James, I decided to post here a little r‚sum‚ of a long message I wrote on February 2 on Yahoo!'s board, as an answer to a post that challenged Donaldson's merits. I hope you don't mind. I just thought that it would save me a lot of time and that the results would be the same. Take note that I include excerpts from the contrarian view between brackets; the following paragraphs are my answer.
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< 1.) First, that the stock is cheap. Looking in a vacuum, this is a bit true. This stock has historically traded between 15X-20X forward earnings; it is currently at 14X. A normal P/E (assume 17.5X) would imply a price of $25-$26, which we would all agree would be a nice little appreciation from here. If one assumes growth into perpetuity under the same valuation assumptions certainly the sky is the limit here. But given the cyclicality of the company, assuming growth in earnings into perpetuity is not wise.>
I maintain that the stock is cheap on a p/e basis, compared to the over-all market. Of course, we all that know that the U.S. market (DJIA, S&P 500, NASDAQ) has reached an extremely rich valuation, on a historical basis. And as you say, Donaldson being considered a small to medium cap, in a cyclical sector, has not been as highly valued as the blue chips or internet and technology stocks lately. But you have to remember that the Asian Crisis has been very tough for many countries doing business with DCI. Furthermore, Donaldson's regular customers in the U.S. - the farmers and Caterpillar, in particular - have suffered through these bad times. I won't say that DCI's management has been absolutely perfect in the face of this adversity, but the company has still finished year 1999 with profits. And yes, it was an other double-digit growth year, even though the numbers were far more impressive than before. It's unfortunate, there was a financial crisis and Donaldson has certainly lost some opportunities - or at the very least had to postpone some projects, which has slowed growth. That's for sure and I admit it.
But does that make Donaldson a laggard? I don't think so. I am still confident that this is a fast moving and disciplined animal. It has been hurt, maybe sick for a few months, but it still was able to deliver the goods. It has gone through the same moves learned over the years: plants have been upgraded; the dividend has been raised as usual; the shares have been bought back; and these last few months it has gone back to hunting, with two acquisitions, the last one adding $80 million to revenues of $944,1 million in 1999. I don't know about the future, but I see that Donaldson's management is behaving much the same as in the past. If you look back to 1987, for example, revenues were in the order of $294,9 million and net earnings, $10,9 million (18 cents per share). In 1999, we're talking about net earnings of $62,4 million ($1.31 per share). Thus, for 12 years, we have a compounding annual growth rate of 10.1% for revenues and 15.6% for earnings. Thanks to share repurchases, earnings per share have grown at a blistering 17.9% rate. Finally, dividend was a mere 6.5 cents in 1987; in 1999, in 1999 it was 23 cents, for a compounded growth rate of 11.1%. Not bad either.
<2.) Second, your enthusiasm for stock buybacks, and this links into my first point. The fact is, Donaldson does not seem to have any meaningful way to use its cash hoarde other than to buy back stock. It is not very acquisitive, R&D simply does not play a significant role at the company and it has a healthy infrastructure established. Valuation multiples will always suffer when EPS growth is due to the only use of strong cash flow being to buy back stock rather than spend on internal initiatives. As investors, we pay the company to grow the business, not shrink the equity base. Considering this, perhaps the modestly lower valuation currently being awarded DCI shares is warrented. If so, you may be waiting another 1-2 years to see the stock sustainably higher than present levels (short-term trading moves, which you abhore, aside).>
Here I don't agree with you at all. Sure, if share buybacks were the only way Donaldson grew the company, we would have a problem, but let's be honest here, it's not the reality. I already talked about acquisitions (I should also emphasize that we have seen too many companies making bad ones...), but R&D is an other topic. If you look at the financials, you'll see that management allocates between 2 to 2.5% of revenues to this field every year. Of course, this is not much compared to Pfizer, to make a comparison, but why would you spend 20% of revenues in R&D if you have excellent results over the years with 2 to 2.5%? Again, that's just prudent and responsible allocation of capital at work. R&D? Sure, but not too much R&D.
<A stock price is made of two components, as we all well know: EPS & multiple. There is a great deal of faith on the former; the latter has never been discussed on this board (a CIBC analyst discussed it at length some time ago, but I haven't seen any research on this company out them in a while for some reason). You should be frustrated by the performance of this stock, but you should not be surprised.>
Multiple? Yeah! Finally, a good point! And you'll be glad, I agree with you. We won't see Donaldson trading at a multiple of 100 for a long time if it's what you're talking about, and we all know that. Maybe, one of these days, if pollution control becomes a hot sector, as I was dreaming... But in an ordinary market - I mean, one very different from the current one - I probably would be very satisfied with a p/e of 15. Now that the market is trading at a p/e of over 30 however, I am not necessarily disappointed or frustrated as you seem to think, but, let's say, puzzled... I mean, I hold other stocks and make money with them, but in regards of Donaldson's intrinsic value and future growth prospects, I can't help but think that a lot of people are investing in the wrong issues right now.
Of course, we are in a free country and I am glad to see other people are getting rich with their investments. It's just that it's a bit sad to witness the rueful chase to performance, in disregard of the true merit of the companies... and human beings (management and workers confounded), which are the living entities behind these stock quotes. I know that some of the "new economy" companies will entirely deserve the high prices attached to their stock in the future, but many won't be in business either in a few years. Meanwhile, the prudent and patient investor should envision future trends and make sure to position himself in a few selected stocks, while they are forgotten, in the shadows... in spite of the fact that they are showing good growth and have a solid future ahead. Which is not to say that you should not invest in the Linux concept, or buy a "fuel cell" story, but do it with clear eyes and keep a few bucks for the ones that deliver...
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Fore those who would like to read the whole message, here are the links (there are two parts):
messages.yahoo.com
messages.yahoo.com
I know this was very long and I hope you did not get bored while reading it.
Marc |
