Hexagon and Vaisala: Quality companies are the ones to buy, especially in difficult times
Translation: Original comment published in Finnish on 9/4/2024 at 7:57 am EEST.
How do you find good buying opportunities in growing quality companies such as Vaisala and Hexagon, which almost always look expensive relative to their near-term performance? We believe these companies should be bought when the market fears the short-term effects of a weak demand cycle - in other words, a dip. Stock prices tend to rise too much when economic booms are prolonged and fall too much when the near-term outlook weakens. We compared the historical stock returns of Vaisala and Hexagon against historical valuation levels, which makes Hexagon in particular look like an interesting stock pick at the moment.
Finding buying opportunities in quality companies can seem difficult
Hexagon and Vaisala are profitable, structurally growing and value-creating companies whose earnings-based valuations continue to appear high relative to the stock market average. Both develop high-value technologies for a wide range of industries, and demand for their solutions is growing faster than GDP, driven by megatrends. Hexagon's and Vaisala's revenues have grown organically by an average of 5% p.a. and 6% p.a. respectively over the last ten years, and the companies have also grown through acquisitions (especially Hexagon). In addition to growth, both companies have been able to consistently improve their profitability levels
Historically, valuation levels have played an important role in future returns
We examine the relationship between Vaisala's and Hexagon's historical valuation levels and actual returns since the turn of the millennium. We look at valuation levels relative to the average actual EBITDA over the last 3 years. EV/EBITDA multiples calculated in this way are always easy to calculate and do not require any insight into future performance. The analysis shows that the return offered by the shares purchased in both Hexagon and Vaisala at time x is inversely correlated with the backward-looking EV/EBITDA ratio measured at time x.
The analysis considers only the return based on the increase in the share price. The annual dividends paid by Hexagon and Vaisala have shown a stable and increasing trend. In recent years, the annual dividend yields of both have been only about 1-2% of the share price, making them a small part of the total expected return. However, over the long term, Vaisala's dividend yield has fluctuated between 3% and 5% between 2004 and 2016. The analysis also excludes acquisitions, which occasionally increase the actual EV/EBITDA ratio, especially for Hexagon (the acquisition increases EV, but the performance of the acquired asset is not reflected in the backward-looking EBITDA).
Returns inversely correlated with backward-looking valuation levels
Hexagon: Valuation and actual capital return time-series
Hexagon: Summary of the relationship between valuation and capital returns
Vaisala: Valuation and actual capital return time-series
Vaisala: Valuation and actual capital return time-series
Data: Bloomberg (NB: Annual returns shown in the graphs do not include dividend income)
Market has often overreacted to near-term earnings expectations
Based on the valuation graphs above, we conclude that Hexagon and Vaisala are generally good buys when the actual valuation level has declined significantly relative to historical medium-term levels. The most typical reasons for fluctuations in valuation levels are related to the industrial cycle. As economic growth weakens, the market is lowering its expectations for Hexagon's and Vaisala's earnings growth. If an investor believes in the long-term earnings growth drivers of the companies, which we believe is justified in the case of Vaisala and Hexagon, short-term cyclical weakness often provides above-average buying opportunities. Similarly, during booms, the actual valuation level has tended to rise significantly, leaving investors with poor returns, especially toward the end of the boom.
Relying on actual valuation levels to make an investment decision requires that the quality and earnings growth profile of the company being purchased remain strong over the long term. We believe that both Hexagon and Vaisala meet this criterion as they both benefit from a diversified customer base, a strong international position in certain niche markets and a structurally growing demand for high-quality technology. While investors should also pay close attention to future performance expectations and a holistic view of the investment, we believe that looking at actual valuation levels provides an interesting complement to the most commonly used valuation metrics.
Hexagon's actual valuation looks attractive to us
In the case of Hexagon, we find it easier to justify the affordability of the current valuation level, as the company's current actual valuation level (3-year EV/EBITDA 16.5x) is, for example, well below its 15-year historical average (~20x). Hexagon’s near-term growth prospects have been impacted over the past three quarters as, despite the diversification of the company's businesses, weak capital spending in the construction and automotive industries, among others, has weighed on sales of sensors and equipment manufactured by the company. At the same time, the share of recurring revenue (software and services) has continued to grow rapidly and is already approaching 50% of total revenue. We expect the weakness in demand for sensors and equipment to continue in Q3, but to begin to ease in Q4 as comparison figures get easier and interest rates fall, among other factors. We expect the company's cost savings program to support earnings growth in 2023-24, along with a potential rebound in cyclical sensor demand in 2025. Hexagon's forward looking valuation multiples are adj. EV/EBIT 17x for 2024e and 15x for 2025e. We expect the still exciting cyclical weakness in the market to continue or worsen in the near term, which we believe creates an attractive buying opportunity.
Vaisala's actual valuation appears tighter
In the case of Vaisala, the attractiveness of the current valuation level is not obvious based on actual valuation levels, as in the first half of our review period from 2003 to 2014, the stock was valued at an average actual EV/EBITDA of 10.5x, compared to the current 3-year actual EV/EBITDA of 21.6x, which makes the stock look expensive. However, we believe that the quality of the business has improved significantly since the mid-2010s, driven by strong growth in the highly profitable Industrial Measurements business and more recently by improved profitability in the Weather and Environment business, which is reflected in the reported numbers. We expect the profitability improvement in the Weather and Environment business to be sustainable as the company has started to focus resources within the business in line with the strategy presented in 2021, which has made the traditional meteorology and aviation weather business more profitable. However, the current actual valuation level is already approaching the average level of 22x for 2020-22, which can already be considered quite high. In our view, the market is pricing in the fact that Vaisala has already passed the lowest point of demand and therefore the stock is pricing in the earnings growth from the budding recovery and the strong order book in the Weather and Environment business area. Vaisala's forward-looking adjusted EV/EBIT multiples are 18x for 2024e and 16x for 2025e. Our positive recommendation on the stock is based in part on earnings growth expectations for 2025-26, but the share price has already risen quite close to the target price.
