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. Investing News

    What You Can Learn from Carl Icahn's Mistakes

    Carl Icahn has been a stellar performer in the investment world for decades, but following his lead these days could be dangerous.
  2. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  3. Fundamental Analysis

    Is a U.S. Industrial Recession on the Horizon in 2016?

    Find out why the industrial economy may be teetering on an industrial recession and what could prevent it from going over the cliff.
  4. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  5. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  6. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  7. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  8. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  9. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  10. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
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