Friday, February 1, 2013

Dover Corp Research and Analysis

A balanced portfolio should be, err, balanced, and while investors would do well not to overload their portfolios with industrial cyclical stocks, I think Dover Corp  presents a compelling GARP opportunity. In summary, the stock has been a bit weak recently thanks to worries over its handset business, but it looks overdone to me. Dover is a highly cash generative company with an impressive long term growth record and diversified end markets. The evaluation is not expensive and given decent global growth this year I think the stock has upside.

How Dover Corp Makes Money

As ever with this type of stock the first place to start is to look at how it actually makes its earnings rather than focusing on its high media impact operations. Doing this reveals that the key profit drivers for the company are things like North American rig counts and its refrigeration and food (Engineered Solutions) based sales. No matter, it is Communication Technologies that the market wants to know about.

In addition, Dover has made acquisitions (Anthony) in the refrigeration markets and announced plans to divest its electronic assembly and test business. Indeed, in an earlier article I pointed out how its electronics end markets were faring. For the record, Dover reduced earnings estimates twice last year and cited weakening electronics orders and tougher conditions in its handset business.

Will it do so again this year?

Handsets, Smartphones, Microphones Etc

Naturally it is the more cyclical parts of its product portfolio that gets all the analyst attention. After all marginal movements in these businesses will make the difference in Dover’s results, but I think there has been too much attention placed on handsets and Dover’s exposure.  A quick look at bookings for Q4 reveals what the market is worrying about.

The handset issue is that Nokia is a major customer of its Sound Solutions (part of Communication Technologies) business and, as the world knows, it has been weak for some time now. Nokia continues to lose market share to Apple  and others, and the future viability of its device operations is a legitimate concern. On the other hand there are some favorable underlying trends here.

Firstly, consider that the weakness in Apple’s share price recently has been due (in my humble opinion) to iPhone sales being less than forecast. A large part of this miss was probably due to analysts overestimating the willingness of consumers (particularly in emerging markets) to pay extra for the new iPhone. Competitors are catching up, and Apple needs to create better entry level price points in its offerings for EM. Now consider that Nokia has a strong position in cheaper phones in EM and is aggressively trying to break the ‘cheap smartphone’ market.

Second, all phones are equal but some are more equal than others. Smartphones tend to have more microphones in them than legacy phones so if for argument's sake, the ratio is three to one. Therefore, one new smartphone sale is equivalent to three lost for Dover Corp. Indeed, if Nokia and others are expanding smartphone sales- and a quick look at what the telco’s are saying confirms this- then Dover should see strong upside. Dover predicted the smartphone market would rise 20% this year.

Thirdly, Dover doesn’t just sell to Nokia! In fact, it sells to a range of OEMs, including Samsung, so ultimately it can benefit irrespective of whoever is winning in the marketplace. Apple is the only major manufacturer that Dover doesn’t have a decent market share with. The problem for Dover really only occurs when there is a big shift in a key customer, and arguably that has already happened with Nokia. Moreover, Samsung is strong across all product price points.

Finally, the Q4 bookings weakness partly reflects normal seasonality. Phone sales are sequentially weaker in Q1, and the OEMs place orders on a short cycle basis. Indeed, Dover was very clear that profits and revenues passed the trough in Q3 in Sound Solutions.

Perhaps the market is fretting too much?

Where Next for Dover?

Elsewhere conditions look good for energy to do well in 2013 with Dover forecasting an increase in the North America Rig Count in the second half.  I would remain positive on this issue as long as oil prices stay above $100, and with Engineered Solutions predicted to have a ‘very strong year’ with particular strength in refrigeration and food equipment, the future looks bright.

It’s not often that you get to buy a company that has just generated nearly 7% of its enterprise value in free cash flow yet has mid-teens earnings growth forecast for the next couple of years. I suspect this is due to fears over Nokia and possibly the North American rig count. If you are jejune over those risks than Dover should look attractive for the cyclical end of your portfolio.