Like Halma (OTCPK:HLMLY), Spirax-Sarco (OTC:SPXSY) is a stock that will frustrate value-driven investors. I don’t know how you question the excellence of execution at this company (feel free to try in the comments), and I can see a path for Watson Marlow continuing to generate high-single digit organic revenue growth (and 30%-plus operating margins) for some time. Likewise, I appreciate both the defensive/acyclical customer mix and the uncommon focus on customer value creation that’s woven into the business.
But we’re talking about a stock trading at around 25x 2021 EBITDA. While I think EBITDA growth could come close to the double digits over the next four to five years, and I believe double-digit long-term FCF growth is doable, I just can’t reconcile the valuation with fundamental drivers like cash flow, margins, ROIC, and so on. This isn’t a unique experience, I’ve seen it with Halma, Danaher Corp. (DHR), Roper Technologies (ROP), and other top-quality industrials, but I can’t really rest easy with a portfolio full of stocks where the valuation argument basically defaults to “trust me… it’ll all work out.”
Defensive Exposures Come To The Rescue
While industrial production does factor into Spirax-Sarco’s growth, the business is quite defensive, with roughly half of the end-market mix spread across a range of defensive, or at least generally acyclical, end-markets like food/beverage, pharmaceuticals, medical devices, and water. In fact, that pharma exposure is hardly “defensive”; with the explosive growth under way in bioproduction, it’s a growth driver for the company.
First-half revenue fell only 5% in organic terms, and while the pharma-driven Watson Marlow business was certainly a positive contributor (revenue up 5% organically), the more traditionally cyclical Steam business outperformed the 8% global decline in first-half industrial production with a 7% organic contraction. The Electric Thermal business, with its more significant exposure to oil/gas and machinery, fared worse with a 12% decline. Likewise, the industrial (non-pharma) component of Watson Marlow also outperformed with a 6% organic revenue decline.
A Long Runway For Pharma Fluidics
Companies leveraged to pharmaceutical production, bioproduction in particular (the production of biological products like antibodies and gene therapies), are seeing strong demand, and that includes companies like Danaher, IDEX Corp. (IEX), and Thermo Fisher Scientific (TMO), the latter of which is a Spirax-Sarco competitor in some cases.
Watson Marlow is the leading player in peristaltic pumps, pumps that use pressure to move substances through tubes/piping while maintaining sterility, and those pumps are not only benefiting from underlying capex growth in biopharma, they’re displacing other technologies. On top of that, biopharma companies have found that, on balance, it is more cost effective to use single-use devices where possible in the bioproduction chain, and that includes single-use tubes and valves for Watson Marlow.
With bioproduction growth likely to remain in the low double digits to high single digits for some time, I like the prospects for strong growth from this business. The business is currently about half biopharma, though, so there will be some drag from other end-markets like food/beverage, water/wastewater, medical devices, and mining, but even there I expect above-market growth as Watson Marlow displaces incumbent technologies and/or the end-markets start adopting process automation systems in a bigger way (food/bev and mining, especially).
Steam Is Special
There ought to be a Harvard case study for Spirax’s Steam business.
What impresses me, in particular, is how well-coordinated the company is with its customers. It is not at all uncommon for Spirax customers to invite Spirax engineers into their plants with the stated purpose of identifying areas where they could save money or otherwise improve operations by using the company’s products. In many cases, Spirax is able to lower energy costs, improve system efficiency, and/or reduce emissions, and often with a payback period of less than 2 years. What’s more, with most of the company’s products being relatively low-ticket (often falling within MRO budgets), there isn’t a prolonged review process.
More than 70% of Spirax-Sarco’s sales are done directly, giving the company sticky relationships and enabling it to understand a given customer’s needs. The exception is in the U.S., where the business is primarily conducted through distributors. While it would take time and spending to shift that, I do see long-term opportunities if the company can shift toward a more direct model in the U.S. as well.
While steam may seem like ancient technology, it’s still a very effective medium for heating, propulsion, humidification, and separation. Given that, it’s not likely to be designed out of plants anytime soon.
I do have some modest concerns around the exposure Spirax-Sarco has to oil/gas through its Electric Thermal business, but I also see ongoing self-improvement opportunities in the business. It’ll never be as lucrative as the Steam or Watson Marlow businesses, but I do see opportunities to improve aftermarket sales/service over time. I also see the potential for some M&A in the future – were nVent (NVT) to be acquired for its electrical products operations, I could see an acquirer looking to sell the thermal management operations, and Spirax-Sarco could be a buyer.
I model long-term revenue growth around 6-7% for Spirax-Sarco, with Steam growing around 5-6% long term, Watson Marlow growing 7-8%, and Electric Thermal growing around 4%. I do see further margin improvement, in part due to the greater mix of the very high-margin Watson Marlow business. I expect FCF margins to move into the high teens over time, driving a long-term FCF growth rate around 10%, with mid-to-high teens ROICs in the next few years.
None of that supports the share price today, let alone a substantially higher target price. As I said, Spirax-Sarco lives in that special quadrant with companies like Danaher, Halma, and Roper, where different valuation norms apply. If you’re comfortable with that and believe that these robust multiples can persist (or even expand), go for it. For me, I can’t get comfortable with the valuation at these levels no matter how much I like the underlying business.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.