KMT - Lincoln Electric Offers Lingering Tailwinds And Excellent Quality But Less Value

Summary

• Lincoln Electric's fourth quarter results were very healthy in absolute terms but a little short of expectations and guidance for FY'23 had some notes of caution.
• General fabrication, heavy industry, and construction/infrastructure are markets to watch for possible weakness, while auto, energy, and longer-cycle mining and ag should be solid.
• Lincoln has steadily built up its capabilities in automation and new welding technologies and I expect even more leverage from these businesses in the coming years.
• Mid-single-digit core growth doesn't really support a substantially higher share price now and this is a name to jump on if there's a more significant pullback.

Lincoln Electric ( LECO ) has been an exceptional industrial stock for a long time, with a long-term annualized return in the double-digits that at least earns it a seat at the table when talking about great long-term holdings in the sector. Not only has management executed well within its core welding equipment market, they have also grown the company’s base of business (particularly in automation), while also delivering strong margins and returns (ROIC, et al).

Up about 20% since my last update , the shares have outperformed the broader industrial space by a healthy margin, including other “early-cycle” names like Kennametal ( KMT ). I do still see some healthy tailwinds across much of the business going into 2023, but I also see rising macro uncertainty and high expectations built into the share price.

While a quality name, Lincoln Electric has given investors repeated 10%-plus pullbacks and occasional 20%-plus cyclical pullbacks. Long-term holders may not want to try to time the markets with this one, but at this point I’d consider waiting for a better entry point given where we are in the cycle but also considering positive long-term fundamentals for the company.

Mixed Results To Close The Year

Lincoln Electric’s fourth quarter results were not bad at all in their own right, particularly with the company delivering top-line growth ahead of the industrial sector average (14% versus around 10%), but the company was a little short on margins and prudently cautious on initial guidance for 2023.

Revenue rose 14% in organic terms, good for a modest beat against the Street, with healthy 4%-plus volume growth and strong pricing (up almost 10% year over year). Americas revenue rose 19% on nearly 8% volume growth, while the International business grew 13% on a little more than 1% volume growth. Harris was the laggard, contracting 2.5% on weak volumes.

Gross margin improved 80bp year over year and was stable sequentially at 33.1%, coming in a little short in a quarter where many (if not most) sell-side estimates were too high. Operating income rose 20%, with margin up 130bp to 15.8%, while segment profit was up 17% (margin up a point to 16%) and a bit short of expectations.

At the segment level, Americas profits rose 37% (margin up 260bp to 19.0%), International profits declined about 20% (margin down two points to 9.2%), and Harris profits declined almost 23% (margin down 260bp to 10.3%).

With ESAB ( ESAB ) not having reported yet, Illinois Tool Works ( ITW ) is the only available direct comp, and their revenue improved more than 15%, with segment margin up 170bp to 31.6%. While it’s a stretch to call them direct comps, 11% growth at Kennametal and 10% growth at MSC ( MSM ), a distributor of metalworking tools, does back up the general notion of healthy industrial fabrication/tool demand.

General Industrial Is Slowing, As Is Construction, But Other Markets Should Remain Healthy

Management’s guidance for mid-single-digit core growth was a little light of expectations, but not really out of line with a more cautious tenor to initial guides for 2023 coming from industrial companies. In particular there is a lot of uncertainty about how general industrial demand will shape up in the second half, as companies are seeing declining demand, high inventories, and persistent input cost pressure.

Specific to Lincoln Electric, I do expect general fabrication (around a third of the business) to slow, and the company did report low single-digit growth in Q4’22 versus low-double-digit growth in Q3’22 (with a tougher comp), though the company’s leverage to ongoing growth in automation could drive “market-plus” results even in a slowing market.

Auto and transport markets were up 40% in the quarter, and while I don’t see that pace continuing, I do think Lincoln should have a good year from end-markets that contribute close to 20% of revenue. Automation is an important driver here, as well as new growth opportunities tied to battery/BEV production like laser hotwire welding.

I also expect healthy ongoing trends in markets like oil/gas, mining, and ag equipment. Capex in these markets is still well below prior peaks and demand should remain healthy through 2023 and into 2024. All told, this is another 15% or so of revenue.

On the less positive side, I expect heavy industrial demand to slow (outside of mining, ag, et al) as strong backlogs roll over into weaker orders around midyear. I also expect weaker infrastructure and construction activity, though I do expect infrastructure to rebound in 2023 and underpin healthy growth for multiple years on federal stimulus spending.

The Outlook

I’m still bullish on Lincoln Electric’s long-term ability to be a “market-plus” grower, in part due to its significant investments in new technologies like automation, new welding technologies (like laser hotwire), and new related opportunities like additive manufacturing.

The automation argument is pretty straightforward – skilled labor is getting harder to find, and with nearshoring/reshoring likely to drive even more demand for welding, automation will be a critical tool to filling that labor/demand gap. Looking at the recent Fori Automation acquisition, though, I wonder if Lincoln has bigger ambitions. Fori is positioned in areas like multi-arm automatic welding, but also in other automation areas like industrial guidance vehicles, assembly automation, and end-of-line testing. This could then be the start of a broader effort in automation beyond welding.

I’ve also been impressed by the company’s efforts to repurpose existing capabilities. Take the August announcement that it would start producing DC fast charger modules in 2023. While that may seem strange at first, the core of what Lincoln Electric does is really electrical equipment (the “business end” of their welding equipment is an electrode), so it’s not so strange after all.

I’m looking for long-term revenue growth of around 4% to 5%, which should be comfortably above underlying industrial production. I do think revenue could decline in 2024 as longer-cycle markets slow, but I expect a quick recovery in 2025. Likewise, there could be some flattening out of margin leverage over the next two years, but I still expect longer-term improvement toward 20% EBITDA margin (FY’25 or FY’26), and mid-teens FCF margins that drive solid mid-single-digit FCF growth.

Discounted back, those cash flows don’t support a lot of near-term upside today. Likewise, even with a two-point “quality premium” to the EBITDA multiple (above and beyond what the margins/returns would normally support), a 14.75 multiple on my ’23 EBITDA estimate only gets me to the mid-$180’s, and I’d consider that a bull-case approach.

The Bottom Line

As I said above, I can easily view these shares as a core holding. But for those who don’t already own the shares, I think I’d prefer to take the risk of waiting for a pullback (and not getting one) than jumping in at a somewhat elevated multiple. I like the longer-term growth and margin opportunities here, but given a history of pullback opportunities, I think patience could work out alright.

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