ALFVY - Dover Has Rallied But It Hasn't Run Away

Summary

• Dover's revenue growth was a little below average for a multi-industrial, but the margin performance was a little better, and guidance was reassuring.
• While orders are likely to decelerate further, Dover looks well-placed to generate better results when demand recovers.
• Mid single-digit revenue growth and mid-to-high single-digit FCF growth support Dover as a worthy stock idea.

I thought sentiment swung too hard against Dover ( DOV ) when I last wrote about this diversified industrial , and the shares have since rallied close to 25%, including a big post-earnings run. That performance puts Dover well ahead of the average industrial over the past three months, not to mention well-loved and highly-valued "compounders" like Danaher ( DHR ), Fortive ( FTV ), and Roper ( ROP ), while a few comps like Alfa Laval ( OTCPK:ALFVY ), Oshkosh ( OSK ), and Vontier ( VNT ) have enjoyed similar or even better runs.

The market seems to be getting more bullish on shorter-cycle industrials, even though companies like Dover remain cautious about the outlook for 2023. It's not unusual for stocks to move around six months ahead of shifts in the underlying fundamentals (and I think short-cycle markets will bottom in the fall of 2023), but it's also not unusual for elevated uncertainty to lead to elevated volatility in industrial stocks. There are cheaper names out there in the industrial space, but in terms of balancing quality, risk, and opportunity, I still think Dover is a name that many investors may find worth their time.

A Decent Margin-Driven Beat

There were a few weak spots in Dover's report, and the order/backlog situation merits some discussion, but on the whole this was a decent-to-good quarter, with margins driving some upside.

Revenue rose a little over 9% in organic terms, and while that was good for a modest beat, it is just below the median of industrials have reported (10.5%). Gross margin declined 40bp year over year but stabilized sequentially at 35.8%. Operating income rose 20% (with margin up 180bp to 17.2%), while segment profits rose 16%, with margin up 150bp to 21.0%. Dover beat by $0.04/share at the segment operating profit line, and the 150bp yoy improvement was above the median improvement (+110bp) seen in its larger peer group.

Breaking Down The Segments

Looking at the businesses, Engineered Products posted better than 16% organic growth, with profits up 65% and margin up 620bp to 19.7%. Management pointed to strength in vehicle services, waste handling and aero/defense. Oshkosh likewise saw strong results in its Commercial business (which includes waste handling equipment), while Vontier, a competitor in vehicle service and fuel dispensing has yet to report.

Clean Energy & Fueling posted basically flat organic results, with weakness in above-ground dispensers offsetting stronger results in clean energy, below-ground equipment, and car wash equipment. Profits rose 23%, with margin up 170bp to 19.7%.

Imaging & Product ID sales rose 9%, with good results outside of China, albeit ongoing weakness in textile printers - not so surprising given ongoing weakness in apparel retail and elevated inventories. Profits rose 12%, with margin up 250bp to 25.1% Danaher posted flat results in its product ID business.

Pumps and Processing revenue fell 4% organically, with the business pressured by destocking among biopharma customers tied to COVID-19. Outside of that, industrial pump precision component, and plastics/polymers demand was solid. Profits fell 20%, with margin down 490bp to 28.6%. IDEX ( IEX ) did note elevated inventories among its biopharma customers, but outperformed on growth with 9% growth in Fluid & Metering and 19% growth in Health & Science. Crane ( CR ), too, outperformed in absolute terms with 8% growth in Process Flow, but I don't believe Dover really detailed the growth in industrial pumps, so this isn't an apples-to-apples comparison.

Finally, Climate and Sustainable Tech was up 27% on strong retail refrigeration demand, CO2 refrigeration, and heat exchangers. Lennox ( LII ) posted 10% growth in its Refrigeration business, while Alfa Laval saw 17% growth in its Energy segment, which consists largely of heat exchangers.

Orders Are Slowing, But The Correction Shouldn't Be Steep Or Prolonged

Dover reported a 17.5% year-over-year organic decline in orders, and given pricing, that suggests underlying volume down something like 22%. Orders were weakest in Climate and Sustainable Technology, Pumps & Processing, and Engineered Products, and only Clean Energy and Fueling showed any growth (and barely there).

This marks the fourth straight quarter of declines and management expects its ratio of backlog to revenue (currently around 34%) to normalize back to the low-20%'s throughout 2023. That suggests ongoing weakness in orders, but it also suggests a year-end order level pretty much on par with 2019, but with a double-digit decline in volume.

Nothing I've seen suggests that level of weakness in the broader economy. While many businesses did accelerate capex spending to handle a surge in business after the pandemic, there had been years of under-investment in capex leading into the pandemic. Said differently, even if orders are as weak as feared, I think underlying demand is stronger than the numbers will say, and I think Dover will be poised for a stronger rebound in 2024/2025.

The Outlook

I have few complaints with Dover. Management has shown that they can take costs out without compromising the business and I expect further efficiency efforts in 2023/2024. I also like how management has handled M&A on both the buy and sell side. I wouldn't be surprised to see additional fine-tuning of the portfolio ,but I don't get the sense that management is looking to make big swings in either direction. I would like to see a little more leverage to areas that are attractive long-term like automation, bioproduction, electrification, and renewable/clean energy, but Dover can afford to be selective.

Based on core revenue growth guidance of 3%-5%, I've boosted my revenue estimate for FY'23 by about 3%, but I've also trimmed back my margin assumptions slightly - mostly just out of caution/conservatism. Longer term, I expect EBITDA margins to improve about two points over the next three years, and I expect to see free cash flow margins move gradually up from the mid-teens toward the high-teens, driving adjusted FCF growth of around 7% on around 4% revenue growth.

Neither discounted cash flow nor margin/return-driven EV/EBITDA suggest that Dover is significantly undervalued now, but after the big move since my last update I wouldn't expect that to be the case. I do see a total annualized potential return in the mid-to-high single-digits now, and I believe there could be upgrades to FY'23-FY'25 expectations over the next year.

The Bottom Line

I'm fine with buying and owning fairly-valued shares of good (if not exceptional) companies, and I think Dover qualifies. There are bigger bargains out there now, but in terms of quality, risk, and opportunity, I still think Dover is a reasonable growth-at-a-reasonable-price name for less adventurous investors.

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