Analyst Note | Aug 24 2020
We are increasing our fair value estimate to SEK 290 per share from SEK 241 for narrow-moat Atlas Copco, incorporating three acquisitions that closed this year as well as better-than-expected first-half earnings and cash flow. Atlas Copco's working capital management and revenue have weathered the pandemic lockdowns better than we expected. The first half revenue was down 6% organically, not bad considering the company's short-cycle product portfolio exposure. Revenue declines were less than we expected, with divergent end-market demand. Semiconductor customers increased the vacuum division's orders by double digits, offsetting the double-digit revenue decline in industrial technique, where automotive customers dominate. Working capital outflows were just SEK 700 million in the first half of 2020 versus SEK 3.4 billion a year ago.
We have also incorporated three acquisitions, including the recently closed and largest, ISRA Vision, adding about SEK 1.4 billion, or less than 1% to group revenue. The business will continue to operate independently but will be reported as part of the industrial technique division, with both having large exposure to automotive end markets. ISRA Vision is a small but interesting niche business with a promising growth outlook but also likely continuous investment needs to keep up with a shorter innovation cycle than some of Atlas Copco's more mature product categories. ISRA Vision offers metrology and vision guidance products related to automation and robotics.
Atlas Copco recently announced that long-time CFO Hans Ola will retire in July 2021. Ola has steered the company through multiple turns in the cycle, including the global financial crisis. We think there is a reasonable probability that his replacement comes from within Atlas Copco and do not expect major strategic changes on capital allocation with the new CFO.
Business Strategy and Outlook | 17 Mar 2020
Atlas Copco's long-term focus on a few niche products has created a lean operation that manages to hold profitability and returns through ups and downs in the economy. The core of Atlas Copco's business is its air compression product portfolio, which also serves as a calling card to introduce customers to other products in Atlas Copco's portfolio. Air compressors are used in the majority of industries, from automotive assembly to food processing, and Atlas Copco is the market leader with a market share of about 25% in air compressors, about 2.5 times as large as its closest competitor in air compression, Ingersoll Rand. Atlas Copco uses this near ubiquity to its advantage by acquiring other equipment and tool portfolios that it can sell to its air compressor base. Higher-volume production capabilities and an installed distribution channel allow the company to globalise the products of its acquired businesses at a lower cost than those operations could achieve by themselves. One third of all cars globally are made using Atlas Copco tools.
We see an opportunity for Atlas Copco to reinforce the switching costs in the vacuum business by leveraging its service network in the core compressor business. The vacuum business, which began with acquisition of the Edwards Group in 2014, derives around 20% of its revenue from service, well below the roughly 37% in the compressor division.
Revenue declines cause short-term earnings volatility but the company's flexible cost structure and high portion of service revenue underpin double-digit margin and returns throughout the cycle.
Fair Value & Profit Drivers | 24 Aug 2020
We have increased our fair value estimate to SEK 290 per share from SEK 241 per share for Atlas Copco, incorporating three acquisitions that closed in 2020, as well as better-than-expected first-half earnings and cash flow through the pandemic-related lockdowns.
Our revenue forecasts are underpinned by diverging divisional drivers with the compressor and power technique most tied to GDP growth, given their broad end market exposures across multiple sectors. Whereas we look at capital spending in semiconductors for the vacuum division and capital spending in autos for the industrial technique.
Atlas Copco comprises three core and complementary divisions: compressor, vacuum, and industrial (tools). Nearly half of the company's profits come from its compressor business. Medium term we expect that business to grow organically in excess of nominal global GDP growth rates, at around 4% per year through 2024. This includes emerging markets, from which the division derives about 40% of its demand. Compressors are used across most end markets in the economy--energy, healthcare, pharmaceuticals, manufacturing and food and beverage segments--and as such benefits from growing investments in ascending economies.
For the vacuum division, we expect revenue growth of around 6% annually through 2024, helped long-term demand for semiconductors and emerging markets. We forecast medium-term growth of 3% for the industrial technique division.
During our explicit forecast period through to 2024, we also expect acquisitions, which is an ongoing part of the company's growth strategy. We model in 1% additional growth from SEK 500 million in acquisitions annually.
Our group EBIT assumptions include modest margin expansion of 50 basis points from 2021 to 22% in 2024, as we expect some increased service take up amongst vacuum customers. It is worth noting that both the vacuum and compressor businesses generate enviable 20% plus, EBIT margins, but the vacuum business has a longer runway on service take up.
Scenario Analysis | 24 Aug 2020
Nearly all of Atlas Copco's revenue is directly tied to the business cycle, with the vacuum business having some exposure to structural shifts toward technological changes in semiconductor manufacturing. Therefore, our scenario analysis focuses on big shifts in the industrial demand caused by cyclical peaks and troughs.
Our bear-case scenario fair value estimate is SEK 220, and during our explicit forecast period, 2020-24, this scenario includes flat revenues, that is a no-growth scenario. We would also expect only modest margin contraction, with the group EBIT margin remaining just under 20% over this period, because the company has previously been able to maintain margin stability through past weak economic periods, owing to the variability of some of its operating expenses, as well as its service contract base.
Our bull-case scenario includes about a 7% revenue CAGR over our explicit forecast period, and a nearly 470-basis-point improvement in the group EBIT margin from 2019. This scenario is predicated not only on a strong economic environment, but also on the vacuum business being more successful at winning service contracts and boosting margins at the vacuum business. It also includes the group successfully selling high-margin preventative maintenance software on a standalone basis across its service customer base, expanding margins. Our fair value estimate for this scenario is SEK 370 per share.
Economic Moat™
Atlas Copco has a narrow moat created by high switching costs and the intangible assets of a high-quality brand with innovative products. Its return on invested capital is consistently in the mid-20s, well above the company's cost of capital, and the company has managed to stay comfortably above its cost of capital even at low points in the cycle.
As a pioneering company, Atlas Copco possesses a patent-protected deep expertise in air compressors. Its compressor portfolio is geared toward high-end compressors, with less exposure to lower-end basic compressors available, for example, in hardware stores. Through the years, Atlas Copco has developed several important innovations that allow it to charge a premium for its products and defend its leading market share position. The most recent of these innovations is its line of variable speed compressors, which offer 35% energy savings on average versus fixed-rate compressors. This innovation was 10-15 years in the making for Atlas Copco. The cycle for such significant innovations is long, partly because new designs need to be tested and tweaked for various conditions to ensure durability and high performance levels across its customer base. For example, an air compressor will operate differently in a high-altitude environment than in a low-altitude environment. Given the development time for this product, we are confident that it will enable the company to defend its leading market position with a differentiated product and reinforcement of its brand quality for several years to come.
Atlas Copco can charge premium prices for a significant portion of its product portfolio. It has had a 1% average price increase every year since 2009; these increases have been driven by Atlas Copco’s innovations and bundling strategy, which obscure like-for-like price comparisons, and a growing portion of service contracts. Service contracts are important contributors to switching costs for Atlas Copco's customers, as they increase customer stickiness. Through its service contracts, the company can deliver service repairs that minimise equipment downtime. It can also ensure that the equipment is running efficiently through, for example, early detection of leaks that increase the compressor's energy usage and can go undetected without close monitoring. These types of proactive repairs are important because as much as 80% of the lifetime cost of a compressor is from the energy it takes to run it. The company has been successful at selling service contracts, with as much as 50% of its installed base of compressors on service contracts. The key to its success in contract sales is that Atlas Copco has internal and customer-specific studies that show how much money the customer would save by taking an Atlas Copco service contract, as opposed to the customer or a third party servicing the compressors. These cost savings stem from lower energy costs and less downtime.
Downtime can be much more costly than a premium service contract, making customers reluctant to switch out of a service contract that is helping them to run their operations without failures. The company has a high renewal rate on contracts, and even in the mining sector, which is going through severe cost-cutting actions, the company has been able to sell new high-tier maintenance contracts. Therefore, we think the service contract base is strongly positioned and will continue to provide customer stickiness in the future.
Within Atlas Copco's high-end and larger compressors, customers have high switching costs, as these compressors are often customised and are the backbone for powering much of the machinery and equipment in many industrial processes. Customised compressors can be designed with different pathways from which the air will be released, in order to maximise the impact of the expelled air's force on the motor or a particular piece of equipment that the compressor is helping to power. The machines can also be adjusted to work with maximum efficiency under specific conditions, such as extreme temperatures or high altitudes. An air compressor that efficiently exerts force can create substantial savings in electricity costs for the end user. The employees of Atlas Copco's customers receive training to operate the equipment, and a portion of its salesforce consists of qualified engineers, reflecting the complexity of its products. Atlas Copco's own service crew receives training for up to two years before being put in the field to service the company's compressors.
Atlas Copco also offers financing for some of its customers, which a smaller company may not be able to do. In recent years, the company has not reported any significant impairments on loans from customer financing.
Why not a wide moat? A wide moat rating for Atlas Copco would require an assumption that the company can continue generating new differentiating compressor designs that enable it to retain pricing power, market share, and returns above its cost of capital for the next 20 years. We are comfortable with the assumption that this is the case for the next 10 years, but 20 years includes increased risk that the company might lose its competitive advantages, in our view.
In most years, innovations in air compressors consist of fine-tuning of current designs to increase performance. These are not necessarily enough to keep competitors, such as Ingersoll Rand, at bay. The big leaps in innovation--such as oil-free, screw design, or the current variable-speed--happen every few decades. These innovations take more time to copy, and therefore offer good moat protection, but they are also rarer, and there is no guarantee that Atlas Copco will again be the first to the market with one of these over a 20-year period.
Atlas Copco spends an average amount on research and development. Among its competitors in the various markets of compression, manufacturing tools, and rock excavation, it is difficult to find a peer that mirrors Atlas across all of its businesses. However, a look at the major competitors in different segments shows that Atlas Copco’s R&D spending is in the middle of the pack. In other words, there is no evidence that the company is outspending its peers by a large margin in order to stay well ahead in innovation.
Atlas Copco’s portfolio offering also includes a broader set of lower-tech tools that are useful to sell in a bundle to its customers, but that on a stand-alone basis would not make Atlas stand out from the competition. Examples include paving equipment, hoists and trolleys, and assembly tools.
Moat Trend
We view Atlas Copco's trend as stable. Its intangible assets, namely engineering expertise, would be difficult for an existing competitor to leapfrog and we think very unlikely to overcome as it has been built up over decades of compressor development. We see no signs of material inroads on either front. Switching costs for customers relying on its service network also look stable, if not improved, by more customers in recent years asking the company to service third-party compressors due to the company's larger network of service engineers, who now undergo training on competitor compressors.
Risk & Uncertainty
We give Atlas Copco a medium uncertainty rating. New equipment revenue is sensitive to the cycle, but the high portion of revenue from service provides a floor on margins and returns. In past downturns both have remained in the double digits. The company's core compressor product garners more than one third of revenue from service.
Financial Strength
Atlas Copco has a strong balance sheet, with a net debt/EBITDA ratio of less than 1 time at the end of 2019. Historically, the company has made regular small (and occasional large) acquisitions that have pushed the ratio closer to 1.5 times. Even with acquisitions and lows in the cycle, Atlas Copco has continued to generate a strong level of cash flow. This has helped it to maintain R&D and marketing spending, even in weaker markets. Given its record and its net debt/EBITDA target ratio of 1, we believe that the company will continue to manage its balance sheet conservatively.
Stewardship | 17 Mar 2020
We assign Atlas Copco an Exemplary stewardship rating. As a regular acquirer of smaller businesses, and occasionally larger ones, in new product areas, the company has been disciplined in its choices. It has maintained high returns on capital in the 20s. Its balance sheet has net debt/EBITDA below 1. It has also taken only one major impairment on acquisitions in the past 25 years, with an impairment on goodwill for a rental business that it bought in the 1990s and then sold in 2002. In its acquisitions, the company targets businesses that are number one or two in their markets and that are in line with its core product focus.
