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LECO's stock suffers from investors' fears, but the world's leader in welding and cutting equipment has plenty to gain from industrial growth in emerging markets
From Standard & Poor's Equity ResearchLincoln Electric Holdings (LECO; $70.60), the world's largest manufacturer of consumables and equipment for the welding and cutting industry, stands to benefit over the next several years from strong demand for its specialty welding products in international markets, especially Asia and Europe, and from the infrastructure, energy, and mining markets. We at Standard & Poor's Equity Research have our highest investment recommendation of 5 STARS, or strong buy, on the stock.
In our opinion, LECO can leverage its competitive advantages of market leadership (by our calculation, it has the No. 1 share in the global and U.S. markets, at 14% and 35%, respectively), strong research and development, and a highly trained technical sales force. We expect that increasing demand for its products will help it expand its margins and boost its already leading returns. Primary demand drivers, by our analysis, include rapid expansion in Eastern European and Chinese infrastructure and shipbuilding, greater investment in oil and gas production in China and Russia, and global commodity demand, which is driving mining activity in Latin America.
In the past month, LECO shares have fallen nearly 10%, while the S&P 500 has remained essentially flat, and they currently trade at a 10% discount to peers on a calendar-year 2008 p-e basis, and 16% discount to peers on a calendar-year 2008 enterprise value-to-EBITDA basis. We view this discount as unwarranted and think it is a result of recent investor concerns about the strength of the global economic expansion and LECO's exposure to domestic construction activity. We believe these concerns are overblown, as the company is benefiting from industry trends that, in our view, appear strong and sustainable.
For example, in the recently completed third quarter, LECO continued to experience domestic strength because of growth in infrastructure projects, commercial construction, and the energy sector. Its international sales, which represented 40% of total sales, continue to expand rapidly. Excluding foreign currency and acquisitions, European sales increased 15%, Asia-Pacific sales grew 35%, and Latin America sales rose more than 40%. We believe these rates are sustainable and should accelerate, given the primary global demand drivers cited above and the fact that LECO is experiencing a significant order rate increase, a substantial portion of which is for export.
We view LECO's valuation as compelling, with the stock trading at 7.8 times estimated 2008 earnings before interest, taxes, depreciation, and amortization (EBITDA), nearly a 16% discount to peers—despite its leading market position, the competitive advantages of its highly trained technical sales force, its low-cost manufacturing, a broad patent portfolio, substantial exposure to rapidly growing international regions, and its focus on the infrastructure, energy, and mining end markets. In addition, we believe the company generates attractive returns, with a third-quarter 2007 return on invested capital (ROIC) of 17%. It maintains minimal leverage, with a third-quarter debt/capital ratio of 11.2%, and offers strong earnings growth, with a 24% three-year compound annual growth rate (CAGR) through 2008, by our calculation.
The Lincoln Electric Co. was founded in 1895 by John Lincoln to manufacture electric motors of his own design. In 1909, the Cleveland-based company manufactured its first welding set, and in 1911, it introduced the first variable-voltage, single-operator, portable welding machine.
Welding products offered by LECO include arc welding power sources, robotic welding packages, and fume extraction equipment. Consumable products (more than 60% sales) include wire feeding systems, electrodes, fluxes, and brazing and soldering alloys—in which it has a leading global position. This large consumable product base generates a substantial repeat revenue stream, while its technical sales team works alongside customers to generate, in our view, healthy repeat business and strong margins. LECO also sells regulators and torches used in oxy-fuel welding and cutting, and brazing and soldering products.
The company's major end-user markets include metal fabrication, infrastructure (oil and gas pipelines and platforms, buildings, bridges, power generation, etc.), transportation (shipbuilding, aerospace), defense, equipment manufacturers (construction, farming, and mining), retail resellers, and the rental market. In North America (62% of latest 12-month sales), LECO's products are sold primarily to distributors and retailers, and directly to end users. In Europe and the rest of the world (17% and 21% of last 12-month sales, respectively), the company maintains a direct sales organization to market products to distributors, agents, dealers, and users.
Eastern Europe, Asia-Pacific Drive Growth
As manufacturing continues to move to low-cost regions at the expense of North America and Western Europe, we expect LECO will continue its aggressive global expansion and capacity additions.
North America and Europe combined to generate 83% of total company sales in the 2007 third quarter. While the two markets are relatively mature, we expect Eastern Europe to drive much of the demand for LECO's products in Europe due to the region's rapid infrastructure repairs and expansion. Management indicated in late October, 2007, that demand in Eastern Europe was very strong and accelerating. In this market, in particular, LECO is facing capacity constraints, and the company has been forced to add capacity. Demand for welding products has expanded at above-average rates in Eastern Europe as heavy industry and shipbuilding have migrated from the relatively high-cost Western Europe region, and as Russia has increased investment in oil and gas production. LECO is well positioned to benefit from growth in the region, in our opinion, as it has increased capacity in its Poland, Turkey, and Russia operations.
The Asia-Pacific region is the fastest-growing market for the welding industry, driven partly by infrastructure buildout and strength in the shipbuilding and energy industries. In China, the region's fastest-growing country, LECO has established a manufacturing base and distribution network primarily through acquisitions over the past two years. In July, 2007, the company acquired Nanjing Kuang Tai Welding Material Co. Ltd., a manufacturer of stick electrode products based in Nanjing, China. In 2004, LECO invested $12 million in Shanghai Lincoln Electric to acquire a 70% ownership interest and to fund expansion. In November, 2005, it invested an additional $5.5 million, to increase its ownership interest to 78%. Shanghai Lincoln Electric manufactures flux-cored wire and other consumables, and opened equipment manufacturing facilities in the first quarter of 2006. In 2004, Lincoln acquired 70% of Rui Tai Welding & Metal Co. Ltd., a manufacturer of stick electrodes located in northern China, for approximately $10 million, net of acquired cash, and assumed debt of $2 million. We expect the company to add manufacturing capacity in India as the market is currently being served by exports from other locations.
The Latin American market has also been strong recently, as rising global demand for commodities has boosted economic activity. In our opinion, LECO has been able to gain market share in Mexico, Venezuela, Brazil, and Colombia by increasing manufacturing capabilities and improving manufacturing efficiencies.
We believe that due to steady revenue growth, strong cost containment, and management's focus on margin expansion and value creation, LECO has continued to generate strong returns over the past nine years and has little long-term debt. We calculate that over the past nine years, the company has averaged a 17.5% ROIC and a 17.3% return on equity (ROE), with an average long-term debt/capital ratio of 15%. We find this to be evidence of what we consider superior management working in the best interests of shareholders to create value.
For the five years ended December, 2006, LECO generated a revenue compounded annualized growth rate (CAGR) of 12%, a gross profit CAGR of 15%, an EBITDA CAGR of 13%, and an earnings from continuing operations CAGR of 15%. Total assets increased at a five-year CAGR of 12%, inventories at a 16% CAGR, and capital expenditures at a 16% CAGR. Capital expenditures were $76 million in 2006.
LECO historically has been able to generate ROIC in the mid-teens, but the measure fell into the single digits in 2003 and 2004 as the company struggled to recoup rising raw material costs. After bottoming in 2003 at 7.3%, LECO's ROIC rebounded to 19.8% in 2006, resulting in the 17.5% average over the past nine years. The company's ROIC compares favorably to that of the industrial machinery average (10.6%) and the industrials sector average (9.9%).
We see organic revenues rising 16% in 2007 and 10% in 2008, led by growth in the energy, mining, infrastructure, and transportation markets, as international sales should help offset more modest domestic demand. LECO is expanding capacity in Asia and Europe to meet rapidly growing demand and alleviate capacity constraints. As an example of regional growth rates, third-quarter Asian sales increased more than 35% from last year and European sales jumped 36%, while sales in Latin America rose in excess of 40%, year over year. We expect price increases, currency translation, and acquisitions to support 2008 sales growth.
We see EBIT margins expanding in 2007 and 2008 to 12.4% and 13%, respectively. We look for LECO to benefit from greater operating leverage on higher volumes, increased efficiencies, and lower selling, general, and administrative expenses as a percentage of sales, partly offset by rising material costs.
We project operating earnings per share of $4.70 in 2007 and $5.20 in 2008, increases of 18% and 11%, respectively, despite our forecast of higher net interest expense and effective tax rates in each year as profitability rates increase.
Our 12-month target price of $91 represents a combination of two valuation metrics. Our discounted cash-flow model indicates an intrinsic value of $91. Incorporating a risk-free rate of 4.9% and equity risk premium of 5.5%, we derive a weighted average cost of capital of 10.2%. As cash-flow growth stabilizes over the next 20 years, in line with both industry dynamics and company performance, we forecast LECO's terminal rate of free cash-flow growth at 3%.
In terms of relative valuation, we apply a target enterprise value-to-EBITDA multiple of 10.4, a premium to peers, to our 2008 EBITDA estimate, to arrive at a value of $92. We believe this premium is appropriate based on the company's leading market position, competitive advantages, comparatively low financial leverage, high returns, and stable free cash-flow generation.
Favorable Corporate Governance
We have a generally favorable view of Lincoln Electric's corporate governance. Some of the practices we view positively are that the board is controlled by a supermajority of independent directors; the audit, compensation, and governance committees are comprised entirely of independent outside directors; the company does not have a poison pill; and officers and directors have a vested interest in LECO, owning a combined 3.3% of the outstanding stock.
However, an area of concern for us is that the chairman of the board and the chief executive officer roles are filled by the same person, which we believe presents a potential conflict of interest. Although the board is composed of independent directors, we have some reservations that it is divided into three classes, which we think tips the balance of power to incumbent management since it makes it more difficult to change control.
Risks to our recommendation and target price, in our view, include weaker-than-expected international and U.S. economic growth; softer industrial, energy, and infrastructure markets; productivity declines; increased raw material supply costs (primarily steel, brass, copper, and aluminum); increased competitive pressures; and potential value-diminishing acquisitions. Other risks include liabilities and fines associated with current and potential lawsuits in which the company is or may be a defendant.
Strong Buy Recommendation
We think that the strong demand trends for LECO's specialty welding products in the international regions and in the infrastructure, energy, and mining markets will help drive revenue and earnings growth. In addition, we believe management's continued focus on cost control and improved productivity should help profitability metrics improve and expand EBITDA margins.
By our analysis, the company's strong returns, low debt levels, and steady free cash generation should allow the stock to trade closer to peer valuations. With LECO trading at nearly a 16% discount to peers on an EV/EBITDA basis, and no fundamental basis for such a deep discount, in our view, we find the valuation compelling, and we recommend purchase of the shares.