Hurco Not Out Of The Woods, But Investors Already Thinking Recovery

Trading below book value when I last wrote about (and recommended) the stock, Hurco (HURC) shares are up about 30% since then - more or less keeping pace with the broader industrial sector. As expected, Hurco's financials are getting pummeled by the sharp business downturn instigated by COVId-19, but investors have already started bidding up industrial stocks in expectation of a V-shaped recovery in many manufacturing sub-sectors.

While I do think Hurco will recover and that the shares are still priced for a double-digit long-term total annualized return, I'm concerned that industrial stocks have come back too far too fast. Given incremental updates on manufacturing end-markets and companies cutting spending to bare bones, I think it'll be at least another quarter or two before Hurco starts seeing evidence of a turn, but I think some of the worst-case scenario risk is leaving the table. All in all, I think Hurco is worth owning here, but I think we may see another pullback before the dust settles.

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Hurco Not Out Of The Woods, But Investors Already Thinking Recovery

Clinical Data Reaffirm That Lumasiran Will Almost Certainly Be Alnylam's Third Commercial Product

Alnylam (ALNY) is well on its way to having its third commercial product before the end of 2020. A prior release of positive top-line data from the company's pivotal ILLUMINATE-A study of lumasiran already indicated approvable efficacy, but the full data presented on Sunday June 7 added some valuable context to what should be a worthwhile commercial opportunity for the company.

As I indicated in my last article on Alnylam, I still regard this stock as a long-term holding in my portfolio, but I wasn't as excited about the near-term price performance potential in early May. With the shares down about 10% since then, the opportunity is more interesting now, though I have some modest "strategic" concerns that the strong rally in biotech relative to the S&P could leave the sector more vulnerable to near-term profit-taking as investors regain confidence in a stronger/quicker post-Covid-19 economic recovery.

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Clinical Data Reaffirm That Lumasiran Will Almost Certainly Be Alnylam's Third Commercial Product

Another Systemic Shock Creates Another Opportunity With Kirby

Barge operator Kirby (KEX) often trades at a robust premium during the good times; while the company’s historically strong operating margins and strong market share would support that to some extent, I’ve often thought that the valuation was just too rich in recent years – and the stock’s performance relative to the S&P 500 has been pretty poor over the last five years. Some of that can be tied to the company’s ill-fated expansion into fracking-related oil & gas machinery services, but some of it, I believe, is also tied to actual underlying free cash flow performance not being as robust as the valuation would other presuppose and the cyclicality of the business itself.

That may seem like a downbeat intro, but I actually think Kirby is a good company. The expansion into oil & gas within the Distribution and Services (or DES) business is an issue, but the core marine operations (inland and coastal barging) are about as solid as you could ask for, and I see little reason to believe that will change. Covid-19 has created some severe disruptions in the energy market, not to mention the economy as a whole, but I believe Kirby offers interesting long-term opportunity at this price.

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Another Systemic Shock Creates Another Opportunity With Kirby

An Abrupt Shift In Business Will Challenge Carpenter's Self-Improvement Story

The outbreak of Covid-19 has dramatically shifted the outlooks and operating environments for many businesses, and in the case of Carpenter Technology (CRS), it's going to seriously challenge the company's recent self-improvement efforts, efforts that had seen notable product mix and margin improvements in the Specialty Alloys business. With aerospace making up about 60% of Carpenter's revenue mix and the likelihood of a multiyear recovery path given the hit to the airline sector, Carpenter is going to have its work cut out for it.

I still see opportunities for Carpenter to drive better results through self-improvement, but the next few quarters will give investors good insight into how much the company's efforts over the past few years matter in real-world downturns. Past downturns have pushed operating margins down to the low single digits, and the company will need to do better than that to support an "it's different this time" argument for a stock and a sector where it's long been difficult to earn sustained market-beating returns.

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An Abrupt Shift In Business Will Challenge Carpenter's Self-Improvement Story

Margin Improvement, Electronics, And Aftermarket Offer Some Opportunity For Wabtec

The last 12 months haven't been particularly easy for Wabtec (WAB), but the shares have more or less kept pace with the larger industrial sector, as well as peers/rivals like Caterpillar (CAT) and Knorr-Bremse (KNRRY). At the same time, management has built some early credibility on its margin-improvement story, as well as its ability to drive growth from digital electronics and aftermarket.

Wabtec is not my favorite industrial, and the freight market is going to remain challenging for a while, but it's a little strange to me that Wabtec should trade at a wider discount to fair value than many other heavy machinery names. I don't see stellar return potential here, but I do see some relative undervaluation, and I think Wabtec may be poised to outperform expectations as railroad and transit operations normalize after the COVID-19 outbreak, leaving some opportunity for upside to numbers and multiples.

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Margin Improvement, Electronics, And Aftermarket Offer Some Opportunity For Wabtec

Middleby's Premium Is Gone, But Longer-Term Demand Destruction Is A Real Concern

For some time now I’ve stayed away from Middleby (MIDD) because I thought the market gave too much of a growth premium to a stock where the underlying company really wasn’t a true growth story anymore. Relative performance has indeed been poor over the last three years or so, as the company has struggled to put together compelling growth and margin leverage despite restructuring initiatives and ongoing reinvestment in product development.

I no longer think that premium valuation is a problem here. In fact, the shares look undervalued if the company can manage long-term annualized free cash flow growth of just 3% (from 2019’s level). That should be an achievable/beatable target, but I don’t want to underplay the risk that Covid-19 will cause long-lasting demand destruction in its core market, nor that management will continue to make questionable strategic and capital allocation decisions.

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Middleby's Premium Is Gone, But Longer-Term Demand Destruction Is A Real Concern

Columbus McKinnon Braced For The Downturn, With A New CEO To Drive Future Growth

As a company tied to industrial production, Columbus McKinnon (CMCO) is already seeing a severe hit to its business, and that’s only going to get worse in the June quarter. Looking beyond the next couple of quarters, though, the company is in a pretty strong position having successfully executed on a multiyear plan to improve manufacturing and supply chain efficiency, eliminate non-strategic businesses, and simplify the portfolio. Now the company is transitioning to more of a growth phase that will include investing in automation-enabling technologies and pursuing select M&A.

Since my last update on the company, industrial production has plunged, but the company has hired a new CEO. If low-to-mid single-digit revenue growth and low double-digit FCF margins remain reasonable long-term assumptions, Columbus McKinnon shares look undervalued today with a double-digit long-term annualized total return potential.

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Columbus McKinnon Braced For The Downturn, With A New CEO To Drive Future Growth

II-VI Looking To Flex Newly-Bought Muscle In Multiple Growth Markets

I wouldn't expect a stock that was up more than 40% over the past year and serving growth end-markets like data centers and 5G infrastructure to be undervalued, but that may yet be the case with II-VI (IIVI). There's an above-average risk here, as a lot of II-VI's value is predicated on grabbing share in markets like 3D-sensing, leveraging capabilities in advanced materials like SiC, and generating healthy margins in markets like optical components where that has historically been hard to do, but those risks seem more than balanced by the opportunity.

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II-VI Looking To Flex Newly-Bought Muscle In Multiple Growth Markets

With A Much Different Risk/Reward Outlook, Independent And Texas Capital Call Off Their Merger

The COVID-19 outbreak has created some significant disruptions for the banking sector, with almost every bank building reserves in anticipation of higher loan losses from the ensuing recessions. Those disruptions have also led to the termination of the proposed merger of equals between Independent Bank (IBTX) and Texas Capital Bancshares (TCBI), with the two parties agreeing to go their separate ways without any termination fees or other commitments.

Looking ahead, I can see both banks as candidates to be involved in future M&A, though the challenges TCBI is currently facing (including the need to find a new CEO) lead me to believe they'd more likely be a seller than a buyer. While the current valuation on TCBI does look exceptionally pessimistic, I'd prefer IBTX at this point given the greater uncertainties in TCBI's business mix.

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With A Much Different Risk/Reward Outlook, Independent And Texas Capital Call Off Their Merger

Liking ING Groep (ING) has been nothing but an exercise in frustration for years, with the recent COVID-19 outbreak only exacerbating what had been an extended period of underperformance. While ING’s credit quality and risk exposures screen relatively favorably, the bank’s heavy reliance on spread lending remains a significant risk and investors have been waiting in vain for a while now for some spark to ignite the business and the share price.

There are a lot of cheap-looking bank stocks out there now, so investors have the luxury of being picky. I do think that ING shares are trading significantly below long-term fair value, but the full impact of COVID-19 on credit quality is yet to be seen and ING has not yet named a new CEO. I believe whomever the board selects will be starting off from a period of low expectations and healthy capital, and I think the valuation is appealing, but this has been a value trap for quite some time now and that may well be the case for a while longer.

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ING May Finally Have Found Its Bottom

Analog Devices Remains Well-Run And Well-Placed To Grow

Even when you’re talking about the best of the best, valuation still matters. While I liked the quality of Analog Devices (ADI) and its differentiated growth drivers a year ago, I wasn’t so fond of the valuation. Since then, the shares have given investors a roughly 15% return, which is better than the return of the S&P 500 over that time, but well below the 40%-return of the semiconductor sector (as measured/reflected by the SOX index).

My main concern today is that the sector (and the market in general) has come back too far too quickly, leaving the risk/reward balance skewed more to the downside, and particularly if the Covid-19 recession proves to be deeper and/or longer than expected. I still really like Analog as a company, though, and I’m excited by the company’s specific growth drivers and growth opportunities, as well as its high-quality management. Valuation makes it hard for me to call this anything more than a hold, but I suppose if I had to own an expensive analog chip stock, this would be my preferred pick.

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Analog Devices Remains Well-Run And Well-Placed To Grow

Danaher: No Need To Fix What Isn't Broken

Danaher's (DHR) multiyear shift away from industrial end-markets and towards life sciences and diagnostics continues to benefit shareholders, with the stock continuing to outperform its former industrial peer group, while performing more or less in line with newer peers like Thermo Fisher (TMO). Although an upcoming CEO transition holds some modest risk, Danaher has amply demonstrated that it has a deep management bench and that it reinvests in internal executive talent development.

The only real issue, and this will be no surprise to most readers, is the valuation. Even though I assume that Danaher will actually grow faster over the next decade than the trailing 10-15 years (growing FCF at a compounded rate of around 10%), that still only suggests mid-single-digit total returns. Maybe that's enough given the above-average quality of this company, but I remain concerned about relatively limited prospects for positive re-rating with what is already a widely-loved company.

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Danaher: No Need To Fix What Isn't Broken

The New Ingersoll Rand Debuts Under Challenging Circumstances

While the combination of the former Ingersoll Rand’s non-HVAC businesses and Gardner Denver into the new Ingersoll Rand (IR) makes plenty of sense on a long-term basis, this is a tough time for this new company to make its debut. A host of short-cycle manufacturing end-markets are under significant pressure now, not to mention commodity markets like mining/metals and oil/gas, and acyclical businesses like medical/life sciences aren’t big enough to pick up the slack.

Ingersoll Rand should see its short-cycle business pick up around year-end, leading the way into a solid recovery in 2021 and beyond. Upstream oil/gas is going to be weaker for longer, I believe, but it’s now a smaller part of the overall business. On top of that are meaningful synergy and cost reduction opportunities. The “but” at the end of the road is valuation. While I do see a path to adjusted operating margins in the mid-teens and similar levels of FCF margin, the share price seems to already reflect that and I’m concerned the company could execute quite well objectively but still underwhelm from a relative price performance perspective.

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The New Ingersoll Rand Debuts Under Challenging Circumstances

Cummins: Sentiment Showing Even Wilder Swings Than The Business

Cummins (CMI) is a cyclical business, always has been and likely always will be, and yet, you still see analysts and investors who treat every cyclical peak and cyclical trough like the new normal. Sentiment has shifted significantly in the last few months, with the stock dropping close to 40% during the March panic but then shooting back up on what I believe may be premature enthusiasm that the worst of the downturn is now understood and “in the numbers”.

Make no mistake, I think Cummins is a great company, and I think management made smart choices to prepare for this downturn. I also think that while the company has been slow to invest in powertrain electrification technologies (particularly axle-centric technologies), it has made it up for that somewhat with other investments. My bigger issue is sentiment. Cummins would seem to offer a decent return now, but I think there could be another pullback after this strong rally, and that’s where I’d look to get more aggressive.

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Cummins: Sentiment Showing Even Wilder Swings Than The Business

Dana Still Worth A Look On Better Decrementals And Recovery Potential

Up another 25% from my last write-up on the company, I still believe Dana (DAN) has more upside from here. Not only is Dana leveraged to recoveries in autos, trucks, and other commercial vehicles, but the company's surprisingly strong decremental margins so far lends a lot of credibility to management's past comments about the resilience of its margin and cash flow structure. Further down the road, Dana has a portfolio of electrification technologies that should enable it to preserve its business as manufacturers and customers shift to electric powertrains.

Low single-digit revenue growth and low-to-mid single-digit FCF margins can support a fair value in the high teens, though the near-term margin-driven EV/revenue fair value is more in the mid-teens. Either way, I think these shares offer appealing potential here even with the risk of a protracted downturn in the company's major markets.

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Dana Still Worth A Look On Better Decrementals And Recovery Potential

Rexnord Has Attractive Long-Term Drivers And Credibility On Margin Improvement

I've liked Rexnord (RXN) as an under-the-radar play on automation and institutional/industrial water for a little while, and while I thought the valuation on the shares was equivocal back in January, the stock has continued to outperform the larger industrial sector - even though "outperform" in this case means "declined less than the others". At this point, I still see attractive automation-oriented opportunities in its process and motion control business, and I believe its water business may hold up better than non-residential construction in general. I likewise still see longer-term margin/cash flow improvement opportunities as the company moves toward mid-teens FCF margins.

With ongoing outperformance, it is perhaps not so surprising that the valuation isn't outstanding. I believe Rexnord is priced for high single-digit returns at this point. That's okay, but I typically favor higher hurdle rates and I consider this more of a hold or a buy-the-dip idea than a "buy now" idea.

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Rexnord Has Attractive Long-Term Drivers And Credibility On Margin Improvement

Tenneco Still Under-Earning And Loaded With Debt

When I last wrote about Tenneco (TEN), I thought this highly-leveraged auto, truck, and commercial vehicle parts supplier was just too much of a risk relative to the potential rewards. The shares have fallen almost 60% since then, and while I think the company may be able to squeeze through these new challenges and survive, I still see significant ongoing operating issues with a company that has long generated underwhelming margins and gone deeply into debt pursuing very questionable M&A strategies.

As I said before, given the very high leverage here, even rather modest changes in long-term growth or margin assumptions (or near-term valuation multiples) can drive a meaningful change in the prospective fair value. Change my ‘21 revenue multiple by 0.025 (from 0.375x to 0.40x) and the per-share fair value jumps almost 50%. Change a model input such that the long-term average FCF margin changes by 1bp and my DCF-based fair value can change by almost 3%.

With such high leverage, a successful restructuring and turnaround at Tenneco could drive huge shareholder returns. Likewise, with such high leverage, a single management mistake (and there have been more than a few of those over the years) could conceivably spiral the company into bankruptcy. I don’t need that kind of risk, particularly in the absence of a better restructuring/turnaround plan, and I’m not looking to buy these shares today.

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Tenneco Still Under-Earning And Loaded With Debt

Hospitals Reopening, But Zimmer Biomet Needs To Stabilize Its Knee Business

I wasn’t overly fond of Zimmer Biomet (ZBH) back in early January, and the shares have modestly underperformed peers like Smith & Nephew (SNN) and Stryker (SYK) since then. The Covid-19 outbreak has certainly created an unexpected disruption for a business based largely around elective procedures, but I remain concerned about Zimmer on the more fundamental level of whether it can stop losing share to knee and hip competitors like Stryker and Johnson & Johnson (JNJ), and whether restructuring efforts can really improve the company’s long-term margin and growth outlook.

At the right price, I think the “better Zimmer” story might have legs, but today’s price looks more “okay” than compelling to me right now.

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Hospitals Reopening, But Zimmer Biomet Needs To Stabilize Its Knee Business

Leadership In Data Center Interconnect Continuing To Propel Inphi

It wasn’t that long ago that I last wrote on Inphi (IPHI), early April in fact, and the shares are up almost another 30% since then. The company did in fact produce the beat-and-raise quarter I expected, but the degree of the “raise” was startling even to me, as the company continues to benefit from physical layer upgrades in the data center.

How do you value Inphi? As is often the case, exceptional growth companies like Inphi don’t really work from a DCF standpoint and they break the models for the sort of multiples a “normal” company should get. You can turn to alternative approaches like peer multiples, but it’s tough to construct a peer group for Inphi – Nvidia (NVDA) and Silicon Labs (SLAB) would arguably belong in that group, but it’s a fairly short list.

You can also look at what the market has been willing to pay for similar growth in the past, or some combination of those approaches. It’s that latter method that I’m gravitating toward now; I won’t defend it as a particularly rigorous approach, but based upon what the market is willing to pay for the growth at companies like Nvidia and Silicon Labs now, and what it has paid for comparable growth in the past, you can get a fair value range of around $115 to $140 today.

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Leadership In Data Center Interconnect Continuing To Propel Inphi

COVID-19 Brings Komatsu Back To More Reasonable Levels

There are ample concerns about both the construction and mining end-markets now, and that can be seen in Komatsu's (OTCPK:KMTUY) 20% year-to-date share price decline, a decline more or less on par with Caterpillar (CAT) but worse than Epiroc's (OTCPK:EPOKY) performance over the period. Although construction and mining activity has held up reasonably well, major customers are far more cautious on capital spending now, and that is likely to push Komatsu's revenue, margins, and cash flows down in fiscal 2021.

The main attraction I see in Komatsu now is that it's trading at what has historically been an attractive multiple. While I do have my concerns with the company's market share in the Chinese excavator market and its leverage to coal mining, I think those issues are more than reflected in the share price. I won't claim this is the best equipment company, but I do think the risk-adjusted return potential is good enough to merit at least a spot on a watchlist.

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COVID-19 Brings Komatsu Back To More Reasonable Levels