Gorman-Rupp’s Shares Have Gone Too Far, Too Fast

Gorman RuppThe Gorman-Rupp Company (NYSE:GRC) is in the pump industry with a focus on water.  Its two key end markets, muni water  companies and construction, have suffered from soft demand, which contributed to earnings declining over the past four years.  Expectations among analysts are that earnings have turned the corner and will grow at a CAGR of 20% through 2015.

The problem with the stock is that analysts have baked in a recovery in the construction and muni end markets, but the orders have not shown up yet.  In addition, the data on commercial construction in particular is not showing signs of improvement.  Delays in the rebound could result in earnings forecasts getting cut and the stock price declining.

About Gorman-Rupp

Gorman-Rupp is an Ohio based manufacturer of pumps and related controls for water, construction, industrial, petroleum, wastewater, agriculture, fire protection, HVAC and other liquid applications.  Gorman-Rupp’s two largest verticals are muni water/wastewater and construction.  It produces various types of pumps including self-priming centrifugal, magnetic drive centrifugal, axial and mixed flow, vertical turbine line shaft and others.

Pump manufacturing is somewhat fragmented particularly in smaller pumps.  The larger firms in the industry, such as Roper (NYSE:ROP), IDEX (NYSE:IEX), Flowserve (NYSE:FLS) and SPX (NYSE:SPW), make frequent acquisitions of smaller players.  Gorman-Rupp acquired American Turbine Pump in 2012 to bolster its National Pump Company business.  The synergies for acquisitions in the industry tend to come from S,G&A and some economies of scale.

Recent Quarter – Orders Stabilize but Backlog declines for Third Straight Quarter

Sales increased by 7% organically – 10% in total – with the increase driven by both its water and non-water business.  Agriculture, fire protection, and power sales all did well.  Not surprisingly municipal government related sales were down.  The gross margin improved again by 70bp to 24.5%.  The company has targeted a gross margin in the range of 24-26%.  S,G&A was down by 70bp contributing to the increase in operating margin to 12.4% (140bp improvement).

When stocks are awaiting rebound they tend to trade based on orders and backlog.  Orders declined by 7% versus 3Q12 levels but it was difficult comp.  Overall the number showed stability and management indicated it was feeling better about the overall operating environment.  The backlog now stands at $191 million and is up by 30% versus 3Q12 but was down sequentially.  Last, the company started shipping equipment for the Permanent Canal Closure and Pumps (PCCP) Constructors in New Orleans.  This is the company’s largest order on the books at $60 million and will ship over the next three years with most of the sales coming in 2014 and 2015.

Construction and Municipal Markets are Key Catalysts for the Stock

Gorman-Rupp faces some key challenges going forward given their end market exposure but fundamentals could start to shirt.  Its second largest market is construction.  It builds the pumps and other parts for fire systems used in commercial construction projects.  Commercial construction has not started to rebound and is still operating far below normalized levels and is at its lowest rate since 2002.  Essentially, the shopping plazas and supporting services get built after the houses are built.

Construction Spending

Residential housing starts have made a significant improvement in 2012 and commercial is forecast to improve in 2014 and will likely at least be flat and stop acting as a drag.

Gorman-Rupp’s largest end market is the municipal water market.  Municipalities fund a bit over 40% of water projects and close to 60% of waste water projects.  This market has been negatively impacted by the budget problems of local governments over the past three years.  Also an anti-tax environment is also hurting the ability to finance new projects.  All this said, one of the largest infrastructure needs in the US is related to water and waste water.  The current systems are aging and need replaced and expanded.  Positively demand is currently stable and the long-term need is there. Over the next few years, as municipal finances improve, spending should accelerate and act as a catalyst for the stock.  However, the timing of this remains uncertain.

Valuation and Earnings Expectations

The stock is up by 40% year-to-date, most of which since mid-July.  The shares trade at 26x, 22x and 19.2x FY13, FY14 and FY15 consensus earnings estimates of $1.55, $1.85 and $2.11, respectively.  This is a premium to other related stocks in the sector although historically it has traded at a premium.  It is important to note that earnings for the past four years have decreased and are forecast to turn the corner with a CAGR of around 20% over the next three years.  In addition, Gorman-Rupp FCF generation should also be solid at over $1.50 per share.  The company has $15 million in total debt and $27 million in cash/short-term investments on hand.

Conclusion

The timing and magnitude of a recovery in the muni and construction end markets are the two most critical factors to the stock.   The stock has priced in a recovery but the signals may not fully support that at this point.  If the orders do not start to increase, the stock will likely sell off.  Over the next few months, investors should closely watch for improvements to commercial construction and muni spending projects.  A rebound can easily be delayed and earnings can get pushed forward for Gorman-Rupp.

What are your thoughts on the future of this pipe company?  Will the housing and muni market rebound in time to support the stock price?

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