|Shares Out. (in M):||58||P/E||0||0|
|Market Cap (in $M):||7,442||P/FCF||0||0|
|Net Debt (in $M):||1,590||EBIT||0||0|
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Executive Summary: Nordson is a leading provider of dispensing equipment and fluid management technology, with dominant market positions in its legacy businesses that afford it significant pricing power and healthy margins. The company benefits from a number of ongoing mega-trends, including rising standards of living in emerging markets, an aging population, and ongoing technological advances that has historically supported organic growth of ~2x global GDP. Looking forward, we expect NDSN to continue to grow organically in excess of global GDP, while strategic M&A has the potential to add ~2-4% of additional growth annually.
Nordson has dramatically improved profitability since the early 2000s through both a combination of LEAN / Six Sigma and significant restructuring in the wake of the global financial crisis in 2008/2009, and we see further improvement via continued strong execution, better mix as higher margin healthcare business replaces lower margin industrial coating systems business, and the completion of final restructuring in its polymer processing business that we think can deliver upwards of $20mn in annual savings.
We expect NDSN to grow earnings at a healthy double-digit clip through at least FY2020 via healthy organic growth and continued margin expansion coupled with complementary M&A. At a recent $126, NDSN is trading at a premium to its historical averages, though we believe the company is under-earning as a result of recent M&A activity and integration work. On a normalized earnings basis – which looks through transient factors depressing earnings - the company is trading at a slight discount to its historical average. Moreover, the company is currently trading at an abnormally large discount vs. peers, suggesting an attractive entry point on both an absolute and relative basis. Accordingly, we have confidence that low-to-mid double-digit total returns can be supported by earnings growth plus its current dividend yield (~1%), with deleveraging plus modest share repurchase activity also contributing.
Company Overview: Nordson Corporation (NDSN) manufactures products and systems that dispense adhesives, sealants, and other fluids used in a wide range of applications. Its systems are found in manufacturing facilities around the world and are mission critical in the production of food and beverage packages, personal hygiene products, smart phones and tablets, medical equipment, and a wide range of durable goods including appliances, building and energy products, agricultural equipment, vehicles, and more. Nordson has developed a reputation for creativity and expertise in the design and engineering of high-tech application equipment that lowers customers’ costs and improves throughput. Moreover, the company further differentiates itself via a direct, technically proficient sales force which not only ensures its products are performing properly, but also provides the company with ‘boots on the ground’ R&D to help tailor development efforts towards solving customer pain points. This combination of strong technology and service has manifested itself in leading market positions, pricing power, and exceptional profit performance.
Roughly 40% of sales are parts and consumables vs. ~20% for engineered systems and ~40% for standard products. In general, engineered systems are sold to OEMs/assemblers to be integrated into a large manufacturing line, while parts/consumables and standard products are sold directly to the end user. In general, parts and consumables gross margins are in the 55-70% range, standard products are close to the company average (~55%), and engineered systems margins are in the 35-55% range.
Key end markets include consumer non-durables, consumer durables, industrial, automotive, medical, electronic components, semiconductors, and PCB assembly as seen in the chart below. Pro forma for acquisitions in FY2017, medical now constitutes ~15% of consolidated revenue.
Geographically, NDSN has a significant global presence, with ~70% of revenue generated outside the US. Its businesses are divided into 3 operating segments: (1) Adhesive Dispensing Systems (~49% of revenues); (2) Advanced Technology Systems (~37%); and (3) Industrial Coating Systems (~14%). Pro forma for FY2017 acquisitions, we estimate the ADS and ATS segments each account for ~45% of revenues with the ICS segment accounting for the remaining 10%.
Adhesive Dispensing Systems: The Adhesive Dispensing Systems (ADS) segment provides products to melt, filter, pump, transport, dispense, and deposit adhesives, polymers, and other materials in the manufacturing of a wide range of goods. By end market, rigid cardboard packaging accounts for ~35% of segment revenues, nonwovens ~20-25%, polymer processing ~20-25%, and general product assembly the remaining 15-25%. These end markets tend to be recession-resistant, growing at 1.5x to 2x global GDP, with segment growth driven by increased global penetration of nonwovens and disposable hygiene products, increased use of packaged convenience foods, and rising consumption of the middle class in emerging markets.
Nordson enjoys a dominant (>70%) market share position in the sale of core hot melt adhesive dispensing systems used in the packaging, nonwovens, and general product assembly end markets. It also has a leadership position in polymer (plastic) processing with market share >20%, though this business is relatively new for Nordson. The company first entered into the market in 2012 (via the acquisition of Xaloy Inc. for $200mn) in order to gain exposure to the growing flexible plastic packaging market (think pouches for kids food), and has made a number of subsequent acquisitions to round out its business portfolio. With its product portfolio now complete, management believes it can execute a similar combination of technological superiority and boots on the ground service to drive market share steadily towards its legacy businesses.
ADS operating margins have averaged 28% over the past 10 years, peaking in 2011 at 34.4%. Operating margins subsequently declined to a low of 23.4% in FY2015 due to a flattening out of organic growth, currency headwinds (NDSN’s manufacturing footprint is over-indexed to the US), and M&A. Since FY2015, margins have improved ~400bps as recent acquisitions have been integrated, and we see no reason margins can’t get back above 30% as the final stages of integration are completed (reducing polymer plants in the US from 3 to 1 and some consolidation in Europe).
Advanced Technology Systems. The Advanced Technology Systems (ATS) segment manufactures automated and semi-automated precision dispensing systems, single-use fluid handling components, and surface treatment and inspection products. The segment primarily serves three end markets: (1) electronics (~45% of segment revenues); (2) medical (~33%); and (3) industrial (~22%). The segment is a collection of businesses with differing degrees of cyclicality but all should generally grow at 2-3x global GDP over the course of a cycle.
In the electronics end market (~$400mn of revenue), Nordson manufactures high-end automated dispensing equipment, surface treatment equipment (i.e. cleaning pre-dispensing), and test & inspection equipment (post-dispensing). Within electronics, Nordson has a leading market share position (est’d low 20% range) in its core markets - semiconductor packaging, printed circuit board assembly, and general electronics assembly. Demand for the company’s equipment is driven by mobile computing growth, circuit shrinkage, product design changes (i.e. form factor changes, adding features such as waterproofing, etc…), and the growing proliferation of small and complex electronics ranging from wearables to vehicle connectivity. The electronics end market is extremely cyclical, though shorter product life cycles (18-24 months) generally lead to shorter equipment refresh cycles, resulting in greater equipment sales offset by relatively fewer parts sales.
The medical end market (~$300mn in revenues pro forma for recent M&A) has been an area of focus for management, with 5 acquisitions in the past 7 years ($1.2bn in capital deployed). Nordson is a leading manufacturer of highly engineered, single-use fluid management components and delivery devices for medical device OEMs. Demand in this segment is non-cyclical, supported by worldwide medical device demand (+MSDs) that is augmented by increased OEM outsourcing of mission-critical highly-engineered consumable products. Management estimates that its addressable market is ~$4bn growing at a high-single digit / low double-digit rate annually. Currently, the market is very fragmented, though management believes it has a top 2 market position and estimates market share in the 20% range.
The industrial end market (~$200mn) is kind of a catch-all, including animal health, construction, industrial, dental, DIY, auto, and pesticides. Essentially, the end market includes processes that require precision dispensing (likely because the cost of materials dispensed is so high) but volumes preclude full automation. Nordson targets these markets via the sale of both equipment and single-use consumables, and recently added to its capabilities in consumable sales with its February 2017 acquisition of Plas-Pak industries.
The medical business contains the highest margins all else equal, though the cyclicality of electronics can distort incremental margins in a particularly strong or weak quarter. Operating margins have averaged 22.5% over the past 10 years, with FY2017 margins expected to reach a high of 26.9% (vs. a FY09 low of 11.7%). Given the cyclicality of the business, management views the mid-20% range as appropriate for the segment, though we think this is overly conservative given outsized growth in the high margin healthcare business (we estimate >40% EBITDA margins on the acquired healthcare businesses since 2010).
Industrial Coating Systems. The Industrial Coating Systems (ICS) segment makes equipment to dispense liquid and powder coatings, finishes, sealants, adhesives, and other fluids primarily to the consumer durable and industrial end markets. Demand for its products are driven by growth in emerging markets, environmental and productivity benefits, and other initiatives such as vehicle light-weighting which management expects to drive growth at a GDP+ rate over the course of a cycle.
The ICS segment is comprised of several smaller businesses. Roughly 40% of the business provides equipment that dispenses powder coating onto durable goods (i.e. appliances, patio furniture, grills, bike frames). Approximately 25% of the business is its cold materials business – which is similar to the ADS segment except the equipment dispenses ambient temperature materials (vs. hot melts for ADS) and is generally better suited for stronger bonding capabilities. The remaining businesses include liquid painting, container coating, and UV Curing. Looking at the portfolio of businesses, cold materials and container coating appear to be the most attractive businesses from a market position and margin standpoint.
The ICS segment differs from the ADS and ATS segments in two critical ways. First, ICS segment has better competition. Whereas the ADS and ATS segment typically competes against smaller, regional players or tiny divisions of larger companies, the ICS segment often competes against GGG and privately held Wagner. Second, the company has no OEM/assembler channel so NDSN has to effectively function as the assembler. As such, margins are structurally lower because they embed a lot of non-valued added content sourced from other vendors. In this light, it is even more impressive what the company has been able to do with profitability, growing operating margins from breakeven in the early 2000s to an expected 19% in the current fiscal year.
Capital Allocation. NDSN generates high quality earnings, historically converting 100% of recurring net income into free cash flow (and 55-60% of EBITDA). Management employs a balanced approach to allocating cash. It is a dividend aristocrat with 54 consecutive years of steadily rising payouts, but the company maintains a low payout ratio (~20%) to ensure it has capacity to invest in the business at all points in the cycle. Since 2010, NDSN has paid out $340mn in dividends and $870mn in share repurchases while reinvesting $330mn in capex and $2bn in acquisitions. The company has funded its investments and capital returns via a combination of operating cash generation ($2bn) and increasing outstanding debt ($1.5bn). Looking forward, we would expect a similarly balanced approach going forward.
Management/Ownership/Compensation/Intangibles. NDSN is led by Mr. Michael F. Hilton, who has been President and CEO since January 2010. Mr. Hilton was previously a senior leader at APD, in charge of its Global Electronics and Performance Materials segment, while also being in charge of the entire company’s LEAN efforts. Mr. Hilton owns ~450,000 NDSN shares worth over $56mn and last sold shares (5,000) in 2015.
Nordson continues to have a high level of family ownership, with founding family member ownership of ~13% of outstanding shares. The company also has an excellent reputation for giving back in its community and historically has contributed ~5% of domestic pre-tax earnings to charitable activities in communities where it has significant operations.
(1) Market position and pricing power sustainable. Nordson’s business possesses many favorable characteristics that suggest its dominant market share position in legacy adhesive dispensing markets (~35% of sales with market share > 70%) and leading positions in nearly all of its markets are unlikely to erode anytime soon. Moreover, we expect the company will continue to maintain its price leadership position (NDSN products generally cost 15-25% more than comparable products) for the following reasons:
a. NDSN operates in fragmented and decentralized markets. Outside of its Industrial Coatings segment (~10% of pro forma sales), the company faces few competitors of scale, generally matching up against small divisions of larger companies or regional competitors.
b. The products NDSN sells cost but a fraction of a project’s total capital cost, but are mission-critical, and the cost of failure/plant downtime significantly outweighs any potential cost savings by going with an unproven product.
c. NDSN’s scale gives it greater resources to invest in innovation that lowers end customer costs and improves productivity vis-à-vis smaller competitors.
d. NDSN’s scale also allows it to maintain an unmatched service footprint at both the assembler/OEM and the end customer, whereas its smaller peers generally sell through distributors who are responsible for servicing the end customer. Their direct presence at the end customer ensures optimal performance while reinforcing its quality branding, and oftentimes can directly enhance R&D efforts by giving the development team first-hand knowledge of customer pain points/ways to solve them.
(2) Multiple paths to continued organic growth in excess of global GDP growth, with M&A an additional lever to augment organic initiatives. Nordson’s 2017 – 2022 strategic plan calls for organic growth equal to 2x global GDP growth, which is roughly consistent with its performance since the downturn, and we expect it will continue to do so over a longer time frame, as the business benefits from a number of secular trends (aging population, ongoing technological advances, and growing middle class in emerging markets) that should drive above-GDP end market growth. Moreover, NDSN believes it can drive further upside from general product innovation that drives continued recapitalization of older equipment, as well as through increased adoption of automated dispensing down market through product segmentation efforts (i.e. bringing automation to the processes like the manufacturing of cell phones and diapers designed for non-high end emerging market customers).
In addition to its organic efforts, NDSN has effectively used M&A to both round out its capabilities in existing end markets and expand into new markets that share similar traits to its core base. Since 2010, NDSN has deployed ~$2bn in capital for M&A, including $1.2bn to grow its health-care business which is now ~15% of the business and growing in the high-single digit range, and $590mn to build out its polymer processing facilities. On our estimates, NDSN should be able to add an incremental $60-$100mn in sales (3-5% of current revenue base) annually via M&A, which should translate into a $0.35-$0.55 improvement in normalized earnings power.
(3) Strong margin profile supported by culture of operational excellence. Since the early 2000s, NDSN has engineered a dramatic improvement in the business’s profitability, raising operating margins by almost 1,600 bps since FY2001. At a current 24%, Nordson compares favorably to a collection of high-quality industrial peers.
Nordson has driven significant margin improvement through the adoption of LEAN/Six Sigma principles beginning in 2001. Upon implementing, the company saw nearly immediate results as it drove a significant amount of productivity by removing waste and improving business processes, and operating margins improved to the mid-teens level within 3 years. Ahead of the global financial crisis, Nordson announced adoption of the Nordson Business System to further embed a culture of operational excellence by codifying best practices and creating a blueprint for achieving sustainable improvement company-wide. And as the economic environment weakened in late 2008/early 2009, Nordson took further actions, accelerating restructuring and integration efforts – particularly within its Industrial Coatings business - while also offering voluntary employee buyouts to lower its cost base. All told, the company took >$60mn of structural costs out of the business, which helped preserve operating margins during an extremely weak period. And when growth resumed in 2010, margins sharply inflected, peaking at 26% in FY2011.
Since 2011, margins declined to a cycle-low of 18.8% in FY2015 as a result of the strengthening dollar, negative mix (both product and segment), and the dilutive impact of its lower-margin polymer processing acquisition, but have since recovered to almost 24% this current fiscal year, and looking ahead, we see further room for growth driven by the following factors:
· Additional opportunities within the Nordson Business System. One of the basic tenets of NBS is that Nordson executives are charged every year to at least offset the 2% cost inflation from wage/healthcare/other inflation via continuous improvement initiatives. Beyond basic LEAN/Six Sigma blocking and tackling, there are several areas within the NBS where NDSN has longer-term opportunities to deliver further margin improvement, including: (1) optimizing its manufacturing footprint; (2) supply chain improvements – particularly with recently acquired businesses; and (3) pricing / segmentation efforts to help continue driving pricing (management estimates 50bps benefit annually from pricing).
· End market mix. NDSN’s fastest growing market - healthcare (~15% of revenue) – is also its most profitable. Not only does management believe it should grow organically in the high-single digit range, but the end market is also a likely candidate for further M&A-driven growth. At the same time, the Industrial Coatings business – which has structural limitations to its margins vs. NDSN’s other businesses – has declined from ~20% of the business a decade ago to 10-12% looking forward. We also would not be surprised to see certain businesses within the ICS segment divested.
· Restructuring / Integration. Since 2012, NDSN has invested $580mn in five acquisitions to build out its polymer processing business, and has been steadily integrating the businesses to get profitability to satisfactory levels. While much has been done, the company is in the middle of consolidating three U.S. extrusion die facilities into one larger facility, and expects the transition to be completed in 1Q calendar 2018. Beyond that, NDSN has some final consolidation work to do in Europe that should be completed during FY2018. While management has not quantified the expected savings, continued consolidation in polymer processing is a critical driver in returning adhesive dispensing segment margins to the 30% range (vs. ~27.5% in FY17), suggesting potential savings of ~$20mn (~$0.25 in EPS benefit).
(4) Earnings set to grow at low-to-mid double-digit rates through 2020. We expect Nordson to grow earnings per share organically from an expected $5.50 in FY2017 (ended 9/30/17) to over $7.50 in FY2020, equating to a 11% CAGR without the benefit of prospective M&A. Assuming NDSN deploys capital at a rate consistent with the cycle, with slightly less aggressive leverage assumptions (60% debt funded vs. 75% this cycle), we estimate EPS can grow an additional 2% annually. Key assumptions include:
· Organic sales growth well below its current algorithm. Our model forecasts average organic growth of 3.8% from 2018 to 2020, which is (1) well below its current cycle average growth of 6.7% and (2) conservative relative to its goal of growing organic sales at ~2x global GDP. Our below trend forecast embeds a degree of conservatism to reflect the challenge of modeling capital equipment spending in a given quarter/year.
· Margins expand to ~100bps annually. We expect operating margins to expand ~100bps annually on good operating leverage, mix shift towards higher margin businesses, cost actions – most notably in the polymer processing business – which we think has the potential to add ~100bps on its own, and continued discipline on corporate expenditures.
The combination of low-single-digit growth and margin expansion should translate into ~9% operating profit growth, while a slight decline in interest expense, stable tax rates, and modest share repurchase activity should drive EPS growth into the low-double digit range. Note – our model does not embed prospective M&A.
(5) Valuation: Expensive relative history, but attractive relative to peers and on a normalized basis. At a current $126, NDSN is trading at 21.7x FY2018 earnings, which compares to a historical average forward earnings multiple of 17.7x (normal range 15-20x). On an EV-to-EBITDA basis, NDSN is trading at 14.7x FY2018 EBITDA vs. a historical average of 11x (normal range 9.5 – 12.5x). Note: NDSN historically has converted ~100% of net income into free cash flow and ~55-60% of EBITDA.
Relative to peers, NDSN is trading at a 16% discount on a forward price-to-earnings basis vs. a historical discount of 7%, and a 9% discount on a forward EV-to-EBITDA basis vs. historically trading a just a slight discount.
On a normalized basis, NDSN is trading at 17.6x FY2018 normalized earnings, which compares to a historical average of 18.7x (range: 15-22x). Our normalized earnings attempt to include the benefit of prospective M&A assuming a constant historical return on invested capital on future acquisitions.
(1) As a provider of capital equipment, NDSN is economically sensitive. While the company is somewhat insulated by less cyclical end markets and a parts & consumables business that accounts for ~40% of sales, capital goods companies tend to experience significant share price volatility at turns in the economic cycle.
(2) As a net exporter, NDSN faces significant currency risk. In FY2015, results disappointed in part due to a strong US dollar.
(3) Overpaying for a deal or missteps during the integration of current and future acquisitions could negatively impact results and/or perception of the company’s growth outlook.
(4) Nordson faces general execution risk, particularly in its polymer processing integration, as the completion of its restructuring is a key driver in elevating Adhesive Dispensing segment margins back over 30%.
Continued earnings growth, patience, tax reform
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