by Daniel Holland
The basis of any moat argument for a diversified firm is centered upon some core competency that filters down among its smaller business units. In the case of Danaher (DHR), the company takes the tremendous institutional knowledge gleaned from the lean manufacturing principles of the Danaher Business System (DBS) and imposes this process on every one of its segments, enhancing cash flow generation. General Electric (GE) and 3M Company (MMM) use their massive research-and-development bases to create technologies that are not only useful for an individual segment, but implemented throughout the organization.
Finding these competencies within the smaller firms is difficult, but a solid indicator is when they find ways to creep into new end markets as avenues for growth dissipate in their current location. For example, Actuant (ATU) pushed into energy asset management, away from its core Enerpac hydraulic bolt tightener business. Roper Industries' (ROP) foray into smart card technology, away from its experience in RF identification and water metering technology, also fits this category. SPX (SPW), on the other hand, has struggled to integrate its businesses during the last several years, with no natural linkage among segments.
The Advantages of Being Nimble
Smaller acquisitive firms have one major advantage over larger peers: size. A $100 million acquisition is a big deal for a $2 billion firm, and coincidentally the valuations on these smaller firms tend to be more reasonable than the larger deals. Because larger firms like General Electric and Danaher don't get as much lift from these smaller purchases, companies like Roper and Ametek (AME) face less competition for their purchases. Synergies are often more reliable when buying smaller firms. For example, Actuant notes that by putting acquired firms on its freight contracts, the company is able to generate better operating margins and free cash flow essentially from day one of the acquisition.
It takes several years of aggressive reinvestment to get too big to be pushed out of this strategy, giving investors ample time to take advantage of these firms' access to more compelling acquisitions. As always, integration risk should be a prominent concern for investors, particularly as less sophisticated targets get wrapped into a larger organization. In talking with several management teams, one difficult hurdle is simply building a strategic plan with former owners, since these smaller targets are not accustomed to projecting product road maps and doing the relevant market analysis found in larger companies.
In Management We Trust
As with any company, investors need to pay particular attention to the leaders of conglomerates. This is particularly relevant since these firms reinvest most, if not all, of their cash flow into the business. Empire building is rarely a trait that we value, so it is worthwhile to ensure that management incentives have some return-based metrics as well as traditional earnings and sales growth targets. Actuant, IMI Group (IMI), and Crane (CR) stand out as having strong incentive programs aimed at driving profits and growth.
The range of return on new invested capital (RONIC) in our subset varies from SPX's disappointing negative 1% to IMI Group's 61%. Also significant is the amount of cash flow that firms are using to execute their respective growth plans. For example, SPX consumed more cash flow than it generated during the period. We often cast a leery eye in the direction of Roper, since the firm seems a bit aggressive in its growth strategy and often seeks external financing to support itself. But during the last five years, roper has proved generated value for shareholders. It is important to note that when looking at RONICs, significant movement in the metric can occur when a firm sells a low-value, noncontributing business. While it may skew the data, this is often the most appropriate decision.
Sifting Through the Small and Mid-Cap Diversified Firms
IMI Group stands out when we look at fundamental drivers of value creation among the smaller diversified industrials. As a manufacturer of highly engineered valves for a variety of end markets as well as heating, ventilation, and air conditioning systems, IMI has benefited from both strong end-market demand and an internal turnaround effort. The result has been earnings before interest (EBI) margin growth of nearly 10 percentage points during the last five years. After going though significant savings initiatives, IMI moved from being the lowest EBI margin firm among smaller diversified industrials in 2006 to the middle of the pack in 2010. This significantly increased returns on invested capital (ROICs) and returns on new invested capital. The company has a fair amount of capital to grow the business both organically and through acquisitions.
For investors not able to invest directly in IMI's London shares, we also recommend equipment manufacturer Ametek (AME). The company consistently delivers returns on invested capital above the weighted average cost of capital and has consistently shown an ability to reinvest within its business at rates that are above the cost of capital. Ametek is a strong operator, boasting EBI margins of 14.6% and respectable working capital turns exceeding 9 times. Unfortunately, Ametek's shares rarely come at a discount, currently trading at a slight premium to our fair value estimate. Below are the overall results from our study.
Factors Used in Our Analysis
Pure Returns - Return on Invested Capital
Managing the installed base and earning a decent return should be the first priority of any management team. Unlike earnings targets or operating margins, a company can rarely buy better returns on invested capital, making it the cornerstone of our evaluation process. Without comparatively high returns on invested capital, it is difficult to make the case for a long-term investment in a company.
New Returns - Return on New Invested Capital and Reinvestment Rate
Incremental returns give us a good indication of how well the management team's decisions have panned out. We use a five-year horizon to evaluate return on new invested capital. Granted, there is still a fair amount of noise in the data, but we think the result would not be much different if we extended the horizon or transformed the data to be more palatable. Importantly, divestitures and streamlined cost structures have a significant impact on the metric, which we think is fair. We use RONIC not as an indictment of management's overpayment for an acquisition, it just gives us a better indication of the incremental return that we can expect from a typical investment decision within the firm.
Having strong incremental returns are good, but unless the company can reasonably deploy that capital, there is little room for investors to benefit from the company's ability to generate those returns. In that vein, we look at the firm's retention rate (as defined as the sum of capital expenditures, acquisitions, and aftertax research-and-development expense compared to adjusted cash flow from operations) as a critical factor in determining the attractiveness of a firm. Because diversified firms often use acquisitions to grow their businesses in the same way other firms use capital expenditures, we think it is appropriate to incorporate acquisitions in any analysis of retention rates.
Operations - EBI Margin and Working Capital Turns
To assess the relative strength of day-to-day operations, we pair EBI margins and working capital turns. EBI margins reflect the company's underlying cost structure and pricing execution. At a consolidated level, investors should be mindful of sagging margins that come from an underperforming segment becoming too large, weighing down the rest of the portfolio. Unlike our argument for ROICs, a management team can purchase better margins by simply buying a higher-margin business and adding it to the portfolio. For this reason, we think it is prudent to view ROIC and EBI margins separately.
Working capital turns is a useful measure since efficiency with working capital requires less cash, giving more room for growth. Additionally, keeping working capital balances low reduces the risks of economic depreciation of inventory and nonpayment of receivables. Surprisingly, Roper ranked toward the bottom of its peer group. The company is known for touting "asset velocity" - its internal nomenclature for working capital turns, noting that its performance beats the S&P 500 and other firms. Unfortunately for Roper, other small firms know how to be nimble and efficient with working capital, exposing a perceived strength as more of a burden than we once assumed.
Historical Growth Rate - Five-Year Sales Growth
Growth is a key driver to any valuation model, and we think it is important to recognize firms that have done a solid job of managing top-line growth through the last cycle. Additionally, with the presence of so many return-based metrics in our analysis, we think it is important to ensure that we capture the effect of the firm having more influence in their respective markets.
Self-Funded Growth Potential - Dry Powder Index
A self-reliant company, by definition, should be able to grow without leaning on the capital markets for help. We think a company that is capable of growing within its means serves shareholders well over the long term, reducing the risk of equity dilution or credit risk. In order to assess the growth potential of a firm we add our forecasted cash flow from operations less forecasted dividends for the next two years to the existing cash balance. This gives us a rough approximation of how much the company could comfortably spend during the next two years. When compared to the company's existing invested capital base, this lets us know how much runway the firm has for organically funded growth. In isolation, this metric may not reveal much more than which firms are hoarding cash, but when paired with other factors, it gives a better sense of potential relative to industry peers.
Smaller diversified industrial firms offer investors more growth potential through acquisitions, though the same metrics that we apply to bigger peers are relevant as well. IMI Group and Ametek have shown they are capable of reinvesting significant amounts of capital and growing in a shareholder friendly way. Pruning the portfolio often provides a much-needed lift in earnings, as is the case for both of these companies, but solid bets on end-market growth also help shape the growth runway for the future.