“Defensive” doesn’t always mean “no growth”, and Halma (HLMA.L) (OTCPK:HLMLY) is certainly one of those companies that has built wide moats around its business and managed to maintain a healthy pace of growth through both organic expansion and M&A. Moreover, served markets like gas detection, explosion prevention, fire and elevator safety, ophthalmology, and water safety aren’t the sort of markets where demand just suddenly goes away because the economy turns.
Valuation is, of course, a challenge. Chances to buy Halma shares on the cheap are about as frequent as chances to buy Danaher (DHR) or Roper (ROP) at a discount (and for largely the same reasons), but the stock has at least provided 10% pullbacks on a pretty reliable basis. Trading at over 20x the estimated EBITDA three years forward there is no way Halma is conventionally cheap, but if you can make your peace with the different valuation rules in place here, I think this is a name to consider on a pullback.
Better-Than-Expected Results To Close The 2020 Fiscal Year
There are more than a few challenges with how Halma reports. First, like many European companies, Halma still only reports results on a half-year basis. Second, those reports aren’t necessarily prompt, with the recent second-half fiscal earnings coming more than three months after the end of the period (likewise, first half results, which ended in September were reported in mid-November). Still, the company managed a modest beat and the business continued to grow into the early stages of the global pandemic.
Revenue rose about 5% organically in the second half of fiscal 2020, coming in about 1% better than expected. Three of the four businesses grew, with Infrastructure Safety up more than 2% (a small miss), Medical up almost 3% (a 12% beat), and Environmental and Analysis up 17% (missing by 4%). Process Safety was the outlier, with revenue falling about 4% and missing by about 4%.
Looking a little closer, fire detection, people/vehicle flow, and elevator safety all did reasonably well within Infrastructure. Biopharma demand for fluidics was strong in Medical, likewise, there was good demand in optical analysis and water monitoring, while oil & gas-related product demand was weaker. None of this really “bodes well” or ill for comparables given the substantial reporting timing lag, but looking at results from companies like Emerson (EMR), Honeywell (HON), IDEX (IEX), and Danaher does corroborate it.
EBITA rose 5% in the period, basically matching expectations, as margin declined about 90bp. At the segment level, Infrastructure (up 17%, with margin up 130bp) was solidly better than expected, while Medical (up 16%, with margin down 90bp) was strongly better (a 14% beat). Enviro/Analysis (down 8%, margin down 270bp) and Process (down 18%, margin down 410bp) were both substantially weaker, with double-digit misses.
A Safer Pick … To A Point
As I said, Halma’s end-markets don’t tend to go away as much in cyclical downturns, but that doesn’t mean there’s no impact. Management reported a 13% organic decline in revenue for the fiscal first quarter (the calendar second quarter); that’s good relative to what we’ve seen early in this reporting cycle from other multi-industrials, but Halma isn’t immune to Covid-19 pressures, and full fiscal year 2021 revenue results will probably see only modest growth.
Segments like fire detection, building security, door sensors, and elevator safety aren’t going to vanish given the meaningful aftermarket elements to these businesses and the fact that these are not areas where building operators are likely to scrimp or cut corners. On the other hand, I do expect non-residential building activity to be pressured in 2021/2022 (calendar), so new installations seem likely to decline significantly. Longer term, overall trends around the world toward urbanization and improved building safety should support Halma’s above-market growth potential.
In Environmental/Analysis, I likewise don’t see much to worry about. Water quality is another of those areas that’s not very economically-sensitive, and again between greater urbanization and rising global safety standards, I believe the demand outlook here is solid. Spectroscopy and photonics demand should likewise remain healthy, and I believe opto-electronics is an area where Halma can boost growth by expanding into adjacent markets (through both internal R&D and supplemental bolt-on M&A).
Process Safety is trickier to evaluate. Aftermarket demand for interlocks (which control critical processes at refineries, chemical plants, and so on) isn’t going to go away, and neither is demand for gas detection, explosion protection, and corrosion monitoring. The “but” is that oil/gas capex is likely to be weak for several years, and companies like Honeywell and Emerson have reported seeing pushouts of on-the-books projects in the oil/gas-petrochemical mega-vertical. Longer term, the world will still need refined petrochemicals, chemicals, and so on, and governments aren’t going to be cavalier about those facilities catching fire and/or blowing up, but this is the segment at Halma that I think could be weakest for longest, with low single-digit growth for at least a couple years beyond FY’21.
Medical doesn’t worry me much. Business is going to be impacted by the significant decline in non-essential procedures (including visits to eye doctors), but the ophthalmology business serves an aging global population and one that is still relatively underserved on a per-capita basis in the developing world. I also see significant longer-term growth potential for patient location tracking (particular in long-term care facilities, which again serve that aging global population), as well as components used in life sciences equipment (micro-fluidics, including pumps and the like).
In the short term, Halma management is looking to offset revenue pressure with cost cuts, but I still think we’ll see a modest (100bp-150bp) decline in operating margin in FY21. Longer term, I still expect management to target a doubling of EPS every five years, and an ongoing enthusiasm for add-on M&A.
Modeling Halma is a little challenging, in part because I think you have to factor in ongoing M&A contributions (something I normally don’t like to do). So, for a company of its size, a long-term revenue growth rate of 8% (split around 60/40 between organic and M&A) looks robust but not unreasonable relative to the track record.
On the margin side, I see some improvement opportunities (particularly from repurposing technology and expanding into adjacent markets), but operating margin has been pretty consistent over the past decade, and likewise FCF margin. Thus, it’s hard to argue for a major change here that will significantly leverage that leverage growth into a higher FCF growth rate.
The Bottom Line
I can’t get close to a fair value for Halma with my normal DCF or margin/return-driven EV/EBITDA approaches. Even with a nearly 9% long-term FCF growth rate, it takes a discount rate below 6% just to get me to today’s price. Likewise, Halma trades well above EV/EBITDA norms for a company even with its exceptional track record and above-average prospects.
So, what do you do with the stock? As you can see with stocks like Danaher, Halma, and Roper, high valuation is not an obstacle to even higher valuations, provided the company continues to deliver. I’m not arguing for “ignore the price and just buy”, but I’m saying that if you want to own these companies, you have to take a different view of valuation and accept a lower prospective return, with the “compensation” coming from a higher degree of certainty about getting those returns.
Specific to Halma here and now, though, I’d recommend waiting for one of those pullbacks; it’ll still be pricey after that pullback, and I probably won’t buy even then, but it will at least provide an opportunity to get in at a slightly better price, and maybe an even better price if sentiment worsens on areas like process industries.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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