Sooner or later, there will be a point when buying Lincoln Electric (NASDAQ:LECO) on weakness doesn't make sense, but I don't think we're there yet. It's true that this company has seen business weaken on tough conditions in markets like shipbuilding, energy and construction, but I don't expect that weakness to continue indefinitely, and Lincoln still has much to gain from consolidation, expansion into automation and growth in emerging markets like China and Brazil. The shares haven't yet pulled back to what I'd call a safe level, but this will ultimately be a good stock to ride a global industrial recovery.
Second Quarter Weak On Lower Heavy Equipment And Shipbuilding
Between the welding companies (Lincoln Electric, Illinois Tool Works (NYSE:ITW), Colfax (NYSE:CFX)) and other companies in the metalworking space (including Kennametal (NYSE:KMT), Atlas Copco (OTCPK:ATLKY) and MSC Industrial (NYSE:MSM)), these are challenging times for the underlying industrial sector as relatively stronger areas like automotive and aerospace are offset by weakness in heavy equipment, energy and so on.
To that end, the bigger surprise to me in Lincoln Electric's reported 2% revenue decline this quarter was that analysts hadn't moved their numbers more in anticipation. Be that as it may, underlying organic performance was weak, as revenue declined 5% on a nearly 5% decline in volume. Both North America and Europe were down about 5% on nearly identical volume declines (just under 5%), while Asia revenue plunged 19% on an 18% volume decline. South America revenue was up 20%, but accounts for only about 6% of revenue.
Although this was a weak quarter from a demand perspective, it didn't result in margin deleverage and that speaks well to the company's cost structure. Gross margin actually improved about three points as reported, while adjusted operating income rose 9% and the operating margin improved 150bp to just under 15%.
Some Share Loss, But Not A Worry Yet
Although Lincoln Electric boasts about one-third share of the North America welding market, it looks like the company surrendered some of that this quarter. Illinois Tool Works had flat overall welding performance this quarter, but 1% growth in North America on new product introductions. Colfax didn't offer up quite as much specificity (with sales down 4% overall), but it sounded like the company's performance was incrementally better in the U.S.
I'm not inclined to make a big deal of this just yet. For starters, some of Lincoln's large direct customers like Caterpillar (NYSE:CAT), Deere (DE) and Volvo (OTCPK:VOLVY) are experiencing some well-publicized challenges in markets like mining, construction and commercial vehicles. Likewise, there was nothing in this quarter's cycle of earnings reports to suggest particular health in the energy market, and management highlighted slower activity levels for shipbuilding in China as a significant source of weakness.
Quarter-to-quarter wobbles are nothing new in this space, and I expect Lincoln to regain whatever it may have lost. A few direct customers (like Trinity (NYSE:TRN) in rail cars) are seeing solid demand, and Lincoln's consistent emphasis on product development at a time when rivals are having to keep an eye on margin improvement should serve the company well over the long term.
What's more, I believe Lincoln Electric still has much to gain in the automation space. Industrial automation companies like ABB (NYSE:ABB), Siemens (SI) and Fanuc continue to see solid long-term demand growth (in the mid to high single digits). Lincoln has room to grow not only with new products and technologies, but also with conversion as ABB still works primarily with Colfax in its welding robots.
Plenty Left To Do
Construction activity seems to be slowing improving, and that should not only help Lincoln Electric later this year and into 2014, but should eventually lead to better construction vehicle demand. Likewise, while activity in the energy sector has slowed, I don't think anybody expects this to continue on a long-term basis. The bigger issue for Lincoln Electric may frankly be that "general industrial" segment of its end market where conditions remain slow and where distributors like MSC Industrial aren't looking for a sharp, quick turnaround.
Longer term, I believe there are still opportunities for Lincoln Electric to grow and expand margins. About 30% of the welding industry market is held by companies with around $30 million to $60 million (according to Elliott Schlang at Great Lakes Review), and though I don't see Lincoln buying indiscriminately, I still see plenty of opportunity for growth via M&A - particularly in emerging markets. In addition, while Lincoln has about one-third of the U.S. market, the company has sub-20% share in Europe and Latin America, and less than 10% share in Asia and I see those as long-term growth opportunities.
The Bottom Line
Between underlying global economic growth, acquisitions and expansion into the automation space, I believe Lincoln can roughly double the underlying long-term industry growth rate and deliver about 7% long-term revenue growth. While I believe there is still room to improve margins and cash flow generation, I don't see as much potential there, so my long-term cash flow growth forecast is about 8%. That works out to a fair value target of about $63.50 today on a cash flow basis, with EV/EBITDA/growth and ROE/PBV suggesting similar targets in the $60s.
I'm not a very dedicated chart reader, but I would be a little cautious with Lincoln right now as the technicals don't seem strong. Moreover, a 10% or so discount to fair value isn't quite enough margin of safety for my comfort. That said, Lincoln Electric rarely stays cheap for long and this remains a high-quality mid-cap industrial, and a stock I'd like to own if the shares slide a bit more from here.
Disclosure: I am long ABB, MSM. 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.