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Looking at Gorman-Rupp (NYSE:GRC) back in March of this year, I did like the company’s exposure to industrial markets like HVAC and longer-term opportunities in wastewater and stormwater/flood control, but I preferred names like Xylem (XYL) and Franklin Electric (FELE) on their combinations of end-market exposures and valuations. Since then, Xylem and Franklin Electric have both done better than the average industrial stock (up almost 25% and about 5%), while Gorman-Rupp has lost about a quarter of its value.
Gorman-Rupp’s has lagged many of its water/fluid control peers in terms of both organic growth and margins this year, and the acquisition of Fill-Rite brought considerable debt onto the balance sheet. Weaker margins and a higher discount rate (due to higher interest rates and a riskier balance sheet) do reduce my valuation some, but the market has more than corrected for this and I think the valuation is a little more interesting now.
Respectable, But Not Exceptional, Growth In The Third Quarter
Revenue rose about 11% in organic terms in the third quarter, with water-related markets up 12% and non-water markets up 9%. The company has been exceeding my organic growth expectations this year, but to a lesser extent than many of its peers, leading to some relative lagging performance.
Looking at comps in the third quarter, Franklin Electric posted 20% revenue growth, Flowserve (FLS) had 7% growth, Ingersoll Rand’s (IR) PST segment had 15% growth, Pentair’s (PNR) IFT business had 14% growth, and Xylem had 16% growth, with 20% growth in the Applied Water segment that includes comparable “non-water” market exposure like HVAC, industrial, and fire suppression. ITT (ITT) likewise reported 14% growth in its short-cycle Industrial Process business, which doesn’t have all that much water or water utility exposure.
Gross margin did improve 110bp to 26.4%, with Gorman-Rupp starting to see some catch-up margin leverage on pricing over cost, as well as leverage from the Fill-Rite deal. Adjusted EBITDA rose 56%, with margin improving 50bp to 14.6%, while operating margin declined 130bp to 10% largely on increased amortization expense.
Orders increased more than 10% in organic terms, which was as good or better than most of the aforementioned peers. Backlog also improved slightly on a sequential basis.
Considering The End-Market Exposures For 2023
Weaker short-cycle end-markets in 2023 are a predominant theme in the industrial space now, and Gorman-Rupp does have meaningful (20% to 25%) exposure here. I do expect weaker “general industrial” demand next year, offset in part by chemical debottlenecking projects, but I’m concerned that HVAC could be meaningfully softer as residential demand weakens and non-residential starts to fade on weaker activity.
Fire suppression is another 20% or so of Gorman-Rupp’s end-market exposure, and I’m not as confident on this market for the near-term. While various non-residential construction indicators do suggest healthy longer-term demand, I believe new-build activity could be weaker in 2023, reducing demand for fire suppression equipment. Likewise with the dewatering market, which accounts for around 11% to 13% of the business.
Agriculture (around 15% of revenue) should be healthy in 2023. While this business hasn’t been especially strong of late for Gorman-Rupp, crop prices should support further spending on irrigation in 2023.
Finally comes the company’s water and flood business, which accounts for around 10% of sales. I do expect a bigger pick-up in this business in the coming years, but 2023 may be early to see a significant impact.
All told, then, I’m not especially confident on the outlook for 2023. It’s not so much that I expect a bad year, as I expect a meaningful slower year, and I do see some risks across “general industrial” categories and non-residential construction if rate hikes spur a greater slowdown than currently expected.
Longer term, I like many of Gorman-Rupp’s markets. Fire suppression should rebound with increased longer-term non-residential activity, and dewatering and municipal water (including wastewater and stormwater/flood) should pick up on increased infrastructure spending as federally-subsidized projects start moving forward.
Fill-Rite Makes Sense, But It Doesn’t Come Cheap
The biggest change at Gorman-Rupp since my last update is the May acquisition of Fill-Rite. The company paid $526M for this leading player in fuel transfer pumps, as well as pumps used in other chemical and industrial fluid transfer indications. Not only do the pro-forma margins look good (25% on an adjusted EBITDA basis), but Fill-Rite meaningfully expands the company’s addressable markets by $1.5 billion, though at the cost of competing more directly with companies like Franklin Electric and Dover (DOV).
At 16x EBITDA (or 13.5x on a tax-adjusted basis), Gorman-Rupp didn’t exactly get a bargain basement deal here. Likewise, I do have some concerns about the fuel transfer pump market and how it will change in light of changing powertrains – this may be an opportunity to invest in areas like LNG and hydrogen. My bigger concern is that the deal adds considerable debt ahead of a short-cycle slowdown, and it will take a couple of years to work back down to a 2.0x net debt/EBITDA position.
The Outlook
This year has surpassed my expectations for Gorman-Rupp, but that’s offset by a worsening near-term outlook. Beyond this, though, I do believe Gorman-Rupp can generate organic core growth in the neighborhood of 4%.
On the margin side, I expect to see some of these input cost pressures ease in 2023, and Fill-Rite should provide a longer-term boost to margins. I’m looking for mid-teens EBITDA margins in the short term, heading toward the higher-teens in FY’24. Long term, I still believe low-to-mid-teens free cash flow margins are attainable, driving high single-digit free cash flow growth.
The Bottom Line
Between discounted cash flow and margin/return-driven EV/EBITDA, I believe Gorman-Rupp shares are priced for a high single-digit long-term annualized return and should trade in the $30’s. This is a virtually unfollowed company, though, and one that doesn’t have the same leverage to drinking water spending as many other water plays. Likewise, it does have more vulnerability to short-cycle industrial and construction spending trends than some investors may want. For the longer term, though, I think today’s price is one where patient investors may want to do some due diligence and consider the name.
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