Dover (DOV) is a well-established industrial conglomerate which got hit hard during the sell-off in energy related stocks at the start of the year. Like many industrial businesses, shares have seen a decent rebound as oil returned towards $50 per barrel and dollar headwinds are leveling off.
The recovery in oil prices and stabilization of financial markets gave management confidence to expand the business with the purchase of Wayne Fueling Systems. While I like this bolt-on purchase, I think that Dover as an overall company has been underperforming in recent years. While conglomerates can have great diversification benefits, I think that Dover is missing focus. The company is furthermore much smaller compared to some of its conglomerate "competitors", making it hard for each individual segment to compete effectively on a global scale.
I therefore think that investors should applaud any move which involves greater focus going forwards. A potential sale of a segment, or even a break-up of the company could sent shares higher. If the company stays on its current trajectory, I see few potential triggers to create meaningful shareholder value in the short to medium term.
A Broad Conglomerate
Dover projects that its sales will come in at $6.8 billion in 2016, with the business activities of the company being divided across 4 units. The engineered business is the largest segment, making up little over a third of sales. Both the fluids and the refrigeration & food equipment business each make up a quarter of sales as the energy business makes up for the remainder 15% of sales.
The fluids business is a key growth area of the company, focusing on pumps and fluid transfers products. Segment revenues have doubled over the past decade, in part the result of a number of acquisitions. Dover enjoys particular strength in retail fueling, as it competes against formidable competitors across the segment including Danaher, Idex and Nordson. While growth has been good on a longer time frame, organic growth as been disappointing over the past two years thanks to exposure to energy related markets.
The energy segment makes up 15% of total sales, but two-thirds of segment revenues are derived from drilling and production activities. This creates very large headwinds for obvious reasons, as sales are down by more than 30% year-over-year. The business has seen its sales fall towards an annual run rate of $1 billion. This makes life very hard to compete against much larger competitors such as Schlumberger.
The engineered systems segment is the core of the business, comprised out of industrials and printing & identification solutions. Core activities include marking & coding, refuce collection and the auto after-market equipment segment. While the segment might be large, the individual business activities being classified in this segment vary a great deal as well.
Finally there is the refrigeration & food equipment segment which generates the vast majority of sales from refrigeration equipment.
Relative Underperformance, A Lost Decade?
While Dover recently held a flashy presentation, detailing the goals for each segment going forwards, the reality is that the operating performance of the overall business has been disappointing. Revenues have come in at $6.8 billion on a trailing basis, indicating no real growth from the $6.5 billion in revenues being reported back in 2010. While gross margins improved a point to 37% of sales, operating margins have fallen a point to 13% of sales on the back of the energy headwinds.
Even if we exclude these recent headwinds, operating margins never really surpassed the 15% mark. While these are pretty decent margins, the reality is that the operational side of the business has been quite stagnant. The one positive development for investors has been the fact that decent cash flow generation has been used for a multi-year buyback program. Dover has bought back a quarter of its shares over the past decade, allowing earnings per share to grow significantly, even as actual earnings are flat.
Diversification Can Work, But Scale Is Needed
There is nothing wrong with diversification as long as each segment is held accountable for its own results. Danaher (DHR), which is a competitor of Dover in many business segments, has a great track record. It too is very diversified but has managed to more than double its sales over the past decade, now supporting a revenue base of over $21 billion. Even as Danaher has been very successful under the conglomerate business model, it is now contemplating a split of the business to ensure future success.
3M (MMM) is another great example. The company runs 5 segments which each post very impressive operating margins north of 20%. It has managed to increase its sales by some 30% over the past decade, now generating over $30 billion in annual sales.
The trouble for Dover might be the fact that it is lacking scale versus these conglomerates, with sales coming in at just $7 billion. Let´s face it, a $1 billion energy business is very small compared to a giant such as Schlumberger. I would argue that investors would be better off with a more focused business going forwards.
Not only is Dover of relative small scale versus some competitors, its businesses are truly uncorrelated as refrigerators have very little to do with energy markets. It is hard to argue that these segments bring benefits to one another, except for the general diversification argument.
To create topline sales growth, Dover announced the $780 million purchase of Wayne Fueling Systems from Riverstone Holdings LLC. This strategic investor bought the unit from GE (GE) back in 2014, for a purchase price rumored at $500-$600 million.
Wayne provides fuel dispensing, payment and related software solutions for fuel stations, an area in which Dover is already active. The company paid a 10 times EBITDA multiple, suggesting an EBITDA contribution of $78 million. This reveals that EBITDA margins came in at 14% based on revenues of $550 million per annum.
The good news is that Dover is expected to derive meaningful synergies from the deal, given that is has a large fueling business already. Synergies are seen at $30 million per year, although it will take three years to fully realize this. This suggests that pro-forma EBITDA could improve by $108 million, suggesting a mere 7.2 times multiple if you include synergies.
The Pro-Forma Business
The purchase of Wayne will increase leverage of Dover a bit further. At the end of the first quarter, Dover held $244 million in cash, operating with a net debt of load of $2.77 billion at the time. This net debt load will increase to $3.55 billion on a pro-forma basis.
The company issued a profit guidance of $3.51 to $3.66 per share at the end of that quarter. With 156 million outstanding shares, that translates into earnings of roughly $560 million. If we reverse engineer these earnings by adding back a 30% tax rate, $350 million in depreciation and amortization charges, and a $125 million interest bill, EBITDA comes in at $1.25 to $1.30 billion. This EBITDA number might improve towards $1.35 billion following the purchase of Wayne, for a 2.6 times leverage ratio.
At $70 per share, Dover trades at 19-20 times earnings. Wayne could contribute $108 million in EBITDA and potentially $80 million in EBIT, assuming that D&A runs at 5% of sales. A 5% cost of interest on $780 million in additional debt will result in a $40 million increase in the interest bill. That suggests that the pre-tax profit contribution could come in at $40 million, already having taken into account the anticipated synergies. This shows that after taking taxes into account, Wayne could add roughly $0.15 to Dover's earnings per share.
At $70 per share, Dover´s equity is valued at nearly $11 billion. The overall enterprise valuation has now risen to $14.5 billion, roughly 11 times the pro-forma EBITDA number of $1.35 Billion. While the operational performance over the past decade has not been too impressive, investors still like the shares. Dover is a true dividend aristocrat, currently yielding 2.4%.
Leverage is increasing following the purchase of Wayne, but remains very manageable. I must say that I like the deal a lot. Including realistic synergy numbers, Dover is paying a mere 7 times EBITDA multiple while the company itself is trading at 11 times EBITDA. This suggests that the value being created, if Wayne is valued at 11 times EBITDA within Dover, adds up to $300-$400 million. That would be equivalent to roughly $2-$3 per share.
That said there are few triggers going forwards in my eyes, after shares recovered from $50 during the February turmoil to $70 by now. Shares now trade at around 19 times earnings which is a more than fair valuation, as leverage is elevated but not a major concern. Investors should therefore expect market equivalent returns going forwards in my eyes, even as I like the Wayne purchase. The real kicker might have to come from better operational performance, potentially triggered by a more focused strategy.
If Dover would be able to divest one or two segments at full valuations, and reinvest proceeds into the core areas in a sensible way, the future might be bright. In such a scenario, Dover might be able to accelerate organic sales growth and expand margins as the remaining businesses would have an improved competitive position.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.