There are some stocks out there that always (or almost always) get the benefit of the doubt when it comes to valuation – names like Atlas Copco (OTCPK:ATLKY) and Danaher (DHR) spring to mind pretty readily – and then there are names where it seems like the market is more apt to just somehow “forget” the underlying quality of the business, and I think Alfa Laval (OTCPK:ALFVY) fits in that group. While there are undeniable cyclical parts to the business, I believe the volatility in the share price is outsized for a company with a good full-cycle track record when it comes to returns on invested capital, free cash flow, and other metrics.
I thought the market was overly spooked by second quarter results and guidance and that the shares looked appealing back in July. With a nearly 30% move in the ADRs since then, as part of a bigger rally in many industrial names, the undervaluation is more or less gone now and the annualized prospective returns seem more in line with the 6% - 8% range that is common now for quality industrials (Dover (DOV), Honeywell (HON), Rockwell (ROK), et al). As such, I think Alfa Laval is a decent hold and a name to consider adding on pullbacks along the way.
Nordic conservatism and restraint may be a stereotype, but the reality is that nobody expected any major changes in strategy or guidance from Alfa Laval at last week’s Capital Markets Day, and the market probably wouldn’t have welcomed any big changes either. If it’s not broke, don’t break it.
Management reiterated an outlook for the fourth quarter of “somewhat higher” demand relative to the third quarter, but did modestly revise 2020 expectations. Management’s call for flat performance in Energy and Food/Water was a little weaker than I’d have hoped for, but the company was also more bullish on the Marine business, with an underlying expectation of some normalization in ship orders (2019 was close to a multiyear low). One thing I thought noteworthy was management highlighting that it has the option and flexibility to reduce SG&A and capex spending more or less in real time if demand trends track softer than expected in 2020.
As far as the long-term outlook goes, management guided to a 5% long-term organic top-line growth rate, 15% margins, and a 20% ROCE – all more or less in line with past targets and present expectations. Management did sound a little more interested in M&A, though, with the company calling out industrial flow control and cryogenic technology as areas where they’d like to acquire a bigger presence. Given a highlighted “sweet spot” of EUR 200M to 400M in revenue for targets, Alfa isn’t looking at especially large deals, though it has identified a number of companies that it is monitoring in case a sale opportunity should arise.
Alfa Laval runs a tight operation and has already relocated a lot of manufacturing to lower-cost areas closer to international customers (roughly one-third of the work force and production centers are in Asia). Even so, management is looking for incremental improvement, including greater use of smart manufacturing technologies and a further reduction in manufacturing sites from 53 to 48.
One of the real themes that you pick up following Alfa Laval is the extent to which the company is dedicated to developing and marketing products that drive real benefits for its customers.
Within the Energy business, for instance, the company’s heat exchangers offer an average of 10% to 15% savings for customers compared to other options, and when you consider that energy costs are about 50% of refinery operating costs and likewise a high percentage of chemical company operating costs, you can see why that matters. Alfa Laval is likewise well-leveraged to the ongoing expansion and upgrading of HVAC systems around the world – a major source of urban power consumption. Also within Energy, management is exploring opportunity to use heat exchangers as part of thermal storage installations that would provide an alternative to larger battery storage systems – it’s an idea that won’t likely be commercial for several years, but it’s worth Alfa’s time and attention.
In the Food & Water business, production yields, energy and resource efficiency (electricity, water, etc.), and leading-edge technology are all important to packaged food companies, particularly with the fast-growing global middle class. One area that Alfa Laval called out as a focus of R&D and product development was in meat protein substitutes. In addition to equipment that facilitates the production of vegetable substitutes (like Beyond Meat (BYND) ), Alfa is also investing in capabilities for utilizing insect proteins, cell-cultured meats, and algae-derived proteins (cue your Soylent Green references now).
The Marine business, too, is about facilitating customer needs, and particularly in a period of changing international regulations. Scrubber orders have been quite volatile, impacted in part by the capacity limits of Alfa and Wartsilla (OTCPK:WRTBY) as more customers opted to go with scrubbers than initially expected (around 2,500 scrubber installations for 2019 versus a prior expectation of 1,200), but there is still growth here as management believes scrubber installations could hit 6,000 by the end of 2022. Alfa has also been seeing greater uptake of ballast water treatment systems, but doesn’t expect this opportunity to peak until 2022.
Current trends for Alfa Laval are mixed. Not surprising in the wider context of comments from companies like Honeywell, ITT (ITT), and SPX Flow (FLOW), oil & gas demand has looked a little more shaky lately, but HVAC, refrigeration, and refinery demand have remained healthy. Energy should be “okay” in 2020, as I expect some strength in HVAC and refrigeration but some pressure from oil/gas and chemicals. Food & Water is always tricky to predict, but I’d expect pretty mediocre demand in dairy, brewery, and edible oils, offset somewhat by pharma/bio. As far as Marine goes, this is a tougher call – I do expect ship orders to improve in 2020, but newbuilds only drive about 25% of the segment, and both scrubber and ballast water order levels have been hard to predict.
All told, I think Alfa Laval will probably see a sluggish market in 2020; Alfa largely side-stepped the short-cycle industrial slowdown, but several process industries have started showing slower trends and I think this will create some headwinds. That said, European PMI numbers have started looking a little better, so the slowdown is likely to be pretty modest.
While I’ve made some fine-tuning adjustments to my model, none of the major outputs really change, as I’m still looking for long-term revenue growth around 4% and FCF growth around 10%. Mid-teens margins and high teens ROIC continue to support a forward EBITDA multiple of 12x.
Alfa Laval shares now trade at the high end of my fair value range. That doesn’t necessarily make them a bad option, but it does suggest to me that the average annualized returns from here are likely to be more inline with other high-quality industrial peers. I do think it’s worth noting that the CEO purchased 10,000 shares in the open market about a month ago at a price around today’s level, so some investors may regard that as a sign of long-term confidence in the business. As it stands for me, I still like Alfa Laval as a business, but today’s price/valuation makes it more of a “buy on the dips” idea for me.
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