Dover's Ability To Create Long-Term Value Still An Open Question

About: Dover Corp (DOV), Includes: DHR, ITW
by: Stephen Simpson, CFA

Dover's consolidated 8% organic revenue growth rate looks quite good on a relative basis, and the 5% growth rate ex-Energy is still quite competitive with the peer group.

Weak margins remain a sticking point for me, as well as Dover's modest market share in a collection of slower-growing markets.

Dover's valuation seems less overheated than many of its peers, but management needs to improve margins and lay out a compelling long-term strategic vision for the company.

Dover (DOV) reported a good fourth quarter, with a very strong top-line organic growth figure and improved margins across the business. Guidance for 2018 was also pretty positive, and Dover will be moving forward with the spin-off of its energy business ("Wellsite") and a sizable share buyback. All of that is welcome, but it doesn't really mitigate a pretty mediocre long-term track record of value creation.

Perhaps the involvement of Third Point as an investor will spur more changes. Dover is certainly not "un-fixable", but the company does need to better manage the assets it has and come up with a better unified vision for where its expertise and focus will be in the future. Although I'm clearly not a huge fan of management, and the shares aren't cheap, the return expectations here seem more reasonable than for many other multi-industrials, so less valuation-conscious investors may still find some upside.

Energy Provides A Big Boost

Dover's nearly 8% organic revenue growth will probably be one of the best results from the multi-industrials this quarter, as the company continues to benefit from a big recovery in its energy business. Energy saw 23% organic revenue growth this quarter, with very strong growth in Drilling & Production (up 31%) and Automation (up 29%) offsetting weaker growth in Bearings & Compression (up 2%). As volume returns to this business in a big way, Dover is seeing better operating leverage and the segment margins improved about three points on an adjusted basis.

Although Energy was the prime driver, the 5% organic growth rate for the remainder of Dover's business is pretty good in its own right and compares solidly to the results from Illinois Tool Works (ITW), Honeywell (HON), and 3M (MMM) this quarter.

Engineered Systems led with 8% growth, as continued strength in waste handling equipment and growth in auto service equipment fueled 12% growth in Industrial and offset weaker 3% growth in Product ID (where Danaher (DHR) saw high single-digit growth this quarter). Dover saw some, but not much, margin improvement here.

Fluids produced 4% organic revenue growth, with good results in Pumps (up 8%) and Hygiene/Pharma (up 8%) offsetting persistent weakness in Retail Fuel, which was up only 1% despite an easy comp. The strength in Pumps was driven in part by good results in plastics and polymers, which corroborates what a lot of specialty chemical companies have been reporting recently. Margins improved here as well, with three points of improvement by Dover's methodology.

Refrigeration and Food Equipment remains weak, with only 1% revenue growth this quarter. Food Equipment popped 24% on strong demand for can shaping equipment, but refrigeration was down 5% despite strength in heat exchangers, and Dover's commercial food equipment business remains lackluster.

At the corporate level, gross margin was actually a point of strength (up more than a point and a half), and Dover is one of the very few companies to report a good balance between pricing and input costs. Orders were generally strong across the business except for Refrigeration/Food Equipment, with 9% growth in Engineered Systems and Fluids and 18% growth in Energy (versus a 3% decline in Refrigeration/Food Equipment).

What Will Be The Next Driver?

With Dover apparently not able to find an opportunity it liked to sell the Wellsite business, the company will be spinning it off later this year. The spin-off should be tax-free, and Dover is looking to structure it in such a way that the business will raise debt to pay a meaningful dividend back to Dover, which the company will use to help fund a sizable share buyback.

Jettisoning the energy business will go a long way toward making Dover less cyclical, but I don't believe volatility and value have all that much to do with each other over the long term. To that end, Dover ex-Energy should produce less dramatic swings in revenue and earnings, but it doesn't otherwise make the portfolio any better.

Portfolio quality remains one of my issues with Dover, as there aren't a lot of businesses here that really excite me. The company's efforts to grow by acquisition in Fluids have had mixed results (at best) so far, and the company's refrigeration business hasn't delivered the hoped-for growth from retrofits in the grocery space. Individual businesses like Markem Imaje, MS Printing, De-Sta-Co, Environmental Solutions, and Vehicle Services are good businesses that compare and compete well with rivals like Illinois Tool Works, Oshkosh (OSK), and Danaher, but a lot of the rest of Dover's portfolio consists of companies with modest share in markets growing at low-single-digit to mid-single-digit rates. Coupled with unimpressive segment level margins (Illinois Tool Works' least-profitable segment is about 400bp more profitable than Dover's best segment), it's hard for me to get excited about this business mix.

I'd also note that there are some market transformation threats down the road. Although it's going to be a long time before electric vehicles overtake conventional cars, the growth in EVs could very well start impacting Dover's retail fueling business in a decade, and the growth of e-commerce in food retail could well lead to less grocery capex on refrigeration equipment. This is why and where I'd like to see Dover start laying out a clearer vision for what this company is going to prioritize in terms of strategy.

The Opportunity

I expect less long-term revenue growth from Dover (3% to 3.5% long-term) than I do from other multi-industrials like ITW, Honeywell, Danaher, and 3M. This could be a mistake on my part, but it is informed in part by the company's track record and its lack of exposure to very many attractive secular growth stories (aerospace, safety, life science, EVs, automation, and so on). I do expect meaningful improvement in margins/FCF margins, as I believe current management will either find a way to do it or activist investors will push for new managers who (eventually) will get there. That supports high single-digit FCF growth, which doesn't produce an attractive fair value on the basis of my preferred hurdle rate but does at least support a total return target in the neighborhood of 8% - which is not bad next to its expensive peer group.

The Bottom Line

I'm not going to be buying Dover for myself, but I can concede some relative value here, as well as an opportunity for wider-ranging transformative steps to make Dover more dynamic and more profitable. The potential is there, but I'd rather see a bigger discount before investing in potential, as I'm not confident that this is the management team to realize that potential.

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.