Sunday, December 23, 2012

Dover Corporation, An Interesting Industrial

Dover Corporation (NYSE: DOV) is one of those industrial companies that the market never seems to knowingly overvalue, and everyone is cautious with it as a consequence. It strikes me that industrial cyclicals are always going to be relatively undervalued because investors can’t be sure how a company will be positioned coming out of a slowdown. In Dover’s case, I think its long term history of performance deserves a bit more respect and, provided investors can tolerate some volatility, it is worth a closer look.

Dover over the Cycle

Dover is certainly a company that knows how to execute across the cycle, having generated a 10% compound annual growth rate (CAGR) in revenues over the last 10 years alongside 14% earnings growth. Moreover, free cash flow tends to consistently be around 10% of revenues, and it has increased its dividend for the last 57 years. As such, it belongs in this group of select companies; throw in the share buybacks and this is a pretty shareholder friendly company.  All of which is fine, but how does Dover make its money?

I’ve broken out rolling segmental earnings.

The case for Dover revolves around diversified end markets and how they allow the company to generate growth across the cycle. Thinking longer term, its strategic focus is benefiting from favorable long term trends in Energy, product ID, refrigeration and Energy markets. Essentially it is a typical ‘GDP Plus’ type of growth story.

Growth Slowing

However, because its prospects are correlated to GDP growth it will fluctuate with sentiment over the macro conditions. As such, Dover’s last results stated the familiar refrain of Europe being stable but weak, China slowing and modestly stronger conditions within the US.

We can see some of these factors represented in bookings.

Dover confirmed that growth is slowing in China and in particular within its export led industries. For example, Dover’s electronics end markets saw bookings decrease by 10% to $343 million and did not forecast any ‘near term recovery.’  The best way to see where future growth in consumer electronics is headed is to keep an eye on Intel (NASDAQ: INTC) because its sales reflects inventory decisions by the large electronics firms. As such, Intel keeps reducing guidance and gross margin forecasts.  It will get worse before it gets better. While that is already in the price, there are other warning signs.

Nokia (NYSE: NOK) is Dover’s biggest customer within handsets, and its travails should be well known to investors. Much depends on its product activity, and prospects there must be seen as uncertain at best. Even if the company is eventually taken over, this implies structural changes which may or may not help Dover.  Other risks include the falling US rig count, which has affected the likes of Baker Hughes (NYSE: BHI) this year. Energy is the largest profit center, and a lower rig count is an issue for Dover because its drilling related revenues tend to be high margin.

The other main threat is the failure to execute at Sound Solutions. Granted it has been a difficult environment for handsets and it is an ever changing market, but there is some tardiness in making manufacturing changes in its Beijing operations. The intent to shift to semi-automated production is music to the ears of Cognex (NASDAQ: CGNX) stockholders since it is a huge beneficiary of Chinese production moving towards automated production lines -- an interesting piece of ‘color.’

Where Next for Dover?

Frankly, no one likes buying companies that have just reduced guidance or changed their outlook over the last quarter, but Dover deserves at least a monitoring look. There are plenty of near term risks (macro, Nokia, rig count, Sound Solutions) that would keep me out of a position right now, but if it dips then it would become interesting.

Dover has generated around 10% of its revenues in free cash flow over time and if you figure that a 5% FCF yield is acceptable then valuing the stock at 2x revenues makes sense.

DOV Price / Sales Ratio TTM data by YCharts

As this graph demonstrates, it never really trades up to 2x earnings, but when the economic going is good a ratio of 1.75x seems to be the peak. Of course interest rates are far lower now, so arguably the stock has room to run. The slowing rate of growth in bookings indicates that revenue growth will be no more than low single digits for the next couple of years.

In conclusion, I think Dover is an attractive stock, but it might be worthwhile monitoring now while keeping an eye out for the risks that I mention above. Apologies if this article doesn’t produce the kind of hard resolution that many readers want, but the greatest weapons a private investor has are patience and preparation, and I don’t plan on giving either up just yet.

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