Dover Corp: Time to Buy Stock?

At some point, oil has to bounce, right? That's the question investors in Dover Corporation must be asking themselves. Dover may be classified as a diversified industrial company, but in 2014, it generated around 35% of its earnings from the oil and gas industry. Given the slump in energy capital spending this year, it's hardly surprising that Dover's full-year revenue and earnings are expected to slump in 2015. However, the stock is also 19% cheaper than it was a year ago. So, is now the time to be picking up shares of Dover? Here's what you need to know before buying.


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Roper Industries Equity Research

Roper Industries  $ROP is one of the most interesting industrial stocks, not least because it appears to be more of philosophical concept than a typical industrial conglomerate. In essence, it's a collection of four disparate businesses that operate within their own highly profitable niche markets. The common philosophy behind each segment is that they are high-margin and highly cash generative companies operating with relatively asset-light business models. While this strategy has been working very well for Roper shareholders so far, is the stock a buy right now?

Roper reports full-year results
In order to quickly outline how Roper makes money here is a chart of its segmental operating profits in 2013.

Source: company presentations

Having disappointed in the previous quarter, Roper reported some better numbers in the fourth quarter resulting in adjusted revenue up 9% and net earnings up 11% for the full year. Moreover, there are six key reasons why Roper can do well in 2013.

Margins and cash flow, increasing software, and growing orders
First, Foolish investors should appreciate how well the management has increased margins and cash-flow generation. Roper's gross margin was around 58% for the full year, but note how it has increased over the last few years, particularly when compared to companies like Danaher   and Dover Corp $DOV .  The latter two are not perfect comparisons, but they do provide a good benchmark to judge whether Roper's gross margin performance is merely a function of the economy or not.

DHR Gross Profit Margin (Quarterly) data by YCharts

Clearly, Roper is outperforming its peers in terms of gross margin, so this isn't just about the economy.  Moreover, its free cash flow generation and conversion is outstanding. Roper generated $760 million in free cash flow last year, representing a conversion rate of 141% of its net earnings. Looking into 2014, management predicted that operating cash flow conversion would be 140% of earnings. Based on my calculations, and Roper's guidance for full-year EPS, its free cash flow will amount to around $8.35 in 2014. In other words, it's on a forward free cash flow yield of around 6%.

Second, one of the reasons that Roper is generating increased margins and cash flows is due to its increasing amount of software sales. On the conference call, CEO, Brian Jellison outlined that "If you look just like the SaaS businesses, pure software businesses, we get more than a fourth of the Company's EBITDA out of that." Moreover, he also argued that if application software was included, the figure would be closer to half.

Usually, software as a service, or SaaS, based businesses tend to generate recurring revenues over longer periods. Indeed, Jellison disclosed on the conference call that Roper has "a lot of recurring revenue in radio frequency and in medical" and the fact that deferred revenue jumped 12.6% to $209 million bears that out. This implies that Roper is increasing the amount of long-term value it gets out of its orders.

Third, Roper's order book looked good in the last quarter, its book-to-bill was 1.01 versus 0.95 in the fourth quarter last year.

Q4 2013	Order Book Growth
RF technology	11%
Industrial technology	3%
Medical and scientific technology	12%
Energy systems and controls	14%
Company	10% organic, 16% reported

Source: company presentations

Recovering businesses, underlying guidance is better, end markets improving
Fourth, the businesses that had difficulty in the previous quarters managed to recover well in the quarter. Imaging (medical and scientific technology) orders were surprisingly strong with a double-digit increase. Meanwhile, its nuclear inspection business, Zetec, was described on the conference call as being weak "as expected", but its orders "tell us that really the worst is behind us". These two nuggets of good news help to de-risk the stock somewhat.

Fifth, superficially Roper disappointed the market by issuing full-year EPS guidance of $6.05-$6.25 when the analyst consensus was $6.20. However, there is an extra tax charge of $0.20 in 2014, without this charge the guidance would have been a more impressive $6.25-$6.40.

And finally, prospects in some of its end markets are looking better. For example, its water pumps business, Neptune (industrial technology), will benefit from increased housing starts. According to Halliburton and Baker Hughes the U.S. oil and gas rig count will at least stabilize in 2014, and this could be a positive for elements of Roper's energy systems and controls segment.

Is Roper a good value?
On a P/E basis, Roper is not the cheapest stock in the sector.

ROP P/E Ratio (TTM) data by YCharts

Moreover, on a forward P/E ratio of around 22 times earnings, it's hard to argue that it is anything more than fair value at the moment. On the other hand, Roper is a high quality company and for the reasons articulated above, it has upside earnings potential in 2014. Foolish investors may want to keep an eye out for any buying opportunity should it dip from here.

Dover Corp Research and Analysis

A balanced portfolio should be, err, balanced, and while investors would do well not to overload their portfolios with industrial cyclical stocks, I think Dover Corp  presents a compelling GARP opportunity. In summary, the stock has been a bit weak recently thanks to worries over its handset business, but it looks overdone to me. Dover is a highly cash generative company with an impressive long term growth record and diversified end markets. The evaluation is not expensive and given decent global growth this year I think the stock has upside.

How Dover Corp Makes Money

As ever with this type of stock the first place to start is to look at how it actually makes its earnings rather than focusing on its high media impact operations. Doing this reveals that the key profit drivers for the company are things like North American rig counts and its refrigeration and food (Engineered Solutions) based sales. No matter, it is Communication Technologies that the market wants to know about.

In addition, Dover has made acquisitions (Anthony) in the refrigeration markets and announced plans to divest its electronic assembly and test business. Indeed, in an earlier article I pointed out how its electronics end markets were faring. For the record, Dover reduced earnings estimates twice last year and cited weakening electronics orders and tougher conditions in its handset business.

Will it do so again this year?

Handsets, Smartphones, Microphones Etc

Naturally it is the more cyclical parts of its product portfolio that gets all the analyst attention. After all marginal movements in these businesses will make the difference in Dover’s results, but I think there has been too much attention placed on handsets and Dover’s exposure.  A quick look at bookings for Q4 reveals what the market is worrying about.

The handset issue is that Nokia is a major customer of its Sound Solutions (part of Communication Technologies) business and, as the world knows, it has been weak for some time now. Nokia continues to lose market share to Apple  and others, and the future viability of its device operations is a legitimate concern. On the other hand there are some favorable underlying trends here.

Firstly, consider that the weakness in Apple’s share price recently has been due (in my humble opinion) to iPhone sales being less than forecast. A large part of this miss was probably due to analysts overestimating the willingness of consumers (particularly in emerging markets) to pay extra for the new iPhone. Competitors are catching up, and Apple needs to create better entry level price points in its offerings for EM. Now consider that Nokia has a strong position in cheaper phones in EM and is aggressively trying to break the ‘cheap smartphone’ market.

Second, all phones are equal but some are more equal than others. Smartphones tend to have more microphones in them than legacy phones so if for argument's sake, the ratio is three to one. Therefore, one new smartphone sale is equivalent to three lost for Dover Corp. Indeed, if Nokia and others are expanding smartphone sales- and a quick look at what the telco’s are saying confirms this- then Dover should see strong upside. Dover predicted the smartphone market would rise 20% this year.

Thirdly, Dover doesn’t just sell to Nokia! In fact, it sells to a range of OEMs, including Samsung, so ultimately it can benefit irrespective of whoever is winning in the marketplace. Apple is the only major manufacturer that Dover doesn’t have a decent market share with. The problem for Dover really only occurs when there is a big shift in a key customer, and arguably that has already happened with Nokia. Moreover, Samsung is strong across all product price points.

Finally, the Q4 bookings weakness partly reflects normal seasonality. Phone sales are sequentially weaker in Q1, and the OEMs place orders on a short cycle basis. Indeed, Dover was very clear that profits and revenues passed the trough in Q3 in Sound Solutions.

Perhaps the market is fretting too much?

Where Next for Dover?

Elsewhere conditions look good for energy to do well in 2013 with Dover forecasting an increase in the North America Rig Count in the second half.  I would remain positive on this issue as long as oil prices stay above $100, and with Engineered Solutions predicted to have a ‘very strong year’ with particular strength in refrigeration and food equipment, the future looks bright.

It’s not often that you get to buy a company that has just generated nearly 7% of its enterprise value in free cash flow yet has mid-teens earnings growth forecast for the next couple of years. I suspect this is due to fears over Nokia and possibly the North American rig count. If you are jejune over those risks than Dover should look attractive for the cyclical end of your portfolio.