IDEX Corporation: Unloved Industrial Has Potential

| About: IDEX Corporation (IEX)

Summary

IDEX's acquisition strategy has been incredibly solid; proven track record of buying quality.

Earnings per share and cash flow have been stagnating due to a weak business environment.

Shares have been range-bound for years. Below consensus 2016 guidance doesn't help, but long-term potential is there.

Like many industrials, IDEX Corporation (NYSE:IEX) has taken a beating of late, with two-year equity returns for the equity basically at 0%. Shares have been locked in a tight trading range between $65 and $75/share over these past two years, a far cry from the massive run the shares enjoyed from 2009 to 2014, a golden time for investors where shares rallied 370%. Recent 2016 earnings guidance, which is slightly below consensus, has further entrenched the shares in this range. At first glance, this trading range appears warranted as earnings per share and cash flow have stagnated, but is there more to the story, and do shares have room to the upside? There are some bright points to the company that might warrant a second look from investors.

Acquisition Strategy

Acquisitions are often a key feather in the cap of successful industrial companies that make it to the $1B+ market capitalization level. Getting to this size through pure organic growth is a long road, and managements that can identify and properly value prospective acquisition targets to identify those that provide returns on capital greater than costs of capital are much more likely to succeed. IDEX has done just that, going from a startup in 1987 to nearly $6B in enterprise value in less than 30 years.

The key to its success is simple to describe, yet difficult to implement. IDEX's acquisition strategy focuses on complementary acquisitions in its niche operating markets. In a world most often characterized by low organic growth for industrials, quality M&A is one of the few avenues to outsized earnings growth.

Over the past decade, the company has completed 29 acquisitions which now account for 40% of IDEX's revenue. The company looks for some key traits in the markets it wants to enter:

  1. Small size ($200M to $.15B)
  2. Complementary to existing business segments
  3. Fragmented, devoid of large multinational competitors
  4. Growing (minimum GDP + 200 bps)
  5. Balanced negotiating power between the customer and supplier

Once identified, the company usually aims to make an acquisition to position itself in the market rather than building from scratch. In the end, if done correctly, IDEX brings its management expertise into the acquired company, helping further its position by improving margins and selling power. These higher margins are generally protected because larger, equally skilled companies have bigger fish to fry than compete in these smaller markets.

IDEX Business Lines

The company states it has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies, and Fire & Safety/Diversified Products. However, in reality, the business becomes even more complicated as the company divides these segments further into sub-segments by product. As a result, the company appears incredibly complicated at first glance, but most products of the company fall into four items: specialized pumps, injectors, valves, and fittings. Key competitors include Dover Corporation (NYSE:DOV) and a variety of privately-held competitors like the Pump Solutions Group and Gardner Denver.

Click to enlarge

Sourced from IDEX Corporation 10-K and 10-Q filings

Segment EBITDA (pre-corporate overhead) across all three of the company's business lines has been growing 10% annually despite weakness in top-line revenue growth which hasn't moved much over the past four years. The growth in EBITDA has been almost solely through margin expansion; average EBITDA margins have been rising about 80bps annually, with margin growth in Fire & Safety being especially strong. This is a long-running trend, with operating margins rising from 16.5% in 2010 to 20.1% in 2014, with nearly 22% operating margins likely in 2015. Expanding margins in what has been an incredibly difficult two years for industrials speaks volumes on management's ability to execute on its acquisition strategy.

Click to enlarge

Sourced from IDEX Corporation 10-K and 10-Q filings

Free cash flow has consistently exceeded $300M, but has tailed off in recent years from the 2013 highs. This malaise in free cash flow generation has likely led to the depressed stock price. However, recent margin expansion gives the company extra leverage if the economy turns around. While IDEX trades at 5.5% free cash flow yield on 2015 numbers, the company's sizeable operating margins means its cash flow will benefit more strongly from revenue increases than most other industrials. Aforementioned competitor Dover Corporation and other similar, although not direct, competitors like Flowserve (NYSE:FLS) don't have the margins that IDEX manages to carry and have actually seen worse revenue contraction than IEX. So while IDEX trades more expensively on trading multiples, it still has the potential to significantly outperform peers going forward if we see a broad industrial market turnaround.

Shareholder Returns

IDEX recently announced an expansion of its share repurchase authorization to $300M. In 2014, the company repurchased $220M in shares and has repurchased $178M through the first three quarters in 2015. Share count has come down 6% since the beginning of 2014 through most of 2015, which, while not amazing, is nothing to sneeze at, and shows management's confidence in current stock value.

The dividend, while yielding just 1.80% currently, has been on a firm uptrend. The company has boosted the dividend at slightly above 18% annually on average over the past five years; if this continued for another five years, the dividend rate would advance to $2.92/share, giving investors a 4.2% yield on cost. For a company with strong further growth potential, it has the opportunity to be a decent pick for investors looking for the next Dividend Champion or Aristocrat.

Conclusion

The next few years look to be tough for multinational industrials. Slowing global demand and a strong U.S. dollar are likely to handicap a wide range of companies, all the way from small companies like IDEX to large, well-known titans of the industry like Caterpillar (NYSE:CAT). The market has shifted its capital away to growth stories in technology and biotech, giving patient investors a chance to pick up quality companies on the cheap.

IDEX likely falls in that bucket. While there are some better picks in the space in my opinion, overall this company's management is extremely solid and has a proven track record of picking up quality acquisitions at low prices. A recently renewed focus on shareholder returns gives a backstop to the share price, and long-term investors are likely to be rewarded with better-than-average returns in my opinion.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.