Makiko Tanigawa
Writing about the Enovis (ENOV) / ESAB (NYSE:ESAB) split back in April, I said that I was more interested in ESAB, as I thought this welding company had often gone underappreciated and under-supported within the dubious conglomerate operations of what used to be Colfax. The performance since then has done nothing to change my mind about that, as ESAB has done reasonably well for itself as an independent company, though it still carries some of the burdens of past issues created by Colfax.
ESAB shares have lost about 10% of their value over that time, trailing Lincoln Electric (LECO) and the broader industrial space, but outperforming many other short-cycle industrials like Kennametal (KMT) and Sandvik (OTCPK:SDVKY) as investors grow increasingly nervous about a short-cycle rollover in 2023. I don’t think this is the best set-up for ESAB, as short-cycle industrial and construction markets could weaken in 2023, but I do think there is underappreciated value and potential in this business.
Mixed Results On Weak Volumes
ESAB’s third quarter results certainly aren’t going to ease investors’ minds about the risk of an imminent short-cycle slowdown, as the company’s 1% volume growth was soft against a broader industrial group average of around 4% volume growth in the third quarter. Still, there was some better news on margins and pricing was solid.
Revenue rose 10% in core organic terms (ignoring forex, acquisitions and the exit from Russia) to $577M, missing expectations by around 2%. The Americas business, where ESAB has #3 share in North America (behind Lincoln Electric (LECO) and Illinois Tool Works (ITW)) and #1 share (by a large margin) in South America, reported 10% organic growth, with 9% pricing and 1% volume growth. The EMEA and APAC segment saw 9% organic growth with the same pricing leverage, but no volume growth.
I’d say these results are consistent not only with weaker activity in the short-cycle “general industrial” end-market where ESAB is more leveraged, but also with growing stress in Europe and ongoing COVID lockdown headwinds in China.
Gross margin fell 70bp yoy and qoq to 33.7%, missing by 70bp on cost challenges that will be familiar to most readers who follow industrials. Adjusted EBITDA rose 5% yoy and fell 9% qoq to $96M, beating by 2%, with margin improving 40bp yoy and shrinking 10bp qoq to 16.6% (beating by 20bp). Americas EBITDA rose 9% yoy and fell 4% qoq to $46M, with margin up 10bp yoy and down 20bp qoq to 16.5%, while EMEA & APAC EBITDA rose 1% yoy and fell 13% qoq to $49M, with margin up 50bp yoy and down 10bp qoq to 16.6%. ESAB emphasizes an adjusted EBITA approach to operating income that I don’t really favor; adjusted operating income by my definition rose 4%, with margin up 30bp to 14.4%.
ESAB lagged both of its major peers. Lincoln Electric reported 21% organic growth, with price growth of 12.5% (up among the better performers) and volume growth of almost 9%, including over 26% growth in the Americas and over 11% growth in the International segment. Adjusted operating margin improved 80bp to 16.4%; here too there are adjustments I’d make that are different than what management choses, but the underlying margin performance was still better (15.5% vs. 14.3%).
At Illinois Tool Works, sales rose 14% in organic terms, with 12% growth in the International business, and operating margin improved 150bp to 31.5%.
Cyclical Challenges Are Going To Hang Over The Story
As supply chain constraints ease, companies are seeing less urgency in their business and demand (as reflected in orders) is starting to weaken. Coupled with higher interest rates, the outlook for 2023 is not that strong, with several CEOs in the industrial space outright predicting a recession in 2023, and the PMI recently slipped below 50 (a mark of contraction).
That’s a tough set-up for ESAB. The largest portion of ESAB’s business is in so-called “general fabrication” which is a broad mix of industrial end-markets that skew to short-cycle, and thus more vulnerable to that upcoming slowdown Likewise, while I think infrastructure end-markets will be healthy next year as federally-subsidized projects start moving forward, I’m expecting weaker conditions in construction. On the flip side, end-markets that I think could do relatively better, including oil/gas and auto, are not outsized markets for ESAB.
Although the cycle won’t be helping, these cyclical moves are part of the business and they’re transitory. ESAB also has other drivers to consider that aren’t cycle-dependent.
Management has been refreshing its portfolio, having completed a refresh of the light industrial portfolio and now working on the heavy industrial portfolio. This process includes portfolio simplification and walking away from lower-margin business, as well as innovation and upgrading the mix.
Part and parcel of this is a greater focus on equipment over consumables. Unlike most markets, in welding it’s the hardware that has the best margins and the consumables the weaker margins; Illinois Tool Works focuses intently on the hardware side (which is why it’s so often that you see a Miller brand welding attached to the back of a truck), and the 63% equipment / 37% consumables mix at least partly explains the superiority of ITW’s welding margins (LECO’s mix is 43%/57%, while ESAB’s is 31%/69%).
ESAB has also been stepping up its R&D and product innovation. Under the leadership of the current CEO (who led the company as a subsidiary of Colfax years before the split), annual product introductions have grown from 24 in FY’16 to over 100 in FY’21 and FY’22, and the company is looking a vitality index (a measure of the percent of sales from new products) of 27% or better this year, with new products like an engine-powered generator for heavy industry and a battery-electric system for the hobbyist market (the Renegade VOLT), a market that has been overlooked by most manufacturers.
The Outlook
There’s still work to do, though. Relative to Lincoln Electric, ESAB has significantly underinvested in automation technologies and capabilities, and this is becoming an increasingly important part of the welding market. On the other hand, management has been building up its presence in higher-growth (relative to the welding market) opportunities like medical and specialty gas control, including the recent acquisition of Ohio Medical.
Free of Colfax, I think ESAB will be able to put more resources toward value-creating M&A, though a high debt level (2.75x my 2022 EBITDA estimate) does constrain them somewhat. I likewise see more opportunities to expand margins through portfolio improvement and improved go-to-market strategies. I think parity with Illinois Tool Works is effectively impossible, though, and I think catching up to Lincoln Electric will be challenging for at least a few years given how much further ahead Lincoln Electric is in areas like automation and specialty materials welding.
I’m looking for around 4% long-term revenue growth from ESAB. I do believe that revenue could be flattish between FY’21 and FY’24 due to the economic cycle, I think that refreshed portfolio can drive better sales, improved market share, and expanded margins. I also see longer-term upside for this sub-sector on increased reshoring and increased spending on the manufacturing base driven by years of underinvestment and the need to refresh the base for automation, decarbonization, and electrification.
I think EBITDA leverage will take some time, and I’m only looking for around 10bp of annual improvement from FY’22-FY’24. Longer term, though, I think margins will scale up and I see the company going from around 9% free cash flow margins into the low double-digits, driving strong mid-single-digit FCF growth.
The Bottom Line
Between discounted cash flow, which suggests a total annualized potential return in the high single-digits, and a margin/return-driven EV/EBITDA (a 10x multiple on my ’23 EBITDA estimate, or a $53 fair value), ESAB shares look undervalued. The economic cycle won’t be helping the company for a little while, but I think there’s undervalued self-help opportunities and I think this is an under-followed company that could ultimately surprise investors with what it can do on its own and with better managers making the final decisions on capital allocation and strategy.
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