Enpro Has Continued To Pivot Toward Less Cyclical, More Profitable Business

Summary

• Enpro has continued to shift its business mix more toward the semiconductor industry; an industry that offers attractive long-term volume growth in the mid-single-digits and good margins.
• The company's more cyclical businesses should perform well in 2022, with healthy ongoing demand in general industry and improving production rates in heavy trucks and autos.
• Mid-single-digit long-term revenue growth and improving margins can drive a double-digit move from here and this under-followed company has some attractive GARP attributes.

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At a point in the cycle where the market really isn’t fond of short-cycle industrial exposure, Enpro’s (NYSE:NPO) decision to shift toward faster-growing, higher-margin, and less typically cyclical business is looking better and better. Since my last update, not only has the company steadily beaten expectations (including full-year results that were comfortably above my expectations), but the shares have outperformed the broader industrial group by almost 15%, with a 16% total return that also surpasses what the S&P 500 has returned.

Given Enpro’s greater leverage to a faster-growing semiconductor end-market, my long-term revenue growth estimate moves from around 4% to between 5% and 6%, and I see stronger long-term FCF margins as well. I still see these shares offering more than 10% near-term upside, as well as long-term total annualized return potential in the high-single-digits, which is better than what most industrials are offering today.

Continuing To Shift The Mix

Between two significant business sales and a major acquisition in FY’21, Enpro has continued to shift its business mix away from its historical grounding in more typically cyclical industrial markets and toward less cyclical growth markets like semiconductors.

With the acquisition of NxEdge, Enpro has increased its exposure to the semiconductor end-market to almost one-third. Better still, a lot of this exposure is leveraged to volume; while the semiconductor sector is cyclical, that cyclicality rarely results in significant sustained declines in volumes, so much of Enpro’s business here should be relatively shielded and acyclical, with good exposure to long-term growth in semiconductor volumes.

I also like the fact that a lot of this exposure is, to be frank, pretty boring. Enpro doesn’t sell leading-edge semiconductor production equipment or highly-advanced components like vacuum seals. Instead, the company’s primary exposures and expertise lie in areas like cleaning and refurbishing equipment, components and assemblies like pedestals and chucks used in front-end processes, and component coatings that extend useful productive lives and reduce the risk of contamination.

While these may not be the most exciting businesses, they can be quite lucrative. The company’s Advanced Surface Technologies segment houses most of the semiconductor business and the segment-level EBITDA margin was over 30% in the fourth quarter, with the recently-acquired NxEdge coming in with around 37% EBITDA margin. That’s basically on par with the EBITDA at VAT Group’s (OTCPK:VACNY), a leading manufacturer of vacuum valves, and in the ballpark of Atlas Copco’s (OTCPK:ATLKY) Vacuum Technique segment (a leading manufacturer of vacuum products for semiconductor manufacturing), though the latter is an apples-to-oranges comparison, as Atlas doesn’t report segment-level EBITDA (but VT segment margin was over 23% in the last quarter).

At the same time, Enpro has continued to exit slower-growing, more cyclical, and lower-margin businesses. The sale of CPI took away a lot of the company’s exposure to oil/gas, and the company has been reducing its overall industrial exposure for a little while now.

Demand Should Remain Strong In 2022

Having written a lot recently about the semiconductor sector, I’m not sure I need to say too much more here. Leading chip companies remain booked out for a half-year or more, and the industry is still managing double-digit volume growth on capacity additions. With fabs running like that, Enpro should be looking at a healthy demand environment, particularly for its in-chamber volume-driven consumables.

The catch-all general industrial market should also remain healthy this year. While indicators like PMI have started slowing, they’re still in growth/expansion territory. With that, I expect healthy demand for Enpro’s various gasket, seal, and bearings products.

Auto and heavy truck are more interesting markets. I expect ongoing healthy trends in the heavy truck market, but I don’t think 2022 will see blowout growth – component availability is still a challenge, and while that should improve as the year goes on, it will still act as a brake on growth and should extend this upcycle into 2023. For autos, production has been hampered by well-publicized component shortages, and while I don’t think these shortages will disappear entirely in 2022, production should accelerate as the year moves on and there should be an inventory-rebuilding cycle that extends demand into 2023 at least.

All of that covers about three-quarters of Enpro’s revenue mix. For the remainder, I expect significant improvement in aerospace demand, but this is a smaller market for Enpro (around 5%). I likewise expect healthy-to-strong demand in food and biopharma, but this too is a relatively small end-market for Enpro (around 5%), though it’s one I’ve been hoping that the company would look to grow/expand through M&A.

The Outlook

Strong results have been driving higher expectations for Enpro, and I think there could still be upside to low-double-digit revenue growth guidance for FY’22. Margins are getting pressured by the same supply chain and labor issues that are impacting other industrials, though a richer mix of semiconductor-driven revenue should offset that pressure and help drive EBITDA margins from around 18% in FY’21 to close to 22% in FY’22.

I do see some risk of further inventory-building limited FCF margin expansion in 2022, but over the next 10 years, I expect FCF margins to move toward the mid-teens versus historical average in the mid-single-digits. With that significant improvement in profitability, I expect FCF growth in the high-single-digits on top of 5% to 6% revenue growth driven by around 8% long-term growth in the semiconductor-driven businesses.

I don’t think Enpro is finished with its makeover process either; I believe management would and will opportunistically consider additional business sales, and I think they would like to acquire more businesses when circumstances allow. It’ll probably be a couple of years before the company can do a larger deal, and I’d like to see more leverage to the pharma/food/hygiene space.

The Bottom Line

Between discounted cash flow and margin/return-driven EV/EBITDA, I believe Enpro is undervalued by at least 10% and priced for long-term total returns in the high-single-digits. This is not a widely-followed company and there are areas that need improvement, but for investors who are looking for a below-the-radar GARP-type story with some attractive drivers (improving mix, less cyclicality, low capital intensity), this is a name to consider even after recent outperformance.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Comments

[mt57]

Good analysis but the chart looks broken to me.

[Stephen Simpson]

@mt57 I'll defer to you on that, but it looks like it's testing support to me (my knowledge of TA is superficial at best).