Investors in industrial companies Parker-Hannifin Corp (PH -0.74%), Stanley Black & Decker, Inc. (SWK -0.52%) and Emerson Electric Co. (EMR -0.14%) have all seen their stocks rise strongly in 2017, only to correct after their last set of results and then bounce back. With the recovery in U.S. industrial production now firmly in place, is this a good time to sell and look for the next investment? Alternatively, are these stocks still a good value?
Parker-Hannifin
Around this time last year, Parker-Hannifin was an attractive value stock. It was cheap on a free cash flow basis and, with its orders having just turned positive ahead of a pickup in U.S. industrial production, the outlook was positive. However, after a near 39% rise in the last year, the stock now looks like it's close to a fair value.
On the positive side, the company's earnings momentum remains good. Parker-Hannifin's financial year ends in June, and the recent fourth-quarter results saw organic sales increasing 6% -- up 13% if you include the Clarcor acquisition. Moreover, orders growth in its industrial businesses (together responsible for more than 81% of segment operating income) have tracked the recovery in industrial conditions.
Data source: Parker-Hannifin presentations. Aerospace systems orders are on 12-month rolling basis. Chart by author.
In addition, management remains on track with its so-called "Win Strategy," which targets the following metrics by 2020:
- Organic sales growth 150 basis points (where 100 basis points is 1%) above industrial growth
- Operating margin of 17% compared to reported operating margin of 14.9% in 2017
- Return on invested capital of 17%
- Cash from operations above 10% of sales -- excluding pension contributions, the full-year 2017 figure was 12.7%
Based on current trends, these targets look achievable. For example, organic Parker-Hannifin operating margin (excluding Clarcor) increased 180 basis points to 15.7% in 2017, and operating cash flow (excluding pension contributions) was 12.7% of sales.
Image source: Getty Images
Putting all of this together, the company has good earnings momentum, and its midterm targets look achievable provided the industrial sector continues to grow. But here's the thing -- the stock price rise means it's largely priced in, and on a risk/reward basis it's arguably no better than a moderately good value.
For example, analysts estimate 2018 earnings per share (EPS) will be around $9.08, and assuming a 120% conversion rate to free cash flow (FCF) means around $10.90 in FCF. Based on my calculation, this puts the company on a forward P/E ratio of around 18.7 times earnings and a forward enterprise value-to-free-cash-flow ratio of around 5.3%. I would regard a forward EV/FCF ratio of 5% as fair value, suggesting there's only low single-digit upside to the stock.
Emerson Electric
In common with Parker-Hannifin, Emerson Electric has broad-based industrial end markets, but it's the company's significant exposure to oil and gas spending -- via its process solutions -- that's been the key to its stock price in recent years. Indeed, the slump in oil and gas capital spending led to underlying sales declining in the third quarter of fiscal 2015, and it only turned positive again in the recent third quarter.
Data source: Emerson Electric presentations.
Moreover, highly respected CEO David Farr has done a good job maintaining margin and restructuring the company -- network power and industrial automation businesses were sold, and Pentair's valves and controls business was bought -- and the company remains one of the top dividend stocks in the electrical equipment industry.
That's all good news, but it's hard not to think that Emerson's valuation is fully up with events. As the chart below shows, across a range of valuation metrics the stock is starting to look expensive.
EMR EV to Free Cash Flow (TTM) data by YCharts
Moreover, if the price of oil should fall from here, then Emerson's revenue could come under pressure. In a nutshell, the stock doesn't look particularly attractive on a risk/reward basis.
Stanley Black & Decker, all about the cash flow
Thanks to some significant restructuring and productivity improvement measures, management has dramatically improved cash flow conversion at the company. Collecting cash quicker and paying suppliers later may not seem like a sexy way to increase shareholder value, but increasing free cash flow is usually a good thing for investors -- not least because it means more cash can be paid to investors (through dividends or share buybacks) or used to make acquisitions.
Moreover, the acquisition of Newell Brands Inc. tools business is expected to improve cash flow and earnings in the coming years. Although FCF was actually a negative $76 million in the first half -- primarily due to supporting strong levels of growth and integrating the acquired business -- management stuck to its forecast for free cash flow conversion from net income of 100% in 2017. As you can see below, the increase in FCF and FCF conversion has been significant in recent years.
SWK Free Cash Flow (Annual) data by YCharts
In addition, management has plans to double its revenue by 2022 and generate 10% to 12% EPS growth in the process, with FCF conversion above 100%. That's not bad for the kind of valuation that Stanley Black & Decker currently trades on.
SWK EV to EBITDA (TTM) data by YCharts
Looking ahead
All told, Parker-Hannifin still looks like a good value, but you are unlikely to see huge future returns from buying the stock. Meanwhile, Emerson Electric's valuation looks fair. Stanley Black & Decker is a good long-term growth story, and provided management can continue executing, it's an attractive stock for investors.
