ATLPF - Atlas Copco: Business Is Softening But Investor Confidence Remains High

Summary

• Atlas had a mixed end to the year, with better than expected revenue, but operating profit and order misses.
• The industrial businesses are holding up quite well, but compressor orders are very elevated relative to pre-pandemic norms and auto demand could trail off quickly.
• I still see risks to a sharper/longer correction in the larger economy, but Atlas is a top-quality name well worth considering if there's a double-digit pullback in the share price.

As one of the best-run industrials out there, and a business that touches quite a wide range of industrial end-markets, evidence of emerging weakness at Atlas Copco ( ATLKY ) isn’t something I take lightly… even if results so far are no worse than I expected (and better in some respects).

Fourth quarter earnings and guidance for 2023 have generally been pretty positive across the sector, or at least that’s how the Street is perceiving it. While many companies have talked about high end-customer inventory levels, weakening orders, and persistent cost inflation, the Street seems more or less willing to waive past that and assume that the economic cycle will see a soft bottoming-out in the fall of this year.

I don’t know. There are similarities between the start of this downcycle and past downcycles that ended up being pretty rough (1957, 1974, 1981, and 1990), and while history never repeats, it often rhymes. I’m reluctant to throw caution to the wind and buy into industrials today. Maybe Atlas stock won’t get significantly cheaper than this, but I think the risk/reward at this point isn’t good enough to step up and take the risk that this downcycle could be worse than expected.

Mixed Results For The Fourth Quarter

Atlas Copco didn’t have a terrible fourth quarter, but for a company that often ticks off beat-and-raise performances like a metronome, there were definitely some areas of weakness that bear watching.

Revenue rose 16% in organic terms, putting it well on the high end of industrial company performances this quarter (the average has been closer to 10%) and about 4% ahead of sell-side expectations. Gross margin was strong, rising a half-point to 42.4%, but while operating income rose 24% (with margin down 190bp to 20%), it missed expectations by close to 6%.

A Look Around The Segments…

Looking at the segments, Compressor Technique posted 15% organic revenue growth, beating by 3%. Profits rose 28%, beating by 1%, with margin down 30bp to 23.6%. CT’s best comp, Ingersoll Rand ( IR ) hasn’t reported yet, but demand for products used in industrial operations generally held up well in the quarter, including metalworking tools ( Kennametal ’s ( KMT ) Metal Cutting business was up 11%) and welding equipment ( Illinois Tool Works ( ITW ) reported 15% organic growth in Welding).

Vacuum Technique revenue rose 14% in organic terms, missing by 10%, and while profits rose 6%, that was a 19% miss and margins contracted almost five points to 18.2%). Again, there isn’t a surplus of great direct comps here, but VAT Group ( VACNY ) did see a similar 14% organic revenue growth rate.

Industrial Technique grew 16% (again, organic), beating by 5%, with strong demand from auto customers for EV launches and healthy demand across aero, electronics, off-highway, and general industrial markets. Strength in machine vision is interesting relative to the challenges at Cognex ( CGNX ), but Atlas’s machine vision business is much more industrial-focused, and companies like Lattice Semiconductor ( LSCC ) have echoed healthy trends in machine vision despite some weak end-markets (like electronics assembly and warehouse automation). Profits rose 6%, missing by 13%, with margin down 350bp to 18%.

Power Technique posted 24% organic revenue growth, beating by 14%, while profits nearly doubled (up 92%), beating by 14%, and margin improved almost two points to 18.2%. Given the health of major end-markets like oil/gas, mining, petrochem, and utilities, this strength isn’t entirely unusual, but the magnitude is nevertheless impressive.

Orders Declining Into An Unknown Downcycle

Atlas reported a 7% organic decline in orders, missing expectations by close to 5%. Orders were up 3% in Compressor Technique (a 6% miss) on very strong late-cycle gas/process orders, but underlying volume was down mid-to-high single-digits (emphasizing how important price is to near-term revenue) and small compressor orders were down mid-single-digits. At this point compressor orders are about a third higher than pre-pandemic levels, and I have some concerns that its going to take time to work through to a more normalized level of orders.

Vacuum Technique orders declined 33%, missing by 10%, but this was broadly consistent with the 43% decline that VAT announced. Atlas saw a meaningful amount of cancellations (SEK 1B compared to SEK 8.5B in orders), and there has been more talk of order pushouts for capital equipment. While many logic markets remain capacity-constrained, I am concerned about weakness on the memory side, as it looks like a lot of tech customers opportunistically purchased large quantities of memory chips to put into inventory.

Industrial Technique orders rose 18%, beating by 16%. A lot of this growth was tied to auto OEMs prepping for EV launches, and I do expect EV production to double in 2023, but given weakening overall auto build rate expectations and weakening industrial capex investment, I’m concerned this could reverse pretty sharply.

Power Technique orders fell 6%, beating by 4%. I don’t have particularly strong feelings about this business, the smallest of the four, but given its skew toward late-cycle end-markets, I would expect that this segment would stay stronger for longer.

All told, Atlas’s order trends weren’t really so different than the broader industrial space, and honestly, excluding Vacuum, they were pretty strong (up 4% organic, ex-VT). I do think some of this can be tied to Atlas’s exposure to an auto sector still tooling up for significant EV production expansion, as well as late-cycle energy and process industries. My concern, though, is that with elevated end-user inventories, fading demand, persistent inflation, and the risk of even more rate hikes, orders will weaken more than the 10% to 12% currently expected. To be clear, this isn’t an Atlas-specific concern, but Atlas just typifies it.

The Outlook

I’m a little below the Street for FY’23 revenue, but still expecting close to 7% year-over-year growth as Atlas rides the tailwinds of strong backlogs and demand in areas like aerospace, auto, and late-cycle/process markets. I’m also a little below the Street in FY’24, looking for about 1% growth as I think that several markets that are holding up better in FY’23 could see a weaker FY’24 (auto, trucks, mining). Long term, I’m expecting around 5% core revenue growth.

Margins should remain healthy in FY’23 and FY’24, and I’m expecting around two points of improvement over the next three years. At the free cash flow line, I expect continued progress toward 20% FCF margins, driving 5%-plus revenue growth to around 8% long-term FCF growth.

Neither discounted cash flow nor margin/return-driven EV/EBITDA suggest undervaluation here, and that’s with Atlas still enjoying a premium EBITDA multiple.

The Bottom Line

I do think there is a real risk that many industrial stocks have recovered too far on what could prove to be excessive optimism about a brief, relatively gentle reset in the economic cycle. Given high inflation, high inventory, extended supply chains, and strong growth going into this downturn, I do still see downside risk.

In any case, specific to Atlas, this is always a name to watch for pullbacks. I see nothing fundamentally wrong with the company and should the shares sell off by 15% or so, I’d definitely consider at least a starter position.

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