Nordson (NASDAQ: NDSN) is an industrial company focused on precision technology that handily beat the S&P 500 over the past decade.Nordson is said to be a quality business, let’s see if it lives up to its name It may even present an attractive investment opportunity at current levels.
What is Precision Technology?
Precision technology is an undefined term that usually means something is precise. Nordson organizes its business into three segments serving five end markets:
- The Industrial Precision Solutions segment, which accounted for 51% of revenue, is the focus of Nordson. The segment includes adhesives, industrial coating systems, management and control solutions, and polymer processing systems. All in all, it is mainly packaging and other processes that occur at the end of the industrial manufacturing process.
- The Medical Fluid Solutions segment accounted for 27% of revenue. This segment also focuses on fluid management and other products focused on storing or transferring medical devices.
- The Advanced Technology Solutions segment accounted for 22% of revenue. This segment consists of electronic handling, testing and inspection systems.
We see Nordson focusing on machines, parts and consumables for the final stages of the industrial manufacturing process such as packaging, testing and inspection. This results in a high percentage of recurring sales (51% of revenue is parts and consumables, the remaining 49% is system sales), which is the holy grail of any investment. Recurring revenue adds certainty to companies (and analysts) in forecasting business and reduces the need to always sell new products. Ideally, you want a small percentage of system sales, requiring high recurring sales. Nordson comes pretty close to that setup.
In addition, Nordson has a very diverse customer base spread across five end markets, which account for 12% to 30% of total revenue. In the image below, you can also get a better idea of the different products that Nordson offers.
Nordson operates in a relatively stable industry due to its high mix of recurring revenues. In the table below, I’ve compiled some numbers based on the different segments in 2022 (expected growth rate/CAGR from management). For the most part, Nordson doesn’t expect any extraordinary organic growth in its business, and expects organic growth in the range of 3-5% across all of its divisions, with some potential upside. 3-5% organic growth doesn’t excite me, so they have to trade at high FCF yields or otherwise grow earnings.
|income||EBITDA margin||Expected CAGR||% of total revenue|
|Industrial Precision||$1.337 billion||35%||3+%||51%|
|medical liquid||$690 million||40%||5+%||27%|
|Advanced technology||$563 million||25%||5+%||twenty two%|
Growth through M&A
Due to the lack of organic growth, Nordson occasionally acquires companies to add to its portfolio. Over the past decade, the company has spent a total of $1.66 billion in cash on acquisitions, which represents just 12.6% of the free cash flow the company generated during the same period. Mergers and acquisitions are notoriously risky ventures for companies, and 70-90% of them are known to destroy value. Therefore, companies undertaking strategic M&A need to demonstrate good framework and discipline in their approach. I would like to see the following aspects of this strategy:
- Strategic fit with business model. This could be gaining market share in an existing line of business, entering an adjacent business, or cost synergies. I don’t like to see completely unrelated businesses being acquired; it often backfires due to lack of existing knowledge in these areas. Nordson addresses this and points to product portfolios within Nordson’s capabilities and high-growth end markets.
- Integrating a new business is always critical; when two business cultures collide, it often leads to failure. Nordson addresses this by requiring a customer-centric business model, as Nordson has adopted in its Ascend strategy.
- A big factor in the value destruction of most mergers and acquisitions is the focus on revenue growth. That’s why I’d like to see a focus on the profitability of the business. Nordson addressed margin issues and required at least 20% EBITDA margin with potential for improvement. Also, they need the ROIC to be higher than the cost of capital within 3-5 years. That last part is a bit generous in my opinion, since a good company should always generate returns above its cost of capital.
- In the end, the price paid matters and is often a significant factor in value destruction. While Nordson didn’t explicitly talk about acquisition threshold ratios or preferred multiples, based on the last added numbers (mid to high teens EV/EBITDA), the company appears to be making acquisitions around its own multiples. Not great, but it didn’t seem like overpaying either.
The last resort a company must resort to is improving margins, because it’s about earnings growth, not revenue growth. The chart below shows that gross margins have held steady at 55%, while margins are trending upwards. SG&A margins are a good metric to track but receive little attention and represent the bulk of a company’s costs. We can see a gradual decline in SG&A margins from 35% to 29%, which coincides with a roughly 5-6% increase in margins. The company still has room to grow profits, but it’s not significant. Also, we can see how efficiently Nordson reinvested by looking at the difference between ROIC and WACC (a healthy 8%). Our goal is at least 2%; otherwise, the company is destroying shareholder value.
High-quality businesses that trade above fair value
To value Nordson, I performed an inverse DCF analysis using a discount rate/required rate of return of 10%, a permanent growth rate of 3%, and assumed share volume reductions of 1% per year through buybacks over the past decade. According to the model, Nordson needs to grow FCF by 12% in the first five years and then by 10% in the next five years. Management is guided by a mid-term (20-25) outlook of 7+% sales growth and 10% EBITDA growth, so we can assume FCF should also be around 10%. At this price, I don’t see Nordson getting a big return. Compared to its historical FCF of 10%, the company would need to deploy more capital for M&A in order to grow fast enough to justify its overvaluation.