Dover Corporation (DOV) Earnings Call Transcript & Summary

Okay. Welcome to the afternoon session or the morning session, if you're in the U.S., I'm Andrew Obin, I'm Bank of America multi-industrial analyst. We are in day 3 of our Global Industrial Conference, day 1 and day 2 were in person, day 3 is virtual. I am still in London, but joining us we have Rich Tobin, President and CEO of Dover. And we also have Andrey Galiuk, Vice President, Corporate Development and Investor Relations. It's always a pleasure to have Rich at these events. Thank you so much. So I think the idea is like we're going to go into a fireside chat and let's see what Rich tells us.

So I guess the first question I have for Rich is on inflation and pricing. How long lasting do you think higher levels of pricing will be for U.S. multi-industrials? When supply chains -- even when supply chain is clear up, do we go back to 1% to 2% pricing like over the last decade? Or are we in a higher range of 3% to 4%?

I hope the former and not the latter. I mean, there's been a significant amount of price that is -- has passed or is about to be passed depending on backlog liquidation into the marketplace. And I think that right now, demand is trumping supply. So there's an ability to do it, which is good. So I think that there's a lot of question about price realization and price cost going into '22. I think that we've got a good view on the fact that we were negative in the latter half in certain products and or certain segments in '21 and that we expect based on pricing actions that we have taken that we move into a positive position in '22, which is reflected in some pretty robust EPS accretion that we've got year-over-year embedded into our forecast. And that's all nice. But I find it concerning that there's a view that this can go on, meaning that if inflation goes on at its current pace, that there's going to be an ability to continue to price it -- to price for it without that having a detrimental impact on demand in the future, which is really now a '23 question, but it's my job to think about '23. So we're trying to manage it as best we can, and hopefully, with actions taken by the Fed and maybe with the geopolitical situation, hopefully improving that inflation will begin to come down because capacity is ramped appropriately globally to meet demand. And if that's the case, we can thread the needle here and we go back to lower inflation and then the pricing would reflect that.

Got you. And just a follow-up question on wages and labor supply. Look, I know you think the wages increase will stick, but what about U.S. manufacturing labor supply over the next 1 to 2 years? Are we in a structural shortage of workers? Or have you seen an improvement in labor availability recently? And I was riding on the subway or on the tube with a friend of mine last night, and that's exactly the discussion we had, right? And the point was a very knowledgeable person I'm sure was going look, I understand the commodity market, I understand. I don't understand where all the employees have gone and why they're not coming back. So a simpler version of this...

I've had many of the same conversations with our business operators. So we just don't -- at certain points during the year last year, we were like, well, what happened even to what was an engaged labor pool prior to COVID seemingly had disappeared. The good news is now that Omicron is behind us that labor availability has improved dramatically from January to February into March, which is terrific. Additionally, the fact remains that inflation is going to drive participation up in the workforce. For the family household has to put more units of labor to work now to deal with the fact that their own input costs are going up significantly. So that is going to -- some of this labor that went missing, I would argue, is now going to come pushing into the available labor force because it needs to accommodate higher costs for power, cars, fuel, food, everything else. So I don't particularly like the reason why it's driving the availability of the labor, but it is making labor more available than -- significantly more available than it was even 2 months ago.

Okay. And are there discernible differences in labor inflation rates in U.S. versus Europe? And what about other regions?

Yes. I mean, well, I mean, it's a reflection -- it's a reflection of inflation, #1. So you've got a higher rate of inflation in the United States than you have in Europe, which is a function of growth rate also because of the disparity in terms of the growth rates. We don't have a lot of assembly businesses in Europe. So labor as a percentage of COGS is different for Dover just based on what our profile is. So it's -- a lot of the labor that we have in Europe is upper-tier blue-collar labor, so trained machinists and the like. So you see some inflation there, but those were a, available and highly paid. So the labor inflation that we've seen has been at the assembly labor category and as a percentage basis because the rate is lower, the percentages are higher. It's just a small math issue. That's all been baked in. We had to do that to attract the labor in '21. We don't foresee significant inflation in labor costs in '22. So significantly less than that's been baked into our forecast that we had to incur in '21 just to get the labor.

And maybe sort of the next point is automation. I think at the recent Analyst Day, Honeywell said they're doubling their own spending on automation in '22 and will double it again in '23. Dover has been at this for some time, spending $45 million in automation CapEx in '22. Do you think that number goes higher over the next few years?

For Dover, yes. I don't think it's going to go materially higher in terms of spend. But I think the drivers of automation are intact with the inflation of labor. The fact remains is that automation, returns on automation projects that are done successfully have gotten better. That's just the raw math because of the labor inflation that's come into the system. Do you -- and -- but that had already been in place because we've been saying for several years that reshoring of supply chains is a thing. And if you were to do so, if you think about low coming -- the wave of low-cost country supply chains, largely was driven by raw materials, pricing and labor arbitrage. That labor arbitrage is now unwound in a lot of emerging markets. It has been distorted now because of the high cost of logistics that we've just incurred over the last 24 months. So to the extent that reshoring takes place, you are not going to put in a high labor content model. You're clearly going to leap 20 to 30 years ahead because that labor arbitrage model does no longer exist to a certain extent. So you're going to -- we believe that we're in a multiyear CapEx cycle driven by kind of the reshoring or dispersion of supply chains. And because it's 2022, you're not going to put in a 1980s plant, you're going to put in a 2022 plant. So that is going to drive CapEx spending and our automation because that's what's going to be put in.

And is there -- what's the gating factor internally for you in terms of sort of more rapid adoption of automation? Is it just your plants already set up a certain way, and you can't do a rip and replace or implementation is complex? Or the technology that you need is not mature enough? What are the drawbacks of accelerated automation spend? You get rid of flexibility, so more fixed cost, I just would love to hear sort of the other side of the story.

Can I say all of that? I mean -- it is -- I mean each project has got its own rationale whether it's pure cost savings or whether there's a quality aspect to it or anything else. The bottom line is that Dover primarily operates medium- to small-sized companies in market niches where the TAM is small for an industrial company. We love those businesses because market structures are rational, and that's a -- which becomes a function of the profitability, but so volumes are generally discrete volumes. I mean in order to automate, you need some amount of scale in terms of unit volume before you get there. A lot of our portfolio already is automated, right? So any of them that requires a machining center de facto was automated, right? And so what you do is you have 1 operator that 10 years ago, it was a single operator per machine, 5 years ago, I'm getting numbers wrong, it went to 2:1 and now it's 3:1, and you get to 5:1, can you get to 10:1, right, in terms of the labor content there. So each of them is driven by different rationale, but you need scale in terms of the demand in order to really drive big CapEx for automation. But consumer good companies, by the nature, right, are high unit manufacturers of consumer goods. So you would imagine the same with auto, same in those industries, we're a discrete manufacturer. So it tends to be all over the lot.

Got you. So maybe the next thing we can hit up is software we're -- and we're thinking about the software business, I think last week, I think it's a hidden gem. But maybe -- and thank you for helping us sort of learn more about it. But can you update us on software as a percent of total revenue? How would you characterize your software strategy? And where does Dover have a right to compete and when? And just as importantly, where do you not have a right to compete? Again, where do you not participate?

Yes, sure. It's about 6% of our revenue, pure software right now, which is twice the size it was a couple of years ago, but still not overly material in terms of our revenue stream.

Maybe you should [indiscernible].

What's that. Yes, yes. Every industrial company is becoming a software company. But we look at it in a two-pronged way, right? And we look at it as an adjacency to market participation that we have where we believe that it adds value to that incumbent business. So let's pick probably the most -- one that seems incredibly boring, but it was actually incredibly successful. So we build truck bodies for the waste industry. Seems like, all right, you're cutting metal and you're welding it together, and it is what it is. Well, the management team there, 4.5 years ago or so, branched into software because it understood the challenges of the waste industry around safety, primarily at its onset, but then where the industry was moving in its ability to do dynamic pricing and pricing on weight load and overfill and everything else. And we generated a significant amount of revenue growth through those by adopting that software strategy and it added value to what I think the market participants would think is -- it's a capital goods business, and it really -- does that thing ever grow and what can the margin possibly be. So that's using software to change the dynamic because you're delivering a productivity solution to your incumbent customer base that they didn't have before rather than looking at you as just a supplier of the capital goods. The other way that we're -- so we do that by operating company. So we've done that in car wash, now we do the software systems that control the car wash and the payment and the loyalty and everything else. We've done it in a variety of places. And that's, let's call that the adjacency to the incumbent businesses where we have the right to [Audio Gap] so we've built up an e-commerce engine here on a Dover scale, [Audio Gap] okay?

I think you're back, yes.

All right. We built up an e-commerce engine on a Dover scale, we believe that this program is possibly the single biggest source of center-led productivity that we have for the next 3 to 5 years. And this is basically the -- like a significant portion of our revenue is sold through distribution, which lends itself to e-commerce platforms. So it's not just the cost of transactions coming down, it allows you to do SKU management centrally on a global scale. It allows you to do pricing management on a global scale where you can imagine these smaller companies were doing it regionally and disparately, now you get the -- so to the extent you can load these thousands and thousands of common transactions on to an e-commerce platform that allows you to increase total productivity, whether that be absolute earnings or working capital significantly over time. So we spent a lot of time and money building that engine. We did $1 billion of e-commerce revenue in '21. Our goal is to get $2 billion in '22. We have some internal debate of how long is a piece of string. But I believe we're looking at the possibility of $4 billion to $5 billion of revenue, of incumbent revenue, that we can get on these platforms over time.

That's fantastic. And I guess that sort of takes us to cost takeout. Does the current operating environment make it more challenging because this is clearly, I think this whole IT thing was clearly, we did not appreciate how significant it is and I think how significant the shift to e-commerce and adoption of software just it's big enough at this point where it actually is moving the needle. So that's clearly a key initiative for you. But that aside, does the current operating environment make it more challenging to take down structural costs with orders and revenue growth you're expecting in '22? Have cost takeout plans internally slipped on your priority list? And do you just automatically maybe shift to driving more e-commerce, more software, does the game plan change given what the world looks like or what can be done in this environment?

Look, we believe we can do it concurrent. Clearly, because the demand function is so high right now trying to do a factory consolidation has got different good problems that need to be managed. The fact is, though, because of COVID, doing any kind of footprint moves was incredibly difficult, right? You couldn't bring in outside contractors, you couldn't move kind of our expertise around the globe to undertake some pretty complex projects. It's not as if we did none during that time period. But due to COVID, we had plans in the pipe that we had to defer just because we couldn't move the people around and all the complexities during that time period. I think we were [ arguably ] working on other things. But -- we still have programs in the pipeline. We will undertake some of them in '22. But to your point, I think we need to be careful to manage it because right now, the fundamental problem that we have is producing to meet customer demand that's already in backlog. So the last thing we want to do is screw up with not having that ability to produce right now. But we will undertake some in '22. These are pretty big projects so they will roll into '23. Concurrently, we're actually expanding capacity in a meaningful way in several of our businesses because we've got a view that this demand that we see is structural in nature. Clearly, the backlogs are driven because of supply chain constraints. But we -- then there are certain products and businesses where we are going to be expanding capacity meaningfully through '22.

Got you. And maybe to shift the gears. M&A, clearly, Andrey is earning his keep more and more every year, particularly given the starting point. You have a very robust M&A practice at this point. So -- and I think people were not expecting this from you, right? Because all of a sudden, this capital allocation story through M&A which, in my view, is actually quite critical to sort of high multiples for these diversified companies, you clearly see the flywheel starting to go here. So congratulations. But so in '19, you did 3 deals for $200 million; 2020, 6 deals for $300 million; and last year, 9 deals for $1.1 billion. So how do you think about M&A as part of the growth algorithm, right? Should we now start including M&A, adding 1 to 2 points of revenue? Or should we think of your M&A strategy as more opportunistic and less algorithmic?

That's a good question. We are not going to buy something to meet whatever is modeled in our demand for inorganic revenue. I think that's a dangerous -- we can model capital deployment any way you want it in the outer years. And I mean, the safety way to do it is to say I've got a view in terms of revenue and profit expansion so that generates this amount of free cash flow. The safety way to do that is all excess cash is invested in capital reduction as -- and that's the EPS enhancement. Now in the terms of hierarchy, our hierarchy for capital deployment is organic investment, inorganic investment and capital return. So let's put the dividend aside because we're never going to break the 66 years of track record that Dover has established. I'm not going to break that while I'm here. So that's almost a given on the dividend side. But so let's talk about excess cash minus dividend. We got some stick back in '18 and '19 of we're going to become more capital intensive. And I can just tell you that the returns on our organic investment have been superior to anything that we've done inorganically, and it should be when you think about it, right? Because you're basically building up a new revenue stream in a lot of those cases. And so you're not -- you're not paying for future revenue and then you're getting returns on whatever the incremental, whether that's synergy or excess revenue growth. So we're not afraid to spend organic capital, and we don't think it's a criticism when we're so-called capital intensive because the returns on that organic investment are then reflected in our portfolio. We've tried and Andrey could tell you [indiscernible] to be significantly more active inorganically over the last 36 to 48 months. But the fact of the matter is that valuations because of a variety of factors were quite high, right? We were coming off what -- 2 years in a row of record M&A [indiscernible]. And when you have that amount of tension added into inorganic investment, it drives up expectation in terms of purchase prices. So we've had to walk away from a variety of different deals because we did not feel convinced in terms of the returned thresholds associated with it. So that -- because of that, by its nature, we are going to be opportunistic in terms of M&A. But I'm very positive about the management team. I'm not talking about the executive management team, the management team of the operating companies and their ability to execute on M&A because of all the hard work that they've done, which has been reflected in the operating margin over the last 4 years. So in terms of -- M&A is 2 things. It's valuation, and it's a convincing story, right? Valuation is rote, and we can do that here centrally. It's up to operating management here to come and make a compelling story of what they can do with that inorganic investment. And I think that, that management team at that layer has proven that we should be deploying inorganic capital to them.

And just a question, as you think about M&A, and as I said, it does seem you're one of the few companies actually that does have a successful internal software sort of growth strategy that's working. I think the question I always ask industrial companies, right? I think industrial investors always focus on return between 3 to 5 years. And some of the sort of more growthy initiatives, you really start getting payoff in the years 5 through 10 and even beyond. So as you guys -- you are a traditional industrial company, you have been able to sort of achieve scale in software relatively -- relative scale, okay? But compared to your competition, and it seems to be successful, how do you guys do capital allocation between sort of traditional CapEx projects that are more traditional industrial versus more growth-oriented, both M&A and internal capital deployment. How do you think about that?

Yes, I mean, we like to buy existing earnings because existing earnings are a reflection of brand equity, installed base and market position. So which lends you to more mature companies at the end of the day, especially in the Dover world, I mean, some of the bigger ones. So our bias is there because those are companies that we understand and we know how to run. We will take smaller bets on emerging technologies and pay crazy multiples if there's a convincing argument that, that emerging technology provides a platform of growth that's adjacent to a market position that we already have. right? So we don't get hung up on -- Dover trades at -- I don't know where we are now -- at 16x EBITDA. So we can't pay over 16x EBITDA, forget it, you know what? If we -- if there is a convincing argument that the company has [ no earnings ], but the convincing trajectory for market acceptance is clear, then we'll pay the appropriate valuation. Having said all that, I find it highly unlikely that we would ever bet the balance sheet on something like that. We would tend to make those opportunistic single product category platforms as kind of free options that doesn't blow up the company by taking a big swing to chase some theme or to transition the company into higher gross margin and more recurring revenue or whatever of the theme du jour that happens to be out there.

No. We're big fans of your M&A strategy. You guys have done a lot of progress from basically standing [ solid ]. So congratulations. So maybe we can talk about synergies. The recent Clean Energy acquisitions came, was [ planned ] for, 700 bps of [ plus ] synergies. So first of all, have you got any more details on the time line of that? And second, if we think about the total portfolio, are merger synergies a meaningful tailwind for '22 and '23?

Yes, I mean, it's early days, right? I mean the -- and these are 2 companies that were growing their top line and expanding the profits. So the last time I was just at one of them on Monday. The last thing we want to do is go and extract synergies and ruin a good thing. So I think that we need to be somewhat deliberate. We do have a playbook that we've discussed before, right? What we are interested in extracting synergies from any business, including our own portfolio, is to take away all of the noncustomer-facing activities within these companies. So all of the [ APAR ] processing, all the insurance, all the IT, all of benefits administration, all of expense reporting, right? We have a Dover engine that has processing centers to do all of that. So we deliberately over time take that out of the operating company, and it's a twofold benefit. Yes, there is an argument through scale that we do it more productively. But the real benefit is that the management teams now who had been in these small companies focusing who knows, 30% or 40% of their time on noncustomer-facing activities, now spend 95% of their time on product development, manufacturing and understanding the customer. And that we've proven has a direct impact on the top line. So it's not just cost saving, it's changing high-quality management's time less being administrators and more concentrating on what they do best in terms of working with the customers, solving the customers' problems. So I have every reason to believe that we'll meet the synergy targets that we had in the deal models of those 2 last acquisitions.

So shifting a little bit, CO2 systems on your Climate & Sustainable Technology segment. Can you explain what is driving the adoption of CO2 in natural refrigeration systems? Seems to be the first thing that comes out in the Hill PHOENIX website. How did [indiscernible] over today and what's the shape of the adoption curve?

It's the fastest-growing portion of that portfolio. I think that, that business is not well understood. I think everybody thinks that it's the traditional refrigeration cases that we see in supermarkets and retail operations. That is we've got -- we're one of the largest players in North America in that particular product line, but we also are a material participant in the central systems that basically run all of the refrigerant delivery into that installed base. Many years ago, Dover bought into CO2 in Europe, a company there, a company called Advansor in Denmark, that's been highly successful in Europe, a market share leader. And that type of system because of the regulatory environment, we believe is going to be increasingly adopted in the United States. We've got one of the largest installed footprints in the world in CO2 systems. So we've got credibility as a supplier there. So we are transferring that technology and manufacturing to the United States as we speak. State of California has adopted that for new builds of a certain scale, but we believe that, that is going to be the winning technology, whether it's driven through the regulatory environment or the ESG environment and we are scaling up to seize that option.

Got you. So maybe margins with the portfolio changes in the Climate & Sustainable Technologies segment, are mid-teens margins build the right target and assuming some easing of supply chains, should we start to see the benefit of the automation project start to come through in the second half?

Yes. I mean we're not -- look, this is the year we're going to get to mid-teens. Whether we get there on a full year basis after a tough Q1 because of Omicron, we'll see. It's in our sights to get there. But we'll hit there during the big production quarters of Q2 and Q3, we'll get to mid-teens and that -- let's get that under our belt. Let's scale on the CO2 side. I just want to hit those margins because it's the one target that we laid out in 2018 that we have not achieved. And this is the year that we're going to do it. And then once we do it, I think we'll have a better understanding of where we go from there in terms of realization of margins in the following years.

Excellent. EMV, I know how much you like this question, but Dover Clean Energy & Fueling segment has always been more international, more diversified versus peers. And the recent clean fuels acquisitions make that even truer. Look, the U.S. fuel dispenser business is only 3% to 4% of total revenue by our math. Now with all that said, your largest competitor is guiding for a meaningful drop in U.S. dispenser sales in 2023. So a very simple question. Do you share that view?

Well, we share the view that the EMV deadline for North America, and it was only North America, was reached in 2020. Absolutely. Our model of the EMV runoff as it relates to revenue, we were spot on in '21. So what we had built into our forecast for the impact of '21 was spot on. So I'm not in a position to say that we're wrong about '22 because we did not over perform in '21. So -- but it was -- this whole EMV question is never that dramatic of an issue anyway for us, because that is a segment with $2 billion in turnover, and we've been very public about the participation of that market position that we had geographically and transparent in terms of the margin there that we had always said that we are not -- we'll talk about the cycle, but it was -- it's just -- it's manageable to us in terms of dealing with the transition. And now if you -- and it was -- and a recognition of that transition has been reflective of what we did from an inorganic point. That segment gets -- there's a view -- a thematic view of that segment that it's exposed to [indiscernible], it's got structural decline built into it. And we're not denying that, that there is a transition to a variety of different fueling sources and there's transition in terms of our retail customers on what they want to do with their footprint in terms of their ability to monetize their retail footprint. So we've been working with them for many years. It's the reason that we doubled down the car wash years ago. It's the reason that we got into hydrogen dispensers last year. It's the reason for spending $900 million in inorganic investment. So we recognize -- we have recognized this issue of EMV all along, this incessant discussion about sizing it year after year isn't really helpful because we believe that the top line of that segment is going to grow over time. And what we've just brought in into the segment is margin accretive before amortization costs that we feel really good about our position.

Excellent. So last question. I'm trying to decide which one to sort of give you. I'll give you a good one. Let's talk about biopharma. Within Pumps & Process Solutions you had very strong growth last year in the biopharma business. You are adding capacity. What gives you conviction in the durability of demand because you did have some COVID vaccine lift in there. But the last question probably ending on a positive note, if you can talk to us about your outlook for biopharma this year, but also more importantly, longer term.

Okay. The most important thing to understand is these are single-use products. So it's not as if we've built this big installed base out there that before you go into replacement, it could be 3 to 5 years. So other than the inventory that's not been utilized in the channel, everything that we've shipped into biopharma is gone. It's been processed. So that's kind of a little bit of the beauty in terms of the participation is that it's single-use. I -- we get this question a lot. Look, there is a change in the manufacturing process due to the growth of biopharmaceuticals, which are smaller batch in size. And I would point you to anybody that's got a participation in the manufacture of either, the manufacture of or the utilization of biopharma processing [ skids ] and that technology and what they're saying about capacity expansion and what they're saying about growth into the future. That is a proxy for the demand of our products because we are a subcomponent into that ecosystem.

Okay. That's a great answer, and we are out of time. Always a pleasure to have you. Thanks so much. And hopefully, we'll get to see the team in person soon. Thanks so much.

See you Andrew. Take care.

Thanks a lot.