Teledyne (TDY) Stock: Qualities Can Support Valuation; Not Cheap

With the market still nervous about the outlook for many short-cycle end-markets in 2023, it pays to have meaningful exposure to longer-cycle or less cyclical markets, and with Teledyne’s (NYSE:TDY) leverage to defense, aerospace, and oil/gas, they qualify in my book. On top of that, we’re talking about a diverse company with strong expertise in sensing, monitoring, and control instrumentation, and those companies don’t typically see dramatic cyclicality or derating even in tougher economic environments.

Valuation has long been a challenge with Teledyne and today is no exception. At best I can say the shares look priced for a mid-to-high single-digit long-term annualized return on cash flow, though there’s an argument to be made for a higher EBITDA multiple given its “compounder” traits. I can see the appeal of these shares for some investors, but I’d prefer a bigger margin of value, as even well-loved compounders can de-rate.

Fourth Quarter Results Were Healthy And Well-Balanced

Teledyne didn’t crush fourth quarter expectations, but still delivered a decent beat relative to Street expectations with no real areas of weakness and an initial guide for FY’23 that was within expectations.

Revenue rose 3% as reported, but closer to 5% on an organic basis, which was just a bit better than expected. The largest business, Digital Imaging, posted better than 3% growth, while Instrumentation grew more than 10%. Aerospace and Defense Electronics revenue grew 9%, while Engineered Systems revenue rose 7%.

Gross margin improved 420bp from the year-ago period to 43.5%. Operating income was up 40% as reported and up about 8% on an adjusted basis, with the former beating expectations by about 2%. Adjusted segment-level profits rose 8%, with margin up 110bp to 23.8%.

By segment, Digital Imaging profits rose 2% (adjusted), with margin up 50bp to 23.8%, while Instrumentation rose 15%, with margin up 160bp to 25.3%. Aerospace and Defense Electronics profits rose 30% (margin up 480bp to 29.7), while Engineered Systems fell 17%, with margin down 230bp to 8.7%.

At the bottom line adjusted EPS beat expectations by about $0.40/share, or around 9%. Free cash flow was light, and although management didn’t include a complete cash flow statement, I’d expect that working capital was the driver of the miss.

Short-Cycle Holding Up, And The Business Remains Diverse

Not too many industrial companies have reported yet, but among those that have, the commentary on short-cycle markets has been encouraging. While these early reporters have generally said they see evidence of weakness and expect markets to slow as the year goes on, they’re hanging in for now. Along those lines, I’d note that Teledyne’s test & measurement business grew 4% in the quarter, which should shape expectations for Fortive’s (FTV) upcoming report.

One of the things I like about Teledyne in today’s environment is its exposure to longer-cycle markets or markets that are typically acyclical.

Aerospace is already recovering and should get stronger as the year moves on. The marine business was up 10% this quarter (part of Instrumentation), and I expect healthy demand from offshore energy to last, as well as demand for marine defense products. Environmental instruments were up 9%, with good growth in drug discovery, labs, air monitoring, and process gas, and only the latter concerns me much as far as a 2023 slowdown.

Within the Digital Imaging business managed did see weaker demand for surveillance and unmanned ground defense products, but unmanned air was strong and demand was healthy in industrial/scientific cameras, X-ray, and commercial infrared. I would expect to see industrial camera demand weaken, as the commentary from companies like Cognex (CGNX) hasn’t been particularly positive, and I do expect weaker demand for machine vision, automation, and monitoring in the near term. Healthcare demand should be healthy, but isn’t as much of a mover for Teledyne.

Longer term, I see a lot of potential applications for Teledyne’s strong core sensing and imaging capabilities. More advanced semiconductors will require more advanced sensing/imaging from FLIR and DALSA, automation of manufacturing and monitoring will drive more machine vision and thermography demand, and Teledyne is also well-placed with technologies applicable to areas like auto ADAS, healthcare imaging/diagnostics, and commercial space. I also would expect to see greater interest over time in unmanned marine/undersea technologies for defense applications.

The Outlook

I believe Teledyne can grow revenue over the longer term at a rate of around 5% or so, with management guiding to organic growth of around 3.5% in a year where there will be pressures on short-cycle markets. One notable “but” in that projection is that it doesn’t really include explicit M&A, and Teledyne has shown repeatedly that it is a very willing acquirer.

While there are still cost pressures on the business, I do expect operating and EBITDA margins to improve from here, and I think Teledyne can achieve high-teens FCF margins relatively soon, supporting long-term adjusted FCF growth in the high single-digits.

Discounted back those cash flows don’t really suggest that Teledyne is significantly undervalued now, and that doesn’t surprise me much given leverage to healthier markets like aero/defense, as well as its strong competitive position in high-value components (sensors, et al).

I do believe that Teledyne has at least some of the credentials of a “compounder”, and I’m comfortable with a higher-than-normal EBITDA multiple as a result. While compounders have traded for more than 20x EBITDA relatively recently, they’re currently more in the 16x-18x range, and I think 18x is a workable (albeit not conservative) multiple. Applying that to my FY’23 EBITDA estimate gives me a fair value of close to $500.

The Bottom Line

I would like to see a higher return on invested capital here, as well as a better valuation relative to the cash flow I expect Teledyne to produce, but neither are complete dealbreakers for me. I can appreciate Teledyne’s leverage to markets that should be stronger in 2023, as well as the leveragability of its core technology into multiple growth markets (ADAS, automation, semiconductors, etc.), but for now I’m content to wait in the hope of a pullback in the share price.