2023-06-05 18:43:14 ET
Summary
- I changed my recommendation on Vontier Corporation from buy to hold as the stock has reached my target price of $30.
- I still maintain faith in Vontier Corporation's business prospects, including its ability to attract larger customers and expand its market share.
- Potential upside from today's share price relies heavily on Vontier's ability to inflect earnings upwards in the near-term.
Description
Everything went just as expected as Vontier Corporation ( VNT ) share price steadily increased to hit my target price of $30 . With that, I am changing my recommendation from buy to hold, as I believe the valuation which has recovered to its historical average has fully reflected the upsides for Vontier Corporation in FY24/25.
At this valuation, any potential upside would require underwriting an acceleration in earnings, which is tough given the EMV impact on FY23, and also valuation to go above its historical average. While both are possible, the risk reward situation compared to the start of the year is just relatively poorer, and the margin of safety from a valuation perspective is worse as well (trades at 10x today vs 7x earlier). As such, I am moving my coverage stance to monitoring and providing updates on the business, until such time when valuation becomes attractive again.
EMV sunset
It's good to know that the last order for EMV will ship in 2022, marking the end of its lifespan. As 60% EMV sales occurred in the second half of 2022, I expect it to continue being a headwind in FY23 financials. As the EMV revenue flows out of the system, I see a modestly net positive impact as:
- With the EMV numbers out of VNT P&L, the market can finally mark and end to the EMV headline risks
- Management do not need to worry about managing expectations around the EMV issue again, instead, they can focus on sending the right message with regards to the remaining $250 million revenue base that has potential to grow
I am of the opinion that there are fundamental growth drivers for the remaining parts of the business, such as additional regulatory drivers (i.e., the level of regulatory cycles continues to rise, with the company announcing the sunset of credit card 2.0 systems in FY24), new site buildout or consolidation driven upgrades, and, finally, a refresh cycle with product upgrades. That said, I believe the primary fundamental driver here is that as the installed base grows, the industry will demand more aftermarket parts and services.
Growth ahead
Though I'm changing my Vontier Corporation recommendation to a hold, I want to be clear that I still have a lot of faith in VNT's business prospects, as the company keeps attracting bigger customers that are looking to consolidate their position in the market. VNT has been able to increase their market share and attract new customers by expanding their product catalog and launching their digital offerings. It's also encouraging to see that management isn't resting on its laurels after achieving some success. For instance, VNT underwent 1 cycle of product simplification, which resulted in a significant SKU reduction by reducing the number of product platforms from 32 to 20. I expect the margin line to show continued improvement as the company persists in targeting and identifying these opportunities. Also, if we take a step back and look at the big picture, VNT is still a business that primarily makes revenue from North America, and given the TAM is so large at $30 billion (source: 1Q23 earnings), I believe there is still an incredible runway of growth left to capture.
Valuation
Remember from my previous post that I expected VNT to generate around $500 million in earnings in FY25, with a price target of $30 based on a 9.2x forward earnings multiple. My model has undergone minor changes today, with the exception of some minor adjustments to reflect consensus estimates. So far, the key driver of returns has been the return of valuation multiples to their historical average of 10x. When the stock was trading at 7.5x, it was an easy pitch to say that multiples could revert to historical averages as the company weathered the EVM headwind and the market became more forward-looking. However, at 10x earnings, one must believe that the company's earnings must grow by at least 10% per year in order for the returns to be attractive (assuming 10% cost of equity, no change in multiples, and no capital returns). According to consensus estimates, earnings growth will be in the low single digits. If we do the reverse math, we can see that the change in multiples and FCF yield must be greater than 6-7% to achieve 10% returns. (Earnings growth + FCFE yield + valuation change = 10% stock return). Looking at the two components of the equation, the onus is on VNT management to return capital to shareholders, which it is capable of doing given its FCF yield of around 10% today based on FY23 consensus figures. However, I do not believe there are enough catalysts at work here to cause multiples to inflect higher up.
As a result, in order to earn a cost of equity-like return today, investors must believe that management will return 70% of their FCFE to shareholders through dividends or buybacks. Given the history of dividends, share buybacks appear to be the only viable option. Even for share buybacks, the yield on share buybacks has been around 2+% CAGR over the last three years (from FY20 to LTM 1Q23). As a result, it is unlikely that shareholders will receive the entire FCF yield. Assuming a 3% capital return, a 4% increase in earnings, and no change in multiples, the expected return from here is only 7% per year.
Own model
Summary
I am changing my recommendation for Vontier Corporation stock from buy to hold, as the stock has reached my target price of $30. While there are potential catalysts for future growth, the risk-reward situation is relatively poorer compared to the start of the year. The margin of safety from a valuation perspective is worse as well, with the stock currently trading at 10x earnings compared to 7x earlier.
Although I still have faith in Vontier Corporation's business prospects, including its ability to attract larger customers and expand its market share, the market would need to see an acceleration in earnings or a significant change in valuation for further upside. Given the current conditions, I am shifting my coverage stance to monitoring and providing updates on the business until the Vontier Corporation valuation becomes attractive again.
For further details see:
Vontier Corporation: Upside Is No Longer Attractive (Rating Downgrade)