Markets & Finance

Carlisle's Even Keel


From Standard & Poor's Equity Research

Carlisle Cos. (CSL), a maker of industrial products, has a solid track record of growth, in our view, with earnings advancing at a compound annual growth rate (CAGR) of 10% over the past decade, despite that the company operates in sectors that are somewhat cyclical.

This well-managed outfit has a disciplined approach to the management of its diversified businesses and focuses on sectors where it can achieve strong market share and high margins. A pruning of its portfolio over the past 18 months, coupled with cost reduction and the addition of new capacity, should allow the company to generate above-average growth over the next six to 12 months, in our opinion.

The company's stock carries Standard & Poor's highest investment recommendation of 5-STARS, or strong buy. We believe these shares are underappreciated on Wall Street as indicated by their valuation, which is only in line with the S&P 500, despite what we see as above-average growth prospects. Also, we view the balance sheet as very strong, with long-term debt only 28% of total capitalization. This should provide significant financial flexibility when pursuing future acquisitions, in our view.

Even though it operates in industries that are moderately cyclical, Carlisle has a history of fairly consistent sales and earnings growth, and its profitability has generally risen higher than its peers'. Its largest segment, comprising 39% of 2005 sales and a major engine of growth, is construction materials. This unit produces rubber and thermoplastic sheeting and insulation, used mainly on nonresidential flat roofs. Markets served include new construction, reroofing, and maintenance of low slope roofs, with about two-thirds of the volume in the sector from the replacement market. Because of its ease of installation and reduced labor requirements, single-ply roofing is steadily taking share from asphalt types. As a major factor in the industry, Carlisle is benefiting from this trend.

TRAILER CASH. Carlisle's industrial components segment made up 34% of revenues in 2005 and produces specialty tires and wheels and power transmission belts for industrial uses. Customers for these products include golf cart manufacturers, lawn and garden equipment manufacturers, boat and utility trailer producers, and recreation, agricultural, forestry, and mining vehicle makers. The lawn and garden business has been sluggish lately due, in our view, to secular changes in demand, but we believe this should help the company over the long term.

The diversified products unit made up 27% of sales in 2005 and includes a variety of businesses such as heavy-duty friction and braking systems for truck and off-highway equipment, specialty trailers, standard and custom-built trailers and dump bodies, high-grade aerospace wire, cable assemblies and interconnects, commercial and institutional plastic food-service permanent-ware and catering equipment. Primary customers for these products include truckmakers, heavy equipment and truck dealers, electronic and communications equipment manufacturers, food-service distributors, restaurants, hotels, and aftermarket distributors.

The company's revenues have advanced at a 9% compound annual growth rate (CAGR) over the past 10 years, with the only decline occurring in 2005 due to divestitures. (However, sales on a continuing operating basis increased 10.5%.) This rate of revenue growth is better than the Industrials group average CAGR of 7.6% over the same period.

IT'S ABOUT DISCIPLINE. Carlisle's net operating profit after tax (NOPAT) grew at a CAGR of 11% from 1996 through 2005, slightly better than the group average of 10.7%. Its NOPAT margin of 6.5% in 2005 was up from 5.5% nine years earlier, but below 2005's peer group level of 8.3%.

However, the company's return on invested capital of 11.3% over the past decade compares favorably with the Industrials group average of 9.2% over the same time frame. We think Carlisle's disciplined approach to volume growth and margin improvement will continue to work well in the future. Our expected three- to five-year EPS growth rate is 13%.

Carlisle's solid track record of growth has been achieved through a disciplined approach that targets businesses with relatively high margins, solid growth prospects, and a limited number of competitors. This method has allowed the company to achieve a leading position in most of its markets while generating above-average returns and steady growth.

BUYING SMALL. The company strives to be the low-cost manufacturer in the various niche markets that it serves. It also tries makes itself the preferred supplier to customers by providing superior quality products, on-time delivery, and short cycle times.

Acquisitions rank as a major component of the strategy, and Carlisle has purchased nearly 50 companies over the past 10 years. The company utilizes a highly decentralized management style and gives the presidents of operating companies a high level of independence. This decentralized approach encourages entrepreneurial activity and allows the leaders to be very responsive to customer needs. Carlisle's acquisition policy typically focuses on relatively small businesses that can be added to existing operations.

However, management occasionally considers businesses that can operate independently from other units. Management keeps a keen eye on all operating entities and divests businesses determined to be unable to consistently meet profitability objectives.

ROOF DREAMS. We think Carlisle is in an above-average growth phase that should last at least through 2007. Over the past 18 months, the company has reduced the number of operating units from 17 to 10, an effort that involved the divestiture of several operations, including the automotive business, which had lower margins than most of the other units.

Carlisle also significantly expanded its roofing business by constructing a manufacturing facility in Utah that employs new technology and has enabled the company to expand its presence in the western portion of the U.S. It has also added two new insulation facilities, giving it a total of six across the country. This was a major reason for the 29% sales growth and 20% profit improvement in the construction materials segment in the second quarter. As volume expands, we expect margins to widen in this very profitable sector.

The purchase last year of a major competitor in the off-highway brake sector is leading to much higher margins in that area, as it added manufacturing capacity and volume with little associated overhead. Demand is strong in that market now, as high commodity prices have prompted a pickup in mining activity.

HUNGRY FOR FOOD SERVICE. We see further gains in this unit, which has some of the highest margins at Carlisle. At Johnson Truck Bodies, a maker of refrigerated truck bodies and specialty trailers, we expect improved results as striking workers at this company's only facility have returned to work after a work stoppage in 2005.

We also feel optimistic about the food-service plastics market. Right now, the category is a little soft due to reduced casual dining resulting, we believe, from the sudden increase in gasoline prices. Over the longer term, however, Carlisle views this as a major growth area. The unit has doubled in size over the past five years, and management says it is disappointed with that level of growth. The company plans to change the basis of competition in the sector by, in our opinion, achieving a dominant domestic market position and then expanding into overseas markets.

Another avenue of growth we see for the company resides in the specialty wire and cable sector. The Tensolite subsidiary manufactures high-performance wire, cable, and connectors primarily for the aerospace industry. This represents a relatively small business for Carlisle. However, the company has developed a new product used in in-flight entertainment systems, and demand for this product has been strong. Tensolite's content on the new Boeing 787 aircraft is 10 times the level it was for the 737 plane, and margins are expected to be solid. With build rates for new aircraft likely to stay at high levels for the next several years, we believe this sector should prove a solid source of growth for the company.

QUALITY EARNINGS. One area that has been sluggish for Carlisle in recent quarters: small tires and wheels for the lawn and garden market. We think a secular change is occurring in this category as more people use lawn services for lawn care rather than mowing themselves. In the near term, this will likely lead to lower sales in the category—but over the longer term, this trend should work in Carlisle's favor as its margins on sales of tires and wheels for commercial machines are higher than on products used in the retail market.

We look for Carlisle's recent strong profit momentum to continue. Our 2006 operating EPS estimate is $5.45, which represents growth of 22%, from $4.46 in 2005. For 2007, we project EPS of $6. Over the next three to five years, we look for Carlisle to produce 12% to 15% compound annual growth in earnings per share.

As measured by our proprietary Standard & Poor's Core Earnings methodology, we believe the quality of Carlisle's earnings is quite high. There is only a trivial difference between our operating EPS estimates of $5.45 in 2006 and $6 in 2007, and our S&P Core EPS of $5.41 and $5.96, with the 4-cent difference in both years reflecting projected pension expense. Although Carlisle has had restructuring charges from time to time when it divests underperforming businesses, they are not a regular annual occurrence.

SHAREHOLDER COMPATIBILITY. Carlisle shares have performed well in 2006, with their year-to-date 18% rise easily exceeding the less-than-1% increase for the S&P MidCap 400. We believe the stock price appreciation has resulted from the company's strong earnings gains in the first half of the year, with first-quarter and second-quarter earnings rising 21% and 20%, respectively.

Despite this robust performance, the stock is only trading in line with the market multiple at 13.5 times our 2007 estimate. Our discounted cash-flow model indicates an intrinsic value of $97, based on our assumptions of a 9.9% weighted average cost of capital, a 6% free cash flow CAGR over the next 10 years, and 4% growth in perpetuity. We believe Carlisle stock merits a modest premium to its peer group forward p-e of 16.2. Applying a p-e multiple of 18.7 to our 2006 estimate of $5.45, we derive a valuation of $102. Our 12-month target price of $100 is a blend of these two measures.

In our view, Carlisle's corporate governance policies are well aligned with shareholders' interests. The board of directors is controlled by a supermajority (more than 75%) of independent outsiders, the company has a committee that overseas governance issues, and the audit committee is composed solely of independent outside directors.

AND A FEW RISKS. However, we are concerned that the company has a poison pill in place, which was not approved by shareholders, and that a former CEO serves on the board of directors.

Risks to our recommendation and target price include weaker-than-expected economic growth, an unexpected downturn in commercial construction, and a further decline in the lawn and garden business. Additionally, although we think the company has a favorable track record with regard to acquisitions, we see modest risk that a future acquisition could present integration problems for the company.

Overall, we think the shares are compellingly valued considering the solid growth that we expect for the company in the near and longer term. Carlisle's high market share in small markets should allow it to maintain wide profit margins for an industrial company, in our view. Recent capacity additions in rubber roofing, strong demand for heavy-duty brake equipment, and renewed growth for high-performance aerospace wire are expected to drive continued earnings momentum.

This well-managed company also has a strong balance sheet, in our opinion, which should easily allow it to pursue additional acquisition growth opportunities.


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