Dover Corporation (DOV) Earnings Call Transcript & Summary

Good morning. We are here with Dover, and we have the company's CEO, Richard Tobin. We're big fans. Dover is one of our top picks. We think this is basically getting IDEX or AMETEK at a 20% discount with very similar performance, that's the pitch we have on Dover. And Rich, it's always a pleasure to have on stage. And Rich doesn't have any slides. So we'll just sit and we'll go into a fireside chat. And if folks have any questions, as I said, feel free to raise your hand in the middle of fireside chat. If not, we're going to leave some time for Q&A at the end. Thank you for being here. Rich, welcome to London.

Okay.

So maybe we can talk about -- we're going to jump into what's happening with the supply chain, right? So, when you think about the margin expansion you expect in '23, how much of a benefit is there from the non-repeat of supply chain issues? And not just on lower logistics costs, but disruptions on the factory floor?

There's some, but I don't think it's overly meaningful. I mean our -- we took the vast majority of headwinds -- forget the pricing element and just in terms of the availability of supply chain. In the end of '21, I think we carried some into '22, but it's been largely repaired. By and large, we are a proximity manufacturer. So our supply chain is in the same region that we manufacture the product with a couple of exceptions, which is generally in the electronics space, which come from Asia.

Got you. And maybe we can talk about price cost. Is the planned price cost spread in '23 higher-than-average benefit? And what are you seeing in terms of your own material costs so far in '23?

Price cost, we do not bake in any new pricing into '23. So it's carryover from '22, the bigger benefit we have is on mix in '23 rather than pricing.

Maybe we can talk about sort of -- which was a big focus for the -- your analysts, your CMD days, it's called here, sort of Pumps and Process margins, right, a big focus. So the Pumps and Process segment, '23 guidance is for flat revenue and margin, largely by destocking biopharma. Even with this pause, segment margins are up above 1,000 basis points since 2018. How do you think about incremental margins in the medium term for the segment? And we'll talk about growth opportunities.

Yes, I think that there's a variety of different pieces of the Pumps and Processes portfolio. Clearly, biopharma, we expect demand to bottom in Q1 and then begin to accelerate out of there. So it's the end or the ending of the destocking from all the COVID shipments that we had made at the time. Our base business in the biopharma space still grows in the double digits. So I think that the headline figures in terms of order rates should bottom end of Q1, maybe midway through Q2. So it will be a headwind for this year but then it will be really should turn into a tailwind. And then it becomes a question of whether we are the beneficiary of that in the back half of '23 or whether it rolls into '24. The balance of the business there is at not the same margin as the biopharma business, but very healthy margin of that portion of the portfolio, whether it's Precision Components, or plastics processing, or the industrial pumps, we expect to grow mid-single digits this year and should convert at gross margin of the segment.

And you are -- what's interesting -- I think what has been interesting about your strategy, it really has been a nice mix of M&A and organic growth. So you have added capacity. How should we think about incremental margin as we fill that capacity?

It will -- you've got a -- you build the capacity, so you're going to have to cover -- you have to cover the cost of that investment. So early on, you would expect sequential ramp over a 3-year period. So we talk about brace plate heat exchangers that go into heat pumps. We're expanding capacity globally by 50% this year. We would expect that to be at par margin in '23. And then to have robust incremental margin from there as we absorb the fixed costs that you've laid in with that capacity expansion. Same thing with CO2 systems. It will be positive incremental to the refrigeration segment in '23, but we'd expect it to inflect positively if the growth is what we expect from that investment side. So where we're deploying capital or where we talked publicly about greenfield capacity expansion, you would expect it to cycle over time with incrementals going up as your volume absorbs your fixed costs.

And maybe we are in -- your big focus on ESG. Maybe can you just expand on sort of SWEP and the brace heat exchangers, very exciting business. Wouldn't have thought there several years ago but -- and also CO2 cooling opportunity in refrigeration. Could you expand what are these businesses? What do they do? And what is the opportunity?

Well, brazed plate heat exchangers are a subcomponent that serves heat pump manufacturers. Heat pumps, in terms of the adoption rate, because of legislation in Europe, as you all know, since we're sitting here, has been proactive. So we're actually at a supply deficit in that -- into that marketplace. It's been wildly successful, both from an energy transition point of view. So if you go take a look at the market participants, our customers, in terms of the heat pump manufacturers, the amount of capacity that's coming on stream, if you believe everybody's going to be doing is significant, but we do it in partnership with our current customer base about what their intentions over time. And as I said, we're actually back shipping product into Europe from around the world. But we would expect over time, as we expand capacity, that we would be -- go back to being a proximity manufacturer. So we're expanding capacity in the Nordics, and Eastern Europe, and the United States, and in Malaysia right now. And we've got a mix between European-based companies to Japanese and Asian-based companies.

You're one of the market leaders in the world, right?

Yes, it's a pretty concentrated market in terms of the supply base.

And can we talk about the sort of CO2 opportunity? Because it also -- we've been getting a lot of questions about food and refrigeration, where you came in, big question, what to do with the business. I think interestingly, at your Capital Markets Day, you did state that it's very rare to hear a sort of a CEO of a diversified company say that all my businesses are actually firing pretty well right now. And certainly seem that food refrigeration is on that list. Can you just describe to the audience, sort of, a, operational transformation in the business that has taken place over the past several years? And what is the green opportunity in the business today?

Okay. Well, the vast majority of the attention of this business is what is your refrigeration cases that you see in retail food. That is the bulk of the revenue back -- if we go back to 2018. It was a market that was overcapacitized. And it really was, for lack of a better word, a body-building business where we buy components and we assemble them. So we'd have a significant amount of labor cost as a percentage of the bill of materials. So if you think about thousands of SKUs and a lot of labor in a market that has overcapacity, so the bad three vectors. So at the time, we put out some relatively aggressive targets in terms of improving the margin, the way that we've -- and we've succeeded in doing that with this past year. And the way we've done it is we invested in the business in automation. So we've taken out a significant amount of the labor cost as a percent of the manufacturing cost. We've reduced the SKUs significantly because you had to do that to allow for automation in the first place. So you're basically deep, complexify the product line. You take out a lot of the labor costs. And then you actually -- and we actually shrunk the size of the business because we basically said this is what the market size is. This is what -- let's capacitize to a scale where we think that we can maximize profitability. And as the market cycles up and down, we won't chase it up or down because the marginal -- the incremental margin on chasing that additional volume wasn't -- just wasn't worth the time. So it took us 5 years to do it. We lost some time during COVID. And now we basically have a business that generates mid-teens margins, consumes no capital. So it's return on invested capital's actually quite high. And it's a cash engine to be redeployed in the group. At the same time, we had bought back in the -- frankly it was 2009-ish, we bought a company in Denmark for CO2 technology that we bought into CO2 technology has been adopted in Europe. So we've got 14,000 installed CO2 systems into retail fuel -- in retail food. And that technology is now being adopted through legislation in the United States. So we've just basically taken that technology, and we've repurposed one of the older refrigeration plants into a manufacturing plant. The good news is because it's new technology, there's some IP around it that we were able to manage the amount of complexity from the manufacturing process, so we really only have four models that we're bringing to the U.S. And we expect that legislation to be progressively adopted. So we think it's an avenue of future growth that we really didn't talk about back several years ago.

Got you. So just to go back to sort of top-down view. Maybe pricing, which is another big sort of question. Your '23 guidance assumes no further price assumptions for '23. Looking at the world, we're sort of 3 months into the year, how do you address the relative probability of having a mid-year price increase? And how do you think about potential for price discounting in second half? What would drive -- what are the scenarios that would drive either of these decisions?

Sure. I mean, we do have pricing baked into '23, but it's roll forward of pricing that was progressively put in, in the previous year. So what we don't have baked into '23 is new incremental pricing over the top. Look, we're taking a cautious stance on pricing. Do I think this is another round of pricing coming in '23? No, I don't, right? Commodity prices have come down and labor costs have stabilized. We can all speculate on the macro and what's going to happen to demand there. But I think that we'll be opportunistic. But I think that in terms of the impact of gross margin, there'll be less price, more on mix in '23 and richness of mix. And that is a function of kind of some of the investments we had just talked about a moment ago. If pricing was to come down, I don't think that it's overly problematic. I mean if you go back and look over the last 18 months, you went through being negative price/cost and then you had it work its way through inventory and then you had to go positive price/cost. But net-net-net, we -- it's not as if we've been a massive beneficiary in margin because of price/cost. Our margins actually were slightly flat year-over-year because you had the top line effect of a lot of pricing and that is actually dilutive to margin if you're net neutral over a period of time. So I'm not -- I'm more concerned about the macro and what that does to demand versus our ability to manage pricing up or down in the marketplace.

Got you. And you sort of mentioned cost deflation. So what are you seeing on your mix of road maps and components? And are you actually experiencing input cost deflation in real world?

Well, not anymore, right? So you've got a lot of deflation on logistics costs at the beginning of '22. And then progressively, because there's an inventory lag, you saw it in raw materials through the balance of '22. Raw materials has actually been ticking up a little bit relative to exit '22, but not to the point where you're not mopping it up with this roll forward of pricing. So I guess it's a little bit of a wait and see. We're cautious about Europe. I mean Europe is about 40% of our revenue. Raw materials are tied to energy costs. There's an amount of subsidization that's gone through there that's buffered that impact. Where it goes from here, I guess we'll see. But again, I think it's manageable.

And maybe orders, I know it's your favorite topic. Sort of 3% to 5% year-over-year organic revenue growth suggests an improvement in second half of this year. That would seem to imply that orders bottomed sometime in the first half. Is that consistent with your framework for '23?

Yes. I mean I know everybody gets all caught up with orders and backlogs and everything else. We would expect and we see that backlog is slowly deflating in an orderly fashion because supply chains repaired themselves, and there's just no rationale to order a year in advance for a product that generally speaking, had in some cases, anywhere from a 6- to 12-week lead times. So you would expect or as backlogs come down, you go a little bit negative orders; backlogs come down and then you get to a stable position. Right now, we were concerned that if we were going to have a slow start to the year that orders would be just optically problematic in Q1, we actually don't see that. So our orders have held in quite nicely, which is a pretty good precursor of what we can expect, barring something getting upset in the macro for the balance of the year.

So the order saga might be over?

We're one of the few that reports backlog orders and book-to-bill, in retrospect, I guess, we wouldn't. But if we take away anything now, it's going to look like we're hiding something. So I guess we're just going to have to deal with that forever.

So let's sort of talk about portfolio management. Sort of in your time as CEO, you've been active on both acquisitions, in around $2 billion, and divestitures, [ $400 million ]. You have an active acquisition pipeline. Can you just talk about the environment there? And also, obviously, what do you think about potential divestitures? And as I said, you made it clear at the CMD day that actually you're very happy with your entire portfolio.

Yes, there's a lot of different ways. Let's deal with the current environment. We are generally a buyer of private companies. So we don't do a lot of public transactions. You went through a period where public valuations came down in '22. There's generally a lag effect on private valuations because you've got a little bit of sellers remorse. So we weren't that active in '22 because we got to the point where pricing was peaking out because of free capital. And then we went through a lag of, gee, I missed my opportunity. Is this temporary? Or is this permanent? Now I think everybody recognizes that interest rates aren't going back -- aren't going to decelerate at the pace that they accelerated going in. So private valuation has now become a reflection of public valuation, coupled with the fact that a lot of the competition that we have in private valuation is through private equity. And as everybody can understand that lending -- the lending environment right now is kind of poor. So that's taken some of the heat off of the competition that we have in private equity. So the pipeline is interesting right now. Valuations are more reflective of kind of the macro and the public markets, which is proactive. The hard part now is what's going to happen with the macro, right? So you're going to have to underwrite what you think the growth rate of these assets that are coming to market right now. I think you're just going to have to make best estimates that what we have in our pocket is, I think, what we have done over the past 5 years, is build an engine that allows us to extract synergy values out of our acquisitions in a much faster kind of by the book rather than doing it over time. I think that we've built this engine with back office consolidation and operations and IT and digital and everything else. But I think if you go back and look at the acquisitions that we did in the tail end of '22, we were able to extract significant value out of those acquisitions within 8 months of making them. So we're always able, in most cases, to hedge what revenue over time is going to look like by having some real tangible ability to create value through synergy extraction.

And can you just talk about the M&A process? Because I think when we talk about Dover and I sort of -- and we can talk about the evolution of your return on capital, where I think the data now shows that you more than closed the gap was the capital allocators. And so operationally, I think you have -- you're starting to get credit for the operational performance over the past 5 years. But in terms of M&A, can you just describe the evolution of the company's M&A strategy from when you were a Board member to where you are right now because I think you have made material changes as to how you think about M&A, the type of deals you do. And it does seem there is a steadier sort of M&A process at Dover going forward, and I don't think you get full credit for sort of steady capital allocation there. But could you just describe what it is you have done in terms of mechanism and how you've changed the criteria because you have.

Yes. All right. Well, there's no point of me talking about the past of before I was the CEO. And I mean that's the past. And I don't think it's a reflection of going forward. I mean I think we carry on...

No, no. It's just -- it's different.

At the end of the day...

That's what I meant, at a pond over before.

At the end of the day, the target generation for the companies that we buy bubble up from the operating companies that are in the marketplace. They know their competitors. They know what their customers are doing in terms of their own R&D pipeline. So if you think about it, we're not the most attractive person for investment bankers to come in and publish their wares because generally speaking, these are medium-sized companies that are private that just aren't of the scale where we generate a lot of fees. And it's good from a certain point where we don't participate in a lot of auctions out there. Generally speaking, the companies that we've closed upon, we've known about these companies because we're constantly evaluating the competitive stack of the individual operating companies that we have in the group and those relationships with those targets are built over time just because of the mutual participation in the marketplace. I'm -- we don't chase themes. We Know the types of businesses that we like. We like adjacencies. We have to understand the customer. We have to have a relationship with the customer. So you don't -- I would not expect us to create another segment through M&A because we want to take execution risk and make that as low as possible. We also like to be able to have a, as I mentioned before, a hedge in terms of valuation with our ability to extract synergies. So there's a pretty strict criteria when we look at kind of the medium-sized companies that we buy. But what we also do is put some amount of risk capital to work. We don't bet the balance sheet on it, but you will see us make acquisitions on their companies, but they're almost individual product lines or technologies. You've seen that's basically how we built our entry into the biopharma space. So we're looking for a niche. We'd like to buy these companies before they get to a scale where they become reflective of multiples into the biopharma space. We like to get them early and they're almost like incubators, if you will, and then we build scale over time. So you'll see a variety of different multiples that we pay. But generally speaking, if it's a company that's been around for 20 years, we understand it because it's either a competitor or an adjacency, execution risk is low, synergy value is high. And then you'll see us from time to time, pay what look to be very high multiples because these are nascent small companies that are introducing new technology, and we're just trying to buy them on the come because of the fact that we believe by using our network and our presence that we can grow them exponentially faster than it would on its own.

And in terms of you sort of -- you described the amount of dry powder you guys have. So does that call for an acceleration of sort of M&A activity? And then the other question I want to ask, given that you do M&A at the business unit level, and a lot of your business is a fairly niche-y concentrated, that would sort of imply that there is a natural limit to how big a deal each individual business can do.

Well, let's start with the second question first, and then we can go back to the first one. Yes, I mean, we need to recognize that a little fish can't eat a big fish, right? Just go back to this issue of execution risk at the end of the day. We need to understand the company. We need to understand the business model. And we need to understand the customer, but we also have to take into account a management team that's running a medium-sized company can't go and realistically, buy a very big company, right? Because now, there are times when we would entertain that but you'd have to have very high confidence level on the target management team because you'd also be doing a reverse integration, right? Taking a smaller company and backward integrating it into the target company. So there are cases like that, that we would do it. Yes, we do have niches, but we define our niches relatively narrowly. But at the end of the day, there's always adjacencies to those niches and then we look at kind of the end market. So when we talk about something like our fueling business, you could define that in a very concentrated fashion because there's really 3 or 4 companies in the world that participate in and -- I believe investing in is taking that presence and expanding into cryogenic components and a variety of other things, which is an adjacency to what the core business had been in the past. And that's kind of a pivot using the cash flow that's generated by a business to pivot into a higher growth area that we see opportunity.

Got you. No, that makes a ton of sense. Thank you, Rich. So maybe just to shift gears a little bit. And I think another area that is underappreciated, and we're lucky enough to see your operations in Boston, is digital strategy. You have a goal -- you had a goal of reaching $2 billion of e-commerce sales in '22, up from $1 billion in '21. Where are we? What are you targeting for '23? And how much of a margin benefit will rising e-commerce adoption have for the company? Because I think that was one of the first things you said when you became the CEO, was just going from paper catalogs to sort of online. And I think it has made a big difference.

It's made a difference, but we're still kind of on the journey. So we would expect the e-commerce revenue, the -- I hate it when I say this, but like $1 billion a year, we would think is how we can platform it. Pretty confident that we can kind of keep up that pace. There is a cost arbitrage of doing e-commerce for all the reasons that we can understand. But the real benefit to it is not just the cost arbitrage. The real benefit is if you can get your revenue and your transactions onto platforms, then you can analyze that data much more efficiently, meaning that you can do SKU rationalization centrally, you can do pricing management centrally. So it's just looking at total aggregate data because these are medium-sized companies that operate globally that historically had negotiated prices locally. There's no reason for that to happen because of the frictional cost leakage that you have in terms of product complexity and then -- and disparity of pricing. So we look at it holistically. It's not just, hey, I get it from a standpoint of I can take frictional processing costs down, and that's part of it. The bigger benefit that we would argue that we get is being able to manage these businesses from a complexity and from a pricing point of view, centrally is really where we get the bang for the buck.

And that actually does pivot us to software. So I think that's really -- I'm not sure if people know you have a real software business, but you actually do. Can you talk about the software revenue mix at Dover today versus 5 years ago? What are the organic growth rates like? And what are the top 2, 3 programs in terms of revenue? And where do you see it going in the next 5 years?

Yes, I've got to be careful. I would call your attention that we just made a kind of tour de force corporate presentation a couple of weeks ago. It's all available on our website. I think that we've disaggregated our revenue streams out of the segments into kind of components and whole goods and software, and I don't want to sit up here and try to guess at the numbers and be off a little bit. So -- but we've been expanding the position. I think more importantly, is our philosophy around software as opposed to industrial companies seemingly love software for all the reasons we can understand about gross margin and recurring revenue streams and all the buzzwords that you hear there. We like software, but we like it as an adjacency to market positions that we have. We're not a software company. We're not trying to transform ourselves into a software company. but we've got some pretty clear examples where we've added software to what looks to pretty boring business models where there's been a significant accelerator in terms of value creation by just adding additional value to the core product lines.

Let's talk about garbage trucks.

You can talk about our Environmental Services Group. That business, in terms of everybody understands the body building portion of that business, that business has actually shrunk in terms of the unitary volume because of the supply chain and a variety of other things over the last 3 years. But between software services that we provided that enhances our customers' revenue stream and by implementing e-commerce in a meaningful way, our spare parts capture has gone up meaningfully over the time. We've actually not shrunk that business and expanded margins over time. So that's just kind of an example of people may look at the portfolio at Dover over time and go, Okay, I get it. But it's pretty concentrated. You got kind of the market share that you're going to get. You're doing a decent job in terms of profit extraction. We look at it as here's our entree into a bigger TAM and what can we do smartly to widen the product offering or enhance the product offering we have. And I think if you go through the presentation that we gave some pretty compelling tangible results of that.

And just -- but just sort of very simplistic view. I mean if you sort of just aggregate what you have on software and it's our estimate, it's -- David and I sort of calculate it. It does add like 50 to 75 bps of annual growth at a very healthy incremental margin. Like it is starting to move the needle.

Look, we like it, right? I'm going to just -- I want to -- our differentiating factor is, is a lot of industrial companies that are pivoting to be software companies and they're going to deal with the prevailing valuation of software in the industrial space. I just -- that's not us. Like I said before, over the last 10 years, thematics and multi-industrials have now taken precedence over returns and we're a return maximization company, not chasing a thematic.

Well, but you do have ESG-friendly businesses. You do have a software business, and they all seem to be real and growing.

We'll be opportunistic without chasing a theme.

So maybe productivity because I think that was one of the first things you sort of talked about when you took over at Dover. So maybe, again, what strikes me also, you are one of the companies that sort of stresses automation. So how much of the sort of $185 million, $195 million in CapEx plan for '23 is geared towards automation and productivity? How does it compare to the last few years?

As a percentage, this coming year, it's higher because we had footprint expansion in '22 that does not meaningfully repeat in '23. So as a proportion, our CapEx is actually down year-over-year just because we did a bunch of greenfields that are -- right? When we talked about brazed plate heat exchangers and CO2 systems, that's kind of in the rearview mirror. But if I look so as a proportion of our capital deployment, it's higher on a lower base in '23. Our maintenance capital is somewhere around 15% of our capital. So you can look at that as every year, it's there. That's just keeping your asset base up to snuff, for lack of a better word. We're a big believer in deploying capital smartly. A lot of the margin expansion that you've seen over the past 5 years is because we've deployed capital smartly. With labor costs going up over the past 24 months, that returns on smart capital deployment have actually gotten better despite the cost of capital going up. So I would expect we're going to further deploy capital to drive productivity over time. It's our highest return. So when we talk about the hierarchy of capital deployment -- organic capital deployment, by and large, has significantly higher returns than inorganic capital deployment because I'm not -- it's in our hands, and I'm not paying for future revenue streams. So we're not nearly penetrated in terms of automation that what's possible over time. So I would expect that to be a reoccurring theme with us for a period of time. I don't think it's going to change as a percentage of revenue. So I think that we're outgrowing the amount of capital consumption that we have. So it's not problematic from a operating cash flow basis and you get the widening of margins. So the widening of margins and the top line growth rate are in excess of the cost of the redeployment of capital internally.

It is late in the quarter. Can you just tell us what you see in the world? How does Dover feel about the world?

Cautious, I think. I think that we're trying to run down the middle of the tracks of, we've got a lot of opportunity out there. I think that by changing the portfolio, and I think that we've made some hopefully, to be pretty smart investments on the come, that we feel good about our opportunity. Our customers are signaling us in terms of their own CapEx plans that they're deploying capital where we can be like a pilot fish behind it. So from that point of view, we feel good. We think in terms of the calendarization of demand, it's pretty much the way that we described it back in January. So, so far, so good from that point of view. But on the other hand, look, we're not -- we're realist. The macro is a little bit choppy. I guess we can call it that, for lack of a better word. So we're doing a little bit. We're pushing our operating companies to seize the opportunities out there, but we're telling it at the same time, you've got to have plans in place that if we run into any headwinds, we've got a playbook that we can reduce costs commensurate with any changes in the macro as it relates to demand. So we're one of the few companies that puts out incremental margin targets that we can talk about. On the upside, I think that those targets are reflective of what it would be on the downside. So there's no real imbalance between margin capture in a growing environment where it's actually significantly higher in a decline. And I think if you go back and look at 2020, our ability to preserve margins in a poor macro during COVID was pretty good.

But your incremental margin guidance is sort of below your run rate. You did build some conservatism?

I hope so.

And finally, like in the remaining 2 minutes, what are you seeing? I know that you have described yourself as a net beneficiary of reshoring for the past several years. So you have been very consistent about it. But what are you seeing in terms of sort of manufacturing in North America, your own supply base? What's happening there?

Yes. I mean it's a slow moving ball, right? I mean at the end of the day, there was -- through globalization and through chasing labor arbitrage, there was a lengthening of supply chains. I think that the benefit of that in terms of the labor arbitrage actually unwound 10 years ago, but the investment was so high that -- and commodity cost inputs were still at an advantage that, that engine kept running until it ran into logistics challenges, both from a cost and availability point of view. So it was almost a little bit inevitable that this was going to happen. And then you saw basically an attempt to rebalance on the supply chain side, but that for as many years as it took to build it in terms of lengthening it, it's going to take that many years to bring it back over time. But that's my previous life with heavy industry and very long supply chains. Dover, for the most part, we're a proximity manufacturer both from a supply chain point of view and from a revenue recognition point of view. That's been to our advantage over this last cycle. And now it just becomes, are we positioned appropriately where CapEx is being deployed by a region or whatever our customers are doing, and that's kind of our positioning now because we are levered to our customers' CapEx at the end of the day.

So we're right on time. We're out of time. Rich, always a pleasure. Thanks so much.

Good to see you, Andrew.

Thank you for being here in London.

Thanks.