Dover Corporation (DOV) Earnings Call Transcript & Summary

Thank you for joining us today. My name is Mike Halloran, industrial analyst here at Baird, and we're pleased to welcome Dover Corporation with us. Rich Tobin, CEO, is going to be joining me for the fireside chat today, and we're really going to dive right in. So if the Internet is working, you can use the card in front of you, send [email protected], and it will hit my handy iPad here, and I'll make sure I incorporate any questions you might have. If that's not working or if you feel bold, just raise your hand. I promise I'll call on you, and I promise I'll make sure you guys are included in the conversation. So with that, Rich, really, thanks for joining us today. Let's just level set everybody. Maybe just give a state of the union on how you're seeing the world as we sit here today. I know you have a lot of strong opinions.

Thanks, Mike. I don't think it should be a surprise. I think we've been pretty vocal about the knock-on effect of liquidity withdrawal and the rise in interest rates that it's going to drive necessarily drive a reduction in working capital throughout the system. And I think we didn't see it very much in the first half of the year, but you can see it accelerating in the second half of the year because -- and I'll point it back at Dover, if you could take a look at what our cash flow forecast for this year was it was a pretty heady number as a percent of sales. And what we said at the time was lead times have come down, supply chain has improved, and there was just not this necessity to carry excess working capital. So as backlogs come down because of that nature that it's just natural that, a, that corporates and our customers that would bring down working capital. So that was always going to be a negative to demand this year. The hard part is forecasting by business by region and then whether it's a slowly deflating balloon versus a more significant deflation. And I think up until midyear, so the previous 18 months, let's say, has just been a naturally slowly deflating balloon, and it was good because pricing was still positive and everybody was kind of managing it. I think what we're seeing now is another 6 months of liquidity withdrawal and a recognition of -- there's macro uncertainty into '24. So the safe bet now is let's all -- let's draw down inventory because what if I need it in '24 and '24 is a better year then I'm expecting, I pretty much can get it back out of the supply chain because if you look at logistics and freight costs and everything else, it's been largely repaired. So in terms of our own posture, kind of we're reacting to that business by business, region by region. We think that the biggest challenge for '24, let's just say it's a low growth and -- well, let's think positive and say it's a low growth environment in '24, and I think that the challenge is going to be pricing in '24. We've had a period of some pretty heady numbers in terms of inflation layer-driven pricing. Everybody says that they're not going to drop pricing to go and gain market share and volume, we'll see. But one of the best ways that you can manage that is not having excess inventory. Because generally speaking, that's where panic sets in. And I've got too much working capital in a low growth environment. I make it through Q1 and then I panic. And what we said at the end of Q3 was based on what we see, which I've just described, that it's better for us to drop production rates between now and the end of the year, manage our inventory down. And then to the extent that we -- and basically kick the production performance in industrial absorption benefit into '24 at this point.

Basically trying to match sell-in and sell out as you get into next year.

Exactly.

So a lot to unpack there. Why don't we start on the pricing side of things because I think one of the biggest questions, not just for Dover, but for the industrial complex in general, is everyone thinks they can make price. History says that is a pretty bold statement. The way we tend to think about it is those models that have always had that 1 to 2 price churn, pull some to the bottom line, highest likelihood of maintaining that price. These models that have maybe a little bit more peaky-peaky type pricing, bigger risk. One, how do you think about it? Two, where do you see the risk and opportunity insulating your portfolio?

We have not taken a lot of price in -- we will -- by the time we finish the year, I think our price benefit is going to be 1 point or 2, right? So we took a lot of price when -- remember, if you go back, our backlog accelerated first, right? We're kind of like a middle man to end users, both distribution and to the OEM partners. So if you go back and take a look at our backlog build coming out of COVID, it was enormous, right? And then everybody -- and at that time, because of all the frictional costs of building it up, we were raising prices pretty aggressively back then. We have not -- basically what we have in 2024 is mostly the rollover effect of pricing that we took in the second half of '23. We've essentially not raised prices hardly at all. I mean, just [ physical ] rates, prices we took.

Second half of '22.

Sorry, '22. Thank you. Second half of '22. We haven't really raised price in isolated incidents we have, but most of our full year price is going to be what we did in the second half of '22. Just trying to plan from what's going to happen. Could you have forced price this year? Sure, you can, right? But it just becomes -- look, we've got a lot of very sophisticated customers. They can see logistics costs coming down, they can see raw materials coming down. When, we were raising prices, what we were saying, logistics costs, raw materials and everything else. So you got to manage the dynamic as best you can. And I would argue that a significant portion of our portfolio because it's either engineered into the product or it's regulatory driven. It provides a buffer as opposed to just the volume price dynamic.

But that also speaks to historically, your ability to pass through price was relatively consistent net across the portfolio.

Yes. Never a lot, but never not highly volatile.

And I mean, it feels like that's what we're going to be reverting back to as we get to 24% plus or minus.

I think so. Like I said, I think the challenge is going to be, if you enter into '24 with excess inventory, you're going to be very challenged on the pricing dynamic.

So now you're taking your inventory down. Are you seeing that same dynamic happen across channels? Do you think people are ahead of you? Following you? I mean it feels like you're early, frankly.

Well, we're -- like I said, because in a lot of cases, we're a subcomponent supplier, we tend to be early in the cycle up and down, right? So we've been -- we can talk about biopharma and some other particular end markets that we have. Yes, we've been taking down. The channel has been slowly taking inventory down, as I mentioned before, like think about a balloon slowly letting air out. We would argue right now, based from our channel checks that are inventory and distribution, this is a general statement because we have a lot of operating companies is below what it should be. And we're having quite the interesting conversation with our distribution partners of this arbitrage between who holds the inventory and who gets to mark up the goods as they pass through distribution. Our argument with our distribution partners is that we're going to have to arbitrage some of that profit away if you're not going to hold adequate inventory. But make no mistake, I mean, think about it. If you're a decent sized industrial distributor and you've got $100 million of inventory that you are financing through working capital loans at 2%. What are they now? 8, 9, it's not immaterial to basically a business that runs at single-digit profit margins.

And yet when you've listened to your tone, it doesn't necessarily sound like next year has a chance to be at least directionally towards normalized, right? I mean you're positioning yourself for growth through a lot of these actions, but you also have a lot of insular things specific to Dover that can help.

Yes, look, macro aside, we like where we're positioned. We've got some growth vectors that we believe that are insulated, let me use a careful word here from kind of the macro and the working capital argument to a certain extent. We are very much regulatory driven in certain of our product lines. I think we highlighted that at the end of Q3. I think that in terms of new product development, I feel better about what's in the pipeline at Dover than I ever have in my tenure here. So it's not always -- I mean, I think a lot of people think that Dover was this margin accretion story. And then there's this argument, okay, where it's going to run out because it's -- we've moved it up close to 400 basis points over this last cycle, while we were doing that, we were actually spending a lot of money in R&D and product development. So I think we've got some vectors of growth. So to me, the worry that I have is the macro. I mean, how good or bad is it get. We're just going to have to adapt to it. But otherwise, I think that we feel really good. On top of that, I think if you go back to 2018, when I started here, there was a lot of questions just like every multi-industrial portfolio, portfolio, portfolio, why don't you sell this? When do you get rid of that? And we said at the time that we thought that the portfolio in total was undervalued, right, and that we were going to work really hard to improve the value of the individual pieces. And as we did that, then we can make more astute choices about monetization of pieces of the portfolio, and you saw us do that in the last quarter, right? So I would argue two points. Number one, by waiting the value of that business that we sold was significantly higher than we would have received in 2018 despite the fact that cost of capital is up. And the multiple we sold it at, I don't think anybody has got that multiple and the summer parts of our businesses. So our optionality going forward is if we're -- if Dover's multiple just because of the complexity of portfolio is not going to command a multiple that we're happy with, we can begin to be smart about monetizing those pieces over the next couple of years.

So as we think about monetization, we think about bringing assets back on, you've done a ton of work over the years to centralized business functions and really start leveraging that thought process. I'm guessing that limits how aggressively you can be on the exit, probably not as much of a limiter on what you can bring in other than what your normal balance sheet looks like.

That's true, right? So bringing in by -- because we've built the central pillars, the amount of our ability to extract synergies quickly and efficiently is a lot better than it was, right? Back in the old days, the Dover, we buy good companies, and we don't screw around the management team. We've got a completely different philosophy here, right? We have to -- the reason for Dover Corp. to exist is to put the tools in place if we're an acquirer to be super efficient in terms of our ability to extract synergies. Yes, there is a negative of gathering a lot of that to the center because when you carve something out. We've sold a couple of businesses and quite frankly, the first one, the buyer is still using our back office because it's so efficient. So we'll see.

Yes. No, you referenced it briefly there. Most recent activity, pretty positive arbitrage in terms of gross margin profile, price paid on a relative basis. I mean, that feels relatively unique relative to the landscape out there. So maybe talk about what the buyer-seller mentality is, ease of pushing some of these portfolio moves forward at this point or if there's opportunity for a pause here just given interest rates, given uncertainty in the backdrop, et cetera.

Well, I mean the good news is that the cost of capital has increased significantly. And one of the drivers of multiple expansion, at least in the hunting ground where we generally are has been private equity, right? Because there was just a free money business model that allowed that to go on for a period of time, and we got stopped out by -- I can't tell you how many, 30, 40 different opportunities over the last couple of years just because of valuation. So one could argue now that having a good balance sheet has put us in a position where, A, the competition is less and B, multiples have come down. And I think that you see that conversely, I mean, if we go back to when we sold DE-STA-CO, the stake was primarily a Tier 2 automotive business. I was the vast majority of the revenue stream. That's not a particular area of interest for us, quite frankly. But at the same time, its margin profile as compared to other Tier 2 auto suppliers was highly accretive. So that allowed that natural arbitrage to take place. And I think if you were to go through the pieces of our portfolio. And instead of comparing the consolidated margin of Dover, which is a lot better than it used to be that there are pieces of our portfolio, particularly in the capital goods portion of the segments that would be margin accretive day 1, if acquired by kind of a peer cap goods competitor, which allows some amount of multiple arbitrage in the selling price.

How much of an advantage do you think you're in today strategically with the capital situation versus sponsors relative to the last few years? It gets a lot of press. I think the magnitude of how much of an advantage it is. It might be slightly overblown, but would love your perspective.

Well, I mean, I think on the bigger deals, there's still plenty of liquidity out there. But then again, we don't participate in kind of the bigger deals. They were our competition with private equity is kind of more middle market. So the nature of those balance sheets are relatively small. And because of that, it actually puts more pressure on the cost of capital as opposed to something that's large which just gives you a different opportunity in terms of structuring the transaction. So for us, we think that we're in a good spot right now just because of the scale of the assets that we look at.

So earlier, you referenced the margin side of things, 400 basis points over the last cycle. Certainly have a healthy margin target, potentially some room based on the guide you put out. I think, obviously, the demand environment is going to play a piece into the timing and how that progresses. But talk about what the levers are today and how that differs from the previous cycle.

Sure. I almost got to do a piece by piece here. We have spent probably over average to our peer group in CapEx over the last 3 to 4 years, and that has been reinvesting in our capital base, of which 90% has been efficiency-based. So if you look what we did in refrigeration, for example, counterintuitively, we made a pretty big capital investment in that business despite the fact was our lowest margin business, and we've moved up. We've basically almost doubled the margin. We've done that in a variety of different businesses, and we haven't earned all of the possibility because there are a variety of different timing in terms of when we made those -- when we did that. We've done some acquisitions, most of them are mix up in terms of margin. So as we grow those businesses, the mix effect, we'll bring them up. And, yes, I think that's probably the two biggest drivers. I think that we've got room in terms of just natural productivity. I mean if you look at -- this has been a difficult year. The fact that our margin is up despite the fact that biopharma is significantly down. If you go take a look at what we were making in Pumps & Process Solutions 24 months ago in terms of margin, the negative mix effect on that and our ability to still have accretive margins is tantamount to the fact that we're not just chasing the businesses that we think that are winners. I mean we're basically investing across the portfolio to push everybody's margin up. And to the extent that we while biopharma was coming down, we pushed up the capital goods and refrigeration up so much that we've held margins. Biopharma is going to turn around one of these days. And when it does, it should be a significant tailwind to us going forward.

Yes, a couple of points in there. First, part of the reference point for this conversation seems to be you've been a little earlier on a lot of things. My guess is the CapEx side is an area you've been early on because you're seeing CapEx budget start moving up, creep in. And if all of these secular drivers play out the way people think, higher CapEx levels in the cycle seems inevitable relative to last cycle. I'd be curious to how you think about this.

I think that putting aside pure expansion CapEx on productivity-related CapEx our CapEx should come down from here, right? We've basically gone on the lower-margin businesses in the portfolio and spent a bunch of money to improve the productivity. Those are every 15-year kind of investments. We're pretty much done there. We spent a lot of money on IT over the last cycle because that allowed us to put all of our central processing together in Manila. You can't do that with a manifestly disparate IT base, right? So we basically collected that altogether, that knock wood, at least in my tenure, we don't have to do it again. I think what remains to be seen, and let's think more positive, if, in fact, the Fed could get its act together and we can get rid of all this ridiculous regulatory issues that are going on, and we can go back into pro-growth cycle. We think that we've got some avenues in terms of organic capital in terms of expansion. So we're in the midst of increasing our capacity. I know you're going to have a follow-on to this, for heat exchangers that go into a variety of markets, one of which is heat pumps. So that's a CapEx out. But again, once we're done, I think that we're done at the beginning of next year, that's a one-timer, right? We're not going to do that again. So I would expect that CapEx as a percent of revenue to come down from here.

You know I was going to lead into the biopharma piece, but you brought up heat exchangers, my little timing on the debate.

Right.

Germany seems slowing heat exchangers back and forth on the short-term dynamics, I don't know if there's a ton of protest on the opportunity over time, but...

Yes, it's been really interesting. I mean we were selling more than we could make for a couple of years. There was a period which I don't think a lot of people paid attention to about legislation in Europe, particularly the U.K. and Germany about the subsidy rate that went on more or less in the first quarter and the second quarter that introduced some uncertainty into the market. Well, while everybody was basically running to build units because I think secularly or structurally that we believe that there's long-term growth here. We can argue about the percent growth and what it is, we believe it's going to grow, right? The technology is proven in a variety of ways, but I just think that there was just this chasing of a market that was growing in the teens, high teens. If you go back and look at the amount of announced capacity additions in heat pumps it's incredible. I don't think that's ever going to happen, quite frankly, but the underlying demand is solid. And if I go back to when I started with this conversation, I think there was another realization that came of wait a minute, we actually had a little bit of a pause of demand there waiting for the legislation and Holy c***, look how much working capital we have, and we got to close the year. So we kind of had a little bit of a hard stop, real hard stop right along with it to the detriment of Q4, but I think that it's a business that we're very interested in. I think that we're in a unit -- almost a -- let's call it a triopoly being fair to one of the competitors, we think we're in a pretty good position in terms of our ability to harvest earnings out of this over the next 10 years.

Yes. It's probably more of a duopoly if we're being honest. So maybe let's touch on some of the things that might be tailwinds in the next year. Biopharma piece, you guys are front end of the spear, you saw it first, talked about it first. It's dragged, but at least as you get to next year, comps do ease and you should be at a point where sell and sell out match a little closer, maybe you get a little bit of a spread there for a period of time.

Yes. Look, we can -- this is a business that we don't sell most of our product. Most of our product we sell to OEMs, so our visibility on inventory levels is what they tell us to be perfectly honest as opposed to a business where you've got a lot of distribution because then you can go do channel checks. It was some dismay of reading the market participants I think that we're getting to capitulation. We were being told by some of our customers that just result -- just released some pretty disappointing results that they thought it was going to pick up in the second half. I mean that's the only place we can get our knowledge at the end of the day. whether it picks up in Q1, I think it's going to be order rates. So when we see order rates come up, that will be the first sign. From what we do know 2 things. We are a consumable product. So we don't need new skids to be built. We just need the product that's been sold to run, right? Because as it runs, we're a consumable part in there, number one. And number two, because this is FDA regulated, you can't keep the consumable inventory forever. It's got a shelf life, you have to throw it away, so those are two positives. But I'm reticent to call 2024 in January, it picks up. I think the comps are easier, and I would expect no later than the second half of '24 for it to pick up.

Yes, that's fair. I mean the pushouts keep coming, do any channel work, and there's a lot of concern points out there still going into next year. What about the DEP side? Really strong backlog, chassis availability is coming, could have some quarter-to-quarter variability, but it certainly feels like that's ready to be a pretty healthy contributor for you.

Yes. I mean we're essentially sold out in the Environmental Services business. It's chassis. We don't need another UAW strike at Volvo. That would be nice. And to us, it's kind of execution. We are not part of the reason that we brought down our guidance was we thought we were going to have a really big Q4, but because of chassis availability, we're not, nonetheless, it's going to be up in '24 for sure. And that will drive -- I think the military business should be up going into next year. Vehicle Services Group is really going to be dependent on what happens in the Eurozone because that's a business of ours that's kind of levered that way to a certain extent. So we kind of want to wait and see what's going to happen there. But the driver of ESG should carry the entire segment along with MPG.

So a lot of moving free pieces on the fueling side. EMV comps, you grow off them. You're expanding in a lot of areas outside of just the traditional fueling piece, CapEx getting pushed out, but those guys need to deploy capital in order to keep those models moving. How do you think about the dynamics on those pieces you put them all together?

Yes. I mean it's very almost exclusively distribution. The entire segment with a few differences on the cryogenic side, which is OEM based. So I like kind of like the traditional as we understand fueling business. under a lot of pressure now because of destocking because of everything that we just talked about. The pipeline looks good. CapEx announced by the end user looks decent for next year, where the EMV story is over. We took a lot of restructuring out of that business. That's why you saw the margin moving up. So if we can go into a little bit of growth there, we've got a target to get to 25% margin in that business, and I think that we've got a path to get there. On the, let's call it, the clean energy portion of the business. Again, I don't want to keep saying destocking over, but we believe that this has got secular growth to it. I mean if you look at the amount of CapEx that's been announced, we're spending a lot of time thinking about our own capacity and how to efficiently expand it going from here.

Makes sense. Well, we're basically out of time. I'll let you out 30 seconds early. Please join everybody and thanking Rich for his time with us today.