Listening to the EMR call last week we are not surprised there was an increased offer, although this new offer is likely on the higher end of what EMR can pay with 4x proforma Debt/EBITDA at close (assuming ~$350M in synergies). While it’s likely to cause a bit of a kerfuffle on top of ROK’s capital markets day, which is typically focused on product and customers vs. financials, we wouldn’t expect management to comment other than to say it needs to evaluate the offer. We believe ROK is for sale when management decides, not when a sole bidder decides. We would expect that an offer large enough to get ROK in discussions would draw in other bidders like ABB or HON implying a floor in shares.
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CFX is down ~16% since reporting 3Q17 results and a ~30% organic decline in orders (ex. FH), with large declines in oil & gas and power gen. We called out CFX as being one of the most crowded names in our coverage since we launched in July, and we think disappointing orders, and a messy, incomparable print, was enough for a lot of investors to take a step back. Despite the selloff, we think there were many who defended CFX thinking that the reaction was overdone and that the stock hit was worse than the earnings, yet after looking at the pro-forma A&GH numbers, we still see a little risk in the stock. Order growth, which remains the key issue and focus, still appears to be at risk on the new numbers with consensus expecting a 24% sequential increase off of a 23% sequential decline in 3Q. Buying the stock here would be endorsing management’s expectations for a pickup in oil & gas in 4Q, but with O&G orders down >60% in 3Q and no indication that there has been any positive momentum QTD, we think it’s unlikely to see an acceleration now.
As we previewed, both JCI and RBC underperformed (by ~5%) after reporting in-line headlines, but operational misses. For RBC, the price/cost phenomenon played out in the quarter, and while there’s a potentially greater hit coming we think valuation is hard to press further at ~9x 2018 EBITDA. JCI held up for the most part until management started discussing the lack of upcoming portfolio shifts, tax risk, 2H-weighted guidance, and backlog margin pressures, which drove shares lower. ROK shares slid 3.5% after reporting F4Q17 results well below consensus on a segment basis, despite an in-line FY18 guide. After talking down the EMR offer on the call, we think the focus for investors was the conservative topline guide, and especially the 1Q18 pressure despite HSD orders. We were most shocked by CFX, which sold off by 21% at the low point (down ~14% for the week) considering the quarter was in-line, however given that CFX was especially crowded ahead of earnings we think the 30% order decline, the messiness of the new A&GH segment, and the lack of detail on filling the Fluid Handling dilution was enough to get investors out.
The long-shot hope that management would talk about a breakup on the call was left wanting with perhaps 5-10% of the Building portfolio up for evaluation. Deep value would have been interested on improving cash flow and the convergence of adjusted and reported FCF in FY19 at 80%+, but also left wanting on weak backlog margins/growth in Building. Tax reform comments have been cited as a drag on shares today, but did anyone not know JCI had a 14% tax rate? We’re concerned that the process of refocusing the Building sales force on profitable growth rather than just growth looks a lot like Tyco’s similar journey. End markets may be a bit healthier, but every company we’ve seen in this transition has taken a step back for 6-12 months. Orders aren’t really growing today with revenue-based incentives, we’re less willing to assume they dramatically accelerate as the focus shifts to profitability. While shares are still inexpensive on P/E, the lack of a portfolio catalyst and some risks to revenue growth leave us at Peer Perform.
F4Q17 at $0.87 was headline in-line with consensus/WR, a $0.01 segment miss. The focal points will not be very focused, as investors pick through orders, FY18 guidance ($2.75-$2.85 vs. consensus $2.94 and WR $2.87), and FCF. The salient point for guidance is the lack of operating leverage (mid-teens incrementals) and weak NA growth, for FCF that 80% conversion is decent but on lower numbers and excludes ~$850M of adjustments (more than we anticipated but perhaps there’s confusion) resulting in ~$1.25B of actual FCF. We believe investors have been anxious to find value stories in industrials, but JCI still seems a bit premature given structural growth, leverage, and cash conversion issues that are still unresolved for now. We expect shares to be modestly weaker today (11/9/2017) as investors expected little, but were likely disappointed.
Automation carries a premium multiple for premium revenue growth, which at MSD for F4Q and through 2018 isn’t spectacular. ROK has fought an operating leverage battle that peaked in F4Q with restructuring and investment spend, but ultimately, we don’t want ROK to print infinite operating leverage – we want growth. 2018/2019 consensus EPS looks too low on margins, but ROK is a revenue story. On the margin front, we’re less concerned about investment/restructuring noise, but more that the output of the investment is solid but not overwhelming growth in FY18. While we view ROK as a “Have” vs. a "Have Not”, the ~2pt comp-adjusted deceleration in revenue doesn’t compel us to stretch higher than the $215 EMR bid without seeing a more substantial output on the investment in FY18/19 growth. We’ll hope to get a more fruitful read at ROK’s Automation Fair on 11/16 (although we don’t expect it to be a positive catalyst for the stock).
We come away from the quarter having seen our near-term thesis play out. Tough price/cost comparisons and a copper spike that was likely to trigger a LIFO charge have all occurred and go-forward operating leverage should be a little better as a distinct margin headwind went underfollowed for 3Q specifically. Looking forward, the question remains, is RBC a structural revenue grower in excess of LSD and can the company procure price to get operating leverage in excess of mid-teens incremental margins? The historical answer to that question is still no and while downward estimate revisions have likely ceased (and we’re not sure 2018 consensus comes down much), the multiple likely still suffers from a lack of core growth or creative capital deployment to take advantage of the toothsome cash generation.
RBC missed consensus on an operating basis on an in-line headline of $1. 37. Our focal point for the quarter and driver of our below-consensus $1.28 was a weak read on C&I margins amid raw material inflation – that played out but was offset by strength in Power Transmission and Climate. Compared to consensus, however, operating profit was a ~$0.04 miss and $0.11 light in C&I. With guidance narrowed at the same $4.85 midpoint ($4.80-$4.90) and consensus parked at the midpoint already, we believe the stock needed a beat to move higher. Shares have modestly outperformed the XLI since the 2Q17 EPS pullback and industrials in general have required upside to work. Given still-unresolved issues on price/cost in addition to the C&I miss, we would expect shares to be weak today.
Earnings this week had few surprises for us – PH (OP, PT $212), CGNX (OP, PT $148), and GNRC (PP) each beat for their own, but obvious, reasons; Flow control names like FLS and FLOW missed (both PP) on the continued weakness in energy maintenance activity; ETN (PP) was in-line, but disappointing given management seemed to be talking up numbers and comps were easy. Most of the stock reactions were in-line with earnings, although a little more volatile than what we’ve seen in a typical season. ETN’s +2% initial move after earnings seemed like an overreaction, but it has since come down, particularly on Friday given the tax reform headlines, which Chris Senyek, WR Accounting and Tax Policy Analyst, called out in his tax reform report as one of the companies with the largest potential headwinds (-9% EPS hit not knowing transfer pricing impact). While tax reform drove a lot of the stock moves on Friday, JCI and RBC (both PP and reporting next week) did not underperform, yet could both be at risk on the new policy, in addition to fundamental risks we’ve previewed.
GNRC stock has been one of the prime beneficiaries of the hurricane, rising >40% since the onset of Hurricane Harvey. After reporting 3Q17 results, the stock sold off, down ~3%, but has since recovered and is back in the 50s. While we are inclined to be negative, given 2018 revenue numbers are risky (consensus has ~5% growth off of 14-15% growth in 2017 vs. our 1.6%), we think 4Q17 could still be a positive quarter given a lot of the benefit from higher-margin home standby will come in then. At the same time, however, we think it’s unlikely the incremental investor steps in after a 4Q17 beat as 2018 comps get tougher throughout the year and there are better 2018 growth stories in the industrial/construction space. Given it’s not trading too far off from its historic average, we expect the stock to trade in a narrow range until visibility into 2018 growth becomes more apparent.
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