantly impact the entire economy and multi-industry firms like Dover.
We think Dover's environmental, social, and governance, or ESG, risk is low. Potential risks that we see include environmental liabilities, including being potentially responsible for the cleanup of waste disposal sites, human capital risks and difficulty attracting highly skilled labor, a potential cybersecurity breach that could meaningfully disrupt operations, product liability for faulty designs, and worker safety in manufacturing facilities. Given the difficulty of attracting skilled manufacturing labor in a competitive market for talent, we consider this Dover's strongest ESG risk.
Capital Allocation| by Joshua AguilarUpdated Oct 20, 2022
We rate Dover’s stewardship as Standard under our new capital allocation methodology. On the positive side of the ledger, Dover has a strong balance sheet, with no debt maturities over the next three years and a net debt to enterprise value well below 25%, as well as average cyclicality after shedding Apergy. Further, we think distributions to shareholders are about right, and commend management for strong execution and investments that we think have and will continue to create meaningful, positive economic value. However, we think share repurchases haven't materially accreted value at times and don't think new investments meaningfully add to Dover's switching cost or intangible asset moat source.
In May 2018, Richard Tobin replaced longtime CEO and 35-year veteran Robert Livingston. We have a comparably favorable view of Tobin relative to his successor. In our view, he is a proven executor; he comes to Dover by way of CNH Industrial, a European maker of trucks and tractors. Tobin is best known for his former role as a lieutenant to Fiat Chrysler CEO Sergio Marchionne. We think it was a good time for Tobin to take over, given the firm’s soft reset after the spinoff of its Apergy business. Tobin has continued to pivot Dover from its upstream business with the 2019 sale of Finder. Before his appointment as CEO, Tobin sat on Dover’s board. Board members are often turned to as replacement CEOs in situations where there are no suitable external candidates or on periods of short notice. In this instance, however, we are impressed by Tobin’s pedigree. Tobin worked closely with Marchionne since the 1990s, eventually rising to COO of Fiat Industrial and CEO of CNH Global. He also has a background as both a CFO and head of IT, giving him a diverse range of business function experience, which we believe will serve him well as head of Dover. We like his focus on making Dover's operations leaner and more efficient through restructuring efforts, and he has demonstrated consistent results during his tenure, leading Dover to mid-single-digit organic growth, strong margins expansion of 110 basis points on average, midteen EPS growth, and total shareholder returns at double the S&P 500 Industrials Index.
From a capital-allocation perspective, Dover has consistently returned cash to shareholders in the form of dividends and share repurchases. For over 60 straight years, the firm has increased its dividend on an annual basis. We expect Dover to return nearly $800 million in capital to shareholders in 2022, primarily in the form of value-accretive repurchases, but with a healthy dividend, implying a yield of over 4% relative to a stock price in the lower 120s.
Finally, from an environmental social governance perspective, the company pioneers solutions that benefit both shareholders and stakeholders, including digital printers that use 60% less water than analog prints, to its closed-loop refuse collection system where waste is collected, sorted at a recycling facility, and converted to fuel used in vehicles the company produces, to producing CO2 refrigerators to eliminate traditional HFC refrigerants.