Description

Enpro (NPO) is an excellent company that earns 20%+ returns on tangible capital, can grow organically mid to high single digits given leading industry positions, and trades at less than 13x forward free cash flow. At a current price of $95 per share I believe there is 50%-75% upside to $140-160 over the next few years.   

Enpro is a leading industrial technology company that has undergone a significant transformation over the last few years. The transformation consisted of divesting lower growth and more cyclical assets and reinvesting the proceeds into much higher quality and faster growing businesses. The business today consists of two segments – Sealing Technologies (57% of revenues) and Advanced Surface Technologies “AST” (43%). Aftermarket revenues are >50% of revenues. At a recent price of $97 and with 20.8m shares outstanding the market cap is $2bn. Total debt is $791m while cash on hand is $335m for a total enterprise value of $2.45bn. The company should generate ~$8+ per share of free cash flow in 2024, increasing to $10 in 2025. 

Sealing Technologies:

Sealing technologies comprises three different businesses – Garlock, Stemco, and Technetics. The core and most significant business within sealing is Garlock, a 130-year-old premium seal manufacturer. Garlock creates seals that adhere to the flanges in a pipeline system to prevent it from breaking and rotting. The strength of the business is its application engineering (different seals for different processes) and brand. Aftermarket is 2/3 of the revenue in this business. Once the seals are specified into a facility they frequently get replaced during the MRO process. As it is less than two percent of the MRO cost and given its reliability the seals don’t get substituted out. Furthermore, the business has very good pricing power as evidence of the ability to increase margins in 2022 in the face of significant raw material inflation. 

In addition to Garlock, the segment also includes Stemco and Technetics. Stemco produces wheel end packages including wheel pins and end seals (where it is estimated to have > 90% share) for the heavy duty truck market. These wheel end packages ad seals keep the lubrication smooth and steady under high heat and usage. Technetics is the smallest of the three and produces seals for the general industrial and aerospace industry.

In 2022 this segment generated $625m of revenue, $159m of EBITDA (25.5% margin) and CapX is only 1.5% of sales. It is important to recognize that since 2019 the company has improved margins from 17% to 25.5% (achieving their 2025 target three years early) with more room to go. I expect the company to continue to see improved margins as raw material inflation abates (and they maintain price) and the aerospace market improves for Technetics. Simply put, this is a best in class sealing business.

Advanced Surface Technology:

This segment comprises four unique businesses focused on the technology industry and for three of them the semiconductor industry. These are – NxEdge, LeanTeq, Technetics Semi, and Alluxa. The first three businesses target the semiconductor industry. While each business has a unique place in the semiconductor ecosystem what is critical to understand is that they are all providing high value-added services and products that once specified as part of the process of record results in an annuity-like stream of revenue.

Technetics Semi: A manufacturer of semiconductor equipment with the largest product being chucks used in a cleanroom. These chucks undergo tremendous pressure and are in harsh environment conditions such that they are often required to be replaced/refurbished. Furthermore, as nodes are reduced and conditions intensify these chucks are required to become more specialized and maintained more frequently.

NxEdge:  The business was acquired in the Fall of 2021 for $850m from private equity owners. The company produces components used in advanced node semiconductor manufacturing as well as offering advanced coatings and consumables. The manufacturing facilities are based in the United States.

Leanteq: The business was acquired in 2019 and is a service business that handles the cleaning and refurbishing of wafer equipment based on the specifications of both equipment manufacturers like AMAT and IDMs like TSMC. This is an annuity business and it is critical that the company be located near its customers (therefore they have facilities in Taiwan and the US including a new facility being built in Arizona).

Alluxa: This business is a niche technology specialist focused on optical films. The end markets are very diverse and the company is led by the founder (it was acquired in 2019) who stayed on post the transaction. This is the smallest as measured by revenues but has the highest margins given it is at the leading edge of technology. Alluxa takes a surface – can be ceramic, glass or PTSE and adds layers of other surfaces or coatings to filter light to a specific point.

As the company has brought Technetics Semi, NxEdge, and Leanteq together they have been able to combine and bring additional services and value to their customers. Importantly, as these products and services are accepted and used they become part of the “Process of Record”. The process of Record is similar to an API in the manufacturing of pharmaceuticals whereby once in place changing to a new supplier is nearly impossible. It can be thought of as the recipe used in semiconductor manufacturing. 

While the AST segment has annuity-like characteristics there is also structural growth, particularly given its scale and share in the United States and the expected buildout of semiconductor manufacturing domestically. According to the Semiconductor Industry Association over 40 new projects have been announced since the introduction of the CHIPS act in 2020 representing $200 Billion in new investment. Importantly, this buildout will mostly be focused on advanced node manufacturing where AST shines. The following is a link to an article detailing the investments: https://www.semiconductors.org/the-chips-act-has-already-sparked-200-billion-in-private-investments-for-u-s-semiconductor-production/.

The segment has grown organically over the last 3 years at a ~15% CAGR while improving margins 1000 bps to 29.7% in 2022. Guidance for 2023 is for revenues to be -5% to flat as wafer starts are expected to be down mid-single digits and capital equipment spending mid-twenties. This outperformance is evidence of the annuity like revenues and exposure to advanced nodes.

Management and Valuation:

Enpro is led by CEO Eric Vaillancourt and CFO Milt Chidress. Eric has been with the company since 2009 and ran Garlock and rising to lead the sealing business. Milt has been with the company since the company was spun off from Goodrich in 2002 and has been CFO since 2015. In my experience I find them to be excellent leaders as evidenced by the tremendous operational performance of the business and strong balance sheet. Strategically they have divested non-core businesses and reinvested the proceeds in high quality assets that have a long runway of growth ahead.

The company has guided 2023 revenues flat to up low single digits with adjusted ebitda of $248-260m, a slight improvement over adjusted 2022. I think that given the near term macro, particularly in semiconductors achieving this guidance would be a strong result. Longer term I think the sealing segment can grow 5-7% annually while advanced surface technology should be higher at 8-12%. EBITDA margins should be 22-25% over time with capital spending of 3%-4%. Taken together, I think the company can earn ~$8.40 of sustainable free cash flow in 2024 and $10 in 2025. Returns on tangible capital are in the mid-twenties. Therefore, I think the business is worth 15-18x or $150-$180 per share. Finally, as evidence of the attractive valuation, I would note that Eric Vaillancourt bought shares in the open market last week. 

Catalyst

Great company with 20%+ returns on capital trading at a low valuation. 

Excellent balance sheet.

Insider Buying.