Alfa-Laval's (OTCPK:ALFVY) shares have corrected sharply since my last update on the company, with the shares down more than 20% on what has been a pretty broad-based downturn for European industrials. Although there are some valid concerns about Alfa’s business mix in 2019 and the need for higher capex spending to support a surge of scrubber orders, there aren’t enough company-specific issues here to think this is more than a broad-based re-rating.
I thought Alfa-Laval wasn’t as appealing of an investment prospect back in July, but I didn’t exactly expect the sell-off we’ve seen in the market since then. While the valuation is definitely more interesting now, there are a lot of other industrials getting cheaper now and I’d be careful about stepping in front of this current market downturn. Still, as one of the better late-cycle names I know, I think this is a name to look at going into 2019.
Cleaning Up In Scrubbers
Due in large part to upcoming industry regulations, Alfa-Laval is seeing a surge in orders for environmental products within its Marine business (ballast water treatment and scrubbers). Environmental products were 40% of the Marine order base in the third quarter, in a quarter where overall orders were up 66% largely because of those scrubber orders.
The company is now sold out through 2019, which is probably an incremental positive for competitor Wartsila (OTCPK:WRTBY), and management is increasing its capex spending plans for the next few years to support this surge in demand. Capex spending will go from around 2% of sales to 3%, and it probably won’t be until the early 2020s that this normalizes. I would also note that it’s not just scrubber capacity that’s driving increased spending – Alfa is also upping its spending on digital initiatives and factory automation.
The surge in the scrubber business remains something of a mixed blessing for Alfa-Laval. The margins and long-term aftermarket opportunities aren’t as attractive as other parts of the marine business (like pumping equipment for chemical tankers), but it’s still a worthwhile business for Alfa to be in and I don’t believe even bearish analysts would seriously suggest they turn away orders.
Alfa management used its recent capital markets day to raise its guidance for the market opportunities in its marine environmental business. Management increased its unit forecast for ballast water systems by more than 10% and its total market value opportunity by almost 30% (from EUR 7B to 9B). Management also stated that its expectations for the scrubber opportunity are now higher than the previous 5,000 vessels (at EUR 1M per vessel), but didn’t quantify how much higher. With only about 500 vessels fitted as of September of this year and DNV GL estimating that fewer than 3,000 vessels will be fitted by January of 2020, this remains a viable growth driver for Alfa. While not all vessels will be retrofitted, and the deadline could get extended, there’s more than enough business to generate meaningful revenue and profits for a few more years.
Energy Continuing To Grow, While Food/Water Remains Reliably Inconsistent
Alfa-Laval reported 14% yoy growth in orders for its Energy business in the third quarter, with ongoing strong demand for heat exchangers in the oil/gas food chain. This echoes at least in part the strength seen at Harsco (HSC) and Chart Industries (GTLS), though Alfa-Laval isn’t as heavily leveraged to U.S. onshore natural gas production as those two smaller companies. Management noted that oil and gas orders are back to about 75% of the prior peak, while offshore orders/spending is just starting to recover. Although there are some emerging concerns that weaker oil/gas prices will pressure capex spending in 2019, I believe current prices still give most energy companies incentive to invest in production/transport-oriented products like heat exchangers, and Alfa-Laval will be launching a new, more efficient product platform in 2019.
The Food and Beverage business remains a volatile business that is hard to predict on a quarterly basis. Orders were up just 6% in the third quarter, with the company not taking in any large orders. Frankly, brewery customers saved the day, as the company saw weaker ordering in dairy, biotech, edible oils, and ethanol/sugar, as well as water/wastewater. Brewery orders are being driven by productivity drives stimulated by sluggish volume growth, while dairy continues to see weak uncooperative pricing and high supply levels (even worse news for GEA Group (OTCPK:GEAGY). For biotech, this was likely just a “wobble,” as biopharma and generics companies continue to invest considerable resources in biologics capacity additions.
What 2019 will hold for Food and Beverage is really just a guess at this point. Ethanol producers like Cosan (CZZ) will be prioritizing ethanol production over sugar given weak sugar prices, and the arguments for ongoing capacity increase in biologics production remain in place. But as for the rest of the food/beverage space? It’s hard to say. Many equipment suppliers have called for “decent” growth (generally in the mid-single digits), but then there are companies like Rockwell (ROK) (which sells a very different type of equipment) looking for stronger demand growth.
The large bulk of Alfa-Laval’s businesses is doing well now, and I don’t expect major declines in 2019 at this point, though I think the oil/gas end-market might be the most vulnerable to changing macroeconomic conditions. Environmental retrofits should continue to support the Marine business, and I think there’s room for improving “core” shipbuilding orders, as Alfa-Laval is still reaping the benefits of a multiyear improvement trend that has seen the company meaningful content share in newbuilds (particularly in tankers and gas carriers).
Although I have revised my FCF margins lower (due to higher capex spending), slightly better operating margins mitigate that to some extent. All told, I’m still looking for long-term revenue growth in the mid-single digits and FCF growth in the high single digits. Discounted back, the shares are now priced for roughly 10% long-term annual returns, which isn’t too bad for a high-quality industrial with good late-cycle exposure.
I also believe that an EV/EBITDA approach supports a more positive stance, as Alfa-Laval’s margins and returns on assets and capital support a low-teens forward multiple and a fair value for the ADRs in the high $20s. I should note that while my EV/EBITDA model attempts to calculate “fair” forward multiples, the market can swing well above and below those levels.
The Bottom Line
Right now the market is definitely going through a re-rating/de-rating process due to growing worries about global growth (including tariff/trade issues). As many industrial stocks were trading beyond what would normally be fair forward multiples, this could be that inevitable correction and one that may stretch out into “over-correction.” Arguing with the Street in the short term can be like playing chicken with a freight train, and sentiment on Alfa-Laval is certainly not strong now; but this is at minimum a stock to keep an eye on for when the sell-off peters out.
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.