Dover Corporation (DOV) Earnings Call Transcript & Summary

Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for day 2 of the Laguna Conference, our 9th annual. Virtual this year. We'll make it up to you next year, I promise or at least I hope we do. Joining me for the next fire side is President and CEO of Dover Corporation, Rich Tobin. Before we get involved in Q&A here and I bring in Rich, I do have a quick disclaimer to read for everybody. Just as a reminder, for any information regarding our research disclosures, please visit morganstanley.com/researchdisclosures. And for all other questions, please reach out to your Morgan Stanley salesperson. Rich, glad to have you as always. Looking forward to the discussion here.

Maybe just to sort of kick things off, I know you and I were talking about it a little bit before we started here. But the word of the day seems to be supply chain. Everyone is talking about it, whack-a-mole in terms of the problem of the day to sort out, whether it's price, cost, logistics, et cetera. Maybe walk through your perspective on Dover's handling that. What are the bigger obstacles? And how do you see those getting resolved?

Sure. Well, glad to be here, Josh. Yes. I mean we've been trying to get this dialogue started since the end of last year when we closed 2020 because I think that the whole dialogue around price cost tends to get -- be a bit basic. It started with raw material inflation that we saw at the fourth -- entering into the fourth quarter last year. We had said at the time that we were going to get on the front foot in terms of accommodating the price increases that we need to cover that. I think that we did. So we felt pretty good about our position going into '21 in that regard. Now raw mats have continued to climb through up until about a month ago where they seem to be plateauing. And so if we take a look at raw mats going forward, spot pricing would indicate that we're at plateau, and there's some tailwinds ahead for us. And that's all well and good, and I think that's what we planned for. I think that what we did not plan for and it was -- that it's becoming increasingly large problem is supply chain constraints and what that means not only to managing the supply chain, it's the cost of freight, both inbound and outbound freight. And just as importantly, as these issues have just -- have not dissipated, it's the stop-start of the production engine, meaning you can only make so many half-built units and put them in the parking lot. After a while, you basically have to start stopping the plant and all of the costs associated with start up, start down, fixed cost absorption and everything else. So it's been difficult managing that, make some mistake. We -- it's not hitting the top line. So we are forcing the product out the door, but it's costing us a lot to do it. So it's a detriment to margins. Right now, it's chicken and egg to a certain extent. We've got customers that depend on us to supply largely some components or components of larger infrastructures, and we're very cognizant of the fact that we just can't say, well, we're having problems here, so we're not going to supply. So we've been doing our damndest at no small cost to get it out the door. Right now, like I said, it's been difficult. I think it's going to make the margin performance here by operating company more choppy than we would have liked or what we had expected at the beginning of the year. I think it's manageable to the extent that I mentioned on the raw material side. I think that the labor issue is also plateauing, that our backlogs remain healthy. So we're booking into next year largely across most of our portfolio at this point. So we're going to have to tough it out and deal with these costs, if you will. But having said all that, I think that it's -- not to be Jay Powell here, but we think it's hopefully transitory because we've just finished our strategic planning process for the next 3 years and in terms of loan. Where we believe that we're positioned from a demand point of view and from a market structure point of view, we feel really good about exiting this year, we're just going to have to tough it out over the next 90, 120 days or so, hopefully.

So I want to unpack a couple of things you mentioned there. Maybe first on the price cost side and some of the plateauing and the inputs. And everyone's cocktail of inputs is a little different. So maybe that's more Dover-specific than anything else. But between things like hedges and purchase agreements and contracts, is that something that starts to show up in this year? Or is that more of a level setting on we don't think we're carrying a lot of incremental sequential inflation into '22?

Yes. Look, we have this discussion around here all the time because you've got an increasing curve up until recently on the input costs. We've been absorbing that. You do take it a little bit in the neck because you're building a backlog that you've taken orders based on prior price increases. So it's a little bit of a rolling ball of the trade-off between building the backlog and the benefit that you get from being able to manage -- backlogs are great for a variety of reasons. And one of them is it lends itself to an efficiency of production because you can see what you need to make well in advance. Now I'm throwing the logistics supply chain issue aside. The bad part about building a big backlog is it's priced at the time that you took it. So if you're moving into inflationary environment, you've got to manage the fact that you get behind in terms of pricing. Overall, I think that we're in pretty good shape in terms of the raw materials and labor portion of the inflation on the backlog, where we're not running into a position where at the beginning of next year, we're running negative. And the bulk -- so I think that part is manageable for us. I mean the bulk of the margin detriment that we're experiencing right now is, as I mentioned before, the fact that logistics costs have just gone parabolic on us. And just as importantly, stopping and starting the production cycle has got a significant amount of cost associated with it. So by and large, we believe that raw materials have plateaued and should start coming down, if you believe, based on futures. We believe that whatever we've had to do to attract the labor is sticky, and that's accommodated into our projections going into next year, but we've got enough tailwinds in terms of productivity and automation and a variety of other things that we can deal with that. The unknown, the 2 last unknowns is when does the supply chain total costs begin to dissipate and what happens to pricing stickiness in '22. And we're going to find that out probably over the next 120 days.

On the pricing front, because you raised an interesting point there about this rolling ball. What is the historical context? And I know this current environment is a bit unprecedented. So everyone is checking out your bingo card unprecedented you get to put in. The -- is there a historical context for having to give back price after big periods of inflation? I would imagine not in a set of businesses, but obviously, you have more insight and visibility on that than we do.

We have a few businesses that have contractual escalator, de-escalator clauses. So it ends up being kind of net neutral. And those would be take a business like SWEP that is stamping metal at the end of the day in terms of configuring your equipment. So that business, it's relatively -- it's not easy, but it's more or less an escalator, de-escalator. It's got some timing differences, but the market -- your total market performing like that to a certain extent. But that's an anomaly. Most of our businesses don't have contractual escalator, de-escalator. So pricing stickiness is entirely dependent upon the demand environment and the competitive framework of the individual business. And as you know, we've got a pretty decent, diversified portfolio here, so there's not one answer that applies to all of them.

Got it. So I'm hoping this is a timely question given that you mentioned you just did your 3-year strategic review. But clearly, we're at the onset of a CapEx recovery. And CapEx means different things to different people and probably there's a lot of different forms in your portfolio as well. But where are you seeing that kind of look most profound? And what gives you the most excitement over kind of the next 3 years in some of the major businesses driven by that?

Well, we've been believers here that reshoring was a thing. And what's happened over the last 6 months is probably making reshoring a real, real thing. So that was part of what we believe, why we believe we are moving into a CapEx cycle. Without getting into the details of individual businesses, we could talk about refrigeration, we could talk about legislative-driven CapEx and everything else. But just as a general comment, we believe that proximity manufacturing and reshoring was a trend that started in -- and you can see it really becoming a thing at around '18, '19. So we've been kind of betting on that to a certain extent anyway. And frankly, despite us bitching about all the costs we're taking about logistics, we believe that we've actually been a beneficiary through this recent cycle because we are a proximity manufacturer with not a lot of instances of very long supply chains. And I think that if you look at the performance that we've seen in Pumps & Process Solutions, for example, we believe that we've been a winner because of the fact that we're largely a proximity manufacturer and actually had the product available to a certain extent. So we believe that's a driver. It is now being exasperated because the supply chain fragility is really becoming a thing. And as I mentioned before, we believe, generally speaking, that labor costs are sticky. So when they move up, they don't tend to move down. So returns on labor reduction at the factory floor actually improved going forward from here.

Got it. So would you say across the businesses, did this kind of beneficiary of being localized is most profound in PPS because the backlog and the order rates would sort of lend themselves to, hey, something is different this cycle. The growth has been way stronger. Anything else that sort of sticks out to you or anything else in that business that you would attribute trying to.

Well, I mean, it's an anecdotal comment. And I would say that it applies mostly to the industrial pumps portion of the portfolio. As you know, we've got a nascent biopharma business that is doubled in probably the last 24 months in size, which is very accretive, and then we've got 2 global businesses between Maag that does equipment for plastics production on the raw material side and Precision Components, which is component parts largely that go into compressor. So the point I was making about the supply chain is not across the entire portfolio. There's different drivers within there, but there are elements where we believe we've been more successful vis-a-vis our competitive set because of supply chain advantage. So while we're taking the pain, we are getting some of the benefit.

Got it. Just pivoting over to the margin side, how would you kind of put the broader cost savings program from a baseball analogy innings perspective? You guys have been at this for a few years. Certainly, the cost environment has evolved a lot since you first took over and maybe something that wasn't painful a couple of years ago is something that you'd want to address more today. But how is that evolution? And where do you think you are in terms of milestones?

Look, it's viewed sometimes externally that this was kind of an SG&A program and at its onset at once. But we were the beneficiary of that program in '18, '19. Since then, it's been a much more broader-based program that we've run largely on 4 pillars, right? So we've had Dover Business Systems, which is kind of noncustomer-facing processing. We are 50% through there. We're never going to get to 100% just because you get to the law of small numbers with some of the smaller operating companies. So we're largely 50% of the journey there. We got another big project coming on in '20 -- my year is right, '22. So that's been successful to date. It's got some runway left. The second piece of the pillar was our India Innovation Center, and that's moving kind of processing of engineering services to low-cost country and allows us to do 24-hour project management in terms of engineering. That's been very successful. I would say that we are depending on what we can do on the software side there in the future. I'd say we're 50% penetrated on that. The 2 ones that we've been building a lot over the last 3 years is in the operations excellence side and then the digital side. We built up quite a bit of cost there, while we've been running these productivity programs. And I believe the lion's share of what we believe that we can get over the next 3 to 4 years is going to be as a result of those 2 pieces in the platform.

Got it. So given that they're not these kind of sweeping actions anymore, they're more drilled down into the businesses, does that make kind of execution on those with this cost backdrop -- I guess does that put kind of the near- to medium-term incremental margin environment at risk, just given that you're now asking a lot of different building blocks to stack up in an environment where no individual action is necessarily as easy anymore?

Well, I mean, I think the opportunity there is as large as that we've seen. So let's take it in 3- to 4-year blocks. The total aggregate -- I got to be careful on the numbers here. But what we've disclosed in terms of our cost savings programs up into this point, we believe we have equal amount of the opportunity going forward within the same duration of time. We're going to go about it differently, right? And it may not entail kind of the restructuring charges kind of as traditional productivity. This is grinded out over time, but we believe the total opportunity of the savings is as large.

Got it. One thing that you guys have announced and I think been pretty big believers of over the past year or 2 that you didn't mention were the automation projects. I think refrigeration, precision components have some bigger actions, probably somewhere else in the portfolio, too. How has that gone with what's happening on the labor side? Is there more you'd like to do?

We would like to do more. I think it's more of a capacity issue than it has been an opportunity issue, part of building up and the investing in the central ops team was to facilitate those kinds of programs because if you think about the individual size of the majority of our operating companies, they don't necessarily have the manufacturing engineering expertise to run projects like that. We believe that we now have that capability in-house. And then I would split the opportunities in 2 phases. We've got kind of the traditional businesses. If you think about Engineered Products segment, where we're intervening on those types of projects for cost, productivity and quality, so we're running 2 sizable projects, one in VSG and one in ESG today on that. We discussed what we're doing in Refrigeration and that's up and running. And then we're looking at kind of changing the business model, which is more capacity expansion types of projects, some robotics in there, a lot of inspection systems, and we're doing that more kind of not the heavy industrial portions of the portfolio. But if you think about biopharma, you think about DPC, we can get to the point where we're automating a lot of the small-scale assembly and a lot of the inspection processes in those companies. So I think we're encouraged in what we've seen in our ability to expand capacity in colder products on the biopharma side that has not required the traditional amount of labor that if we had done this project 4 or 5 years ago would have got. There are different categories. I think there's lots of opportunity. I think the good news is we've built up kind of a central core to kind of manage them because they're just not easy to do.

Did the technology just get better and that sort of created the tipping point? Or is this more in the low-hanging fruit category prior?

Well, I mean I think that the technology is always -- I mean like auto and aerospace drives a lot of this technology at its onset. Scale is big. The size is big. The unit volume is big. So it lends itself and the labor content is massive. And that's been going on for 10 or 15 years. So I think that what's changed recently is you -- that that's -- those same kind of benefits don't require that kind of scale. Maybe you can buy some systems that give you the same kind of benefits that have been reaped out of those large industries now into kind of components manufacturing for lack of better word.

Got it. Kind of sticking with the margins and the margin opportunity. Engineered Products is probably taking the brunt of price cost and mix for that matter in '21, maybe more than the other segments. How do we think about the path back to historical margins? Is it just kind of snap in the line and no more incremental inflation and price catches up? Is there something more structural that has to happen? How do you think about the kind of the journey back to peak?

Look, I mean, we have the backlog and we price for the raw materials. So returning to what we talked before, does the supply chain unwind? And can we run the plants without stopping and starting them? Because that's, by and large, the vast majority of the margin dilution that we're experiencing there has been driven by those 2 factors. Now there's a bit of labor availability. I think that we've borne the brunt of that already. So I don't expect that to get worse going forward. So based on our backlogs today and based on our view going into '22, as long as something doesn't go wrong in terms of the competitive dynamic around pricing, we can snap right back because we have the hardest part. And the hardest part is building the backlog. We're likely to carry it right into '22.

Got it. And maybe on the other side, Refrigeration & Food Equipment, particularly on the Refrigeration side, I guess, a lot of solid improvement this year. Business has cycled up nicely. Obviously Belvac has backlog for the rest of its life. We -- are we kind of through a big chunks of margin expansion? And if I think back to kind of that first Analyst Day right after you took over, what was that, 3 or so years ago now. It seemed like the message around the segment was -- or Refrigeration specifically was we got a lot of stuff we can do here before we think about the long-term rationale for keeping this. It seems like you've sort of gotten through a big bulk of that effort and have seen -- have gotten paid on that through margins. Maybe there was just more to do by annualized in the calendar. But are we closer to having that be a part of the consideration given that it's -- not to be George Bush standing on a destroyer deck, but like mission accomplished.

Look, we feel good about the progress that's been made. There's been a ton of heavy lifting operationally was done there. We believe that the demand environment would have changed last year, but COVID kind of blew that up. So we entered into this year in where we know that we've done a lot of work operationally and we had a backlog. Unfortunately, just like Engineered Products, that is a business that buys electrical components, sheet metal and has a lot of assembly labor associated with it. So it's going through the same challenges that the Engineered Products portion of the business is. But again, it's not endemic to the -- what we believe to be the long-term performance of the business because the backlog there is continuing to build. So the margin trajectory is going to have a little bit of a headwind here for a couple of quarters, hopefully, one. And then we'll get right back on track. We would have expected to get into the low teens and consolidated margin on Refrigeration, not the segment on the Refrigeration piece. This year, we're going to take some setbacks going through the process. As I mentioned before, we've got to deliver to our customers at the end of the day. So we just don't have the luxury to say, well, we've got to shut the plant down for a month because that's the most economic thing to do here. We're pushing the product out at no small cost to satisfy the customers because at the end of the day, once we get beyond these challenges we want that backlog and the demand environment to remain strong with us because we believe we're in the onset of a 3-year cycle here in terms of the demand side. So we'll be in the teens in this business next year for sure. Is it -- are we at the peak? Arguably no. I think that we've got a driver on the CO2 system side today that we did not have back in 2018. And we also -- and we believe if we manage ourselves appropriately that we can drive margin expansion in the core business, and we can be successful on the CO2 systems side, one which allows us to drive that -- that top line has got a positive margin mix associated with it. So on core, is it mission accomplished on '18 largely on what was the core business? I think what's changed the dynamic now is this CO2. And if we can execute appropriately, I think that, that lifts the bar in terms of margin performance going forward from here.

Got it. Got it. Just kind of trying to put some of the comments on backlog and the order environment together. I mean you're carrying way above normal backlog. And you mentioned early on booking into '22 across a large percentage of the portfolio. Have you seen orders decelerate at some level because customers are like, well, I don't know what '22 is going to look like. Like let's wait until we're closer and have more urgent need before I want to place an order? Or is opening up the '22 book just a continuation of what you guys have seen thus far?

It's hard to say because August is always a funny month. And maybe I'm being biased on recency bias. You just don't get a lot of orders in August. So it's -- August is lower than what we've been tracking, I guess the best way to put it. But in absolute backlog, the environment is still kind of building. Look, I think that if we can't get on the other side and how transitory is this inflation? I think that's what everybody is getting kind of worried about, right? And make no mistake, backlogs have been built because of everybody's fear of the supply chain to a certain extent. They just don't have the luxury anymore of ordering for next month and we can get it out the door because everybody's got a fundamental understanding. So I think I made the comment at the end of Q2, we will see what order rates are between now and the end of the year, whether they start to soften or not. I don't have -- up until now, I don't have enough data to say there's a trend because, as I mentioned, August is always a bit of a weird month. But if we can get by these logistics constraints, our backlogs are going to go down next year anyway because that's just going to be more a reflection of I don't have to order that much in advance. And I mentioned at the end of the Q2, we're going to get into '22, and we're going to show backlogs going down and someone's going to write like panic is ensuing, right? All they're going to do is normalize to deal with the fact of COVID bounce backs gone back, coupled with supply chain constraints. But as I mentioned before, we've gone through that strat planning in terms of what we think the opportunity set backlogs aside. We feel good about what the growth potential of the portfolio is going into '22.

I imagine the only headwind to that. And by the way, I'll say I won't write that note, I'll promise that right here. But I agree, someone will. It seems like other than EMV, no clear over owners over the medium term that you would say are unsustainable in the next year. I mean Belvac has been super strong, but it has almost too much backlog to matter in that regard. So anything else that would stick out to you?

No. I mean we are always trying to unpack this COVID issue on the biopharma side from what we can tell, nothing to be overly concerned about.

Got it. And then one final question. I have had some coming in on the portal here. We've gotten to many of them. But one, just to kind of put a finer point on some of what you said. It seems like the overall message is sales is a little bit better, demand has been really strong, maybe a little bit more chop on the margin front. And does sort of feel like a push from an overall kind of blending of that message? Is that sort of the best kind of near-term takeaway from that?

Yes. I mean let's not overreact in terms of some choppiness on the margin side. We know what caused it, and it's not endemic to the future demand profile of the portfolio. We're just going to have to take it for a while because we don't have the luxury to wait until it unwinds and stop shipping things. So -- because we've got to meet customer requirements. So look, to us, we're not backing off anything. There's lots of levers to pull. It's a bit choppy, but I don't think that makes us unique. Backlogs are very good. We will get beyond Q3 and a portion of Q4, and we believe that we've got margin accretion opportunity for '22.

Awesome. Well, I see we're out of time. We'll leave it there. Rich, I appreciate the time as always. I promise we'll do it with a cocktail and a better tan next year.

Thanks, Josh. Good to see you.

Like wise. Be well.