These are still good days to be an industrial company tied to electrical equipment and the electrification of a wide range of end markets. Leading names like Eaton (ETN), Hubbell (HUBB), and nVent (NYSE:NVT) have pulled back a bit lately, but that needs to be seen in the context of significant outperformance (25%-plus) versus the broader industrial sector since my last update on nVent. This hasn’t just been a bubble, either, as many of these companies have outperformed on volumes and margin leverage, while still looking forward to above-average long-term growth potential.
Specific to nVent, I admit some nerves going into the third quarter report. I don’t think Belden‘s (BDC) warning is entirely applicable to nVent, but volumes have been tapering off (-1% in Q2’23, flat in Q1’23 and Q4’22), and I do see some risk from the company’s short-cycle industrial and building exposures as the Street focuses more on near-term volume growth prospects. In the longer term, though, I like the company’s leverage to the “electrify everything” trend, as well as more discreet opportunities like gaining share in the data center market (liquid cooling especially).
Electrification plays have been getting a premium, but even with a 100bp boost to EBITDA multiple, nVent looks somewhere between fairly valued and 10% undervalued. There are worse things than owning quality companies at fair prices, and there are opportunities to exceed my expectations, but I’d be a little more cautious on this name now, even though I do still like the long-term story.
Will Short-Cycle And Non-Resi Drive Weaker Volumes?
The Street is looking for about 10% sequential revenue growth, but with M&A influencing nVent’s numbers, I expect the real focus to be on the company’s organic growth. As for many other industrials, nVent has been seeing waning tailwinds from both pricing and volume, with volume going slightly negative in the second quarter and pricing driving 5% growth (down from 8% in Q1’23 and 15% in Q4’22).
With Belden warning on weaker enterprise solutions and industrial automation, I do have some concerns about nVent’s short-cycle industrial exposure in the second half of 2023, as well as its exposure to commercial buildings.
Based on second-quarter commentary from industrial automation companies and developments through the quarter (presentations at sell-side conferences, customer commentary, et al), I think we’re going to see even more evidence of a slowdown in industrial automation capex, as companies hit pause and step back in the face of macro uncertainties in most markets. I see no real risk that the trends of re-shoring and automation are going to end prematurely, but Wall Street can be exceedingly short-sighted (particularly when investors are nervous), so I’m expecting weaker guides for the automation players and, by extension, companies like nVent that facilitate those systems.
So too in the commercial and residential building space. Weakness in the residential market is widely known now, and it’s also clear that non-resi activity is slowing as well. While there are incentives in place for building owners to upgrade and electrify their systems (which drives more demand for cable management, power connections, and surge protection for nVent), it’s hard for owners in the office, retail, and warehouse space to justify those expenditures given where trends in those markets are pointing now.
Data center, too, remains something of a question mark. Enterprise spending has definitely slowed, with expectations that activity will pick up toward the end of the year, and hyperscale has slowed as well as companies “digest” prior capex programs. That said, there has still been activity in upgrading power and cooling systems, and coupled with share gain/market penetration opportunities, this could patch over some near-term end-market weakness for nVent.
Looking For Leverage
Between improved component availability, falling commodity costs, and improving mix (including an increased impact from newer products), nVent has been seeing good margin leverage in recent quarters, with gross margin climbing from the mid-30%s to the low 41.3% in the last quarter. This has flowed through to segment earnings, with EBITDA margin improving toward the mid-20%s and segment-level earnings margins in the low 20%s.
The comps are getting harder, though, and I think the momentum is going to slow. I do still expect year-over-year improvement in both gross margin and segment margin Q3’23, but I expect more modest sequential improvement now.
Attractive Long-Term Opportunities
I don’t want to belabor my concerns on the short-term outlook. I do think 2024 is going to be a challenging year for organic volume growth for many shorter-cycle industrials and pricing power is going to be a lot harder to come by. I’m increasingly of the mind that the U.S. will avoid an outright recession, but I think a few quarters of “muddle through” are on the docket, particularly with companies potentially pausing on further capex ahead of the election cycle.
Beyond this short-term uncertainty, though, I’m bullish on nVent’s market opportunities.
Factory automation and digitalization are only going to grow from here, and use cases like industrial IoT and digital twining are still in their early days, as are local micro-grids. As companies increasingly automate and digitalize their operations, it will drive demand for a host of nVent offerings, including enclosures, cooling systems, connectors, cable management, and surge protection. Are these sexy products like robots? No, but they’re still essential for an automated plant.
I likewise see further opportunities for the company in utilities and renewables. Utilities have been spending on grid renewal/hardening, but there’s still a long way to go before the job is done.
Looking at the data center, management estimates that only about 5% of data centers are using liquid cooling, and while that may never be necessary for more basic enterprise centers, the expansion of centers focused on AI (with their higher power demands) will drive more cooling needs, not to mention demand for power connections, surge protection, cable management, and so on. Last and not least, building electrification has a lot of government support both in North America and Europe and continues to offer good retrofit opportunities over the long term.
The Outlook
Between significant M&A (the $1.1B deal for ECM the largest among them), end-market developments, and management’s own product/market development efforts, I’m more bullish on the longer-term growth prospects. I expect high single-digit revenue growth for nVent over the next 3-5 years, slowing to 5% over the longer term, which is still likely around double the underlying growth for the broader industrial space. This growth is predicated on the ongoing growth and expansion of electrification, and nVent’s ability to leverage that opportunity.
On the margin side, I’m expecting mid-20%s near-term EBITDA margins and mid-teens free cash flow margins. How much of the revenue growth and margin leverage I expect that get translated into FCF is still an important unknown for me. Right now I’m expecting gradual improvement toward the high-teens, supporting nearly double-digit annualized FCF growth, but progress here has proved more challenging. At a minimum, the high debt load should have management focused on cash generation as a way to work down that debt/EBITDA ratio back to 2.0x or below.
Between discounted cash flow and EV/EBITDA, I think nVent is more or less fairly valued. With a 13.25x forward EBITDA (based on margins and returns like ROIC, and including a 100bp premium) I get a fair value of $55 and discounted free cash flow gives me an expected total annualized potential return of around 9%.
The Bottom Line
A high-single-digit expected return isn’t bad, and I do still like electrification names as longer-term plays. My hesitancy here is mostly that I’ve seen how the Street reacts when growth darlings slow, and I do still see a risk on organic volumes for a few quarters. With that, I’m more tempted to wait for a greater pullback than to step up today, but I don’t think there’s anything fundamentally wrong here.
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