The CEO of one of the med-tech companies I covered as an analyst was fond of saying, “The bigger they are, the harder they hit,” when explaining why he steered his company into defensible niches largely ignored by large players, and that is largely the approach taken by IDEX (NYSE:IEX) in its process technologies business. Despite competing in a wide range of “typical” process industry end-markets, IDEX has focused on pumps, meters, precision fluidics, dispensing equipment, and clamps that occupy highly-defensible, mission-critical slots in segments that don’t attract competitive attention from mega-cap rivals.
I continue to love IDEX as a business, but the valuation is problematic even if you believe that U.S. markets are going to return to growth in 2020. While I am very bullish on the long-term outlook for the company, and acknowledge that I may be underestimating future contributions from M&A, it’s tough to make the numbers work as they are, and so this occupies a spot high on my watch list for now.
What Will The Cycle Look Like For IDEX?
Like the fluid handling/control businesses of Crane (CR), Dover (DOV), and Emerson (EMR), IDEX has outperformed the average industrial thus far through the cycle, as process end-markets like chemical processing, water, food/beverage, and life sciences have held up much better than more discrete, machinery-oriented end-markets, and as the company has relatively modest exposure to markets like autos and semiconductors.
Even so, process industry end-markets have started showing signs of slowing, and these companies have seen a slowdown in their businesses. For IDEX, orders went from flat to down 5% between the second and third quarters, though the Fluid & Metering Tech segment has stayed at “flat” orders despite a downturn in shorter-cycle markets. Likewise, management offered early guidance for little organic growth in 2020 (+/- 2%).
I expect IDEX to get through this cycle more easily than most industrials, and despite the downturn in orders, I believe this could may get by without a string of meaningful negative year-over-comps. I can’t say I feel good about assuming no contraction at all for the Fluid & Metering Tech or Health & Science Tech segments, but I think this will be a shallow correction unless the global economy decelerates even further.
Although the U.S. onshore oil & gas market is weak, IDEX is far more exposed to midstream markets, where spending has been more consistent (at least for the segments it addresses), and large process automation companies like Emerson and Honeywell (HON) are seeing some order/project push-outs, but no cancellations. Water and municipal spending remain quite healthy, food/beverage companies continue to spend on automation (albeit inconsistently), and life sciences and pharma investment continues to grow nicely.
All of that said, investors should realize that if IDEX does see some revenue contraction, the operating leverage of the business is going to take a bite out of the margins. Management has said that a 5% revenue decline could drive an 8% EPS decline, and they’d be unlikely to use significant headcount reductions to offset the pressures (as they believe it would impair the long-term competitiveness of the business). I like management’s commitment to run the business for the long term, but I do know that 40%-plus decremental margins could be the wrong kind of wake up call for investors given the typically strong margins of this business.
If It’s Not Broken, Don’t Break It
Nothing in the recent earnings calls or sell-side conference presentations suggests any meaningful change on the horizon for IDEX. This is a company that is all about sticking to a proven strategy and looking to drive incremental improvements wherever possible. While IDEX does embrace an asset-light model wherever it can, it’s not following Roper (ROP) or Fortive (FTV) down the road of heavy M&A investment into software. That said, I do see the company looking for incremental opportunities in areas like predictive maintenance that it could easily add to its existing offerings.
M&A is likely the biggest near-term driver. While IDEX has been a relatively enthusiastic buyer in the past, the company is very disciplined with respect to both fit and price, and management hasn’t found the price of available deals to its liking. If and when valuations correct, I could see IDEX putting $1 billion to $2 billion to work in M&A, though likely not in the form of especially large deals – IDEX’s niche-market focus sort of works against large M&A transactions.
One other risk factor seems worth mentioning – the risk of management turnover. As seen recently with Columbus McKinnon (CMCO), smaller companies with excellent executives often see them targeted by larger companies who need new talent. Rumors about other companies poaching IDEX’s CEO have been in circulation for a little while, so much so that he has had to flatly deny them from time to time at sell-side meetings. I see no reason to doubt his denials, but it is always a risk when you see very strong management at smaller companies (particularly when they don’t own a sizable chunk of the business).
The Outlook
I’m not modeling much of a slowdown for IDEX at this point. Weak end-markets like agriculture, autos, and semiconductors aren’t a big part of the mix, and I’m not yet seeing evidence that I need to worry about most of the rest. The midstream oil/gas and chemical processing businesses are probably the most vulnerable, but there really haven’t been any warnings yet that trouble me with respect to IDEX.
Still, this will be a big topic around fourth quarter earnings and guidance in a couple of weeks – what are companies like AMETEK (AME), Dover, Emerson, Honeywell, et al seeing in those markets over the next two to six quarters. Given the high valuation at IDEX, a meaningful negative revision to expectations for the process sector would be a clear threat to the stock price.
I’m still comfortable with modeling assumptions that work out to a long-term core revenue growth rate around 4% to 5% and a long-term FCF growth rate around 6% to 7%, with FCF margins in the low 20%’s over the long term. M&A can, and almost certainly will, boost those numbers further, and adding incremental estimated M&A boosts my long-term revenue growth rate to over 6%.
Even then, though, the valuation doesn’t really work for me. Like many (if not most), high-quality industrials, IDEX looks priced for a mid-single-digit return. I’m not going to argue that’s unfair given the quality of the business, but it doesn’t meet my hurdle rate, and likewise with a 15x forward EBITDA driven by my margin and return (ROIC, et al) expectations.
The Bottom Line
I’d like another crack at IDEX below $150, but I’m not expecting that anytime soon. Still, with the Street already counting on a strong second half story from U.S. industrials, a meaningful downward revision with fourth quarter reports could drive a big enough sector rerating to make that a plausible buy-in price for IDEX. In any case, I have no qualms about this company from a quality standpoint, but I just don’t see good enough return prospects today to elevate from a watch list candidate.
