It's an underappreciated fact of investing in industrial companies, but margin performance goes a long way toward explaining stock performance. With the market basically sold on the ability of Colfax (NYSE:CFX) management to turn around the ESAB welding business (now part of Fabrication Technology), the shares have done well this year and sit just below a 52-week high despite ongoing wobbles in industrial orders and soft welding demand. Although I don't doubt management's ability to drive better-than-expected margins, it's getting harder to justify the stock's premium.

Making Progress In A Tough Market
With Colfax reporting a 4% decline in welding sales (“Fabrication Technology”) in the second quarter, the company found itself in the same boat as Lincoln Electric (Nasdaq:LECO) and Illinois Tool Works (NYSE:ITW) in terms of challenging end market demand. Almost anywhere you look, conditions have gotten (or stayed) challenging – including major sectors like energy, shipbuilding, general industrial, and construction. 

Even with a soft top line, Colfax continues to make progress with the multi-year turnaround program. Plant closures and process streamlining continues to pay dividends, with the segment seeing almost two and a half points of year-on-year segment margin improvement. While that margin is now up into the double digits, the operating margins of both Lincoln Electric and Illinois Tool Works offer the hope of meaningful further improvement potential.

Plenty Of Challenges In Howden And Colfax
Although the end market and geographic exposures are different between Colfax's welding business and its fluid and gas handling operations, conditions are tough in both right now. Although Colfax managed almost 4% organic growth in gas/fluid handling revenue for the second quarter, organic orders dropped by double-digits with every segment except marine down.

Ultimately Colfax will be fine. Coal-fired power generation is not going away in China, and the country's recently announced air pollution initiatives should lead to both upgrades and improved orders for more advanced products in the coming years. Likewise, there remains a significant volume of work on the books in the energy sector, and that should ultimately lead to a demand rebound for Colfax and rivals like ITT (NYSE: ITT), Dresser Rand (NYSE: DRC), Flowserve (NYSE:FLS), and IDEX (NYSE:IEX).

The question, though, is timing. The recently-announced decline in durable goods isn't exactly encouraging, and neither Europe nor China appear to be rebounding quickly. Moreover, large factory and process automation companies like Siemens (NYSE:SI) and Honeywell (NYSE:HON) have been reporting shaky near-term order and demand patterns.

On a more positive note, though, there's an ongoing process improvement story within fluid and gas handling. Sell-side analysts have certainly talked up the potential (and necessity) for margin improvements within the welding business, and for good reason as it was a turnaround opportunity at the time of purchase, but I think there's an underappreciated margin leverage story in this segment as well. To that end, operating margin improved more than a point in this segment in the second quarter.

The Bottom Line
There are good reasons to like Colfax. The company has strong share in several industrial markets, including welding, heavy duty fans, and screw pumps. What's more, the story is similar to Danaher (NYSE:DHR) with respect to a focus on continuous business process improvement and disciplined value-additive acquisitions. Between the prospects of better orders within the next year, ongoing margin improvements, and eventual acquisitions, I understand why Colfax is popular.

But I think it may be too popular now. Even with a long-term revenue growth estimate at the high end of its industrial peers and a double-digit free cash flow margin, these shares are at best fairly valued today. That may leave some room for even more progress on margins or a faster/stronger order recovery, but it seems like Colfax is already priced with an eye towards all of the things that could go right at a time when other industrial stories can be bought at a discount to fair value.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

Related Articles
  1. Stock Analysis

    Starbucks: Profiting One Cup at a Time (SBUX)

    Starbucks is everywhere. But is it a worthwhile business? Ask the shareholders who've made it one of the world's most successful companies.
  2. Stock Analysis

    How Medtronic Makes Money (MDT)

    Here's the story of an American medical device firm that covers almost every segment in medicine and recently moved to Ireland to pay less in taxes.
  3. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  4. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  5. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
  6. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  7. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  8. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  9. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  10. Investing News

    The UAE: An Emerging Economy for Investors

    The learning from UAE on how it succeeded with timely diversification when the BRICS nations and the neighboring oil-rich economies faced challenges.
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center