Dover May Be Bottoming, But The Street's Already Thinking Recovery

By Stephen D. Simpson, CFA | April 18, 2013 AAA

Dover (NYSE:DOV) is one of those industrial conglomerates that is so diversified, it's not hard to feel a little sympathy for the analysts that cover the stock. From energy to smartphones to commercial refrigerators and gas pumps, covers the gamut of end-market exposures.

To that end, it doesn't say anything especially great about the economy that first quarter results were pretty weak, though the book-to-bill and management's optimism about a second-half recovery are encouraging. When it comes to the stock, however, it's a little hard for me to believe that the Street hasn't already skipped ahead a few pages and priced this stock for a recovery.

Q1 Sluggish, But Basically On Target
Although Dover had a soft first quarter, it was pretty much in line with expectations.
Revenue rose 4% as reported, but fell 1% on an organic basis. By segment, engineered solutions was the weakest with a 5% organic revenue decline, while communications was strongest with a 4% improvement. Energy came in flat with its organic revenue growth, while the printing & ID business was down 1%.

Even though Dover saw a 1% decline in volume and nearly always has one or more acquired businesses to integrate, gross margin declined only 10bp from the year-ago level and came in a little better than expected. Operating income was flat on a reported basis, while segment operating profits increased 1% (printing and energy were strong, communications and engineered solutions were weak) and came in almost in line with expectations.

SEE: Analyzing Operating Margins

Will Management See Its Big Turnaround?
Dover management is continuing to make the case that results will improve in the second half of 2013. Remember that while the news (and anticipation) cycle has already moved on to the future, what we're seeing reported here was the end result of pre-election spending/ordering worries coupled with adjustments made to cope with sequestration.
Management is looking for an improvement in drilling activity (Dover competes with companies like Baker Hughes (NYSE:BHI) and National Oilwell Varco (NYSE:NOV) for drilling-related products like drill bits and downhole equipment), and the Baker Hughes rig count has been getting better. The expected recovery in Europe may be a riskier bet, but other Dover-specific factors like easier comps in refrigeration and new products in consumer electronics and printing will also help.
On one hand, Dover did report a 1.09 book-to-bill for the first quarter, with results no worse than flat in the four major categories. On the other hand, major competitors like Danaher (NYSE:DHR) and Illinois Tool Works (NYSE: ITW) have been a little more cautious in their outlooks (though to be fair, both have a reputation for being conservative with their projections).

A Good Business, But Be Wary Of Outsized Expectations
There's a lot to like about Dover. The company runs over 30 independent companies under its umbrella, and has been pretty consistent with generating solid returns on invested capital. What's more, the company is no dilettante or dabbler – the Phoenix Hill company is a major name in commercial food service, Knowles is a dominant supplier of MEMS microphones, and Heil is a major name in garbage trucks.

SEE: Cash Cows Or Corporate Chaos?

What I don't like so much is the tenor of expectations. Analysts are pretty bold with their projections of ever-higher margins at Dover, even though management has already boosted margins from the very low double-digits in 2003-2005 to the mid-teens over the last two years. This isn't a Dover-specific problem, but rather a market problem and I think investors and analysts may be getting too bold in just assuming that margins can go higher and higher forever. So it's not that I think Dover is likely to do poorly, but rather I worry that investors are baking almost impossible-to-achieve expectations into today's valuations (not unlike what happened in the tech bubble over a decade ago).

The Bottom Line
While Dover has grown its revenue and free cash flow at rates of 7% and almost 8% over the past decade, I'm looking for about 5% and 6% growth over the next ten years. If Dover can achieve that, the stock's fair value today should be around $76. That's not too bad relative to a current price below $70, particularly when there aren't all that many bargains to be found these days.

I'd be cautious about buying Dover today, but really only because of my worries that the second half rebound may disappoint, that the market may be due for more correction, and/or that the “Peak Margin” hypothesis may have some validity. Outside of those macro worries, I like Dover just fine and I think it's a more than respectable industrial name to consider today.

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