CR - Crane Off To A Good Start And Targeting The Right Opportunities

2023-09-28 02:56:23 ET

Summary

• Crane management has set out a bold vision for remaking this company now that it has split from Crane NXT and is purely focused on industrial and aerospace markets.
• Pivoting the Process Flow business toward higher-growth markets like hydrogen, advanced sustainable materials, biopharma, and automation makes a great deal of sense.
• The plans for the Aerospace & Electronics business seem more like "keep executing on a good business", and that should be fine, particularly with the tailwind of increased aircraft production.
• A $4B M&A program is ambitious and management cannot afford big stumbles.
• CR shares look modestly undervalued even with some cycle-related risks in the Process Flow business over the next 12 months.

So far so good for the new Crane (CR). Having separated from Crane NXT ( CXT ) earlier this year, Crane is now more of a typical industrial conglomerate, with core operations in process equipment (valves, pumps, and related instrumentation), aerospace, and electronics (power conversion, microwave systems, et al). Initial financial reports have been solid, with management raising guidance, and the company looks well-positioned to execute not only on opportunities in its existing core but also on an ambitious M&A program that could meaningful remake this company over the next five years.

Regular readers of my articles know I have some concerns about multiple industrial end-markets in the near term, as well as longer-term concerns about some well-established process end-markets like chemicals, but also a fair bit of bullishness about opportunities in markets like factory automation, new energy, and aerospace. While execution of the M&A program will be paramount and not every valuation approach has Crane looking cheap today, I still see a worthwhile case for owning these shares.

Will The End-Markets Hold Up?

A key issue going into the second half of 2023 is how well industrials will hold up in an environment of flagging demand, persistent inflation, tighter credit, and customer destocking.

While management commentary has been encouraging here, I do have some concerns about the Process Flow business over the next few quarters. Industrial automation demand has been trailing off, and given where Crane's products sit in the food chain, I'd expect some of that weakness to start showing up in the next couple of quarters (I see companies like ABB ( ABBNY ) and Rockwell ( ROK ) as earlier-cycle players there, with companies like Crane and ITT ( ITT ) lagging).

I also have ongoing concerns about non-residential construction, pharma, some areas of the chemicals sector, and "general industrial" exposure, and that covers a large swath of Crane's market/revenue exposure. Along similar lines, I would note that orders declined 5% in the second quarter after rising 1% in the first quarter.

I have no such concerns about the aerospace market, and Crane has itself talked about being capacity-constrained and unable to meet all of the demand it sees. While there have certainly been some bumps along the road, commercial aerospace OEMs like Airbus ( EADSY ) and Boeing ( BA ) are on good trajectories with their production rates, and I expect further acceleration in narrowbody production next year.

To be clear, the challenges I see in the Process Flow end-markets are not structural market problems or issues with Crane's competitiveness. Instead, they're just more of your run-of-the-mill economic cycle challenges, as I do expect more evidence of a slowing economy as we end 2023.

Ambitious Targets, But Not Out Of Reach

Management has laid out some relatively bold goals for the new Crane. I don't think hitting all of these targets is going to be easy, and certainly not a sure thing, but I don't think they're ridiculous or unreachable either.

I like how management is looking to pivot toward growth opportunities in Process Flow, including entering the market for valves, pumps, and other equipment used in the production, transportation, and storage of hydrogen. I liked Dover 's ( DOV ) move into these markets and I like it for the same reasons here - I expect hydrogen (green hydrogen) in particular to become a meaningful market in the coming decade, not only as an alternative vehicle fuel but also as a replacement energy source in industries like cement and steel.

Likewise, I like the company's pivot toward chemical products that facilitate other green initiatives - products like sustainable refrigerants (a focus on the development/manufacturing side for Honeywell (HON)), fabrication materials used in solar and wind, and new high-performance coating and insulation products. As some of these products have "finnickier" handling characteristics, this should drive demand for more exacting and mission-critical products, and that in turn should be good for Crane's margins.

I've spoken many times about my belief in the long-term growth potential of factory automation, and Crane's transmitter, positioner, and transducer products are facilitators (picks and shovels) of automation. I've also spoken of my belief that biopharma investment into biologics production capacity will continue; this is arguably one area where I think Crane may not be ambitious enough - I think there's a wider area of addressable opportunities for the company than they've highlighted/targeted, but it could well take expensive M&A to really get there.

The projections and discussions of the aerospace and electronics operations seem less transformative to me. I think that has a lot to do with the fact that the company has arguably under-appreciated leverage on the aerospace cycle through areas like power conversion/management, brakes, sensors, fluid management systems, and microwave systems. I do still expect meaningful investment in R&D and product development here (focusing on opportunities like vehicle electrification and commercial space, and I could see the company investing some of those M&A dollars in adjacent markets like thermal management.

The Outlook

I don't find management's projections of 3% to 5% core growth in Process Flow to be unreasonable, particularly with the company actively targeting more attractive growth markets like hydrogen, advanced materials, automation, and water. I do see some risk of erosion in legacy markets over time (more traditional petrochemicals, oil/gas, fossil fuel, et al), but 4% growth at the midpoint is a reachable goal, particularly if the company continues to execute initiatives to drive product vitality higher (a larger percentage of sales coming from recently-launched products).

I likewise don't find 7% to 9% core growth in Aerospace & Electronics to be overly ambitious. If Boeing hits its production targets for monthly build rates out through 2026-2029, underlying volume growth can support that target, and I'd also note that original equipment business wins generate a long tail of aftermarket revenue, so this ramp in aircraft production can drive a sustainable lift in Crane's revenue and profit base.

Management's margin targets strike me as more ambitious. Again, not unattainable, just more ambitious. Driving adjusted EBITDA margin from around 17% today to 23% in 2028 won't be a slam dunk, though Crane's increased focus on premium markets and the added leverage from new product launches and higher volumes in aerospace will certainly help.

The most aggressive part of the outlook may be the goal of deploying $4B into M&A over the next five years. To be sure, spending large amounts on M&A is not difficult, but paying the right multiples for the right businesses is not so simple, which is why companies with good M&A track records enjoy a premium but so many other wannabees destroy shareholder value trying to copy them.

I'm expecting around 4.5% core long-term revenue growth from Crane (a little below the midpoint of management's target), but executing the M&A program could boost the actual growth rate to over 10% (and that's assuming an average multiple of 2x revenue, which is higher than industrials typically trade). I'm also still expecting free cash flow margins to improve over time toward the mid-teens, helping drive a little extra growth at the FCF line.

Discounted cash flow suggests a fair value in the low $100's today. The shares don't look quite as cheap on my multiples/return-based EV/EBITDA model, but then Crane is underleveraged right now and so "under-earning" relative to what I think will be the norm over the next three to five years.

The Bottom Line

There's a lot of execution risk to the Crane story now, as management is looking to meaningful transform this business over the next five years. I like the plan, including pivoting Process Flow toward more attractive growth markets (and markets that will pay premiums for performance and reliability) and maximizing the opportunities in the aerospace up-cycle. I'm also on board with the M&A goals, even if this could be the most challenging part of the plan.

I'm not so bothered by execution risk tied to ambitious goals, though, and I do find today's price to be fairly attractive. With that, I think this is a name worth consideration even when factoring in some downside risk from weaker industrial end-markets over the next year or so.

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