Lincoln Electric (LECO) remains one of the most-respected companies I follow in the industrial space; even analysts who are negative on the shares for whatever reason usually feel compelled to acknowledge its strong share, variable cost structure, attractive ROIC history, and solid strategy. That said, the shares have basically traced the performance of the average industrial over the past year, lagged the sector over the past two years, and significantly lagged over the last five years – a phenomenon I attribute more to the high valuation the company has often enjoyed rather than any long-term reduction in business quality.
As far as considering the shares today, I’m not quite sure what to think. I see growing risks from macro headwinds in a number of important end-markets, but I don’t think my long-term growth assumptions are all that heroic and the shares look priced more or less in line with a lot of other industrial names that I believe to be less well-run. I think Lincoln shares may not do all that great in 2019 unless there is a favorable resolution to the U.S.- China trade issues and there’s re-acceleration in multiple end-markets, but as a long-term holding today’s price is at least okay in my book.
A Weird Fourth Quarter
Lincoln’s organic revenue growth rate was above-average in the third quarter but slid to significantly below-average this quarter, as revenue grew less than 2% against an average industrial/multi-industrial growth rate of about 6%. What’s worse, the company missed by a pretty significant margin at the operating line, with non-operating items like taxes saving the day for reported EPS.
Within the 1.6% organic growth number, Lincoln reported mid-single-digit growth for the lower-margin consumables business and a low-to-mid single-digit decline in the equipment business. By comparison, Illinois Tool Works (ITW) reported much stronger 7.6% organic growth in its welding business, with high single-digit growth in both equipment (7%) and consumables (8%). Colfax (CFX) reported even better results, with 11% growth in its Fabrication Technology business, with consumables outperforming equipment.
Lincoln’s Americas segment grew more than 8%, with all of the growth coming from price, as scant volume growth was underwhelming relative to expectations, even granting the difficult year-ago comp (up 10%). The International business was weak, down 10%, with significant volume weakness (down 14%). Harris was up about 3%, though the company saw weaker pricing here this quarter.
Gross margin improved almost two points, as the company has been able to effectively offset input costs and tariffs through pricing. Adjusted operating income rose 7% (with 90bp of margin improvement), while segment-level profits rose 12% and margin improved 150bp. Americas profits rose 15% (130bp of margin improvement), coming in a couple pennies weaker than expected, and International profits rose less than 3% (110bp adjusted margin improvement), while Harris saw a 5% profit decline and 80bp of margin contraction.
There were a lot of parts and pieces here that I find strange, including the significant underperformance relative to ITW and Colfax. The integration of the Air Liquide business is clearly causing some outsized disruptions in Europe, with Colfax looking to be the prime beneficiary. In the U.S., business weakened throughout the fourth quarter but orders have apparently picked up in January.
Looking at the end-markets, Lincoln reported strength in a lot of areas where other companies are reporting emerging signs of real weakness, including double-digit growth in heavy industry and construction/infrastructure, and growth in autos, with general fabrication described as “steady” and energy as “mixed”.
The Challenges Are Likely To Get Worse Before They Get Better
I believe management’s guidance for low-to-mid-single-digit revenue growth in 2019 to be credible, not to mention consistent with many industrials/multi-industrials (albeit a bit lower than ITW’s outlook for 1% to 3% growth). That said, I am concerned that Lincoln, like many other companies, is putting too many eggs in the “second half recovery” basket, and I’m concerned we could see another round of revisions around midyear if global macro conditions don’t improve (resolution of the U.S.-China trade dispute would certainly help).
With more than half of Lincoln’s automation business tied to the auto industry, it’s not so surprising that this business could soften in the first half as car companies cut back on capital spending – while it’s true that Lincoln’s auto business isn’t so tied to auto unit volumes as other companies, they’re still vulnerable to softer spending trends.
At this point, though, I’m more concerned about the risk of growing headwinds/weakness in general fabrication, heavy industry, energy, and non-residential construction. Plenty of companies with general industrial exposure (including Atlas Copco (OTCPK:ATLKY), ITW, Parker Hannifin (PH), and Sandvik (OTCPK:SDVKY) ) have warned of slowing trends to varying degrees, and heavy industry companies like Caterpillar (CAT) and Deere (DE) have likewise seen expectations heading lower. Longer-cycle process industries are doing relatively better, but Lincoln’s greater skew to upstream oil & gas is a risk, and there’s not much good news these days in the power gen market.
Longer term, I think Lincoln is still in good shape. The company’s commitment to automation is likely to pay off for years to come, and I’d note that Lincoln’s revenue from automation roughly approximates the combined automation revenues of Colfax and ITW. The company has also been building up its additive manufacturing capabilities, including its R-BAAM (Robotic Big Area Additive Manufacturing) platform that it will start commercializing in 2019. This platform allows customers to prototype large components and systems (like engine blocks) in one-third or less the time it takes with conventional tooling, and although it won’t be a major contributor to revenue or profits for a while, it tells me that Lincoln’s vision of the future goes beyond just welding.
The Outlook
I have reduced my near-term revenue growth assumptions for Lincoln (by about 4%), but the longer-term impact isn’t as significant and I still believe Lincoln can generate long-term revenue growth above GDP growth and in the neighborhood of 4%, helped in no small part by the company’s growing automation business and its enhanced capabilities in alloy/specialty welding, which I believe will become more important as customers in a range of industries (including autos, energy, and power gen) use more specialty alloys in future products.
The changes to my margin assumptions are less severe. I am concerned about some volume-related deleverage, but Lincoln’s highly variable cost structure should offset that to a significant degree, and the company should start seeing some improved margins and synergy from the Air Liquide deal.
All told, I still expect Lincoln to be a low-to-mid single-digit long-term grower on the revenue line and a mid-single-digit grower at the FCF line. Running that through my DCF model, I think Lincoln is priced for a high single-digit total annualized return now, which isn’t bad relative to the industrial space as a whole, even if it’s not quite as high as I’d like for a new position. Lincoln likewise looks undervalued on the basis of its margins (which drives my EV/EBITDA multiple), but not dramatically so – more in the neighborhood of “strong hold” as opposed to “buy”.
The Bottom Line
I know there are readers/investors who believe in buying quality (or what they perceive as quality) irrespective of valuation, but that’s never been my approach and I’m not changing that now. To that end, Lincoln doesn’t often get all that cheap, but I’d rather wait for the right price than pay up and resign myself to long-term underperformance. Given that it’s still in what I see as a valuation “grey area”, I’m not inclined to buy Lincoln today, but it’s definitely a name I’d reconsider if macro headwinds blow harder in 2019 than the market and management current expect and the shares sell off as a result.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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