ESAB Corporation shares: a lot of upside if growth continues

Obradovic

ESAB Company (New York stock market :NYSE: ESAB) is one of the market leaders in welding and cutting equipment. As a recent spin-off, the title is priced well below its main rival despite having a similar level of profitability. The extrapolation of its constant historical operating performance presents the stock at an attractive price. However, if a global recession hits earnings, there may be better opportunities to buy ESAB shares in the future. Meanwhile, ESAB seems to have plenty of capacity to increase its dividend.

The trend to relocate manufacturing and reduce reliance on China could support ESAB’s business in the long term. Likely winners like Mexico, Vietnam and Eastern Europe are within reach of ESAB, which makes half of its sales in emerging markets. The lack of skilled labor is forcing the company to move faster on its robotic welding initiative as the competition has taken more advantage of the opportunity.

Company presentation

ESAB is a recent spin-off from Colfax, or Enovis (ENOV) as it is known today. Trading began in April 2022 at $50 per share. Colfax acquired ESAB in 2012 as part of an agreement to acquire Charter International. At the time, ESAB’s revenue was approximately $1.8 billion, and Colfax designated ESAB as its new growth platform. Plans change and, since the spin-off, Enovis now focuses on medical technologies.

ESAB is a truly global company founded in 1904 in Sweden. Today, the company employs approximately 9,300 people on six continents. In 2021, revenue was $2.4 billion. Although the company’s primary brand is ESAB, its portfolio includes several regional brands.

ESAB manufactures welding, cutting and gas control equipment, as well as various consumables and accessories that welders need to get the job done. The company aims to grow by welding robotics, digital and software sales and the continuous introduction of new products.

The company performed well in the first half, posting strong growth, particularly in the Americas segment and consumables. Ailing Europe and modest growth in new equipment sales could be the first signs of a slowdown.

Half-year performance of ESAB.

Half-year performance of ESAB. (10-Q, author’s own calculation)

ESAB against the competition

The welding and cutting equipment industry is a $20 billion market, according to Lincoln Electric (LECO), a key competitor to ESAB. According to ESAB, its core markets are $25 billion and the total addressable market (“TAM”) is approximately $30 billion if ESAB’s growth areas of gas control, digital solutions and welding robotics, are included. These latter segments are expected to grow faster, at a rate of 6-8% per year, compared to an expected growth of 2-3% for core businesses.

With a turnover of 3.2 billion dollars, Lincoln Electric is a formidable competitor. 58% of Lincoln’s sales are consumables. Lincoln is ahead of ESAB in welding automation. Its goal is to double sales of the automation offering to $1 billion by 2025. Over the past three years, Lincoln’s return on investment has averaged over 20%. Geographically, Lincoln is a market leader in the United States, where it generates 57% of its revenue.

ESAB claims market leadership in all other major geographies. ESAB entered emerging markets very early. The winning strategy was to localize the product offering, achieve the widest sales and distribution reach, and educate local welders. ESAB’s long-term goal is to achieve sales of $3 billion to $3.5 billion. ESAB seeks growth and profitability through innovation and optimization of the manufacturing footprint. It expects to generate a significant amount of sales from automation and digital solutions in the future.

ESAB plans to use the basic elements of the capital allocation manual: disciplined acquisitions, organic investments in new products and areas of growth and dividends mentioned above. After raising $1.2 billion in debt as part of the split agreement, ESAB’s debt position is currently at the upper end of its target range of 2 to 3 times EBITDA.

In addition to Lincoln, another formidable competitor is Illinois Tool Works (ITW), which operates in the industry primarily under the Miller and Hobart brand names. ITW’s revenue in the welding segment was $1.65 billion in 2021 and the operating margin was 30%. Geographically, 80% of revenues were generated in North America. ITW boasts incredible operating margins for its welding business, averaging 27% over the past six years.

The following table shows how ESAB fared against its main competitors. Coming out of a lower level of profitability, ESAB managed to grow its operating margin faster than Lincoln and ITW. In terms of sales growth, Lincoln performed best and ESAB grew faster than ITW.

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Financial performance of ESAB compared to its main competitors. (10-Ks, author’s own calculation)

The stock is valued at fair value if earnings growth slows

Given its growth profile presented above, its leading position in the market and its strong brand, ESAB is moderately valued compared to its peers. By all multiples, ESAB is worth less than Lincoln. The comparison with Illinois Tool Works is less relevant because welding represents only 11% of the company’s total sales. Of note, the company is targeting $210 million in free cash flow for 2022, which would bring the P/FCF multiple down to 11.7.

Valuation of ESAB and its competitors.

Valuation of ESAB and its competitors. (Looking for Alpha)

Taking the lower end of guided revenue of $2.45 billion and applying an 8.5% net income margin realized in the first half, we arrive at EPS of $3.41 for 2022. The consensus of analysts currently stands at $4, but given current and potential headwinds, it’s not advisable to be overly optimistic.

If ESAB continued to grow its earnings at a slightly slower rate than historical, given, for example, independent company interest and expenses, ESAB would increase the dividend at a rate similar to that of Lincoln. If valued at a multiple of 15, slightly below Lincoln, the stock would be significantly undervalued. According to these assumptions, the increase would be around 40%.

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Value the stock based on historical growth rates. (Author’s calculations, model by Lyn Alden Schwartzer)

However, in the current macroeconomic landscape, the use of more conservative assumptions is warranted. By lowering EPS growth rates, we can see the current stock price. The market expects growth rates that are still quite high. EPS growth of 8% would be a big challenge in a recession, as we will see in the section below.

What is the price in the stock.

What is the price in the stock. (Author’s calculations, model by Lyn Alden Schwartzer)

If you omit the multiple expansion and use a P/E multiple of 12 Where if EPS is halved in a recession and returns to the original level, the stock would be a buy at $33 per share.

In conclusion, ESAB’s relative valuation is attractive, but the current share price expects earnings growth to continue at a relatively high level. Given the risks in the event of a global recession, the stock seems quite valued at the moment.

Plenty of room to grow the dividend

ESAB recently launched a modest dividend of $0.05. Given the latest quarterly earnings of $0.92 per share, there is plenty of room to increase the dividend. The current quarterly dividend only translates to a dividend yield of around 0.5%.

ESAB is likely to want to reduce its debt position to a targeted level before committing to a higher dividend. For 2022, the company has forecast to generate $210 million in free cash flow and the current dividend is just $12.2 million annualized.

LECO has been increasing its dividend for 19 years, with a five-year average growth rate of 10%. Given ESAB’s historical performance and fundamentals, it is difficult to explain why ESAB could not be at the start of its series of dividend increases.

Currency headwinds and slowing manufacturing pose a threat

In the last major recession year, 2009, Lincoln’s earnings per share fell 77%. It took two years to return to pre-recession levels. Sales were down 30%, almost entirely explained by lower volumes. Consumables are recurring revenues as indicated by welding equipment companies, but these revenues depend on the manufacturing volume of industrial companies. Therefore, a major crisis in the manufacturing industry would most likely hurt ESAB to a large extent, as its business profile does not differ much from that of Lincoln.

Another key question regarding consumables is their nature. Consumables are not proprietary, but to some extent interchangeable between different manufacturers. In addition, there are many other consumable producers other than welding equipment manufacturers. However, quality matters, and customers who want better welding quality use ESAB products, as one welder interviewed said.

Since ESAB generates most of its revenue outside of the United States, there is a risk that currency headwinds will affect ESAB’s income statement. In the second quarter, the company raised its negative impact forecast to 3-4%. Additionally, the exit from Russia hurt ESAB revenue by $40 million and adjusted EBITDA by $8 million.

To a limited extent, a potential long-term threat to welding equipment companies is 3D printing, which allows manufacturers to produce seamless parts. Welds are the weakest point of every manufactured part, so removing them has many benefits, ranging from stronger parts to fewer individual parts to produce. Naturally, technological change in manufacturing is slow and unlikely to make welding obsolete.

Conclusion

Turning our backs on a looming risk of a global recession, ESAB is an attractively priced market leader with a nice path to dividend growth ahead of it. As a recent spin-off, the title seems to be getting relatively little attention from investors, creating an opportunity to find titles at a fair price.

Debt reduction, increased dividend and the success of its higher margin business opportunities are the potential catalysts for ESAB’s share price to rise in the medium term. If the economy does not fall into a recession, the stock is an excellent buy. An investor requiring a larger margin of safety initiates a position around $36 per share.

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