The Stock Price Is Unlikely To Increase Soon
Dover Corporation (DOV) has various moving pieces, none of which is strong enough to signal a clear direction for the stock price in the short term. The pandemic has undoubtedly created a demand vacuum in the industrial space, and the adverse effects will not disappear quickly. However, the world economy is in a consolidation phase and is gradually moving toward recovery. Consequently, I think the company has found a few openings. Its recent acquisitions in the plastic and polymer processing industry and industrial and packaging applications are testimony to its growing confidence in a recovery. I think the stock can produce moderately positive returns in the short term.
A possible decline in revenue forced the company to look inward and manage its operating margin through cost reduction and efficiency enhancement measures. It has also bolstered its liquidity. It may lower capex further to improve free cash flows. It has high leverage, which can be concerning in a crunched environment. Fortunately, there is no debt repayment pressure in the short term, which, along with sufficient liquidity, should serve to lower the financial risks in the long term. Over the medium to long term, I think the growth factors will rebound and lead to improved returns from the stock.
Gauging Outlook: Geographical and Cost Drivers
In Q2, a geographical breakdown of DOV’s performance brought out the drivers that would impact its performance in Q3. For obvious reasons (economic and industrial slowdown), sales in the U.S. declined by 10%. However, the retail fuel segment put up a better show. China accounted for much of the decline in Asia, although the rate of decline decelerated in Q2 compared to Q1. In particular, the Imaging & Identification and Engineered Products segments were up in China, but a slower demand from the local, national oil companies will undermine Asia’s growth prospects in the near term. In August, the company acquired Solaris Laser, which supplies advanced fiber, ultraviolet, and CO2 laser systems for the industrial and packaging applications. Apart from the U.S. and Asia, Europe does not provide much room for positive growth in the near term.
June was a breakthrough month for DOV. After a steep fall in May, bookings increased by double digits in all of its operating segments in June. The company’s longer cycle and shorter cycle businesses exhibited strength, leading to an 8% year-over-year rise in its backlog. The uptrend is expected to rub off on the company’s margin. As I discussed in my previous article, it targeted to reduce costs by $50 million by FY2020.
Although the EBIT did decline following the drop in revenues, the cost containment and productivity initiatives partially protected a steep margin decremental. During Q2, it focused on IT and back-office efficiency, which helped offset some of the adverse effects of under-absorption of fixed costs due to lower volume. It looks like these measures will continue to benefit margins in 2H 2020 and 2021. Strong backlog and positive recent trends allowed the company to reinstate its annual adjusted EPS guidance to $5 to $5.25 per share.
Prominent Drivers In Q2
Let us discuss the Engineered Products segment, which witnessed the steepest revenue fall (16% down quarter-over-quarter) in Q2 2020. Vehicle aftermarket, industrial automation, and industrial winches – the operations that typically depend on capex were the most vulnerable in Q2. Although lower capex will continue to transpire into lower earnings, the company’s cost reduction measures can reduce the effect to some extent in Q3. The segment has the highest share in the revenue mix (23% of Q2 2020 revenues). Sequentially, the segment EBITDA declined by 23%.
Supply chain disruption and budget deferrals following the pandemic adversely affected the segment performance. However, investors may note that the EMV (EuroPay, Mastercard, and Visa) adoption in this segment has been going up for the past three quarters. EMV is the global standard created for a secured card transaction. Margin in the company’s marking and coding division showed considerable resilience because it managed the cost structure well during Q2.
On the other hand, the digital textile printing business suffered as the pandemic affected the fashion industry severely. As we advance, I expect the overall segment revenues to remain weak, while the margin can remain steady in Q3. From Q1 2020 to Q2 2020, DOV’s Fueling Solutions segment revenue fell by 9%, while the segment EBITDA decreased proportionately during Q2.
Deciphering The Mixed Outlook In Other Segments
The Pumps and Process Solutions segment, which maintained a steady top line in Q2 compared to Q1 (only 3% down), can see higher plastics and polymer businesses on the back of a higher backlog. In September, it acquired XanTec, which designs and manufactures plastic and polymer processing machines. The acquisition is expected to benefit DOV’s aftermarket, remote service, and monitoring solutions for polymer processing.
Investors may note that the maintenance, repair, and aftermarket drive demand for the pumps and precision components business. The deferral of capex and refurbishment spending in refining and pipelined operators will lead to a further decline in precision component sales. However, the management expects the industrial pumps – a shorter cycle business – to recover shortly. The crude oil price has been steady in Q3 so far after the lows in early 2020. While the completed wells have declined rapidly in Q3, the DUC (drilled but uncompleted) wells have been steady. Also, in recent times, biopharma and medical have exhibited robust growth.
DOV’s Refrigeration & Food Equipment segment underperformed (6% down quarter-over-quarter) in Q2 because the restaurant and school closures affected it severely. As volumes decreased, it led to under-absorption of fixed costs and lower operating margin. However, I expect the company’s cost restructuring initiatives to improve productivity and automation in 2H 2020. The measures already had a positive effect in Q2, as reflected in an EBITDA margin expansion compared to Q1. The segment revenues and earnings in 2H 2020 can continue to increase compared to a year ago, expects the management.
In August, the ISM Manufacturing PMI went to 56, which indicates an expansion in manufacturing activities. According to the U.S. Bureau of Labour Statistics, the U.S. unemployment declined to 8.4% in August after it went as high as 14.7% in April. According to data available from the U.S. Census Bureau, the new privately-owned housing units increased by 18% in July 2020 compared to the previous month. Although the indicators are mixed, I think they will culminate in a slightly brighter outlook for the company in the short term.
DOV pays a quarterly dividend of $0.49 per share, or $1.98 annualized, translating into a 1.76% dividend yield. In comparison, Snap-on Incorporated’s (SNA) forward dividend yield is 2.93%, while Fortive Corporation’s (FTV) dividend yield is lower (0.37%). DOV may not repurchase stock in the near term due to the uncertainty related to the coronavirus pandemic.
Cash Flows and Debt
In 1H 2020, DOV’s cash flow from operations (or CFO) increased by 49% compared to a year ago. Despite the year-over-year revenue decline, an improvement in working capital led to the CFO rise in Q1. Capex, excluding the acquisition part, decreased in 1H 2020, leading to an 89% higher free cash flow (or FCF) in the past year. The company expects to reduce capex in 2H 2020.
DOV’s liquidity (cash plus undrawn revolving credit facility) totaled $1.6 billion as of June 30. During Q2, it secured a new $450 million revolver facility to bolster its liquidity position further. Its debt-to-equity ratio (0.97x) is higher than its competitors’ (SNA, FTV, and IR) average of 0.54x. It does not have debt repayment before 2025. The company might want to reduce leverage to lower financial risk.
Linear Regression-Based Forecast
I have observed a regression equation based on the historical relationship among the U.S. unemployment, the U.S. GDP, the Industrial Production Index, and DOV’s reported revenues for the past five years and the previous eight-quarter trend. Based on the model, I expect revenues to increase moderately in the next twelve months (or NTM) and recover more sharply in 2022.
Based on a simple regression model using the average forecast revenues, I expect the company’s EBITDA to remain unchanged in NTM 2021. It can then grow rapidly in the next two years.
I have calculated the EV using DOV’s past and forward EV/EBITDA multiple. Returns potential using the forward multiple (15.9x) is higher (13% upside) compared to returns potential using the past average multiple (6% downside). The sell-side analysts also expect positive returns (11% upside) from the stock. I think the stock has a moderate positive bias at this price level.
DOV’s forward EV-to-EBITDA multiple expansion versus the adjusted trailing 12-month EV/EBITDA is in contrast to the peers because the sell-side analysts expect the company’s EBITDA to decrease versus a fall in EBITDA for peers in the next four quarters. This would typically result in a much lower EV/EBITDA multiple compared to peers. The stock’s EV/EBITDA multiple is lower than its peers’ (SNA, FTV, and IR) average of 21.4x.
What’s the Take on DOV?
Post-COVID-19, higher adoption of EMV has leased life to the otherwise dull automobile industry in the Fueling Solutions segment. The company’s backlog has gone up by the end of 1H 2020, lending steady revenue visibility beyond the short term. Also, in 2020, the company focused on IT and back-office efficiency. Although sales volume is expected to decline, the cost containment and productivity initiatives can offset the margin decremental in 2H 2020. Strong backlog and an uptrend in sales allowed the company to reaffirm its annual adjusted EPS guidance for FY2020.
While the U.S. market can remain weak, the company expects the pressure in China to ease in 2H 2020 as activities return. The European market, however, will continue to trend down in the near term. As a result of the savings from the cost-cutting measures and lower capex, the company’s FCF increased in 1H 2020. Capex will remain low in 2H 2020. The company has a higher debt-to-equity ratio, which is a concern in today’s environment. Despite that, I think sufficiently strong liquidity will ensure that the financial risks remain low in the long term. I do not think investors looking for sharp short-term returns can benefit from the stock.
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.