Atlas Copco Stock: Always Excellent, Almost Always Expensive (OTCMKTS:ATLKY)

Maybe no other company illustrates the challenges with the idea of “you have to pay for quality” better than Atlas Copco (OTCPK:ATLKY). While the Swedish industrial conglomerate doesn’t get quite the same “compounder” fanfare as companies like Fortive (FTV) or Roper (ROP), the company nevertheless has an established track record of above-average margins, ROIC, free cash flow growth, and so on … as well as a 10-year total return (annualized) below that of the S&P 500. I believe a long history of an elevated valuation has contributed to keeping a lid on the share price, though a 10%-plus annualized return over a long period is not exactly “bad”.

These shares are down about 7% since my last update, and now there are a lot more concerns in the market about industrials – particularly whether these companies (and stocks) are going to get squeezed between slowing demand (as indicators like the PMI slow) and persistent supply chain pressures. I think Atlas will navigate these challenges well, but the valuation is certainly not in straightforward bargain territory. While this is about as attractive as I’ve seen the valuation in a while, investors should be alert to the risk of further derating.

Growth Remains Solid…

Atlas Copco recently presented at a sell-side conference and management noted there that 22 of the company’s 23 divisions were still growing. That’s encouraging, but the company’s recent track record has been less than pristine, with higher than expected order growth offset by modest revenue misses, as supply challenges limited the company’s ability to ship to demand.

I’m not overly concerned about the demand outlook at this point. The Compressor Technique business does have a lot of “general industrial” and manufacturing end-market exposure, but they also have an energy angle. Energy costs make up about 80% of the lifetime cost of a compressor and Atlas leads the field in energy efficiency, with compressors that are typically 25% to 30% more energy-efficient. With high energy prices one of the challenges that many industrial companies are facing, the opportunity to reduce operating costs by upgrading/updating compressors could drive ongoing growth.

Beyond that, I do see other growth opportunities in Compressor worth monitoring. The business does have leverage to LNG (and hydrogen), and I suspect that LNG projects are going to get a second look given Russia’s invasion of Ukraine and the limited number of options Western Europe has to wean itself off of Russian gas. Another opportunity to watch is industrial cooling, as management looks to leverage its Eurochiller acquisition and underlying compression technology to more directly address this $8B/year market.

I have few near-term concerns about the Vacuum Technique business, other than the company’s ability to fulfill demand (management has mentioned capacity as a growing issue). The semiconductor shortages hitting the global economy are well known now, and fabs like TSMC (TSM) are responding with significant capex programs.

Moreover, I’m not so worried about the risk of a sharp peak in demand that leads to a cyclical drop-off. I’m not saying that semiconductor capex is “higher forever”, but I am saying that companies like Texas Instruments (TXN) have significantly increased their long-term (five years or beyond) capex spending forecasts and fabs like TSMC are shielding themselves from overbuilding capacity by increasingly requiring purchasing commitments from customers.

…But Cost Pressures Are Real

Atlas Copco enjoys its strong margins and low capital intensity in part to the fact that it operates an asset-light model (or at least “lighter”) – outsourcing a lot of its manufacturing needs and focusing on the 20% to 30% that management considers “core”. While that helps margins, it doesn’t insulate the company completely. As I mentioned above, the company is seeing supply chain issues restricting its ability to ship to demand, pushing some revenue out into future quarters. While operating margin was up 90bp in the last quarter, incremental margin did decline to the high-20%’s on a reported basis – below the typical 30%+ target.

This is hardly a crisis, but it does likely limit the amount of near-term upside investors can reasonably expect to see from margins over the next couple of years. Given how much of the strength in the industrial sector was driven by stronger incremental margins, this isn’t a trivial concern.

More M&A Seems Very Likely

Atlas Copco has been a fairly active acquirer over the years. They haven’t jumped headfirst into the software space like some industrial companies, paying high-teens multiples for deals with long payback periods, but they have continued to acquire foundational technologies here and there, including machine vision and metrology.

Atlas has a good track record of taking modest-sized acquisitions and then building onto them internally, so I’m not necessarily looking for large deals in either machine vision or metrology, but I do think Atlas is on the prowl for other automation/automation-enabling technologies, particularly in areas like assembly, quality control, and material handling.

The Outlook

Relative to where my numbers were when I last wrote about Atlas, the company did well in 2021 from a financial perspective. Revenue was about 5% higher than I’d initially expected, with EBITDA outperforming by 8% and FCF by about 15%. Although I do expect some slowdown in industrial demand in 2022, the business is still overall in fine shape.

I’m expecting high-teens growth in FY’22, led by over 20% growth in Vacuum Technique and strong growth as well in Compressor. Industrial is a harder call right now given challenges in the auto sector, but I expect healthy spending tied to EV assembly.

As I mentioned above, I’m not expecting much margin leverage in the near term. I do expect EBITDA margin to be higher in FY’22 than ’21, but I expect EBITDA margin to hang around 27% until later in FY’24. Likewise, I’m only expecting a few tenths of a point improvement in operating margin through FY’24. Longer term, I believe FCF margin can hit 20%, driving nearly double-digit normalized FCF growth on around 6% revenue growth.

The Bottom Line

Atlas Copco is not cheap on a discounted cash flow, nor on an EV/EBITDA basis using a multiple based on what the market typically pays for this level of margins and returns (ROIC, et al). On the other hand, the DCF-based long-term total annualized potential return does appear similar to that of Dover (DOV) or Honeywell (HON) and is about as good as it has been in a while. While Atlas isn’t often talked about as a “compounder”, I believe it qualifies and if you use an EBITDA multiple more in tune with that group (19x to 20x), the shares look up to 20% undervalued.

I can’t say that Atlas is cheap in a “core value” sort of way, but it’s as reasonable as it has been in some time. I think this could be an opportunity for long-term investors, but I do at least want to be clear about the potential risks from a sentiment/valuation standpoint. Readers should weigh the risk that companies like Atlas get squeezed further by weakening growth and higher costs and that that leads to further derating across the industrial space, as Atlas shares are still well-above long-term valuation norms.