TKR - EnPro Becoming A Slimmer More Profitable And Less Cyclical Multi-Industrial

Summary

• EnPro's sale of the GGB business is consistent with management's stated goals of addressing faster-growing markets with higher engineering-driven barriers to entry.
• Semiconductor volume growth is likely to slow in 2023, but this is a manageable risk; short-cycle industrial and truck markets offer a little more headline risk today.
• EnPro looks capable of mid-to-high single-digit revenue and FCF growth, and at today's valuation, that's not bad but not quite enough to make me an enthusiastic buyer today.

EnPro ( NPO ) management has been transparent about its intentions to continue to remake the company into a more niche-oriented multi-industrial focused on less-cyclical, faster-growing markets, and with a product portfolio more skewed to high barriers to entry driven by engineering and sticky customer relationships. With the sale of GGB done, EnPro goes into 2023 focused on its specialty Sealing Technologies and Advanced Surface Technologies businesses, both of which offer better growth and margins than the company's historical trends.

These shares have done well since my last update , appreciating more than 15% and beating both the S&P 500 and the wider industrial group.

I do see some near-term sentiment risk for EnPro, as the company is heavily dependent upon the semiconductor industry and still has meaningful exposure to cycle markets like heavy-duty trucks and short-cycle "general industrial". While 2023 likely won't be a banner year, I do think the company is well-placed for organic growth in the mid-single-digits and strong EBITDA and free cash flow margins. The shares aren't particularly cheap now, and I'd rather wait in the hopes of a pullback, but I like the strategy management is following, and I think EnPro can be a long-term outperformer in the multi-industrial segment.

Addition By Subtraction

Management took a bigger step forward in its transformation strategy in the fall of 2022 when it announced that it was selling the GGB business (bearings, gaskets, joints, and related products) and looking to sell the Garlock Pipeline business as well. This wasn't a bad business, with mid-teens segment EBITDA margins, but it was an outlier relative to the company's higher-earning operations and didn't really fit with the company's drive toward faster-growing businesses underpinned by durable engineering-driven moats.

EnPro sold GGB to Timken ( TKR ) for $305M, and based upon the information provided, that looks like a roughly 9x multiple. That's pretty close to what the underlying profitability of the business would argue for in terms of EBITDA multiples in the current market environment. Perhaps the company could have gotten a better multiple in a year or two, but I don't know that it would have been substantially better and there would be risk of more serious end-market erosion in the meantime.

As of this writing, I haven't seen any releases or filings regarding the Garlock Pipeline business, but given the size of the segment, a sale wouldn't be particularly material, so I wouldn't consider this lack of news to be all that important.

EnPro was okay from a liquidity perspective prior to the GGB sale, but this deal does give the company some expanded flexibility with respect to M&A. Acquiring adjacent products for the sealing business, perhaps more relevant to food/bev, life sciences/healthcare, and/or renewable energy, could be an option, as could further expansion of the company's portfolio in optical products and/or semiconductor cleaning.

Slower Demand Is Likely, But A Big Downturn Seems Unlikely

The new EnPro is moderately less cyclical than before, as eliminating GGB does reduce the company's leverage to end-markets like autos and short-cycle industrials. Though I expect auto production to be fairly healthy in 2023, I'm not as bullish on "general industrial" machinery, and I do think there will be a modest recession here.

The semiconductor end-market now makes up about 40% of EnPro's revenue base, and semiconductor investors have definitely been worried about a downturn in 2023. Evidence has indeed been mounting of such a slowdown, with lead times starting to shrink and inventories starting to grow.

I think there's a specific detail about semiconductor downturns that's important to remember in regard to EnPro's exposure - while the semiconductor industry is cyclical, it's typically pricing that drives the cyclicality. It's relatively rare to see meaningful unit volume declines in the industry, and I think that will be the case again here. Though there are some markets where I see more volume risk (like memory), I think overall demand will be fine; business will likely slow, but I don't expect a very sharp correction. Moreover, with companies pushing hard to maximize production throughout 2022, I could see more demand for EnPro's refurbishing services.

I'm a little more concerned about the medium/heavy-duty truck market, and EnPro generates close to 20% of its revenue here. The first half of the year should be strong, as OEMs continue to catch up on backlogs created by component shortages, but I expect demand to shrink pretty significantly and this end-market (about one-third of the Sealing business) will likely look quite a bit weaker later in 2023 and into 2024.

The Outlook

There's really not that much else that concerns me with EnPro, and I think "keep on keeping on" would be just fine here. As I said before, I like this refocus around engineering-driven barriers to entry and a greater focus on end markets with above-average growth (and higher recurring revenue opportunities). That's a playbook followed by many successful multi-industrials, including names like Danaher ( DHR ) and IDEX ( IEX ), and I believe it will serve EnPro well.

I do expect more M&A, and given the market/product attributes that management is now targeting, I can see some risk of short-term sticker shock as deal multiples are likely to be higher than what is typical of more run-of-the-mill industrial M&A transactions.

Without any explicit modeling of future M&A, I believe EnPro can generate mid-single-digit long-term revenue growth in the 4% to 5% range. EBITDA margins in the mid-20%'s should be attainable over a few years, and I expect mid-teens free cash flow margins over the longer term, supporting high single-digit FCF growth.

Discounting those cash flows back, I believe EnPro is currently priced for a high single-digit total annualized long-term return. That's not bad, but it's not compelling either. Likewise, the company's margins and returns can support an EBITDA multiple of around 11x (closer to 12x in a more normalized part of the cycle), and that gives me a low-to-mid-$120s fair value on my FY'23 EBITDA estimate.

The Bottom Line

I don't think I'd be in a hurry to sell EnPro if I already owned the shares; I like the strategic moves that management is making, and I believe they are laying the groundwork for higher growth, margins, and multiples over the long term. I think buying at today's price would probably work out over time, but I would prefer to try to pick up shares on a pullback, should one come around over the next 6-12 months.

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