Thurtell/iStock via Getty Images
Cyclical downturns can be a good time to look for quality names looking at depressed near-term results, and that would seem to apply to Lincoln Electric (NASDAQ:LECO). This leading player in welding and factory automation has seen basically all of its major markets slip into contraction and with higher rates, economic uncertainty, and nervousness around the election all in play, a recovery may not be in the works until sometime in 2025.
Down almost 30% from its high, Lincoln is up about 10% since my last update on the company, underperforming the broader industrial sector over that time, as well rival ESAB (ESAB), while Illinois Tool Works (ITW) has done even worse (while ITW is a large conglomerate, it has a sizable welding business and is exposed to many of the same markets through other product categories).
Valuation is never easy with Lincoln Electric; it’s a much-loved industrial that has earned a lot of respect through years of top-notch execution on margins, returns, and so on. Do the shares look “can’t miss” cheap? No. Can I be sure that there isn’t another leg down on even weaker industrial end-market demand? No. Even so, I’ve long since learned that timing the bottom of cycle is luck and I find any undervaluation for a company like Lincoln Electric something to consider seriously as an opportunity.
It’s Weak All Over The Place
Although there is plenty of quarter to quarter volatility in the performance of Lincoln’s end-markets, the last quarter report showed no growth in any of the major categories (energy was the best, and that was “steady”) and management’s late May guidance cut points to worse-than-expected trends in key markets like autos, heavy industry, and general short-cycle industrial.
Management’s guidance cut has the company looking at a full-year mid-single-digit organic sales decline that’s likely more or less on par with the 6% decline reported in the last quarter, with the second quarter likely down mid single-digits as well. Margins appear relatively stable despite the unexpected shortfall in sales, and free cash flow should still be healthy.
Lincoln’s warning only added to what has been a weakening picture for industrial end-markets. MSC Industrial (MSM) lowered expectations recently on weaker end-market conditions, and Fastenal’s (FAST) last couple of monthly sales reports have been weaker than expected, with May sales up 1.5% and fasteners down 4.1%. That’s plenty of evidence for softer conditions in “general industrial” segment, and Deere’s (DE) recent cut to guidance likewise supports the notion that heavy industry is slipping.
Although I don’t think there have been any recent guidance cuts specifically tied to the auto sector, there hasn’t been much good news there either. Vehicle sales are slowing and with EV sales coming in below expectations, OEMs are hitting the brakes on capex investment, hurting demand for EV-related equipment and automation from Lincoln.
I’ve talked many times in recent articles but softening trends in non-residential construction (starts down mid-single-digits year to date), as weakness across the board (but led by warehouses) is hitting demand. Energy is holding up relatively better, but with rig count still pretty weak, I’m not sure how long this will hold up (though sectors like renewable energy are stronger and there’s a fair bit of welding that goes into wind and solar installations).
Although there’s a fair bit of quarter to quarter deviation between Lincoln, ESAB, and Illinois Tool Works, I’d be surprised if Lincoln’s competitors escape this weakness. While ITW’s welding business is less skewed to autos, energy, and heavy industry, weakness in general industrial and MRO demand will be a problem, as will weakness in construction. ESAB is a tougher call, as I could see faster growth in markets like India offsetting at least some of the pressure in North America.
The Business Is Shifting, And There Are Still Credible Drivers
I think it’s interesting that Lincoln’s business mix has been shifting over recent years toward more equipment sales (recently 47% versus a long-term average closer to the low-to-mid-40%’s). That’s relevant because welding is an unusual industry where the equipment is where the more attractive margins are; ITW has long enjoyed stronger margins by virtue of its much greater skew to equipment (think about the number of Miller welding generators you see in the back of work trucks).
Not surprisingly, then, Lincoln’s margins have also been heading higher, with EBITDA climbing from the mid-teens into the high-teens and taking ROIC and the EBITDA multiple higher as well (as I’ve said in the past, the market places a huge premium on higher margins).
Along the way Lincoln has continued to strengthen its position in automation, growing that business from a mid-teens percentage of revenue to over 20% in 2023. It’s more impressive to me that Lincoln has done this while also diversifying away from welding within automation and incorporating more complementary systems like automated material handling, as well as additive manufacturing. Oftentimes the “ancillary” parts to an automated welding system (like material handling components) are lower margin, and so I find it interesting that Lincoln has continued to grow and diversify this business without much, if any, negative impact on the business.
These investments have also let the company take advantage of capex cycles like that for the EV industry 2021-2023. The bloom may be off that particular rose now, but Lincoln has positioned itself to play a leading role in bringing automated welding to a host of industries with exacting specifications, and I think that will keep the company well-positioned for the future.
As far as drivers go, I see no lasting decline in automation adoption; companies have gotten much more careful about capex now, but given the scarcity of skilled workers and the desire to reshore more manufacturing, I think Lincoln will have no problem finding buyers in the coming years. I’d also note that in addition to reshoring, the capex base of the U.S. industrial sector is still over-aged and upgrading or replacing sometimes can continue support growth.
The Outlook
I’m on the lower end of expectations for FY’24 sales for Lincoln, as I do think there’s a real risk of more pain across multiple industrial end-markets. I do expect some recovery in FY’25, and a stronger recovery (mid-to-high single-digits) in FY’26. Long term, I expect around 4% growth from Lincoln, which is only a modest step down from its 10-year and 20-year growth rates.
I may be a little too high on margins for FY’24, as I do think Lincoln will still see some modest EBITDA margin improvement, but either way I expect 20%+ EBITDA margin in FY’25 and 21% or better in FY’26. I still expect free cash flow margins to improve from the low double-digits to the mid-teens over time, pushing that 4% revenue growth to over 7% free cash growth.
Even with what may well be bullish estimates (FCF hasn’t historically outgrown revenue by as much as I’m forecasting), I can’t really get to a compelling fair value for Lincoln through discounted cash flow, and I’m not too surprised – this is a well-loved industrial and the implied discount rate is quite low as a result.
Discounted cash flow is only one tool in the box, though, and I’m also fond of using margin and return-driven EV/EBITDA for valuation, as there has long been a pretty tight relationship between metrics like operating margin and ROIC and what the market will pay for a stock. A 14.5x forward multiple gives Lincoln credit for those positives, but only gets me into the low-$190’s for a fair value.
The Bottom Line
Whether or not I’m underestimating the recovery potential for FY’25, I’ve learned through experience that “a little undervalued” is about the best you can hope for with stocks like Lincoln unless there’s serious fear in the market. I don’t rule out more downside risk here from a slowing economy, but the risk of buying in before the bottom may be the price you have to pay to get in at a reasonable valuation.
