Ametek (NYSE:AME) is a global manufacturer of electronic instruments and electromechanical devices. Ametek is a strong leader in most of its niche markets having either a low-cost advantage over competitors or higher-quality products that address critical customer needs.
Despite the company's strong competitive position and its excellent acquisition track record, the market underestimates its growth potential mostly due to non-company specific reasons. I believe and will demonstrate that the company is worth up to $78 per share or 60% above its current $48 per share market price with little risk.
Ametek is essentially a collection of many businesses that were acquired over the years. The company is organized in two segments, the Electronic Instruments Group or "EIG" and the Electromechanical Group or "EMG".
The EIG segment provides products for the process, aerospace, power and industrial markets and its products are used for monitoring, calibration and display in usually critical operational functions like product development and production.
The EMG segment builds various highly engineered products like electrical connectors, electronics packaging for sensitive electronic devices, advanced technical motor and motion control products. Its products are targeted for the aerospace, defense, medical and industrial markets.
(click to enlarge)(Ametek's products - Source: Ametek's website)
Within its two segments Ametek categorizes its products either as differentiated or as cost-driven. Differentiated products are innovative proprietary products that the company sells at a premium price. The cost-driven ones are price sensitive, commoditized products for which the company employs a low-cost strategy using its manufacturing scale.
Competitive Strengths - Moat
Ametek is the leader in most of the market its serves and benefits both from lower-costs due to its manufacturing scale and from a locked-in customer base due to switching costs. To demonstrate what I mean and how well positioned the company is, here are some examples of typical (for Ametek) products.
Ametek makes testing and measurement equipment for tire manufacturers who use it for quality testing their products and calibrating their manufacturing process. Given the critical network of their use and their small relative cost, these products are somewhat price-insensitive and mostly quality focused.
This ensures great profit margins for Ametek and revenue stability because no manufacturer is going to risk the quality of its products or disrupting its operations by changing supplier. As long as Ametek continues to make top-notch quality products its customers aren't going to even look to other equipment suppliers.
One of Ametek's business units repairs and overhauls a wide variety of components for the aviation industry. Furthermore it's one of the few repair shops with fuel systems repair capabilities. To be successful Ametek's business unit must be able to conduct its repairs in a quick but most importantly in an absolutely reliable way. No one wants one of its planes crashed because he didn't hire the best repair company around.
And this is where Ametek's strength lies. Due to the life-critical nature of its services it can charge premium prices without losing any customers. No customer would be willing to compromise the quality of its repaired components just to save a little more money. Thus it is highly unlikely of customers ever switching to another repair provider.
Despite the company's solid competitive position and its extremely good acquisition record, analysts underestimate its growth, projecting only 10% EPS growth over the next 5 years which is a little more that half of what I believe Ametek is going to have. But let's examine each one of the market's concerns about the company.
The first concern the market has is that due to the dollar's weakness the company is going to face higher acquisition costs. The reasoning goes like this. The Fed through its QE operations manipulates the USD to go lower. Since Ametek is a US company this would increase the company's costs for international transactions like acquisitions. Since there is no end for QE in sight the company is in more than just short-term trouble.
This view, while it seems quite reasonable, overlooks one "minor" detail. More than half of Ametek's revenue (and FCF) is generated outside of the United States. This means that while the company will experience some negative impact from a weak dollar, this will be offset by the currency appreciation of its international cash flows.
The market also worries about Ametek doing business in Asia. Although this is a big market for Ametek to sell its products, analysts are more concerned about copycats replicating and selling its proprietary designs in lower prices. Ametek is currently expanding into Asia and Latin America. It has already built and operates plants in Mexico, Brazil and China. Furthermore, to continue expanding, it has gone into joint ventures in China, Japan and Taiwan.
The infringement risk for Ametek comes specifically from China where copyright and patent laws are either too flexible or not applied for the benefit of local manufacturers. While this is a real threat, I believe that this risk is overblown. The overwhelming majority of Ametek's products have life-critical applications like the products I presented above and their users aren't focused on price but on quality, efficiency and reliability.
Since Ametek is highly focused on innovating new products and improving its existing ones, it will always be several steps ahead of its copycats. Furthermore Ametek's customers are unlikely to change their supplier just for the sake of price. They depend on Ametek's products for their operational efficiency and stability and saving a few dollars isn't worth the disruption risk of changing suppliers.
For example I can't imagine Boeing deciding to dismiss Ametek as its supplier for critical airplane flight sensors (like the temperature sensors it uses in its 787 Dreamliner model) in favor of an untested copycat design just to save a few thousands dollars per plane and risking its reputation for safety and excellence.
Another issue that worries the market seems to be the amount of goodwill Ametek carries onto its balance sheet. Ametek has $2.2 billion of goodwill on its balance sheet and it is almost equal with its equity of $2.5 billion. Furthermore the company's total intangible assets are $3.5 billion which is 67% of its total assets and 140% of its shareholders equity.
By normal standards this is a huge and dangerous amount of intangibles for an industrial company to have. The danger being a big write-down that could severely damage (or even wipe-out) the company's equity.
However Ametek isn't an ordinary industrial company. Ametek has bought and integrated dozens of companies over its history and has proven to be quite disciplined both about price and strategy. Ametek's strategy is to buy companies that have a differentiated product that can command a premium price. Ametek then focuses on innovating and improving these products constantly.
In this context it is quite obvious that the businesses Ametek has bought are worth more than their assets. As a result, the goodwill Ametek has accumulated all those years (which equals the difference between what Ametek paid and what it got asset-wise) is a good representation of the extra value these companies had due to their differentiated niche products and their pricing power.
We can also conclude this from the fact that over the last decade Ametek has paid $3.2 billion in acquisitions and earned $2.3 billion of cumulative operating income as a result in excess of what it would have earned if it just maintained its 2002 profitability level.
However keep in mind that this is a gross calculation since not all of the increase in operating profits can be attributed to the acquisitions. Part of it is just plain and simple organic growth (adding new customers) and the introduction of new products and product innovations. But even if just half of it is due to the acquisitions, it is quite clear that Ametek hasn't overpaid for the companies it bought.
And this proves that the goodwill in Ametek's balance sheet is indeed representing value and it may even be worth more than what the company's balance sheet shows it to be.
The fourth source of the market's worry about Ametek is the broader economic environment and what the future holds for the global economy. I can't predict the future and thus I don't know how the global economy will fare in the following years.
However I know this. Ametek benefits from recessions almost as much as it benefits from a growing economy. The reason for this is simple. When the economic environment is bad Ametek is able to find new businesses to acquire for less money than it would have to give during an economic boom.
This and the critical nature of its products helped Ametek navigate the Great Recession with only one year of falling sales, 2008. In 2008 Ametek's revenue fell by 20% but the next year it bounced back to pre-crisis level and continued to rise.
Ametek's growth strategy is based on continuous innovation of new products and acquisitions. Both are crucial because Ametek is already a leader in the niche markets it serves and as a result its potential within those markets is limited.
Fortunately Ametek's track record in both of these tasks is excellent. In 2012 alone the company introduced 12 new products. And as we've already discussed the company has a long and successful history of acquiring and integrating leading niche businesses.
Ametek is expected to generate $2.12 of EPS for 2013 and $2.32 for 2014. At its current price of $46 per share the company is trading at 20 times its 2014 earnings.
Since we addressed the market's concerns I believe that the company will continue to grow at its average 18% rate since it is still small in size and has a lot of room to grow within the industries it serves. As a result the company's fair value should be between 20 and 28 times its forward earnings. This leaves us with a fair value range of $46 and $65 per share.
Nevertheless, I believe that EPS isn't the best metric to use when judging this stock. What matters for Ametek's expansion and future profitability is how much free cash it generates every year. Historically its free cash flow has been on average about 1.2 times the company's earnings per share. So if we use FCF/share in our valuation instead of EPS we get a fair value range of $55 to $78 per share.
Ametek is an excellent company with inherent competitive strengths that provide it with stable business and great growth potential. At its current price of $46 per share the company's stock has the potential for a 40% to 70% rise. Unfortunately I don't see any catalysts for the company's rise in value other than the company's quarterly earnings reports. I believe that it won't be long before the market realizes the company's true worth and that all four of these fears aren't well founded.