Tuesday, July 9, 2013

Ametek Offers Aerospace Upside

It’s been a mixed earnings season for industrial-based stocks and Ametek’s (NYSE: AME) last set of results provided a pretty good microcosm of what has been going on. In short, companies with heavy exposure to industries like automotive and aerospace have done well, while almost everything else has found things difficult. So what makes Ametek interesting and what can we read across for other companies?

Ametek generates growth across the cycle

The company is attractive for a few reasons. Firstly although it is not a pure-play aerospace company, it has heavy exposure and as the industry is looking set for good long-cycle growth, it has good prospects. Secondly, Ametek has long been a company categorized by its management’s ability to make earnings-enhancing acquisitions without damaging its return on invested capital (ROIC).

As the chart indicates, Ametek has done a pretty good job of consistently generating ROIC even when market conditions are not great. An acquisition-led growth strategy does have its advantages and disadvantages. On the plus side, the company can carry on generating growth by getting companies cheaper in the downswing (and benefiting from the hopeful upswing in the economy); but on the downside its management will be under pressure to make the right acquisitions. And making the wrong decision can occur irrespective of where the economy is positioned.

Recent results

The good news is that Ametek’s management has a strong track record in this regard and acquisitions are a key part of the focus for 2013 as well. Even in the latest Q1 results we saw organic sales decline 2% but acquisitions contribute 9% and –even in a weaker environment for aerospace- its sales were up 7%.

As ever with this type of company, cost management and lean manufacturing will be a strong focus. Indeed cost reductions were made in the quarter, without which, EPS would have been up 18%. There was good news on the cost-cutting front with estimates for total full-year savings rising to $95 million from $85 million previously. Operating cash flow rose 11% and full-year EPS guidance was raised at the low end to imply 11% to 13% growth. Moreover the commentary on linearity was positive with April cited as looking ‘good’. Like many in the industrial sector it saw some weakness in March.

Industry background

As usual with earnings season, Alcoa (NYSE: AA) tends to set the tone for the industrials. A brief look at the conclusions from its earnings reveals that areas like aerospace and automotive remain relatively positive. Europe remains weak on the whole and the heavy truck and trailer market is experiencing a sharp slowdown. Moreover much of Alcoa’s growth is predicated on stronger conditions in China. The surprising thing was that Alcoa did not alter its full-year end-demand outlook by much even though the consensus is that Q1 did get weaker overall for industrials.

Alcoa’s trends were confirmed by Ametek when it discussed some softness in its power and industrial business created by the North American heavy truck market, so no surprises there. Furthermore within its process business segment the strongest performer was oil and gas while metals analysis revenue was relatively weaker.

The key strength in the business was from aerospace. Its electronic instruments group (EIG) saw aerospace (commercial, business and regional jets) revenue rise by low double digits and growth is expected to remain solid for the rest of the year inline with build-out rates at Boeing and Airbus. Overall EIG sales were up 3%.

It was a similar story in the other segment. The electromechanical group (EMG) saw its differentiated business sales up in the mid-teens with particular strength cited in its aerospace maintenance, repair and overhaul (MRO) operations.  However, overall sales for EMG only rose 3% thanks to a 14% contribution from acquisitions.

Which stocks read across well?

Frankly I think investors should try and stick to the themes that are working well and try and find value in them. If aerospace and automotives are doing well and companies like Alcoa and Ametek are confirming this, then why not stick to the idea? Three names that I like are Heico (NYSE: HEI), Precision Castparts (NYSE: PCP) and PPG Industries (NYSE: PPG).

Heico recently reported strong results and the business clearly has good long term prospects from helping airlines to try and reduce costs by outsourcing flight support activities. Even though Heico argued that its success in the quarter (its flight support group saw sales and income rise 10% and 14%, respectively) was largely a consequence of internal execution rather than industry growth, I think that there are enough positive signs within its performance to suggest further growth this year.

Its space-related sales may well be variable and its defense sales will be subject to sequestration effects so now may not be the best time to buy into the stock. But if you can tolerate these fears, the stock is attractive.

Precision Castparts is attractive because of its heavy exposure to commercial aerospace (75% of its market) and its opportunities to generate synergies from its acquisitions. In addition, it is ramping up production in order to meet demand from Boeing on the 737 and 787.

My one concern with this company is the cyclicality of its cash flows. The aerospace industry is cyclical but there is evidence to suggest that it is likely to experience better conditions in this cycle. However companies like Precision Castparts always need to make significant capital expenditures in order to service demand.

This is great when demand is good but it leaves them exposed should demand start to weaken. You can make the argument for making an evaluation based on assessing its long-term earnings or cash flow performance but in reality I think the market just trades these stocks based on momentum.

My favored play on this theme would be PPG Industries. The company has good exposure to aerospace and automotive and its purchase of Akzo Nobel’s US household paints operation is timely. Costs appear to be moderating and it has some cost synergies coming from the acquisition. Margins are expanding thanks to its restructuring efforts (such as selling some of its commodity-based businesses) and its cash flow generation remains very strong.

Meanwhile the recent court order over the Pittsburgh Corning (a joint venture with Corning) has somewhat de-risked the stock from uncertainty over future asbestos claims. Earnings growth is being held back this year thanks to some of the issues discussed above but, this is a business which has generated an average $1.1 billion in free cash flow over the last three years and trades on an EV/Ebitda multiple of 9.5x. Looks like good value to me.

Where next for Ametek?

This is an impressive company and a real ‘go to’ option for a pick in the industrial sector. Unfortunately its trailing PE of around 22x plus its EV/Ebitda multiple of 13.1x suggest it is largely pricing in the good news. It’s well worth monitoring and hoping for a dip because $42 looks like a fair price for the stock. Given any kind of market retraction it's worth a close look.