NDSN - Nordson Is Starting To Look Interesting

2023-05-29 10:00:00 ET

Summary

• Nordson has underperformed the market since I first covered the stock.
• After lowered guidance in Q1, the stock dropped over 10% and hasn't moved much since.
• Valuation looks attractive to consider starting a position.

In January, I first published an article on Nordson ( NDSN ), highlighting the high quality of the business but also the high price and putting a hold rating on NDSN stock. After a disappointing Q1, shares plunged over 10% and the price hasn't moved much since then. The company also reported Q2 results last week. Let's see if the company is now a compelling investment after a tough first half of 2023.

Disappointing first quarter results?

First quarter results aligned with expectations and missed EPS by 1% and revenue by 2%. Overall revenues were flat, driven by 1% organic growth, 3% growth from M&A and a 4% forex headwind. Free cash flows increased and saw a strong cash conversion rate of 109% (compared to adjusted net income). The market got spooked by a lowered full-year 2023 guidance:

• Sales guidance lowered from $2,616-$2,772 to $2,590-$2,667
• Adjusted EPS guidance lowered from $8.75-$10.10 to $8.75-$9.5

Overall not a terrible quarter; a slightly lowered guidance on the high-end of the EPS guide shot the stock down over 10%.

Second quarter

Second quarter results beat the top (7%) and bottom line (2%). Once again, currency headwinds held growth down a bit, but EPS saw a healthy 18% jump. Free cash flow almost doubled from $84 million to $159 million and saw a strong 118% cash conversion. Q2 saw another update to the full-year guidance:

• Adjusted EPS was narrowed down from $8.75-$9.5 to $8.9-9.3

The market reacted neutrally toward the results.

A textbook Compensation structure

It is vital to understand the compensation and ownership structure of a company. To do that, it's best to look into the Proxy statement . We can see that most management compensation is at risk, meaning it depends on business performance. 88% of CEO pay is at risk (76% from long-term compensation, 12% from short-term compensation and 12% base salary) and 77% for the average named executive officer (62% long-term, 15% short-term, 23% base salary). This is a good mix and we should always prefer pay for performance compensation.

The short-term compensation or annual bonus is paid in cash and (depending on which NEO) is based on 40% organic revenue growth and 60% base business operating profit. I like these criteria because they do not incentivize management to make bad acquisitions to meet their targets.

The long-term incentives are paid in 40% performance shares, 40% stock options and 20% RSUs. Stock options and RSUs do not have special criteria, but the performance shares are tied to EPS growth (40%), ROIC (30%) and EBITDA margin (30%). In 2021 the company switched its long-term compensation from total shareholder return benchmarked against the S&P 900 to these metrics, a great change! Management is aligned to prioritize profitable growth with a high return on invested capital. My only criticism is the lack of a cash flow metric (EBITDA is a proxy for cash flow, but I'd like Operating or Free Cash Flow instead).

Lastly, it is essential to know if there is insider ownership. While the management team owns under 1% of the equity, around 9% of the shares outstanding are with the Nord Foundation and Nord family members.

Price is starting to get attractive

Let's value Nordson using An inverse DCF model and multiples. Below you can see my inverse DCF model. I use traditional Free cash flow and Owner Earnings (Free cash flow - SBC +/- changes in NWC + growth capEx). We can see that free cash flow was suppressed quite a bit by changes in NWC and if we adjust for it, we get $703 million in owner earnings. Using a 10% discount rate, Nordson would have to grow its owner earnings by 8% for the next five years, followed by 5% growth for the next five years. This seems reasonable if we consider that Nordson guides for 7% revenue CAGR and 10% EBITDA CAGR until 2020-2025. Nordson expects its Industrial Precision Solutions segment to grow at 3%+ over the long term, while Medical Fluids and Advanced Technology Solutions should grow at 5%+ over the long term. These aren't exceptionally high organic growth rates, but Nordson has a history of accretive M&A and increasing the company's margin profile. The valuation doesn't look demanding for a proven company.

On a multiple basis, we can see that PE and EV/EBITDA are slightly elevated compared to the last decade, but most of the valuation premium it had in 2020-2022 is gone. The FCF yield is above the 10-year median.

Overall, Nordson is not a screaming buy at these levels, but it might be a good starting point to accumulate shares in a high-quality compounder.

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