Dover Stock: Looks Like A Long-Term Opportunity (NYSE:DOV)

The vagaries of institutional investor sentiment can drive you nuts, but it can also create opportunities for the patient investor. When I last wrote about Dover (NYSE:DOV) in March of this year, I was concerned about the valuation and the extent to which it seemed like sell-side analysts were scrambling for ways to make the stock appear cheap. Since then, the market has soured pretty dramatically on shorter-cycle industrial names, and Dover shares are down about 20%, more than doubling the broader decline in industrial stocks.

I’m not suggesting that there is no risk to the outlook for Dover in 2023/2024, but I do think the cyclicality/short-cycle exposure is perhaps a bit overstated and that the company isn’t getting credit for its diversification and opportunities for longer-term organic growth. I still believe Dover can generate long-term revenue growth in the neighborhood of 4%, with FCF growth of roughly double that, and while I wouldn’t call Dover “super-cheap” now, it’s a name to consider for investors willing to step in front of poor sentiment in pursuit of quality long-term holdings.

A Sluggish-To-Weak Quarter Doesn’t Help The Bulls

Dover didn’t report poor third quarter results, but the margin weakness was not welcome, and combined with a third straight quarter of order declines, it isn’t going to help sentiment or ease the worries that Dover is heading toward a short-cycle cliff.

Revenue rose 9% in organic terms, just barely beating sell-side expectations. Pricing contributed 760bp to growth, and that underlying 1.4% or so of volume growth is not exciting. Despite that strong pricing, gross margin still declined 160bp (to 35.8%), missing Street expectations by about 200bp. Adjusted operating income rose 12%, with margin up 80bp to 18.1%, but that was a 4% miss versus expectations. At the segment level, profits rose 10% and modestly beat expectations (by about $0.015/share), with margin up 50bp to 21.2% and nearly 29% incremental margin.

Dover posted its third straight quarter of year-over-year order declines, with an 8% decline this quarter. Backlog rose 12%, though, and while it’s true that the market has usually traded industrials on the basis of order trends, I think the nature of this cycle (supply shortages that drove over-ordering) suggests that backlog should at least factor into the discussion.

Mixed Trends Across The Businesses

Dover’s Engineered Products segment produced 18% organic revenue growth this quarter, beating by 4%, as the company saw strength in vehicle services, waste handling, and aero/defense. Segment profits jumped 34% (margin up 250bp to 17.5%), driving a $0.04/share beat, and orders rose 2%. The strength in the vehicle services and waste handling should bode well for Vontier (VNT) and Oshkosh (OSK), and I’d expect more companies to report improving trends in aerospace – General Electric (GE) had a good report, while Crane’s (CR) was mixed, and Honeywell (HON) may well have reported by the time you read this.

Clean Energy & Fueling reported a 1% organic revenue decline, missing by 3%, as the business was once again dragged down by weaker above-ground fueling station spending and challenging EMV-related comps. Segment profits rose 13% (margin down 10bp to 19.4%), but missed by about $0.055/share, while orders declined almost 8%. The weakness in above-ground fueling is a watch item for Vontier, but below-ground trends should be positive for Franklin Electric (FELE) (though it’s a small part of FELE’s business).

Dover’s Imaging & Identification business grew revenue 5% in organic terms, missing by 2%. Segment profits rose 5% (margin up 230bp to 26.4%), beating by $0.035/share, and orders fell 4%. This was the first time in a while that Dover outperformed Danaher (DHR) here, and stronger marking/coding and improving demand from China should help going forward.

The Pumps and Process Solutions business reported 2% organic revenue growth, missing by 3%, and the business seemed to take a bigger hit from a slowdown in COVID-19-related spending in the biopharma market. Segment profits fell 14% (margin down 460bp to 29.7%), missing by $0.055/share, while orders fell 15%. This segment confounds me the most so far, as Dover talked about strong short-cycle industrial and plastics/polymers demand, but Crane did considerably better, and I didn’t believe the biopharma segment of this business to be so large that it would explain the weak results.

Last comes the Climate and Sustainable Tech segment, where revenue rose 19% (beating by 6%) on strong demand for retail refrigeration and can-making equipment. Segment profits jumped 51% (margin up 470bp to 16.3%), beating by $0.045/share, but orders dropped 22%. While Dover is booked out in refrigeration and can-making equipment through year-end (and is taking orders for ’23), and heat exchanger demand remains strong, but I’m worried that the significant retail refrigeration and can-making capex cycles are ending, not to mention future weakness in heat exchanger orders from HVAC customers as both residential and commercial new-builds soften.

The Outlook

I understand why analysts and institutional investors are concerned. The weakness in Pumps & Process Solutions is harder for me to understand (at least without seeing more flow control earnings reports) and suggests a potentially sharper short-cycle correction, and there doesn’t seem to be much near-term momentum in above-ground fueling, biopharma, or textiles.

Likewise, I can see an argument for significant year-over-year declines in vehicle services, waste management, refrigeration, HVAC, and possibly packaging. Add in the prospect of weaker biopharma, and Dover is looking a little short of markets likely to accelerate over the next 12 months – clean energy, aerospace, and oil/gas are on that list, but don’t make up all that much of Dover’s revenue base now (around 10% or so).

The issue for me isn’t so much that 2023 isn’t looking strong, but how much Dover’s valuation should be punished for that slowdown. I don’t believe the U.S. economy is heading for a deep recession, and I believe that Dover will still manage some growth in 2023 as it delivers out of its backlog, before reacceleration in 2024.

Likewise, I do think the company still has levers to pull below the top line, including increased digitalization of orders, factory automation, plant consolidation, and deleveraging, and management seems to be taking a very pragmatic attitude toward its business planning – working down its inventories in shorter-cycle businesses and accepting the risk that it may come up short on product availability if demand is meaningfully stronger in 2023.

I have reduced my 2023 and 2024 revenue expectations, but I still see longer-term growth opportunities in areas like clean energy, biopharma, and automation that can drive reacceleration after this upcoming slowdown. The end result of all of this is that my long-term revenue growth rate is still around 4% and only slightly lower than before. So too with margins, where I do see a little more pressure in 2023/24, but still believe that FCF margins will approach the high teens over time, driving roughly 8% FCF growth.

The Bottom Line

As I said before, Dover isn’t “can’t miss” cheap yet, as discounted free cash flow suggests a long-term annualized total return in the high single-digits. Even so, high-quality industrials don’t often offer too much beyond that, so I’d still consider this a good potential entry point. Sentiment remains a risk though, and will likely get worse in the short term as the slowdown approaches. Shorter-term multiples-based valuations for industrials have already corrected and swung to below-average levels, and even on the basis of reduced near-term margin expectations, I think Dover should trade closer to the $140’s now.

Ignoring sentiment can be painful in the short term, but sometimes it’s the only way to get into high-quality large-caps at reasonable prices. I think that’s the case now for Dover; I do see growing risks to the 2023 outlook, and the shares could get even cheaper in the interim, but I feel like the market is already pricing in some pretty underwhelming near-term results and ignoring (or at least undervaluing) the longer-term big picture.