It is hard to understand the optimism of the market towards Nordson Corp. (NDSN). The momentum behind NDSN’s shares is strong. The company reached its all-time high of $200 in June, surpassing its February highs. Shares are taking a breather, as they have retreated towards a recent $184. Still, that is approximately an 80% return since the March bottom.
We can’t explain why NDSN has had such a strong rebound, but the market is pricing-in spectacular growth ahead. With valuations multiples at all-time highs, investors are willing to pay up with the belief that future growth will compensate them. With a recent price of $184, NDSN’s forward FCF yield stands at a paltry 3.5%. We can add the dividend yield of 0.84% for a total expected return of 4.3%. In a world of near 0% rates, 4.3% sounds like a solid return. However, with no margin of safety present, we wouldn’t feel comfortable holding this stock.
That said, NDSN is a high-quality company with hints of competitive advantages. The company has averaged mid-to-high teens’ returns on invested capital and operating margins in the mid-20s. That is an indication that customers are willing to pay for their products and do so constantly. If we do not include goodwill in the capital base, then returns on tangible capital can reach 40% to 50%, which is impressive for an engineering and manufacturing company. However, since M&A has been part of NDSN’s growth strategy, including goodwill gives us a more realistic view of the returns they can generate.
The Big Picture
Source: company filings
NDSN is a manufacturer of systems used for precision dispensing, applying, and controlling of adhesives, coatings, polymer, sealants, and other materials. These types of equipment are found in the manufacturing lines of many conglomerates and OEMs providing a critical role in their manufacturing process. NDSN product offerings are highly engineered and customizable to their customer’s specifications. For example, the company is working on a fabric bonding application to replace stitching in athletic wear and feminine undergarments.
Top-line growth at NDSN has been consistent, considering they operate in a cyclical industry. From 2010 to 2019, the company has had negative sales growth only in 2015 and most recently in 2019. However, they have been able to grow the top-line at a 9-year CAGR of 9%.
Source: investor presentation
The consistency of their top line can be attributed to their product mix, from which half of their sales come from their parts and consumable segment. That gives the company a recurring source of revenue, which currently stands at 54%, as customers need to replace old parts due to wear & tear and maintenance schedules. We believe this gives the company some degree of competitive advantage in the form of switching costs, as it would be difficult for a customer to replace vendors since NDSN plays a critical role in their manufacturing lines, they use proprietary technology in their products and the cost of their components are relatively low compared to the total cost of production:
“If you think of about Nordson, most of our products and components are very low in the cost stack for the customer, but yet play a very important critical role, be it in a manufacturing line or in their product performance. So it’s less susceptible to cost pressures from the customer because we provide a unique value.” – Wells Fargo Industrial Conference
As such, we believe NDSN can maintain a “razor blade” business model, as their customers won’t risk disruption at their production lines just to save a few dollars. Unscheduled downtime can cause heavy losses.
By looking at the trends within NDSN’s cost structure, we could see that COGS and operating expenses have run at a slightly faster rate than revenue growth. For example, in 2010, COGS as a percent of revenues was 40.3%, but throughout the decade, that number has increased to a now current 45.7%. As a result, gross profit margins have decreased from 59.7% to 54.3%. The reduction in gross profit margins (or the increase in COGS) can be attributed to the number of acquisitions the company has made from 2010 to 2019 ($2.1B). As the company acquires other businesses, the complexity of the entity increases. Their product mix also changes, which can be a trade-off between volume vs. margins. Acquisitions also add depreciation and amortization expenses, which pressures margins:
Source: 2012 10-K and 2019 10-K
While COGS has been increasing, the company has done a good job of managing their expenses below the gross profit line. From 2010 to 2019, administrative costs have decreased as a percentage of total sales from 34.7% to 32.6%, while keeping R&D costs at an average of 2.6%. However, as the company becomes bigger, R&D expenses (which we view as an investment) have increased from $23.8M in 2010 to $60M by 2019. R&D is key to NDSN by keeping them in a constant product innovation path, strengthening their competitive position. Their product portfolio is protected by approximately 2,000 patents.
Growth and the Bottom line
The company currently sees two areas of growth: its medical equipment portfolio and the roll-out of 5G.
Their medical segment is growing and today accounts for about 17% of their product portfolio. The company provides catheters, connectors, balloons, tubing, syringes, and other products. As hospitals move away from sterilized components to single-use disposable plastic components, the company is set to benefit from the change:
“So in terms of growth levers, the base market itself is growing about 5% to 6%. It’s really a very nice part. The second is product innovation. There is continuous rapid innovation cycle in med devices. Our medical device customers really want to focus their R&D and manufacturing resources on developing, designing and manufacturing medical devices. One more thing I would add is that we have — this is a very fragmented space. It still has a lot of smaller properties. We have a ability to acquire. We have a design and development capability that really helps us.” – Wells Fargo Industrial Conference
In terms of the roll-out of 5G, the company benefits across the supply chain, in multiple different applications:
“In terms of where we are working on, we’re working on multiple fronts. We’re working on a number of applications, all the way from chip packages to RF components, to switches, filters, antennas, base station. So we’re working on a number of different applications in these many different components. In terms of application, primarily where we are involved in is we’re involved in dispensing thermal paste, which have thermal interface materials. We’re definitely working on conformal coating of large boats in the base station. And also another exciting part for us is our test and inspection capability. This is a capability we have built over the last few years and that one is really becoming a huge asset for us as 5G rolls out.” – Wells Fargo Industrial Conference
It’s hard to tell exactly how much of those growth expectations are already embedded in the current share price. But the market feels optimistic about the future growth in NDSN as they are willing to pay high multiples:
With valuations at sky-high levels, there is no margin of safety. With no end in sight to the COVID-19 pandemic, there are still unknown risks lurking. Paying for shares in NDSN is betting on a perfect outcome, which at this point, we are not optimistic about. We really don’t understand the optimism of the market, and therefore we would rather stay on the sidelines.
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.