In our last article, we said that Atlas Copco (OTCPK:ATLKY) is expensive for a reason, stocks are rarely cheap, and we’d consider buying if they drop another 10-20%. Since then, stocks are down about 11.5% in dollar terms, and we’re now tempted to buy the shares. In this article, we will focus more on the valuation and recommend readers unfamiliar with the company to check out our previous article.
It is important to note that a large part of this decline is simply due to the strength of the dollar which has appreciated considerably against European currencies such as the euro and the Swedish krona, in which Atlas Copco AB trades at l ‘origin. The strong dollar means it could be a good time for US-based investors to diversify into European equities. Either way, it helped make Atlas Copco much cheaper.
To remind us why we love Atlas Copco so much, it has incredibly high and stable profit margins, with operating margins averaging over 20% for over a decade. This is remarkable for an industrial company. Few of its peers have similar margins, an exception would be Illinois Tool Works (ITW), which also has higher margins, and both have much higher margins compared to competitor Ingersoll Rand (IR).
The quality of the company is also reflected in its impressive returns on capital employed, which have averaged ~27% over the past decade. This has enabled the impressive capitalization that stocks have provided over the past decade.
Atlas Copco not only shows superior financial results, but also decent growth. Growth is cyclical as shown by order growth by quarter in the chart below. Still, it appears that on average, growth has accelerated for the company compared to previous periods of growth.
The company is expected to be less cyclical going forward after splitting off its mining, infrastructure and natural resources segments in 2018 and forming Epiroc AB (OTCPK:EPOKY), which is now a fully independent company.
For the near-term outlook, Atlas Copco expects the level of customer activity to remain strong, but to weaken from the very high level of the first quarter.
Atlas Copco’s balance sheet is very strong with almost as much cash and short-term investments as long-term debt. Atlas Copco has an A+ debt rating from Fitch and A+ from Standard & Poor’s Corporation for long-term debt. The company has an Altman Z score of 8.8x, which also reflects its strong financial position and balance sheet, and that it is unlikely to go bankrupt anytime soon.
Compared to its historical valuation, and in absolute terms, the shares seem attractively valued at ~13.5x EV/EBITDA. This is a similar multiple to where stocks were trading at the height of the Covid crisis, and below the ten-year average of around 15x.
Compared to similar industrial companies like Ingersoll Rand and Illinois Tool Works, Atlas Copco is trading at several turns cheaper EV/EBITDA. Note that this has not always been the case, and even just a year ago Atlas Copco was the one trading at the highest valuation multiple.
Atlas Copco’s price/earnings ratio also looks attractive at ~21x, a significant discount from the past three-year average of ~32x.
The company normally pays around half of its earnings in dividends, so the current yield is around 2%, which we consider very reasonable given its safety and growth potential.
While we are not overly concerned about the strength of the balance sheet given its strong liquidity and high credit rating, we are somewhat concerned about the cyclicality of earnings. Historically, there has been good cyclicality, but this has been tempered by the highly variable cost structure that Atlas Copco uses, as well as the separation of some of the more cyclical parts into Epiroc. Yet the remaining segments that are heavily concentrated in compressors and vacuum pumps have a high concentration of customers in industries like electronics that remain cyclical.
Atlas Copco is an exceptional company that rarely bargains low. Right now, we think stocks offer a rare opportunity to buy them at an attractive valuation. They might not be a bargain, but they’re priced reasonably enough to offer decent potential returns for long-term investors from current prices. We plan to buy the shares around current prices with the intention of holding them for at least a few years. We are also updating our rating from “Buy” to “Hold”.