Description

Summary

• Following 5+ years of major changes, Enpro's radically transformed portfolio is gives the best version of itself but has yet to realize the fruits of their labor given a 2-year semi unit downturn which have troughed with recovery underway.
• Once we are fully underway in the upcycle, both segments should both be above 30% adj. EBITDA margins in a normalized environment with Sealings already operating at +30% margins. I expect Sealings to grow HSD (MSD organic + bolt-on M&A) and AST at mid-teens outgrowing the overall semi market via share gains and increasing need for cleaning and coating of wafer fab equipment as fabs continue to move down nodes.
• With a strong fixed cost base, expect Enpro to produce strong operating leverage leading to mid-high teens EPS growth over the next few years.
• This does have good compounder potential although it’s a long-tail bet. We can draw parallels to an early stage Nordson/Idex Corp and Enpro with the path they took to get to current state and its current product type focus and capital allocation.
• Base case assumptions into 2027: MSD+ revenue growth, +100 bps EBITDA margin expansion per year, and low teens EPS growth.
• Shares trading at ~13x FY25E Adj. EBITDA and ~18x FY25E EPS on base case assumptions.

I suggest reading the 2023 write-up on this to get further details on the business mix and anything I might have missed below. The stock is up 50% since that write-up but this is an attractive entry point as the semi business has been mostly de-risked and core end markets for both Sealings and AST at cyclical troughs.

Business overview

Enpro Industries spun out of Goodrich in 2002 and has largely been a transformation story over the past few years which explains the massive outperformance relative to the pre-2020 decades. The company has significantly de-risked its core industrials business by shedding businesses with lower margins, high commodities exposure, high cyclicality, and high capital intensity while also reducing its European end market exposure.

Additionally, Enpro had an asbestos liabilities overhang that ended in a landmark case in which the company was able to escape with a very attractive settlement relative to accusations and ended up being the poster child for getting out of asbestos liabilities.

Today, Enpro focuses on high-end niche industrial applications with two core segments - Sealings Technologies and Advanced Surface Technologies (AST) both of which have moat-like characteristics, strong pricing power, high recurring revenue mix, 20%+ EBITDA margins. MSD+ topline growth and exposure to high end markets with secular tailwinds. Additionally, the simplified two segment structure makes it much easier for investors to digest eliminating justifications for a "diversified industrial discount".

Sealings Technologies

The sub-segments in this comprise of 1) Garlock 2) STEMCO and 3) Technetics. The best way to think about the sealings business which is where management is focused for M&A is that it's a highly diversified, highly differentiated inputs business that provide mission critical products with a high aftermarket mix (2/3 of overall segment) which helps counterbalance end market cyclicality.

Products include gaskets, dynamic and mechanical seals, compression packing, elastomeric components, hydraulic components, test, measurement and sensing applications, hoses and fittings and fluid transfer products. These serve key end markets like nuclear energy, chemical and petrochem, hydrogen and natural gas processing, food and biopharma processing, metals manufacturing, mining, water and waste treatment, commercial vehicles, aerospace production, medical filtration, and wafer fabrication.

• Garlock (~50% of mix) is most exposed to industrial chemical production (key indicator) and provides high end static sealings, hoses and fittings. The brand has been around for over 130 years and is highly regarded as the Kleenex of seals.
• Stemco (~30% of mix) is exposed mainly to the commercial vehicle aftermarket specifically truck trailers with 2/3 aftermarket exposure. The focus is on sealing critical wheel ends to prevent corrosion and freeze. OEM margins avg ~20% while aftermarket is in the 50%+. Mgmt. has stuck with this business given its highly spec'd in with attractive cash on cash returns.
• Technetics (~20% of mix) is focused on high performance metallic seals and is well diversified across commercial aircraft, aerospace and nuclear (core focus). Examples of use cases include fail safe rupture discs to prevent overpressure scenarios on space shuttles, shaft seals to prevent metal to metal contact in gearboxes and nuclear pressure vessel seals to prevent leakage of reactor core and coolant.

The Sealings segment is mainly run as a job-shop production where it’s mainly small batch customized products (almost across the board). Enpro doesn’t really have any big production lines splitting out widgets endlessly. It’s more about using the same processes but different sizes, materials and shapes which acts like a very customized business. So, while you can argue there may be detriments to economies of scale, Enpro products become very sticky and are highly spec’d into customer processes and products given the customization element. They do not compete on price as these are all high end customized premium products which are still a small piece of the customer’s bill of materials but highly critical / catastrophic prevention components.

Sealings is mostly sold through distributors, Garlock and Stemco are 80/20 distribution/direct sales. Garlock is almost entirely selling into the aftermarket.

Advanced Surface Technologies (AST)

Four sub-segments: 1) Technetics Semi, 2) LeanTeq, 3) NxEdge and 4) Alluxa. This is mainly a services business involved in upfront cleaning, coating and refurbishment of wafer fab equipment with Applied Materials and TSMC being their two biggest customers, both of whom Enpro has very good relationships with.

Technetics Sem is their legacy semi business acquired in 2011 which makes shower heads and chucks that go into the wafer production process. Specifically electrostatic chucks (ESC) and shower heads. During the fab process, these chucks essentially hold the wafer in place during the etch / deposition process.

Where AST is really differentiated is on the cleaning and coating side within LeanTeq (acquired in 2019) and NxEdge (acquired in 2021 - largest acquisition to date) with 2/3 aftermarket and 1/3 OEM mix and higher margins than the overall AST segment. The largest served tool sets are PVD and etch tools. Since 2016, 85%+ of LeanTeq's revenue came from sub-7 nm nodes with the overall business expected to grow strong DD teens moving forward. Once a tool gets built, it is put through the cleaning/coating certification process before entering the fab. It then gets used and then will come back for re-cleaning/re-coating and then rinse, wash, repeat. AST isn't missing much in this entire process.

Both have leading edge lines serving nodes 7 nm and below with clear line of sight on 2 nm. Other players tend to be backfill on the mature node side where it's more commoditized. There is some memory exposure within Technetics and NxEdge.

Alluxa (acquired in 2020) sells optical filters for lithography, inspection and metrology. ~3/4 of mix have applications beyond semis and are used for example in 5G systems to improve data transfer efficiency and for infrared in aerospace and defense. Commercially, all four businesses are aligned using the same commercial team. 

Thesis Key Points:

AST, after years of acquisition and integration is the most complete it's ever been and ripe to reap the gains as the semi cycle ramps up.

2023 as with most semi ancillary players was a year of continuous downward guidance resets with AST revenue ending down -16% y/y and adj. EBITDA margins down from 29.7% to 23.8%. Q124 revenue took another 21% downturn with EBITDA margins at 20%. Although we may have another quarter of weakness, management did note backlog growth across all segments with improvements in advanced node cleaning and coating demand while seeing continued weakness in longer cycle capital equipment spend. Nonetheless, 2024 guidance implies DD growth for AST in H2 and I believe will see mid-teens topline growth with margins surpassing 30% once volume fully ramps up.

Over the next few years, I expect AST to grow topline by 15%+ outperforming the semi cycle via share gains given their high mix to advanced logic nodes as the need for cleaning and coating of wafer lab equipment increases as fabs continue to move down nodes. AST's vertical integration enables this via strong synergies between their four businesses as the majority of services/products are used in steps close to one another in the wafer fab process. A key appeal of AST is its supply chain Chain of Custody, as customers can do all their cleaning, coating, and refurbishment all in one stop. This means no freight shipping back and forth with long lead times, having to worry about what gets damaged, who cleaned what, etc.

AST has been doubling down on this strategy focusing their growth CapEx in the last 2+ years to expanding existing and building out new cleaning/coating facilities in Arizona (for TSMC and Intel support). With the US CHIPS Act funding domestic advanced node manufacturing, AST should participate fully in the growth ramp up.

The current portfolio mix is the best it's ever looked with the transformation drawing parallels to an early-stage Nordson/Idex Corp/Parker Hannifin. If management continues this trajectory, this will likely be a decade long compounder assuming prudent bolt-on acquisitions in niche and adjacent markets.

Enpro Industries has long been treated as a moderate growth industrial business with heavily cyclical exposure. That has changed drastically in the past few years as they’ve made a series of divestitures and acquisitions. They exited Fairbank Morse (large complex power systems for defense) in 2019, exited Stemco Brake Products in 2020 (break-even profitability), sold Compressor Products International (CPI) to Howden in late 21’ eliminating any oil & gas exposure, and recently sold GGB to Timken in late 22’ which was heavily weighted toward OE, lowest margin, and most economically exposed.

Today, we have a much simpler segment structure both targeting advanced materials with high aftermarket mix, operating in concentrated markets and/or with low competition and higher structural margins and topline growth.

Aspirations as an early stage Nordson (NDSN) and Idex (IEX): We can add Ametek (AME) into the mix too as all these guys transformed their asset base over time by having a process for deploying capital and adding value through M&A into niche and higher growth/margin products.

Nordson (NDSN) used to be a largely traditional industrials business selling into adhesive dispensing, consumer non-durables, industrial coatings, etc. Over time they expanded into electronics, test, and inspection, and medical now with electronics and medical being half the business. 

Idex (IEX) which had always been a complex holdco structure shifted over time increasingly toward niche industrial tech markets. From 2009 to 2021, the stock was a phenomenal compounder due to consistently accretive bolt-ons that were growth focused with higher margins and acquired at attractive returns (~2.5x revenue on average).

Management is following a similar playbook with small but accretive acquisitions with the focus on expanding their non-semis business. The most recent acquisition was AMI (sells analyzers, compressors for carbon capture and LNG) at YE24. Although AMI's core market is energy, it has sensitive packaging technology, pricing power and gave management more intel on what was going into existing customer processes across aerospace, biopharma, food & packaging, etc. which AMI does have exposure to.

It is unlikely we'll see more acquisitions for AST anytime soon as management has been pushing back on expanding their semi exposure any further although there's a chance they can bolt onto AST's advanced node services.

The core operating model is capital light with a solid fixed cost base which will enable them to produce high operating leverage leading to mid to high teens EPS growth over the next few years as AST ramps and Sealings continues to execute.

With 2024 being a high mark in CapEx as they ramp up on completing their two new sites, normalized intensity should range between 3-4% moving forward. SG&A has averaged close to ~$280m, which I expect to be range bound despite AST ramp up. Adj. EBITDA margins grew from 17% in 2019 to 25.5% in 2022 demonstrating the success of shifting toward a high aftermarket mix.

With shares trading 19x FY24E EPS and 13x Adj. EBITDA, this is an attractive entry point as this is still a relatively underfollowed stock with questions remaining on how much AST will participate in the semi cycle ramp up as well as when industrial end markets will turn. The lack of attention from the street is more prevalent than actual doubt in the fundamental prospects with the last call (q124) having only 3 sell-side analysts in attendance.

Upside

Base case assumptions into 2027 excl. any bolt-on M&A: MSD+ revenue growth, +100 bps EBITDA margin expansion per year, and low teens EPS growth. Even if we have zero multiple expansion and are purely dependent on EPS growth, base trajectories should earn 40%+ upside.

Shares are currently trading at ~13x FY25E Adj. EBITDA and ~18x FY25E EPS on base case assumptions.

The bull case for the long-term growth algo should closer to 10% topline driven by HSD growth in Sealings (LSD to MSD+ organic revenue growth + a few points from bolt-ons) and low to mid-teens organic growth in AST. With strong operating leverage, NPO should be earning well over $11 of adj. EPS and over $10 of FCF per share by 2027 implying low teens forward multiples.

Catalyst

AST inflection and outgrow vs the semi market.

CHIPS Act funding flowing through + AZ and Singapore facilities coming online in 2025.

Commercial vehicles end market inflection (2024 will be a down year with weakness starting in late 2023).

Accretive bolt-on acquisitions.

Increased sell-side coverage.