LECO - Lincoln Electric: Automation And Innovation Driving Growth Year After Year

2023-12-04 18:17:42 ET

Summary

• Lincoln Electric is a high-quality company with a strong track record of performance and growth.
• With 27 straight years of dividend raises, investors can feel confident in LECO's capital allocation strategy.
• LECO has a focus on innovation, automation, and employee culture, leading to consistent returns and financial health.

Introduction

Lincoln Electric ( LECO ) is a high-quality company that is firing on virtually all cylinders. The company has been in operation since 1895, hasn’t had a layoff in over 70 years, has raised dividends in 27 consecutive years, consistently maintains a high Return On Capital (including a 31.4% ROC at present) and has demonstrated that it can increase earnings and free cash flow at double digit percentages. LECO needs to be on investors’ watchlists, as the company is expanding globally and continuing to introduce innovative new solutions to gain further market share.

Company Overview

Lincoln Electric is a leading international producer that specializes in products for cutting, welding, and brazing. LECO maintains a global leadership status in the design, development, and manufacturing of brazing and soldering alloys, arc welding products, automated joining systems, assembly and cutting systems, plasma and oxy-fuel cutting equipment, and assembly and cutting systems. Arc welding equipment, consumables, plasma and oxyfuel cutting systems, wire feeding systems, fume control equipment, welding accessories, custom gas regulators, and instructional solutions are all included in the company’s product lines. Additionally, LECO provides an extensive range of automated solutions to address a variety of industrial processes, including cutting, joining, material handling, module assembly, and end-of-line testing.

The wire feeding systems and arc welding power sources offered by the company accommodate a wide range of technologies, from entry-level units intended for light maintenance and production to sophisticated robotic applications specifically engineered for welding and fabrication in high-volume settings. Coated manual or stick electrodes, solid wire for continuous feeding in mechanized welding, and cored wire for continuous feeding are the three principal types of arc welding consumables manufactured.

The Company operates globally and has production facilities in numerous nations, including the United States, Australia, China, Germany, India, Mexico, and the United Kingdom. The company is structured into three operational divisions: The Harris Products Group, Americas Welding (which encompasses North and South America), and International Welding (which includes Europe, Africa, Asia, and Australia) (including global cutting, soldering, and brazing businesses, specialty gas equipment, and the U.S. retail business).

Investment Case

Having been in operation since 1895, potential investors have a large amount of data to consider when evaluating Lincoln Electric. Across many different areas, LECO exhibits the traits of a high-quality and high-performing company. Starting with the company’s business model, LECO has leveraged a proven “razor and blades” business model to drive growth over the years. The company sells its welding equipment, along with consumables, which tends to create sticky customer relationships and leads to a flywheel effect. 58% of the company’s revenue is generated from consumables today.

LECO also believes that it has the broadest portfolio of welding products in the industry. The chart below is supportive of this view and highlights the depth of LECO’s product lines. This portfolio serves customers across segments and different industries.

In recent years, the company has focused considerably on automated welding technology and solutions. LECO’s automation solutions are making welding processes safer, less costly and driving up productivity. Additionally, welding is an area that has frequently faced labor shortages, so the use of automation helps customers increase output. Industry trends also favor LECO. Renewable energy, smart infrastructure and the electric vehicle industry are all turning to LECO’s welding solutions to create end-use products.

LECO is also strongly focused on technological innovation and building deep employee relations/culture. On this front, the company has not had any layoffs in over 70 years, which demonstrates its commitment to employees, but also diligent cost discipline. Lincoln’s Incentive Management system also ties employee incentives to productivity. The system has helped foster a culture of efficiency, motivation and accountability that competitors have been unable to match. Over the years, LECO has maintained a commitment to research and development, in order to continue introducing innovative welding products to its customer base. The slide below provides a more detailed look at LECO’s technological innovation efforts.

Management has also focused on delivering robust growth, even though the company operates in a very mature market. The chart below shows the company using a combination of innovation, organic initiatives and M&A to drive growth.

Financial Overview

Financially, LECO is likely to appeal to both dividend and “growth-at-a-reasonable price” investors. LECO is currently on a 27-year streak of increasing dividends and has also generally maintained a payout ratio of 35% or less. Meanwhile, the top-line has consistently grown too. The chart below shows quarterly revenues since 2018, with sales growing from $740M 6 years ago to $1.03 billion today.

As noted previously, management maintains a consistently high level of cost discipline. While gross margins have been in the mid-30’s for nearly a decade, LECO has consistently been able to increase its net margins.

Assessing LECO’s financial health, there do not appear to be any red flags. Debt-to-equity is below 1.0 and the company currently has a cash balance of $343M. Perhaps more importantly, free cash flow generation has been robust and consistent. Over the LTM period LECO has generated more than $500M of FCF per TIKR data. Quarterly FCF growth has followed suit and reached an all-time high recently.

Having employed consistent cost discipline, along with a culture of growth and innovation, it’s no surprise that LECO is generating consistent returns for investors. As shown in the chart below, LECO has succeeded in generating higher returns on total capital quarter after quarter. Most recently, Return on Capital hit 31.4%.

Further consistency in LECO’s ability to execute is seen through the fact that it has beaten Wall Street’s earnings estimates over the last 14 quarters and revenue in 12 of the last 14 quarters.

Investment Risks

Although Lincoln Electric faces a number of risks, including high levels of competition and significant regulatory requirements, this section will focus on risks that could undermine the investment thesis and result in a significant destruction of value.

As a company that focuses on serving customers in the manufacturing, construction and industrial sectors, LECO is highly sensitive to current economic conditions. During the last 2 recessions (Pandemic, Global Recession) LECO’s revenues suffered double-digit drops both times. With a possible recession on the horizon in 2024, potential investors will want to keep a close eye on customer activity.

Supply chain disruptions and raw material prices are further watch items. LECO operates internationally with a global customer base. Any supply chain disruptions or raw material price increases are likely to cause production and distribution problems and thereby impact LECO’s financial performance.

Product liability is another area of caution. Although LECO is not facing any material product liability claims, the company continues to build out new and innovative solutions which face liability claims down the road depending on performance.

Finally, in recent years, LECO has been active on the M&A front. Potential investors will want to consider integration risks as LECO has indicated that it will continue to seek further acquisitions and will also want to watch the company’s debt load to ensure it remains manageable.

Valuation & Outlook

Lincoln Electric currently has a market cap of $11.5 billion and trades at a P/E of 22.1. According to Seeking Alpha’s valuation metrics, this is right in line with LECO’s 5-year averages of 21.39 ((TTM)) and 20.7 ((FWD)). Analysts are currently projecting 5% EPS growth for 2024 and total EPS of $9.57. Looking ahead to 2025, the projections increase to 9% growth and EPS of $10.43.

For the base investment case, we’ll assume that LECO maintains its 5-year TTM average P/E of 21.39 and that the company hits the consensus earnings target of $9.57. This would imply a year-end 2024 stock price of $205. Looking at 2025, things only get slightly better assuming the P/E is maintained and earnings targets are achieved – share price increases to $223.09. Note that at the time of writing, LECO is trading at $201.77.

Turning to the bull case, LECO could overachieve on earnings, which the company has a history of overachieving. For this scenario, we’ll model 12% growth in both 2024 and 2025. This would bring EPS of $10.18 in 2024 and $11.40 in 2025. Assuming the 5-year average P/E, LECO shares jump to a price of $243.93, a 2-year total return of 21%.

In the bear scenario, projected earnings decline by 10% in 2024 to $8.20 due to a potential global or multi-region recession. Here LECO’s share price would decrease to $175.39, though in reality shares would likely decline more during a recession as the market tends to overshoot both on the way up and the way down. If this scenario plays out, LECO shares could trade in the $155-$160 range.

Overall, LECO demonstrates many of the traits that potential investors tend to seek in a company – quality management, commitments to growth and innovation, a strong employee culture, a history of strong ROIC and free cash flow growth, 27 years of dividend increases, a product suite that is core to the global economy and other factors as well. The downside of being such a high-quality company, is that the stock appears to be fully valued at the moment. Potential investors would have to have a strong commitment to believing the bull scenario to earn a decent return. However, we always advocate for buying at a margin of safety to ensure downsides are limited. Right now, that margin of safety just doesn’t exist in LECOs shares. A preferred entry point for LECO would be a stock price of $165 or less. This doesn’t seem to be in the cards at present, so LECO earns a neutral/hold rating.

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