Writing about Lincoln Electric (NASDAQ:LECO) in August, I was concerned about the risk that the Street had come back too far too fast on expectations for improving results in 2021 and beyond. While I was partially right, insofar as Lincoln Electric shares have basically tracked the broader industrial space since then, I missed just how much more investors were willing to bid up industrials, particularly on hopes of a strong short-cycle rebound in 2021, and these shares rose more than 25%.
Industrials may hold up a little better in a market downturn, but I’m still concerned that valuations are stretched, and that applies as well to Lincoln Electric. While I do have some concerns about the company’s lagging performance (relative to peers like Illinois Tool Works (ITW) and Colfax (CFX)), I do still believe that this company is an exceptionally well-run mid-cap industrial, a potential buyout target for a company looking to add a new vertical, and still leveraged to growth opportunities in new materials and automation.
As far as valuation goes, Lincoln looks priced in line with other high-quality industrials as far as return prospects (a group that includes Dover (DOV), Emerson (EMR), Parker Hannifin (PH), and Rockwell (ROK)). If you’re comfortable with the overall valuation of industrial stocks, I suppose Lincoln should still be attractive, but I regard valuations as more stretched today.
Mixed Results In Q4, But With Underlying Improvement
Although Lincoln Electric did underperform the “average” industrial in terms of organic revenue performance in Q4’20, the company did do better than average on margins, and results were comfortably above expectations on the operating income line. That said, Lincoln continues to lag peers like Illinois Tool Works and Colfax, and I think that’s worth watching.
Revenue fell 5.6% in organic terms this quarter, to $694M, beating expectations by about 1%. By product type, consumables sales fell at a low-to-mid single-digit rate, while equipment sales fell by mid-single-digits and automation revenue fell mid-teens. As a reminder, unlike most industries, welding equipment is actually more lucrative than welding consumables (part of the reason why ITW focuses more on equipment).
Gross margin improved 30bp to 33%, while adjusted operating income rose almost 2% to $93, beating by about 9%, with margin up 100bp to 13.4%. At the segment level, profits rose about 1% from the prior year.
Looking at the segments, Americas revenue declined 11% yoy to $387M (organic), matching expectations, but did improve 4% qoq. Segment profits declined 8%, beating by more than 14%, with margin up 60bp to 16.7%. International revenue fell 3% yoy (to $215M) and rose 9% qoq, beating by 3%. Segment profits rose 32%, beating by 19%, with margin up 170bp to 6.9%. Harris revenue rose 18% yoy to $92M, beating by 2%, with segment profit up 25% (beating by 7%) and margin improving 110bp to 14.2%.
Growth here continues to lag peers, with Illinois Tool Works reporting a 2.4% organic revenue decline in its Welding segment, while Colfax reported a similar 2% organic declined in its Fabrication business.
Conditions Are Getting Better, And There Are Emerging Opportunities
Unlike many industrials, including those with leverage to improving short-cycle end-markets, Lincoln guided not for low-to-mid single-digit revenue growth in 2021, but high single-digit growth, with price contributing low single-digit growth. Lincoln management also noted that 50% of its end-markets by revenue were growing again, up from 45% in the prior quarter.
Management was likewise pretty unperturbed about material inflation risk, believing they have the pricing power to offset that (a common refrain this quarter). I will be very curious to see how this plays out across 2021, as I do question how much pricing power there really is in the industrial space and the extent to which higher prices will start choking off recovery demand. On the other hand, many companies are confident they’ll hold on to some of the cost reductions they drove during the pandemic, so I suppose that would give some leeway for paying higher prices for supplies/components.
As far as end-market conditions go, Lincoln noted growth in general industrial markets and improving trends in heavy industry – consistent with the reports of many companies (including Illinois Tool Works and Parker Hannifin) and my own expectations. I was a little surprised to see auto described as “steady” given the improvements in build rates, but this is likely due to the larger influence of automation sales, and capex sales to the auto industry are still relatively soft.
Problematic markets include energy (“weak”) and construction (“choppy”). Higher oil prices may accelerate a recovery in this end market (from 2023 to 2022), but I still expect soft trends for 2021. For construction, I’ve written before that I’m pretty bearish on construction for 2021 as the funnel of new projects dries up, though I expect improvements in 2022 and an infrastructure stimulus bill could likewise boost 2022 demand.
The pandemic has also apparently created some new longer-term growth opportunities for Lincoln. The automation business, which was around 15% of pre-pandemic revenue, has been a good growth engine for Lincoln, but largely (60% or so) built around the auto industry. Now, though, Lincoln is seeing increased customer interest and orders from a wider array of general fabrication customers, as these companies look to cut labor costs, create safer work environments, and better manage their supply chain risk. This is part of an overarching theme of greater automation adoption outside autos, and also bullish for companies like ABB (ABB), Fanuc (OTCPK:FANUY), and Yaskawa (OTCPK:YASKY).
I expect automation revenue to reaccelerate in the second half of 2021, and I like Lincoln’s ongoing investment/reinvestment into R&D in areas like high-strength welding materials and welding materials for more demanding environments/end-markets. Maybe that sounds like basic “blocking and tackling”, but Lincoln has been a faster, earlier, mover here, and I think it will pay off over the longer term.
Stronger results in the second half of 2020 (or maybe better described as “less bad”) and a stronger outlook for 2021 leads me to reposition some of my growth expectations. I’m not really changing my long-term outlook much (my 2025 revenue number is between my former pre-pandemic estimate and my last updated model), but I am expecting a stronger 2021 and 2022 for both revenue and margins. Longer term, I expect revenue growth around 4% as the company continues to outgrow its markets through investment and innovation in areas like automation and share gains in markets like Europe.
On the margin side, I don’t expect quite as much incremental improvement here as with other companies, but that has everything to do with Lincoln’s already superior cost structure and its ability to flex costs in downturns (so they don’t get hurt as much as others in downturns, leading to less incremental recovery). Even so, I expect about 200bp of long-term FCF margin improvement, supporting mid-to-high single-digit FCF growth.
The Bottom Line
Lincoln Electric doesn’t look cheap on either discounted cash flow or margin/return-driven EV/EBITDA, and that’s actually pretty normal for these stocks. Lincoln Electric is a well-respected and well-liked company on the Street, and it usually only trades at a real discount in periods of fear (if not panic).
The 7% or so prospective long-term total return potential I see here isn’t bad next to other industrials, but is still below my typical hurdle rate. If you think lower interest rates justify a lower expected return, and/or you’re more comfortable with current industrial valuations, there are solid arguments for Lincoln as a “first among peers” pick. For me, though, I’ll wait for a better entry point, however long that may take.