Pentair Punished As Investors Shift Away From Expensive Water-Theme Stocks

 

I’ve long been unwilling to pay up for popular “theme” stocks, and with the correction in valuations for industrial “compounders” and water stocks, I don’t feel so bad about passing on the group six months ago. The performance of Pentair (PNR) hasn’t been the worst in the group since my last update on the company, but a greater than 20% drop is still painful underperformance all the same.

Not unlike in the HVAC space, there are worries now around how Pentair will handle increasingly difficult comps in its core residential pool business, to say nothing of the question of how much demand was pulled forward during the pandemic lockdowns (when a lot of people redirected spending to renovating and improving their homes). I do believe that water treatment offers some upside and I think the industrial filtration business is better than commonly appreciated, but I do think Pentair faces a tough one-two combination of slowing revenue momentum and weaker margins on cost pressures.

Like many other former darlings, I’m conflicted about Pentair today. I do have concerns about “lower for longer” revenue performance, but this is also a company with growth drivers outside of pools and a return on tangible assets that is well above average (one of the highest among multi-industrials). While I do worry that sentiment could limit near-term outperformance, a long-term annualized total potential in the high single-digits for a well-run company is hard to ignore.

 

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Pentair Punished As Investors Shift Away From Expensive Water-Theme Stocks

Pentair Establishing Tough Comps, And The Valuation Is No Clear Bargain

 

Credit where due – Pentair’s (PNR) management has done a good job of streamlining and improving this business, shifting the sentiment away from Pentair’s legacy as a disappointing, under-executing, would-be empire-builder. There’s a lot to like about a business with a large aftermarket revenue mix, strong margins, and good market share, and there could be further portfolio transformation in the future.

All of that said, the strong growth in the Pool business over the last 12-18 months will make for tougher comps, particularly as the pandemic-driven remodel/renovation trend seems to be falling off. Moreover, while the mid-single-digit revenue growth and double-digit FCF growth I expect from Pentair compares well to many industrials, the valuation is already pretty fair today.

 

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Pentair Establishing Tough Comps, And The Valuation Is No Clear Bargain

Alfa Laval Buoyed Again By Strong Marine Results

As has been the case for most multi-industrials, particularly in the capital goods sector, Alfa Laval (OTCPK:ALFVY) (ALFA.ST) has shaken off some of the malaise that had pushed the shares down until relatively recently – while Alfa has outperformed its industrial peers since my last update, the 6-month and 12-month comparisons have Alfa lagging the market as sell-siders and investors have grown worried about what will happen as scrubber orders start to fade.

Although I’m not wild about the valuation (nor the valuation on industrials more broadly), this is still a company that I like quite a bit. I think there’s more opportunity in marine than just scrubbers, and I think longer-term opportunities in food, beverages, life sciences, and HVAC are not always given their due. Give me a 10% to 15% pullback and these shares get much more interesting as a potential longer-term holding.

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Alfa Laval Buoyed Again By Strong Marine Results

Emerson Transforming, But Is It Improving?

I haven't been a big fan of Emerson (NYSE:EMR) or its management team in recent years, and the stock's double-digit decline over the last three years does stand out next to the flattish performance of ABB (NYSE:ABB) and Siemens (OTCPK:SIEGY) and the stronger performance of Rockwell (NYSE:ROK) and Honeywell (NYSE:HON). All of these companies have been hurt to some degree by the sharp drop-off in process markets like oil/gas, power, mining/metals and chemicals, but Emerson has been hurt a little worse due to its overexposure to weak markets and some questionable execution from management.

With the sale of the Network Power business and part of the Industrial Automation business, the company certainly has some options to consider as it rethinks its future. Given some past poor decisions regarding M&A and an inability to meet past targets for growth and margin improvement, I think my skepticism toward management isn't unreasonable, and I think Emerson will struggle to replace what it has sold in terms of earnings/cash flow power. Emerson has done better than I thought it might since my last update (although it has still lagged ABB, Rockwell, Siemens, and Schneider (OTCPK:SBGSY)), but I'm just not comfortable with the valuation right now given the considerable challenges that remain.

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Emerson Transforming, But Is It Improving?

Seeking Alpha: Emerson Skidding On The Oil Spill

There's not a lot more left to say about the state of multi-market industrial conglomerates that I haven't already said. Companies that have outsized exposure to commodity/resource markets and emerging markets, and that definitely includes Emerson (NYSE:EMR), are getting hit hard and there isn't much relief in sight. Although Emerson's CEO believes that orders will bottom in the spring of this year, that's well outside of the norm of what most peer company CEOs are saying and the company's lack of exposure to relatively healthier markets like aerospace, auto, food/bev is a drawback.

Emerson has been going through tough times longer than its peer group and management seems more realistic about the need for capacity curtailments. Even so, I think the company could find it hard to get full value for its Network Power business and the Industrial Automation assets it has targeted for sale. Emerson scores well for its margins and returns on capital, but it's hard for me to see how the company generates enough revenue growth to really drive an attractive fair value from here.

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Emerson Skidding On The Oil Spill

Seeking Alpha: Xylem May Yet Be Better Than It Seems

It has been more than two years since I've publicly updated my thoughts on Xylem (NYSE:XYL). Back in early 2013, I thought that the company looked like a pretty typical example of an industrial that didn't immediately pop out as a bargain, but where I nevertheless expected further gains. That forecast has sort of worked out; I say "sort of" because although the shares are up about a third since that article, most of the progress was in the last quarter of 2013 and the shares have spent most of the rest of that time trading around the mid-$30s.

I think Xylem has made a lot of progress under its current CEO in fixing its operating structure and improving its margins. With that progress, it sounds as though the company is back on the hunt for acquisitions. The "but" is that the water market really doesn't seem to be what a lot of investors have long thought it was/would be. There's a long-term steady growth opportunity from maintenance and replacement and urbanization in emerging markets, but water isn't the municipal priority that some investors want to believe it to be, and strategic buyers have generally undervalued pumps (XYL's core business) relative to filtration, desalination, and other product categories.

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Xylem May Yet Be Better Than It Seems

Seeking Alpha: Rotork Has All The Quality You Could Want

I'm not sure how a reader could fault Rotork (OTC:RTOXY) on the basis of quality. This British industrial company has established leading market share in valve actuators (devices fitted to valves to control them, and the flow of fluid and gas), and actually grew through the 2009 downturn when most industrial companies were seeing significant pressure in their business. Rotork has not just grown, it has grown profitably, with a five-year average return on invested capital over 30%.

Quality isn't the issue with Rotork, but valuation might be. I readily admit that high-quality companies often get and hold a premium multiple. Rotork is also looking to redefine its business once again and expand its addressable market by about a third in the process. I'm not recommending betting against Rotork, but the market already seems to be counting on 10% annual free cash flow growth for the next decade and there are cheaper industrials out there right now.

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Rotork Has All The Quality You Could Want

Seeking Alpha: Are Investors Too Thirsty For Growth From Xylem?

As I mentioned about a month ago in a discussion of Gorman-Rupp (GRC), almost any company with substantial operations in water infrastructure gets a premium in the market. As one of the largest and most diversified pure-plays on the water sector, it's no surprise that Xylem (XYL) too carries such a premium. That leaves investors with a valuation quandary - absent acquisition interest from a larger company, is this a good name to add to a portfolio today?

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Are Investors Too Thirsty For Growth From Xylem?

Seeking Alpha: Is Gorman-Rupp Overpriced, Or Is Cash Flow Not The Right Metric To Use?

The water industry is a nearly perennially hot topic - almost every investment writer looks at the trends in freshwater infrastructure and eventually writes their "water is the commodity of the future" piece. For better or worse, the long-term potential of many players in the water space is pretty well accepted by investors, and many of these companies sport valuations not only higher than non-water industrials, but higher than what their cash flow would seem to be able to support. So it is worth asking, then, whether the well-run and well-respected Gorman-Rupp (GRC) is indeed overpriced today, or whether discounted cash flow just isn't an effective way to value this stock.

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Is Gorman-Rupp Overpriced, Or Is Cash Flow Not The Right Metric To Use?