Atlas Copco's Premium Valuation Comes With High Expectations
- Atlas Copco continues to post excellent results on a comparable/relative basis, but here too margin leverage is coming in weaker than hoped and order growth is slowing down.
- Strong order growth in the Compressor business should be a good sign for the overall industrial market, but uncertainty seems to be reigning right now.
- A company with Atlas Copco's excellent track record deserves a premium, but even this 20% pullback isn't enough to bring it back to a truly exciting entry price.
I don’t know that there’s any real doubt or debate that Sweden’s Atlas Copco (OTCPK:ATLKY) is an exceptional company and worthy of premium valuation. Just how much of a premium is reasonable, though, is very much up for debate as the shares' nearly 20% pullback off its 52-week high raises the question of whether there’s been enough of a dip in valuation to wade in.
For now I’m inclined to hold off. Between growing worries of a short-cycle slowdown, significant uncertainty about capital spending in the semiconductor space, and possible turbulence related to Atlas Copco’s spin-off of Epiroc, I’d rather wait until the dust settles a bit more and there’s a real gap to what I think the underlying fair value of this excellent conglomerate is.
A Familiar Pattern – A Good, But Not Good Enough, Quarter
Like many other industrials, Atlas Copco's shares took a beating in the market when it reported earnings in late April, as the company missed at the operating/segment profit level and didn’t really offer that “above and beyond” needed to sustain a very high valuation.
Revenue rose 9%, which was a very strong result given the company’s end-market exposures. Compressor Technique saw 7% revenue growth, while Vacuum Technique grew 13% on top of a steep comp. Industrial Technique grew 7% and Power Technique grew 10%. While reported as a discontinued operation pending the spin-off, Epiroc’s revenue rose 9%.
Adjusted operating income rose 8%, with 40 bps of margin expansion, but missed expectations by a few percentage points. Compressor Technique saw only 10 bps of margin expansion, while Vacuum Technique saw 10 bps of margin compression – neither business offering the sort of incremental margins that investors wanted to see. Both Industrial and Power Technique did notably better, with margin expansion of 80 bps and 390 bps, respectively. Epiroc margins declined 70 bps in the quarter.
Like many other industrials, Atlas saw its order growth slow on a sequential basis – from up 14% yoy in the fourth quarter to up 9% in the first quarter. Compressor Technique saw 13% order growth, while Vacuum Technique’s order growth was just 2% (against a very tough comp, though). Industrial and Power Technique reported order growth of 9% and 16%, respectively, while Epiroc orders were up 21%.
When Data Points Create A Jackson Pollock Painting…
I believe one of the issues with the industrial/multi-industrial sector right now is that investors really don’t have a lot of confidence about where various end-markets are in their cycles. Without a firm grasp of where things are trending, I believe many investors have chosen to reduce positions, book profits, and go hang out in sectors like technology/IT.
For its part, Atlas Copco management noted an ongoing recovery in demand for compressors used in oil/gas and other process industries. Natural gas production has been quite healthy in many areas, leading to more spending on processing equipment like compressors. Like Emerson (NYSE:EMR), Atlas Copco is also seeing recovering demand in other process industries like chemicals, helping support compressor demand. With close to half of Atlas Copco Compressor Technique sales coming from “manufacturing”, though, I would argue that the double-digit growth in orders is still pretty encouraging for the overall health of industrial markets.
The outlook for semiconductor spending for Vacuum Technique is harder to figure out. Atlas Copco still says they’re seeing strong demand, and most of the semiconductor equipment companies have likewise been pretty bullish. On the other hand, other multi-industrial suppliers of equipment to the semiconductor industry have sounded more cautious and there are third-party research groups forecasting a spending downturn. Perhaps some of the “noise” comes down to product mix, with Atlas Copco’s high-end vacuum equipment playing an essential role in more advanced manufacturing processes. I think the long-term demand outlook here is strong (particularly as China wishes to become more self-sufficient), but I wouldn’t be surprised if the next few quarters get choppy.
The outlook is no clearer for Atlas Copco’s other businesses. Atlas Copco’s Industrial Technique business generates about half its revenue from the auto/vehicle end-market where it sells assembly tools, fastening tools, and other types of equipment. Management said demand was strong here overall, in contrast to companies like Stanley Black & Decker (NYSE:SWK) and Illinois Tool Works (NYSE:ITW), though they did acknowledge that North America was weaker and Asia was stronger, so geographic mix could explain some of the difference.
While many companies that pursue serial M&A do so because underlying organic growth potential is weak, that hasn’t been the case for Atlas Copco, and the company screens very strongly as one of the better organic growers over the past decade-plus. Likewise, its asset-light model produces excellent operating margins and the company’s returns on invested capital are consistently excellent. Simply put, Atlas Copco is an exceptional company.
The “but” is that the shares are often priced accordingly. Even with an expectation of long-term revenue growth of over 5% and additional improvements in FCF generation, Atlas Copco shares don’t look particularly cheap on DCF or EV/EBITDA. I would also note that the pending separation of Epiroc makes the valuation process a little more challenging; you can calculate fair values for the two businesses, but it remains to be seen what valuation the market actually gives Epiroc when it begins trading in June.
The Bottom Line
Unless the underlying health of short-cycle industrial markets is actually a lot better than it seems from first-quarter earnings/guidance, it’s tough for me to see how Atlas Copco is cheap right now. I’d dearly love to take advantage of a real opportunity here, but unless this sell-off continues on from here, I expect to be stuck on the sidelines a while longer.
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