There's a pretty broad universe now of beaten-down industrial conglomerates that would seem to offer attractive upside for patient investors. Dover (NYSE:DOV) would seem to be among them, as the sharp decline in the energy business has mauled the company's financial results but not so much that the company couldn't still generate double-digit FCF margin in 2015.
Dover has never been the most exciting of the conglomerates, but I don't think mid-single digit long-term growth in free cash flow should be out of reach, and that still supports a fair value in the high $60's. The problem is that it's hard to see what gets investors interested in owning the shares in the next few quarters. Dover doesn't have meaningful exposure to popular end markets like aerospace, construction, healthcare, or passenger vehicle production, so unless energy starts recovering sooner than most expect, this stock will probably require some patience.
Uglier Than Most, Even Without Energy
It's looking like Dover's peer group is going to generate a 1% average contraction in revenue for the fourth quarter, but Dover came in below that level. Reported revenue declined 14% and organic revenue declined 12%, but even excluding energy only lifts the result to a 2% decline. Dover also came in light on margins, so there's not a lot to really celebrate here.
Energy was a mess, with organic revenue down 40% and significant weakness in all of the major segments. Fluids and Refrigeration/Food Equipment were also both weaker than expected, with both reporting a 6% decline in core revenue. Engineered Systems was the sole source of good news, with organic revenue up 6% on surprisingly strong 8% growth in Printing and Product ID. Given the results posted by Danaher (NYSE:DHR), Dover either gained some meaningful market share or found some meaningful new markets/customers.
Gross margin eroded by 40bp and reported operating income declined 23%. Segment margins declined 150bp from last year, with Energy business margins plunging on the revenue weakness. Fluid margins held up well and Refrigeration/Food Equipment margins improved nicely as the company has traded off lower-margin business at Wal-Mart (NYSE:WMT) for a lower level of more profitable business. Engineered Systems saw some margin erosion, but it was less than a point.
… And Now?
Dover and its investors are probably going to spend most of 2016 in the storm shelter waiting for the mess in energy to blow itself out. Although Energy was once about a third of Dover, it's likely to shrink to 20% or less in 2016. With rig counts so weak, there's not much call for Dover's drill bits, valves, bearings, or artificial lift products. There are calls out there for energy to bottom out and start recovering before the end of 2016, but the truth is that nobody knows.
Dover's refrigeration business now stands as the largest business, but the 11% decline in organic revenue in the fourth quarter isn't encouraging (though this was a byproduct of seeing some low-margin Wal-Mart business go away). Unlike Illinois Tool Works (NYSE:ITW), which is benefiting from generally solid demand for equipment in the food service sector, capex spending in supermarkets and C-stores doesn't look as strong and the "close the case" driver hasn't developed as hoped.
The next-largest contributor to Dover is that vague "general industrial" end market that's basically a catch-all for things that aren't big enough to really break out independently. While Dover's reported Industrial sales (part of Engineered Systems) were up 1%, Oshkosh (NYSE:OSK) had generally encouraging things to say about refuse vehicles and Illinois Tool Works has been seeing decent results in the auto service sector.
The bigger problem for Dover is that there's really not a lot to get excited about. It would be great if that strong performance in Printing/Product ID can continue, but there's not a lot outside of that. Illinois Tool Works has the advantage of exposure to construction, food prep, and auto production (and minimal energy), and companies like Honeywell (NYSE:HON), General Electric (NYSE:GE), and 3M (NYSE:MMM) have exposure to markets like commercial aerospace, construction, and/or healthcare to help offset less attractive exposures to oil/gas and the general manufacturing malaise.
Hunker Down For Now
While management is still looking for areas to cut expenses and leverage its supply chain, core operating margin at been at a historic high before the energy market fell apart, so I'm not sure how much additional restructuring is really possible. It doesn't sound as though management really wants to gut the Energy business with mass-firings and facility closures (which is a reasonable long-term decision, as GE isn't panicking either), and most of management's comments at the December Investor Day were skewed toward long-term plans to build the business.
I think Dover can reasonably be expected to grow its top line at a roughly 4% annualized rate over the long term. Energy will eventually recover (though how much lower it goes in the meantime is a fair question to ponder), and the company has credible growth opportunities in areas like polymers/plastic processing, retail fueling, textile printing, and sterile process equipment for the pharmaceutical industry. Refrigeration isn't so exciting, but I would expect that Dover can at least generate good margins and cash flows from its sizable market presence.
I'm looking for long-term FCF growth in the neighborhood of 5% as the company gradually improves its margins and free cash flow generation. Discounted back, that supports a fair value close to $70, as does an assumption that Dover can maintain a mid-teens ROE over the next few years.
The Bottom Line
Not to harp on it, but what's the reason to buy Dover today other than it looks undervalued on a long-term basis and pays an okay dividend? That's fine if you're a patient investor, and if you think the energy market will turn around sooner and/or more strongly, Dover is certainly a way to play that idea. In the meantime, I'd be concerned about the risk that Energy gets worse before it gets better and that Fluids and Refrigeration likewise continue to disappoint through 2016. As far as relative value goes, though, Dover does look cheaper than stocks like Illinois Tool Works, Honeywell, 3M and General Electric, so I can understand why value hunters would want to dig deeper here.
Disclosure: I am/we are long MMM.
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.