Dividend Champion Spotlight: Dover Corp.

Summary

• Dover Corp. is a long time dividend champion of 63 years. The company is an industrial conglomerate that just spun off its oil & gas businesses.
• The company is in the process of recalibrating its operations post spin-off. The business will be more consistent, but profitability needs to improve.
• Dover Corp. has a new CEO, and is focusing to improve efficiency and strengthen its portfolio.
• Shares are expensive compared to historical norms, and the question marks due to unestablished performance post spin-off make Dover a risky investment at this time.
• This article is part of a series that will put a spotlight on "Dividend Champions" and the fundamentals behind their success.

Industrials are a common sight on the dividend champions list. An ever growing population requires constant advances in technology and efficiency, offering continual opportunity for the companies that drive industrial production in our world. Today's dividend champion spotlight features a long time champion in Dover Corp. (NYSE:DOV), whose dividend growth streak currently stands at 63 years. Despite a long history, the company is currently in transition after spinning off its volatile oil and gas business into what currently trades as Apergy (APY). We dive into Dover to identify the current state of the business, and where management hopes to take the company in the coming years.

Dover Corp. was founded in 1947, and is headquartered in Downers Grove, IL. The company is an industrial conglomerate that designs and manufactures components, equipment, and specialty systems for a variety of industrial markets and applications. The business operates in three primary segments: Fluids, Engineered Systems, and Refrigeration & Food Equipment. The company generates approximately $7 billion in annual revenues.Source: Dover Corp.

As we dive into our analysis, it's important to put emphasis on the past two quarters. In May, the company completed its spin off of Apergy, the company's oil and gas business. This removed what was a more volatile business segment from the company. When oil & gas commodity prices fluctuated, it would in turn swing the financials of the overall company. By spinning that business off, the operating performance of the company will be more consistent moving forward. While the spin-off saw Dover send off a volatile (but at times very lucrative) business segment, Dover did receive $700 million as part of the deal, and will set out to enhance the remaining product portfolio.

Financial Performance

Source: Ycharts

The company has been very cyclical, with extreme revenue and earnings gyrations over the past 10 years. With the oil and gas business pulled out, this should smoothen out quite a bit. Over the past 10 years, revenue growth has been very slow at just 0.81% CAGR, while earnings have grown at a CAGR of 4.68% over the same time period. Growth moving forward is a bit of a clean slate. The company is going to focus on maximizing the potential of its three remaining segments, while potentially augmenting them with additional assets.

Looking at Dover's financials, the first stop in our analysis is the company's profitability metrics. We want to look at operating margins to see how profitable Dover is in its operating environment. We also want to see the conversion rate of revenue into free cash flow because it's important that a company can generate a healthy stream of cash flow. Cash flows allow for a dividend to grow, or growth investments to be made without relying on debt to do it.

Source: Ycharts

When you consider the reliance of oil and gas on commodity prices, and the general economically sensitive nature of the industrial space, it makes sense that recessionary events such as 2009 and oil price pullbacks such as 2015-2017 resulted in operational struggles. It's impossible to draw definitive conclusions about the current state of Dover because the new entity lacks much of a record. What we do know, is that the improved stability of the business will allow it to better weather changes in the operating environment.

Next, we will look at Dover's cash rate of return on invested capital (CROCI). This is a useful tool that measures a couple of aspects of a company. It measures how effective management is at utilizing the company's resources to generate cash. It is also a baseline indicator of the strength of a company's competitive "moat". A strong CROCI (typically in the low teens or higher) is indicative of a company that is well managed, profitable, and not overly capital intensive.

Source: Ycharts

Dover has had a pretty solid CROCI record for the majority of the decade before seeing its CROCI erode over the past few years. I view this as a sign that falling oil prices really hurt the overall performance of the business. In addition, Dover saw a new CEO in Richard Tobin take over in May of 2018. With a new leadership direction, the opportunity is there for management to re-establish Dover's past performance levels.

The last area of review before moving on, is the balance sheet. It's clearly important for a company to avoid taking on too much debt. Being over-leveraged can result in vulnerability to rising interest rates, or a potential cash flow problem if the business sees an unexpected downturn. With such cyclicality in Dover's business, this is especially important.

Source: Ycharts

The company currently operates at a leverage ratio of 2.35X EBITDA. This is just below the 2.5X threshold that I use as my "warning signal". The company is in a bit of a tight position right now, because investments may need to be made for growth in the form of strategic acquisitions. During a recent corporate update, management indicated that depending on the opportunity, a strategic acquisition could drive leverage as high as 3.5X EBITDA. I don't wish to see Dover take on this level of debt, so it remains to be seen how this plays out.

Dividend Outlook

Dover is a long time dividend champion with 63 years of consecutive increases to its name. The dividend is paid every quarter, and totals an annual payout of $1.92 to shareholders. The dividend yields 2.23% on the current stock price. Income focused investors will likely favor 10-year US treasuries that offer a bit higher of a yield at the moment (2.92%).

Source: Ycharts

Dover has been a solid dividend growth stock with a 10-year CAGR of 11.0%. In recent years, however, the cash payout ratio has risen causing the dividend's growth rate to slow down. The three-year CAGR is a bit lower at 5.5%, and the most recent increase was only 2.1%. While Dover has a long growth history, the debt load combined with management's focus on sparking growth likely means that the dividend will be a lower priority in the immediate future. I would still consider the dividend to be safe, but investors should expect low single-digit increases for a while.

Growth Opportunities & Risks

As we have mentioned throughout the article, Dover is in a state of transition. The company has an objective to rebuild its long-term growth engines moving forward. One of the first major focuses of management is to increase profitability by cutting wasteful costs and increasing efficiency.

Source: Dover Corp.

Dover spends a higher portion of its revenues than its peers on SG&A costs. The company will be cutting workforce while investing in R&D, e-commerce, automation, and operational talent for a net savings forecasted at $100 million for 2019. In addition, the company will undergo some consolidation of its facilities through 2020.

Moving on to the actual business segments, the removal of the oil & gas business leaves room for attention to its remaining segments that serve various niche markets through industry. Management is looking to add to its portfolio by potentially targeting other synergistic markets, including pharmaceutical, fluid handling, printing & identification, and precision components.

The risk in all of these agendas goes back to execution. Management will need to answer some key questions over the next two-three years. Can Dover meet its cost cutting targets? Can Dover provide enough growth to its portfolio, both organic and through bolt-on acquisitions? Can management do this without overloading a balance sheet already levered to 2.4X EBITDA?

Valuation

Despite these questions and concerns, the stock trades in the upper end of its 52-week range at just over $83 per share. Management is guiding to an EPS range of $4.80-$4.85 for the full fiscal year. This places the stock at an earnings multiple of 17.3X earnings. This is drastically higher than its 10-year median earnings multiple of 10.78X (a premium of 60%).

This is a very high premium, so to get some clarity we will review Dover's free cash flow yield. FCF yield is a great valuation tool, because a company's cash stream is an organic gauge on its performance. Investors can set themselves up for strong returns by optimizing the amount of cash flow they receive per dollar invested.

Source: Ycharts

With a current yield of 4.21%, we can see that the FCF yield has trended lower over the course of the decade. While the incoming changes to the business should help boost FCF production, the current yield and premium on the earnings multiple point to significant overvaluation of the stock.

Wrapping Up

The open questions that management will need to answer with future performance make it difficult to establish a target price. The company is currently bloated with expenses, and a balance sheet that lacks a ton of room for ambitious ventures.

Despite this, the company needs to reform in a manner that spurs growth over the long term. That isn't to say that it won't work, but the uncertainty of success with many industrial dividend growth alternatives pushes me away from Dover Corp. until a new performance track record is established.

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Author Disclaimer: Wealth Insights is an investor and investment author. His content is not geared to anyone's specific investment goals, time horizons, or risk tolerance. Content is for illustrative purposes only and is not intended to displace advice from a fee-based financial adviser. Accuracy of data is not guaranteed.

Analyst’s 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.