Dover Corporation (DOV) Earnings Call Transcript & Summary

Good morning, everyone. Thank you for joining us. Welcome to the 52nd Baird Industrial Conference. My name is Mig Dobre. I'm the analyst covering machinery and diversified industrials. It is my pleasure to introduce to you today Dover Corporation. As you might know, Dover is a premier diversified global manufacturer. We're happy to have with us CEO, Rich Tobin, for an update. Rich, welcome. It's great to see you in person. Great to be able to do this again.

Happy to be here, Mig.

Excellent. Well, as we get going into our discussion, I want to remind all of you that you can submit questions by e-mailing session 1 at rwbaird.com.

And with that, maybe I'm going to start, Rich, with -- mic check. Okay. All right. You can tell this is the first session. We haven't quite figured out the microphones. All right. So I don't know how much of that you have heard. But since we're getting going here, I wanted to remind you all that you can submit questions by e-mailing [email protected]. So Rich, maybe I'm going to start with the most obvious question that can be asked. Give us maybe an overview as to how you see demand evolving. I know you reported recently, but you managed to close here another month. So if there's any update, we'd love to hear it.

Well, I mean, let's separate the difference between the numbers that get discussed endlessly in terms of backlogs and book-to-bill versus kind of just aggregate demand in the marketplace right now. It remains solid, but there's an air of caution in talking to our customers about moving into '23. So right now, we don't see any significant slowdowns. We don't see any cancellations. We saw some slowness in our above-ground fueling in the quarter, which we expect to remain the same through fourth quarter. But that's really the only portion of the portfolio. But I think it's fair to say that this period where we've gone through of our customers trying to get as much product as they can and being really worried whether we can make the deliveries, that period is over. So we would expect backlogs to normalize as we move into '23. And I think that -- justifiably so, I think that there's an amount of caution across all of the industries that we participate in because of raising -- rising interest rates and whether we're going to go into a recession or not. So as I mentioned at the close of Q3, we are adopting that same stance. So we are cutting production to manage inventory levels going into '23. We believe it's appropriate to do that because supply chains repaired themselves enough now that, look, if demand accelerates into '23, which would be a great scenario, we don't have any fear about not being able to get the subcomponents or the labor to ramp production. So we think it's the prudent stance to take between now and the end of the year.

Understood. And as we've gone through the reporting, we've certainly seen this dynamic where maybe shorter lead times are resulting in customers adjusting their order patterns. As you're looking at your business, how much of that is a factor of maybe the decline in bookings relative to the cautiousness and the macro? I don't know if there's a way to sort of separate those elements.

No, I don't think you can mathematically solve it at the end of the day. But I think that we would have naturally seen backlogs come down even if demand was to remain constant through '23 because there's just no need to be ordering 8, 9 months in advance anymore, at least, on the short-cycle portion of our businesses. There are certain categories of our business where it's make-to-order and hence these businesses will always carry longer lead times. So you really have to separate it as you go through the portfolio itself.

Can we get another microphone here? Sorry about that.

Yes, no worries.

And you touched upon something that I wanted to maybe take a closer look at. Your consumer exposure versus maybe the industrial businesses that normally operate with longer lead times, more of a backlog dynamic, perhaps you can differentiate that a little bit for us as well.

Yes. We're neither a -- I'm going to have to speak -- okay. Well, I mean, I think that you'd have to take a look at our portfolio as relatively diversified between long cycle and short cycle. And I would call your attention, if you take a look at our Q3 earnings release, we tried to graphically represent that by showing you pre-pandemic backlogs versus today's backlog, that there are certain categories of business that are never going to build backlogs just by the nature of the customer and the demand. And then there are certain portions of the business where you think about the Maags and the Belvacs of the world, where we're constructing bespoke pieces of equipment for customers, and in order to do so, you've got to order those traditionally 8 or 9 months in advance. So we're not -- I don't think we can fall into either bucket between long cycle and short cycle.

This is not awkward at all, by the way.

Not going to sit on your lap. Go ahead.

I actually think your microphone is working. I don't even know where to go from here, actually. All right. Well, that's helpful. One argument I think some folks have made or a dynamic that we try to understand is whether or not higher prices are leading to demand destruction. We're getting to the point where we're seeing that effect on the marginal buyer. And I'm curious, I know that pricing probably varies across your segments, but I would imagine that you have some where the pressure -- the upward pressure relative to the historical norm has been significantly higher. I'm thinking something like a refrigeration, for instance. So I'm curious, what do you think of that dynamic and what's at play here?

I think it's more caution right now in terms of the macro for '23 rather than a notion of, "I think prices are going to come down, so I'm going to wait until prices come down," right? Just because we're a subsupplier into the industrial marketplace as opposed to a whole good supplier, I mean, we don't have any consumer exposure whatsoever. So I think that there -- it's more a macro caution rather than, "I'm going to wait for prices to come down," from what we can see today.

Understood. Maybe one last question around this. It's interesting, as I was doing my prep work for this discussion, I was reading back some transcripts from prior conferences and appearances that you've had. And you've been pretty consistent in saying, "Hey, the sell side is not perhaps as constructive as it needs to be in terms of our organic growth potential." And I get it, there's some cyclical concerns that we're seeing right now, but expand on that, if you would. I mean, what do you think is structurally different at Dover now versus, say, the pre-COVID era?

Well, I mean, I can't -- I don't think it's worth talking about pre-2018, not just because I became the CEO then, but that was the period when Dover had a much larger exposure to oil and gas, which, as we know, highly cyclical. So we just got to the point where the tail was wagging the dog, to a certain extent. For whatever reason, I think that dynamic has always held in terms of people looking forward outside the forecast here of the organic growth rate of the company. I think that it's 5 years in a row that we've beaten that growth -- that implied growth rate that's in the DCF models of the valuation of the company. So I mean what we see is we'll wait until February. We'll come out and give the guidance, everybody will model in '23's guidance, and then we'll be bottom quartile for '24 if things hold appropriately. Despite the fact that if you look over a 5-year period, we've been no worse than top [ X ] and in several years in top quartile in terms of organic growth.

Understood. But is there something that you can highlight in terms of either the product development process or vitality or anything of the sort that would sort of make it different on a base business relative to what we've seen in the past? And I get it that oil and gas is not part of it anymore.

I know, but I think that if you look at portions of the core business, they have grown better than bottom quartile, right? So Markem-Imaje has grown, along with its base competitors. I mean it's not really difficult to understand, other than the fact that most of the competitors in the portfolio at Dover are not publicly traded companies. They're private companies. So discovery on the comps becomes difficult at the end of the day. Now arguably, that's in a better position to be in because, by and large, the individual companies within our portfolio are in niche industries that are highly concentrated. And that gives us an advantage because of the fact that all of those smaller companies who are competing with private companies have access to the Dover balance sheet, which allows us to be arguably more aggressive. So when markets are moving in the right way, we can invest behind those markets in a meaningful way. So let's talk about -- I'll give you a particular example. So I know that all the HVAC guys are talking about heat pumps. Well, that's been going on in Europe for several years. We produce brazed plate heat exchangers that supply into that market. We're one of the market leaders worldwide. We believe that, that's got structural growth. And because that's a highly concentrated niche market, we're in a position where we can expand for production sites worldwide on the back of what we believe is that structural growth. So that's -- but that scenario applies to all of the pieces of our portfolio. It's the same thing that we're doing on CO2 refrigeration units that is in our Refrigeration business. That is a European technology. It's been legislated now in California. We believe that, that -- the adoption rate for that particular product is going to be significantly larger over a long duration of years in North America. And so we basically have the technology, and we've expanded our capacity in North America significantly over the last 12 months. So that's really the business model, and it applies to how we run the individual companies, and it actually applies to how we look at M&A also. We like -- we look at market structure and we look at the competitive environment because we believe, if we get that right, we can extract disproportionate profits.

I want to take a question from the audience here as well that was e-mailed in, and it's really surrounding price/cost. Maybe a little bit of commentary on that into '23. And the question is really pondering the sustainability of pricing into '23, and whether or not, especially in the back half of '23, we're starting to see whatever benefits accrue starting to weigh in on that.

Yes. I mean, I've heard a lot of people making statements about never reducing prices. Again, I find that interesting. Look, at the beginning of '23, it's going to be a tailwind. So if you go take a look at our results in the back half of this year, what we've been saying all along is, on the businesses that had raw material exposure on the capital goods portion of the portfolio, let's call it that way, that we had to cycle through inventory. So you basically had high-cost inventory and then you had pricing, we said, in the back half of this year, you would see that cycle through. So if you take a look at the margin performance of our Engineered Products segment in this particular quarter, I think they're up 500 basis points. So that is the flip, right? So the inventory -- the higher-cost inventory is cleared. The pricing is sticky. We expect that dynamic to go through the first half of '23. And then back to your other question, we'll see what happens to market demand. If market demand is to shrink, I would expect -- and raw material costs are -- do not accelerate in '23, there's going to be some give back on price, for sure.

And just a follow-up here. Do you think that the market has -- demand has to shrink or normalize? Because we're already seeing that normalization.

Hard to say. Again, we're a niche supplier with not many competitors. So it's not a question of we get one of these situations where you have a rapid -- everybody tries to grab market share through price kind of scenario. I don't foresee that happening in any of the businesses. The fact of the matter is, our customers know that raw material prices have come down. We're having that conversation with them all the time now. And we're basically saying to them, "Hey, wait a minute, we ate it through the end of '21 and the first half of '22." We get it as this rolls through, and we'll see where we find some kind of equilibrium. The X factor is going to be what is demand in '23 going to be? Is it going to be down? Is it going to be flat -- in a flat scenario? Probably have the opportunity to hang on pricing more if it's down, then we'll see what happens within the competitive environment. My inkling is when there's a -- when raw materials is a significant portion of COGS and the raw materials -- let's just pick one, steel base, if you will, some of that's going to have to come back. Weirdly, if managed correctly, it's positive to margins. It's negative to revenue. And there's an argument to be made that it's positive to margins because if you look at margins over a 12-month cycle, you went negative to positive. Generally speaking, we are marginally accretive price/cost on a 12-month rolling basis, which is to the detriment of margins. Because you get all that pricing and revenue and if you're basically even or slightly accretive, it's dilutive to your operating margin. So I mean, I think -- look, I think it's manageable, but I think this notion of pricing is never going to go -- come down again. In an environment where raw materials are coming down, I think that's naive.

No, that's great color. Sort of sticking with this margin theme, maybe let's talk a little bit about your restructuring. You've announced that in your dispenser business. Is this the first of other actions to come? I think you hinted at that on the Q3 call.

Well, I mean, on the dispenser side, it was going to happen in '23. We've been preparing for post EMV for several years now because of accelerated -- the demand has accelerated a little bit in the back half. We've got a very flexible operating model. We just pulled the trigger on what we're preparing to do anyway. So we've announced what the total is there. I think that there's more to come, but that is going to take some time because we're talking about doing some interesting things in terms of the consolidation of the footprint, but that takes time to manifest itself. What we've done in the shorter term has just taken structural cost action on the business. And I think if you look at our disclosures at Q3, we give you the roll-forward benefit of what that is from there. Having said that, you got to remember that between '20, '21 and '22, the COVID period and then the post acceleration of demand outside of COVID, it's been very difficult to do anything in terms of structural cost when we're talking about footprint. Just you couldn't do it during COVID and then you couldn't do it again because you're actually chasing capacity for the last 18 months or so. So we've got quite a few things in our pocket in terms of what we think that we can do to reduce structural costs. In any given year, the playbook for us is, here's our organic growth. Here's how we can convert that organic growth. What do we have in our pocket that is productivity? And when I say productivity, that's all-encompassing in terms of what we spend on CapEx to get productivity versus what we can take out in cost. We should have a bucket every year there. And then hopefully, we have another bucket that says we've been active on M&A. So when you do the roll forward year-over-year, you should be able -- the way that we manage the business is, we want to have -- if we do that EPS bridge, it's productivity and cost takeout, it's organic growth conversion and, hopefully, M&A in any given year. And then the X factor always is, to the extent that we're not doing M&A and we're generating a lot of cash is, what do we do in terms of cash return strategy. So in this particular year, because it's been difficult to do M&A, you see $0.5 billion in share count reduction and the benefit of that. So those are really -- it's a relatively simplistic model. It's hard to run at the end of the day. But if you want to step back and not dive deep, deep, deep into the portfolio, you can almost stand back and say, "Okay. I get the operating plan here is, if I get a little bit of this every year, I should be seeing mid-teens kind of returns on an EPS basis."

I want to come back to the footprint comment that you made earlier. But I'm sort of curious, as you think about the leverage -- the cost leverage that you have available in whatever sort of macro environment lies ahead of us, how much flexibility do you think you do have? Because the one reality that we all have to deal with are very tight labor markets and a lot of labor cost inflation. So presumably, you're not immune to that.

The labor cost has been baked in. We're talking about factory labor now. Let's separate kind of direct labor for us from indirect labor. The direct labor, cost inflation has been baked in since the back half of '21. So we took all of that kind of in the ramp period coming out of COVID. It's actually been relatively stable in '22. Now we have a bunch of inflation. That really applies to the white collar side of it. We'll see how that goes. But my personal feeling is, you're not going to see the labor inflation that everybody thinks that you're going to see, especially if there's a lot of caution about the macro environment and demand.

So the traditional sort of tools to respond, do you think, are still available to you?

We're not worried about labor, I guess, is the best way I can say it, either availability and/or cost.

Okay. On the footprint side, and I get that, to some degree, I don't want to front run the formal announcements that you guys are going to have. But conceptually, what is it that's still to be done here? Is -- and I ask it from the angle of all this discussion that we have around reshoring. Are you really part of that, and that's how you're approaching it? Or is there something else that you have in mind?

We've been a beneficiary of reshoring. But on the other hand, Dover does not have very long supply chain. So when I say that we've been the beneficiary of reshoring is, our customers have been arguably been buying more from us because, generally speaking, we produce and sell in-geography. So there's not a lot of movement. We have some that we can action, but by no means are we like an automobile company or anybody else with big, long supply chains and that like. So I think it's been to our advantage that we're a local producer. What we're doing is different. The -- what I say around Dover is we still make the first product that we ever made. And we've been doing a lot of work about SKU reduction within our portfolio, and we're beginning to see the benefit of that undertaking. So when you take a look at the margin performance in the Vehicle Services Group, for example, one could say, well, it's post lifts and wheel changers, and that's kind of interesting, but not the most interesting business. But at the end of the day, we're lifting the margins significantly by the fact that the management team there has been doing a ton of work on brand consolidation and SKU, and that feeds right into our performance on the manufacturing level, reducing our costs significantly. So there's lots of ways to skin the cat. And at least, on the industrial portions of our portfolio, we've been doing a significant amount of work on SKU reduction over the last 36 months or so.

Before we run out of time, I want to ask a couple of segment-specific questions. And obviously, I think most folks have been talking about your pumps business. The life sciences exposure there, demand sustainability, how do you think that plays out? And I think the bigger question at this point is not demand sustainability as much as contribution to segment margin and what that means for segment margin as that business moderates.

Well, it's more than moderated this year. We basically came out of the COVID demand. This concept of over-earning, I always get a chuckle about, right? When the demand is there, I come from a world, you meet the demand and you harvest as much profits as you can out of it. . So that -- we're in a transition phase right now as we come out of COVID. But the fact of the matter is, in that particular business, it's winning the spec, which is the most important thing, right? And so to the extent that you're specified in the types of equipment that are used for the production of gene therapy and the like, we feel that our ability to seize market share during that run-up is going to pay us dividends over a decade or so. So we've got a bit of a headwind in terms of the top line, but I'm quite proud of the fact that our margin at the product level has not suffered at all. So we're still making very good margin. The inventory is going to clear out of the system, hopefully, by the end of the year or early into '23. And then when we get that, we expect demand to snap back. The underlying core business, even if we eliminate COVID demand, is growing in excess of 20% a year.

And the 30% margin is still something you're comfortable?

That's the 30% margin at the consolidated segment level is, well, comfortable. We're never comfortable with anything, Mig, but yes, that's the number we think that we can deliver.

Understood. Then I wanted to ask a little bit about alternative fuels. You owned LIQAL for a year. You got some hydrogen fueling exposure. So you've learned a few things about this market as an owner rather than just an outside party looking at it. What's the big picture here? What's the goal for Dover within this space?

Well, we did a couple of different acquisitions, right? We did LIQAL because we believe that LNG kind of dispenser technology is going to be used across a variety of different fuel types. We did RegO, and we did Acme because we wanted to have more exposure into, let's call it, the greater gas complex. Both those acquisitions have delivered more than we would expected in the first year. So they're businesses that I believe that we know how to run. Acme was almost a little bit of a free option on what you believe about hydrogen in the future. So we're still learning a lot about our participation strategy in that particular complex, but the amount of capital being diverted into that sector is what it is. So it's just for us to find our niche within that space. I mean we're not going to be -- we're not moving it to EPC. We're not going to be building big units there. We're looking for key components that have significant barriers to entry. And I think that between RegO and Acme, I think that we found a very interesting position that we think not only can we grow those positions organically, it also -- as we learn more, it's providing us some knowledge about adjacencies where I think that we should have the ability to compete.

Okay. I think we have time for last question, and I'll ask it this way. You were clear about organic growth, perhaps being underappreciated. So if we leave that to the side, is there something else that you think investors might not fully appreciate as far as your profit algorithm and value creation?

No, I think that we touched on it, right? I think that we've -- I think that we don't get the credit for the growth of the business. I think that our ability to improve margins and extract productivity out of the portfolio is proven. I don't think that we're, by any means, at the end of the runway. I hear sometimes as well, all that work that got done in 2018, '19, it's a one-trick restructuring pony that's far from the truth. And I think that we're showing you, going that into '23. So the algorithm remains the same. It's organic growth conversion. Total productivity year-over-year. M&A, when we can get it. If it's not there, it's going to be capital return.

All right. That's great. Thank you, as always, for the very candid comments and good color. Please join me in thanking Rich for his presence today.