Spin-Off Should Reveal Dover's Earning Power

Three major factors are behind our fresh take on

Dover DOV :

• The spin-off of the company's upstream oil and gas business as publicly traded Apergy.

• The naming of Richard Tobin as CEO, effective May 1.

• The October 2017 disclosure that Daniel Loeb's Third Point hedge fund has taken a stake in the company.

We have increased our fair value estimate for Dover to $86 per share from $81. However, we retain our narrow economic moat, Standard stewardship, and medium fair value uncertainty ratings. The shares currently trade at an 8% discount to our intrinsic value.

Even as the recent spin-off means Dover has lost some moaty assets, we don't believe its moat has narrowed, which is why we leave our stable moat trend rating untouched. In fact, we think the Apergy spin-off leaves a more focused, leaner machine that should unmask Dover's earning power. Many of the company's businesses hold the first or second share position in consolidated niche markets. However, Apergy was a Jekyll-and-Hyde business. It was hard for Dover to consistently hit its intended target of 3%-5% annual top-line growth over a long-term cycle when approximately 20% of its business (depending on the year) faced a declining oil market.

It's difficult to sell diamond drill bits or submersible pumps to customers when the price of oil drops from over $105 a barrel (August 2013) to a trough of around $26 per barrel (February 2016). The precipitous drop in the price of oil also wreaked havoc on margins. Dover's former energy segment saw its operating margins drop to 5% in 2016 from nearly 12% in 2015. Bottom line, we think the market rewards certainty with a higher multiple.

We currently forecast organic top-line growth of 4%-plus for 2020-22 based on several secular trends, including food label regulations, technological advancements in digital printing, customer demand for energy-efficient solutions, and rising urbanization in the world.

We also welcome the hiring of Richard Tobin. Before his appointment as CEO, Tobin was a director on Dover's board. While a board often turns to its members as replacement CEOs for situations in which there are no suitable external candidates or on short notice, we think this is an exception. Tobin had worked closely alongside Fiat head Sergio Marchionne, who is credited with driving a 10-fold increase in market capitalization (including the merger with Chrysler as well as the spin-off of Ferrari and CNH Industrial) in the past 13 years. It's also worth mentioning that John Elkann, the leading member of the founding Agnelli family who also serves as Fiat Chrysler's chairman, specifically mentioned Tobin as a potential replacement to Marchionne.

Even though previous CEO Bob Livingston saw Dover's stock price quadruple in his nine years at the helm, surpassing the S&P 500's increase over the same period, the stock has recently languished behind peers. We think Livingston may have been slow to make hard decisions regarding the company's portfolio. In contrast, we could see Tobin implement the same Marchionne formula at Dover: delinking noncore businesses from core businesses that are punished by a conglomerate discount.

Finally, we project that Dover can improve its profitability through productivity initiatives, albeit to a level that is slightly more conservative than management's 300-basis-point planned improvement by 2019. We model a 250-basis-point improvement by 2020. In addition to these initiatives, we think that even though Third Point owns only 2.5% of Dover's outstanding shares, the involvement of high-profile investor Loeb applies pressure to achieve established targets.