Outlook for Industrial Manufacturing Stocks

Includes: AME, DHR, ITT, ROP
by: The Wall Street Transcript

The Wall Street Transcript recently interviewed James C. Lucas, a Managing Director with Janney Montgomery LLC, on his outlook for Industrial Manufacturing stocks. Key excerpts follow:

TWST: Who is at the top of your good company list?

Mr. Lucas: At the top of the list are Danaher (NYSE:DHR) and Ametek (NYSE:AME) — Danaher in the large cap, Ametek in the mid-cap space. After that, it would be ITT (NYSE:ITT), another large cap name, and Roper (NYSE:ROP) in the mid-cap space. So those four high-quality names are at valuations that you just don't get to see with these names.

TWST: Why Danaher? What makes them number one?

Mr. Lucas: Danaher, to put it quite simply, is best in class. Just go back to the first criterion, identifying companies with strong management. With Danaher, it all starts with the Danaher Business System. In my 15 years of research, it is the most unique operating culture that I've come across, and it is a culture that permeates the entire organization. Danaher is a prodigious cash flow generator, and they do an exceptional job of redeploying that cash in a shareholder friendly manner, meaning that, when there are opportunities when the stock is undervalued and there are not a lot of acquisitions to do, they buy back stock. But acquisitions are the principal growth driver of the portfolio.

Danaher today has six growth platforms: Test & Measurement, Medical Technologies, Environmental, Product Identification, Motion Control and Hand Tools. The last two are the more mature, economically sensitive platforms that you can think of more as cash generators to then help fund the growth in the other four platforms. If you look at Danaher today, about one-third of the portfolio is services and recurring revenues and that's something that wasn't there back in 2001.

The other thing that Danaher has going for it is a business model that's predicated on diversification. Not all businesses are going to be firing on all cylinders at one time, but while you have the more economically sensitive businesses like Motion and Hand Tools, which clearly are having a harder time these days, you also have businesses like Medical Technologies, where I like to say people don't stop getting sick in a recession, and Environmental, where it's everything from water quality to retail petroleum, meaning investments in gas stations and underground storage tank leak detection. So it's a diverse portfolio, but, more important, it continues to generate a lot of cash that gives the company ample opportunities to invest in a down market. You put all that together and you get a premier company at a reasonable valuation — that's why it's at the top of my list.

TWST: Is the valuation reasonable?

Mr. Lucas: The valuation is very reasonable. Again, we don't know what the estimates are but even if we assume that the estimates are 5% to 10% too high today, you are still looking at a stock that's trading around 8 times EBITDA, that's trading around 12 times earnings, trading around 10 times cash flow, so for a company with the type of cash generation they have, the type of growth that they can deliver over an entire cycle, that seems like a pretty good entry point to me.

TWST: How about Ametek? What's the appeal there?

Mr. Lucas: Ametek is my favorite "get rich slow scheme." It is an extremely high-quality name that you can sleep with at night. If you think of baseball, this would be a small ball team. You hit singles all day long, occasionally you might get a double, but you are not swinging for the fences. At the end of the day, you just keep scoring runs. When you look at Ametek, the company has a well-articulated four-pronged growth strategy: operational excellence, that's the core of what they do; new products; strategic alliances and acquisitions; and geographic and market expansion. It's a very straightforward, four-pronged strategy. When you look at their portfolio, it is 85% differentiated businesses and 15% cost-driven businesses. Cost-driven is exactly what it sounds like — the businesses are being managed for maximum profitability and cash generation.

Ametek has a goal of doubling in size every five years and a little over half of that is going to come via acquisitions. When you look at Ametek today, you have got about two-thirds of revenue that is generated from the longer cycle aerospace, power, and energy businesses. They have acquired over $300 million of annualized revenue this year and at the core is what they do — operational excellence — continuously taking costs out of the system. You add all that together and that puts them in a relatively good position for 2009 when you are going to have a very uncertain market. And despite the fact that they have acquired $300 million of annualized revenue, they still have ample capacity on the balance sheet to continue making acquisitions. It appears not here in the short term, but 2009 is likely to be much more of a buyer's market than we have seen in quite some time in the M&A environment.

TWST: Have they done a good job of integrating these acquisitions and making them work?

Mr. Lucas: Integration is a core competency. If you look at Ametek's acquisitions in the first year of ownership, pretax income on average increased 40%. So what that means is, if you pay 7.5 times EBITDA for a business and generate the returns that AMETEK does, it effectively reduces the multiple paid by a point or a point and a half. AMETEK has a very good track record on the integration front because they are buying good businesses that historically have been undermanaged.

TWST: They have the expertise to manage them much better?

Mr. Lucas: At the end of the day, it's fundamental blocking and tackling and giving the businesses tools with which to grow.

TWST: How about ITT?

Mr. Lucas: With ITT, 50% of the businesses is defense and 50% is commercial businesses with the lion's share of that being in water. ITT also has a few niche businesses in motion and flow control. When talking about defense, the first thing that comes to mind for investors is, "Oh! We've got a new administration and the defense budget is going to be cut and we are going to pull troops out of Iraq." Well, all that is potentially true, but it doesn't happen overnight and even if it does, you have to take a step back and see where ITT is positioned. When you look at the types of products that they are manufacturing, it's things like night vision goggles, tactical communication radios, IED jammers, as well as about 40% of the defense business in services.

Beyond the U.S. Army, ITT is seeing growth opportunities with allies internationally and some non-defense related businesses such as working with the FAA in terms of building the new air traffic control system or managing NASA's communication systems. There's a lot of diversity within the defense portfolio, and when you look at areas like security and communication, areas that the new administration has talked about, that's exactly where ITT's defense portfolio is positioned. The company currently has a $5 billion backlog and that provides some good visibility in these current uncertain times. Yes, the growth rate has moderated from the double-digit growth we've seen in the last couple of years, but a 5% type growth is not too shabby in this type of environment.

Then there is the water business and the first thing that comes to people's minds is, what happens with municipal funding? No doubt municipal budgets are going to be strained going forward, but, again, it's important to look at the diversity within the ITT water portfolio. Specifically what you have is about 70% of that business is aftermarket and replacement driven. It's not as dependent on new municipal projects. In addition, over 50% of their water business is outside the US, from developed markets like Western Europe to emerging markets, the Middle East and China in particular, so you see good growth there.

ITT also has a very strong balance sheet with a 20% net debt to capital ratio and over $800 million in cash. Granted, a good portion of that is overseas right now and we will be watching to see if any of that cash is repatriated. ITT is in a very good position from a liquidity standpoint and very well positioned going into 2009 to either buy back stock, increase the dividend or make select strategic acquisitions. What you have is a well-managed company with a more defensive portfolio than some of the other industrial names that we see out there, and a valuation that puts the stock at less than 6 times EBITDA, less than 10 times earnings, and a very attractive 10% free cash flow yield. Once again you have a high-quality name with a strong portfolio, very good cash flow and a very reasonable valuation.

TWST: What's it going to take to get investors to pay attention?

Mr. Lucas: That's a question I've been trying to figure out as the stocks have been going down all year. I wish I had a clear-cut answer to it, but part of it is, I think people are growing more familiar with ITT's defense portfolio, just understanding exactly what's in there and that the company is not dependent upon how many ships the U.S. Navy is going to build or how many planes the U.S. Air Force is going to order. It's more dependent upon keeping our troops safe around the globe. That's with regard to the defense business.

With regard to water, yes, you've got to be concerned about municipal budgets, but again, you are somewhat defensively positioned because if we think about water and waste water in particular, you still need to get drinking water, need to have treatment facilities. Those will continue to be built and the ones that are already built still need to have maintenance done. That business is much more defensively positioned.

The one thing we will watch closely is the impact of the strengthening dollar as it relates to currency translation, but that seems to be priced into the stock.

TWST: The final name was Roper.

Mr. Lucas: I would classify Roper as the higher beta name of the group, but this is a company that has a very good track record on the growth side and some of the highest margins in the space. In fact, their EBITDA margin is close to 26% and that's worth noting because there are quite a few industrial companies out there whose gross margins are only in the low 30s. The fact that they have a 26% EBITDA margin speaks to the profitability of the niche focus within their portfolio.

Roper reports four segments; if you take water, energy, RF (radio frequency) and life sciences, that's about 80% of the portfolio. All those segments have very good long-term growth drivers. When you think about their RF segment, the main business there is TransCore, which is in tolling. In the Northeast, we have E-ZPass and while that's a competitor's technology, if you look at the rest of the country, such as SunPass in Florida or some systems in Texas, that is Roper's business. And it's not just developing the tolling systems, it's making the tags that you put in the car, and there is a high service component. For instance, if someone were to go through an E-ZPass lane in Pennsylvania and the tag doesn't get read and a ticket gets sent to them, when you call to dispute the ticket, the phone is answered "Pennsylvania Highway Department," but it's actually TransCore that's operating that for Pennsylvania.

This year, Roper has made a couple of acquisitions to build up the RF portfolio. They bought a company called CBORD, which serves the university and hospital markets by providing one-card access. If you think about a college student being able to enter their dorm, pay for their meals or go to the bookstore, and to do everything with one card, that is what CBORD does. They have one large competitor out there, but there is a big enough market for the two of them to share. It's a very profitable business, very good growth characteristics, and it's a business that Roper has owned for a little less than nine months and it has been a very nice addition.

Another business they bought, a little smaller one, Horizon, is in nutrition management in the K-12 space. If we think about schools needing to know what kids are getting in their meals, what they are eating, whether it's for government-related programs or nutritional needs, Horizon's software is helping manage the nutritional aspect of the K-12 market. And again, it's more of a software subscription model, not necessarily what you think of with an industrial company.

And then, when you go over to the water side of the business, there is Neptune water meters. Just like in tolling, where you have the cash register for the state highway department, with the water utilities, you have the cash register once again with water meters. The market there has moved to automated meter reading. With the old way, a guy goes around and reads your meter for you; it's very labor intensive and not always the most accurate. With automated meter reading technology, water utilities can either have a guy who can walk up and touch a probe against the meter to get the reading, have a van driving down the street that picks up the reading, or a fixed network where meters can be read at a central location. Depending on the size of the water district and what kind of investment they want to make, there are multiple levels of the automated technology that they can use.

When you look within the energy space, there are a lot of niche businesses there as well. Roper is focused on protecting customer assets, whether it's doing maintenance at nuclear facilities or leak detection or vibration analysis or engine shut-off valves.

In medical, Roper has a unique technology on patient positioning. Whether it's getting chemotherapy or MRIs, where you need to make sure that the patient is in the same position, this helps secure the patient so that the treatment or the scanning is in an accurate way.

These are all very niche-oriented products with good long-term growth characteristics, and, again, here you've got a name where people are going back and thinking about Roper in 2001 when it was a completely different company. They've more than doubled in size since the last downturn. The businesses that they ran before, some of them are no longer in the portfolio. For instance, back in 2001, Roper used to do a fair amount of business with Gazprom. They were serving the Russian gas market and they also served the cyclical semiconductor capital equipment market. They are out of those businesses altogether. Roper has done a good job of remaking the portfolio. They took good margins and made them even better. They throw off a ton of cash because these are asset light businesses. This is a portfolio that should deliver growth, albeit modest growth, during a downturn, since a fair amount of the portfolio has a recurring revenue model. When we look at Roper today, less than 8 times EBITDA and less than 12 times earnings, and less than 10 times cash flow, quite frankly, these are valuations we haven't seen from Roper since it was a pump company in the 1990s. This company has effectively changed its stripes, yet the valuation is reflective of the old business model. That is why Roper is up at the top of our list as well.

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