Enpro Inc. (NPO) Earnings Call Transcript & Summary

I am Abe Landa, the high-yield research analyst covering industrials and metals and mining for Bank of America. Today, we're joined by EnPro. And representing the company is Milt Childress, EVP and CFO; Chris Ravenberg, VP and Treasurer; and James Gentile, Vice President, Investor Relations. EnPro is an industrial company producing Advanced Sealing and Surface Technologies focused on the semiconductor, aerospace and other sectors. Company has reshaped its portfolio over the years while also deleveraging significantly to under 2x post its recent sale of certain businesses. And the stock market seems to be pretty happy as its trading near its 52-week high. Let's now turn it over to the management team, and they'll provide some more background on the company.

All right. Thank you, Abe, and good afternoon, everybody. A lot of -- a few friendly faces in the crowd. So it's good to see people we know, and welcome to those who are joined to hear a little bit about our story. Before I start, I just wanted to get a little show of hands. Who in here does not really know anything about the EnPro story because that will help me in providing a few introductory comments before we get into the fireside chat and Q&A. So if there's anyone here that doesn't really know us at all, so everybody has some fundamental base of information around who we are. Okay. That's helpful. Okay. So I'll make my opening comments pretty brief. James, do you want to just advance that? Okay. Let's skip this one and we'll come back to it later. We'll use this as just a snapshot of our company. So you know us that we're an industrial technology company. We've been working hard over the past several years, I would say, in the 3-year to 4-year time frame to reshape our portfolio to take the best of what we've had in our history. Our history goes back spin-off from Goodrich in 2002. And so we've been working hard over the past few years with some very specific criteria, which we'll get into later to reshape our portfolio to divest businesses that we don't -- didn't really see interest in investing in going forward and to build upon some of our stronger businesses. And so I like to think of it as we're now the best of what we were at the time of the spin-off with -- with growth that we've had in the best of our businesses going back to the start of our company. And at the same time, we have built more on the technology side, which you'll see in one of our segments. So we now report in 2 segments, Sealing Technologies. It's largely some of our legacy businesses, once again, very high-quality businesses that serve critical needs of customers. We -- our products perform extremely well in harsh demanding environments. They're typically a very, very small component in the cost structure of what they're going into. And they're typically associated with if there's a failure, it could be catastrophic to customers, both in terms of environment or downtime in facilities or even human health. So our products are critical, and it's a very fine group of businesses. There basically are 3 businesses in the Sealing segment. One is Garlock. It's a very old brand, over 130 years old. And Garlock has really been the bed of innovation that has driven our growth in the company over years. Out of Garlock came a high-performance metallic sealing business that we now refer to as Technetics Semi -- I mean, excuse me, Technetics Sealing. And we have developed that business over time, but it came out of Garlock. Similarly, the start of our semiconductor business started with Technetics Sealing. And then we -- our team in the Semi area developed a growth strategy, and we've grown significantly both organically and more recently through acquisitions over the past couple of years. And now that form the basis for the new segment, which I'll talk about now, Advanced Surface Technologies. So Advanced Surface Technologies is largely a semiconductor business. We also have a optical filter business that serves many industries, one of which is the semiconductor industry. So those are our 2 reporting segments. You can see on the slide, we're largely at this stage with the portfolio reshaping a North American-centric company. We have about 13%, 14% of total revenues in Europe and Asia Pacific, each of those 2. And then you can see our market exposure. So we serve a lot of markets. Semiconductor at this point is our largest at 40%, as you see here. Okay. So that's a little bit of an overview. Now I want to go back a slide, and just so this highlights what our strategy has been. And it really has been to transform our portfolio to accelerate our growth in industrial technology businesses. So our filter at the time we've gone through decisions about what businesses stay in EnPro and what businesses are no longer part of EnPro, it's very intentional. We wanted to position the portfolio where we had economic moats in the businesses that we operate that allow us to command strong gross margins and EBITDA margins north of 20%. We also wanted to have businesses that the investment in assets matches well with our ability to earn a return, and we define that as cash flow return on operating capital greater than 20%. And then going forward, as we look at investing, we want to invest in markets that are growing above industrial production or GDP. And so let's define it as 5-plus percent or more. And it's that lens that we created, it sounds fairly simple, but it really has been kind of a guiding north star for us in evaluating our portfolio over the last 3 years or 4 years. It led to us divesting a really strong engine products business, which was a fairly capital-intensive business and also one that was characterized by some ups and downs. We have divested last year an oil and gas business called CPI. We just announced fairly recently the sale and completed the sale of GGB, which is a plain metal-polymer bearings business. And once again, a strong business, one of the leaders in what it does globally. But it also did -- just did not meet our standards of what we're looking for going forward in terms of overall margin and cash flow return on operating capital, and it wasn't a place we were going to be investing for the future. Fortunately, we found a good home with a company where it makes really sense that has some synergies and carry on the fine tradition there. So that's a little bit about our portfolio reshaping. And I've also talked about several other points here. And this shows you the time line in recent years on the number of moves that we've made, both on the divestiture side and on the acquisition side. I'm not going to talk a lot about the divestitures at this point because I think I've really covered that. The acquisitions, let me just mention LeanTeq is a semiconductor-related business with operations both in the Taiwan and the United States, a very fine company we acquired in the third quarter of 2019. The Aseptic Group, that was part of our Sealing segment and is one of our moves on the pharma side, it's one area where we're expanding a pocket of growth that we're interested in investing in, in the Sealing segment. And then Alluxa, as you see in the fourth quarter of '20. So about 2 years ago, that's our optical filter business. And then NxEdge, a significant acquisition, that was an $850 million investment for us, and that was completed about a year ago that expands our presence in the semiconductor industry. So I think with that, just for opening remarks, I'll stop, and I'll turn it Abe back to you.

Thank you. You answered a lot of my questions actually. Yes, a lot of my questions were initially focused on this portfolio transformation. It is clear that M&A is a very important capital allocation strategy of yours. Can we maybe delve a little bit deeper into that? What is your M&A process? What is your criteria that you're looking for? You touched on that briefly. Maybe more detail on that?

Yes, it's a good question, and I'll tell you how we think. We are a very strategically focused company. We don't look at M&A as part of our strategy. We do look at it as a tool to enable accomplishment of a strategy. So the way I would look at it is we're focused in both segments on profitable growth, whether it be organic or inorganic. And a lot of our inorganic or M&A moves are building upon some element of our company and positioning us to make that inorganic move which then drives organic growth of the future. We also, for the most part, will shy away from something that might just be a totally new leg. So we're a group, once again, that's strategically focused, and we're building on some aspect of businesses that we already own. And if you look at our history, you'll see that throughout, even Alluxa, which is an optical filter business, we weren't in the optical filter business before, but we were drawn to what they were doing in the semiconductor industry. And while it's certainly not the largest part of the optical filter business, there was a threat of a tie there. And obviously, the semiconductor moves. We first entered the semiconductor industry through our high-performance metallic sealing business that I mentioned earlier back in 2010. And we more than doubled the business organically over a few years of time before we even made an acquisition in that market. And then our team has worked on a strategy, which included geographic expansion, technology differentiation, customer diversification, and that led to the couple of acquisitions in LeanTeq and NxEdge that we made in that sector. So going forward, I think you would expect and we would expect more of the same. We're going to look at the hook and the fits. We're open to acquisitions that help with our strategy in both the Sealing segment as well as the Advanced Surface Technologies segments and looking for the fits. So we do have a small team, a small M&A corporate development team. The 3 of us up here are obviously involved in that conversation. Our CEO is obviously involved in a lot of the work in the review. But we have an active network and help from our strong relationships, some of whom are right here in this room. And then we're also trying to develop relationships directly with companies through customer relationships and just knowledge of the industries that we serve.

That actually leads to another question just kind of the process of the M&A. So from scouting to negotiation to a purchase integration, to post integration, how is that process? What is done internally versus externally? Maybe kind of talk about your -- I mean, you touched on it briefly, but further expand on that?

Yes. One of the differences, if you look at our recent history and some of what we're doing now is -- I've been around the company for a long time. And we really believe in you make mistakes and you learn from those mistakes. And so what we've been doing in the M&A area over the last few years is really very different than what we did in the early part of the EnPro history, where we were buying a lot of small businesses, and some of them were turnarounds that we were fixing or trying to fix. And more recently, what you've seen is that we're -- on the M&A front, we're really going after larger, high-quality businesses, that are strong businesses before we step in. And I think the reason I wanted to mention that is it has led us doing larger deals. And because of the larger deals, we do tend to rely on advisers and almost everything that we do, whereas in the past with smaller deals, a lot of times, we handle all those in-house with our corporate development and M&A team. So some of our ideas do come from our relationships and from advisers, and some ideas that lead to transactions come directly from relationships that our business executives, business team have with customers or other people in the industry. Do you have anything else to add, James?

I think if you look at the strategic kind of acquisitions that for since 2019, there's a cultivation that goes along prior to the actual consummation of the acquisition. So -- and in some cases, it could last years, make sure that there's a cultural fit and make sure that the businesses are well aligned from a strategic perspective. And then in the early days, we leverage our very strong commercial excellence supply chain efforts to help them along on the cost side, integrate them from a payments and benefits perspective and then proceed with the strategy of growing the business organically in the family that they've recently joined. So it's a basic blocking and tackling type of process. But when it comes down to cultivating the acquisitions that are interested in joining the EnPro family, sometimes we have to be patient.

And I'll have one other -- your thoughts, James, triggered one other thought of mine. In most cases, in recent years, the companies we've acquired had teams that preferred to have EnPro as an owner. And some of that is a function of our culture, and the way we work, it seems kind of normal to us because we live in the company. And it's sometimes is a little bit surprising to me that others that we approach kind of see something a little bit different in us. And so the EnPro way of working is very real. I know a lot of people talk about culture, but it's something we've worked really hard on over -- really over the past decade as a company, and it's operating in a way with integrity and with transparency. And I think we're known for that. And I think that does help us, and I think people we talk with, whether on the M&A front or other fronts, see that as well. I don't want to toot our own horn too much, but I do think that's been a factor in our success with several acquisitions.

Absolutely. And the feedback on new team members and colleagues that have joined our family, they're very pleased in the collaborative environment. We offer a psychologically and physically safe environment and things like that, that maybe they're not used to it overall.

So you were mentioning that you used to acquire smaller turnaround storage, and now you've acquired larger companies. I guess in thinking about future M&A, how would you fund those transactions? How high could leverage get post the transaction? And then kind of further down the line, what is that leverage target you would kind of be thinking about longer-term?

Yes. We're pretty conservative bunch when it comes to protecting the balance sheet. And then going into the environment that we're in with some uncertainty going into 2023, we're probably even more conservative than we would be otherwise. On the other hand, the portfolio today has reshaped is much more resilient. I guess we'll have a chance to find out how it operates and performs if there is a slowdown, which I think most people are saying is likely, if not in the first half of the year, in the second half of 2023. But we do believe with a strong aftermarket because we're roughly [ 50-50 ]. We're actually closer to [ 55% ] aftermarket or recurring revenue at this point, which does give us some cushion when it comes to an economic downturn. We also believe that how we're positioned in the marketplace and with customers that will outperform doesn't mean we're immune to a downturn in the cycle, whether it's semiconductor or other markets. But we do believe that and have confidence that we can outperform the economic indicators in those industries and markets. So I haven't really answered your question other than to say, from our point of view, now is the time to be a little bit cautious, and that's even coming from a group that tends to be fairly conservative on the balance sheet front. So I mean, I would give you a number. I mean, we did take -- I'll give you one time where we did lever up a year ago when we acquired NxEdge, we levered up to, I think roughly [ 3.7x ] trailing EBITDA. One of the reasons that we went that high is that we knew we were going to be selling some businesses. We knew we'd be able to bring the debt down pretty quickly, which we have. And we expect by the end of the year to be somewhere around 2x net debt to EBITDA or a little bit below, we'll see how the year, rest of the year plays out.

And we're interested in the new rising rate environment where maybe some processes for high-quality assets where we're well capitalized, and we have a bit more of a track record and a totally reshaped portfolio. We're very well positioned in the intermediate term to take advantage of opportunities should they come along at appropriate prices.

Absolutely. But we're patient, and we're in no hurry. If you look at our history, it's been a little bit more of the tortoise rather than the hare. And I think that's what you can expect going forward.

Do you like being around the 2x leverage area or...

Yes, I would like to be a little -- actually a little bit below that, as we continue to generate cash over the coming year. And then that gives us an opportunity to -- on the M&A front to step up with something that's more significant when we find the right fit.

Something I've heard from other companies when talking about capital allocation and shareholder return, and I haven't heard that yet. What are your thought process maybe just starting capital allocation priorities, but shareholder returns versus M&A versus debt paydown versus internal CapEx?

Chris, do you want to take the return on capital to shareholders?

Yes. I think it's certainly an important component. If you look at kind of the 3-legged stool of capital allocation, growth and investing in the business, and then returning capital to shareholders through either dividends or share repurchases, which we've been active in share repurchase programs within EnPro's history. We do have a continual kind of share repurchase authorization outstanding just because it gives us flexibility in how we deploy capital. But I think the important thing is we have a consistent dividend policy. And that's really our prime way of consistently returning capital to shareholders is through our dividend program. And yes, I think that's kind of the way we look at capital allocation from that perspective.

Shifting gears, as I look at the slide over here, I see semiconductor is 40% of your business. And I think we've all kind of seeing the headlines, the CHIPS and Science Act has just passed. I think we've seen some big announcements from TSMC and Intel, maybe how does your company play with all that capital spending coming on board? When would you realize revenue from a lot of that spending? Maybe just a general outlook on this space?

Yes, we've been through several changes, a number of changes over the past decade in the semiconductor industry. So the whole industry and the cycle and how it moves is not new to us. Now semiconductor is a larger part of our company now. Where we have grown -- I'm digressing a little bit, but I think it will be relevant to your question, where we have grown in semiconductor has been with a focus on higher technology applications, advanced nodes is some terminology you'll hear in the semiconductor industry. And so there's a fairly significant part of what we do that's focused on advanced nodes, which is the leading edge applications and most advanced chips, equipment or services that go into manufacturing the most advanced chips. And what we're going to see, what we believe we will see is an ability to use our current platform to take advantage of some of those investments that are happening as we speak in a very real way and significant way in the United States. We've announced that we will be upfitting a facility in Arizona to support some of the new foundries or fabs that are going up in that state. And that could be a start for us. I mean there are other investments that are being made throughout the United States. So I think we're going to see -- continue to see significant investments in the United States as there's a little bit of a decoupling of the [ global ] supply chain for reasons that we're all aware of. And so that will benefit us well. We're well positioned. United States is our largest footprint in our semiconductor business. We do have a meaningful presence in Taiwan as well. But by far, the largest part of our manufacturing base is in the United States. And I think that will serve us very well given trends in the industry.

I believe you have mentioned that you're going to do something like a new plan, a new project in Arizona. If you can maybe just briefly talk about that, the timing, the ramp-up cost?

Yes. You asked about revenue earlier, too, when might some of those investments, might we see some impact on the top line with our business. So if you read everything that I would say here is public when it comes to customers, both TSMC and Intel have announced that they are making investments and hope to be operational sometime in 2024. So if you take that as a springboard, then I would say by kind of late 2024 and maybe early 2025, that you'll see some benefit on the revenue side to investments that we are making currently. So that's the general time line. It's still early, and we don't -- we can't be really precise, but we think it will be somewhere in that time frame. We have closed, by the way, on a facility, and we'll be continuing to upfit that facility as we head into 2023.

Is that a significant CapEx or that will be self-funded?

It is a significant -- fairly significant CapEx. And I can't remember what we have disclosed publicly. We've indicated early on, and this goes back quite some time before we were able to fine-tune before we had specific opportunities that we expected an investment of roughly $25 million to $30 million. I think we said on our last earnings call that we're now expecting that investment to be a little bit larger. So let's just call it around $40 million, certainly sub $50 million, but it will be a sizable investment for us. However, the returns are quite attractive as well.

I believe earlier, you mentioned the R word, recession. And it seems like it's a foregone conclusion at this point for many market participants. Do you have a playbook for dealing with a downturn? Any thoughts on decremental margins, how it impacts your various end markets, et cetera?

Yes, I'm not sure I used the word recession. I think I've talked about an economic downturn. So that sounds better to me. We've had these businesses. If you look at Sealing, we've owned our core businesses for a long time. And so our teams are seasoned and they've been through several cycles. In semiconductor, as I mentioned, we first entered that market in 2010. So we do have some history of ups and downs in that industry. So this will be the first time that you as investors will be seeing our reshaped portfolio and how we respond should we see an economic downturn of significance. We're not immune to it, as I mentioned earlier, but we do think we'll outperform.

And some of the key elements of the reshaping strategy, such as reducing our European exposure, reducing -- eliminating our automotive exposure, significantly reducing cyclicality from oil and gas capital expenditures over the years, [ fair mix, more as qualifying business ] was very volatile on a quarterly basis from a capital allocation perspective. And all of those combined don't exist in the portfolio today, and both Sealing and elements of the longer-term organic growth algorithm for the Advanced Surface Technology business is quite favorable.

And I would add, I think our ability to -- from -- to generate cash from operations, I think our free cash flow characteristics are pretty strong. And if you look at going into 2023, we're really in a position of strength from liquidity and balance sheet and perspective.

Yes, it's an exciting time to be part of EnPro for sure.

I know we're coming up to the -- towards the end of the presentation. But I do want to give you the last word. And maybe can you talk about what you think is underappreciated by investors about the EnPro story?

I think we're starting to see more recognition of the hard work that's been underway for quite some time. Certainly, in our stock price, you've seen it since our Q3 earnings release. So we feel like we're starting to get that recognition that for the value that we think has been there for quite some time. And so I would start there. It's -- I think we've reached the tipping point, but there's still a long way to go because if you look on a trailing basis, investors have not yet seen what our portfolio now looks like on a trailing basis. And so we believe the best is yet to come. So that's one thing. I mentioned culture and the way we work earlier, and I'm not sure that investors have a full appreciation for what that means to us and to our company. But I don't think that that's necessarily fully appreciated or understood. And some of that's captured here on the slide that's up now. James or Chris, do you have any last thoughts on that?

EnPro basically is comprised of best-in-class industrial technology assets that have a very strong aftermarket component that have been enduring almost self-fulfilling long-term capability for innovation. The margins are best-in-class versus our peer group, and we have plenty of opportunities for growth both organically and inorganically, and we're disciplined stewards of capital.

Great.

It's a good way to end it. Thank you very much for presenting the EnPro story. Thank you.

Thank you.

Thanks, Abe.