That big second-half rebound in industrial demand is starting to look weaker and weaker. Although companies like Grainger (NYSE:GWW) and Fastenal (Nasdaq:FAST) have been reporting decent demand for industrial supplies and equipment among manufacturing customers, Actuant's (NYSE:ATU) guidance suggests that most industrial, energy, and vehicle markets are still crawling along. While I do believe growth should pick up again, the value proposition here doesn't look very compelling.
Sluggish Results Due To Sluggish Demand
Actuant's results aren't showing much underlying strength in key end-markets like industrial, energy, or vehicles. Overall revenue was flat on a reported basis and down 2% on a “core” or organic comparison. Industrial revenue rose 1% as reported, and energy rose 3%, but sales in the engineered products business were down about 2%.
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With weak revenue, margin leverage and incremental margins have evaporated on a consolidated basis. Gross margin declined almost half a point from last year, and operating income was down about 3% for the period. Although margins in the engineered business weakened (down four full points, and the lowest by far of the three businesses), both industrial and energy saw stronger segment-level margins.
No Man's Land Isn't A Fun Place To Be
Actuant looks as though it's stuck between cycles. Late-cycle businesses like energy seem to be petering out, but early-cycle businesses like transportation and mining are still very weak. To that end, while management cited good activity in deepwater umbilicals (used for offshore drilling and production rigs), areas like commercial trucks, agricultural vehicles, and off-highway vehicles were weak within the engineered business.
As I said earlier, reported demand from major distributors Grainger and Fastenal has been okay over the past three months, with sales growth to manufacturing customers growing in the mid-single digits. I'm not suggesting that there's a one-to-one relationship here, as Actuant sells much more into markets like commercial/civil construction, mining, oil/gas/chemicals, and so on, but it is interesting to consider in the context of relatively tempered guidance from Actuant management. All told, it looks like demand conditions in “heavy duty industrial” aren't very good at present and that could point to challenging conditions for a host of larger companies like Caterpillar (NYSE:CAT), Eaton (NYSE:ETN), and Illinois Tool Works (NYSE:ITW).
Slimming Down Makes Sense
Actuant has also recently announced its intention to divest its Electrical business – a business largely built around commercial (especially marine) and residential electrical tools and consumables. Although this business was a meaningful percentage of the company's revenue base (about 20%), it had sub-optimal margins (contributing 10% of earnings). I expect Actuant to have little difficulty in selling this business, and I would expect it to sell for an enterprise value around $400 million.
Assuming that target is reasonable, Actuant will emerge as a leaner (and debt-free) company focused largely on hydraulic tools and components in the energy, infrastructure, agriculture, and natural resources markets. At the same time, I would expect at least some of the proceeds to go towards focused bolt-on deals that can be easily integrated into the existing business.
The Bottom Line
Although Actuant is a leader in many, if not most, of its markets, that leadership has never meant much in terms of margin leverage or returns on capital. Divesting the electrical business should improve margins, but I think investors would be wise to keep their expectations for future improvements relatively restrained.
I'm looking for mid single-digit revenue and free cash flow growth for the long term, which points to a fair value of $34 (including the assumed/forecasted proceeds for the electrical segment). That's not enough undervaluation to prompt me to buy these shares today.