Still Waiting For A Better Entry Point On IDEX
- Execution is never the issue with IDEX, and most of the company's end-markets will be growing in 2021, but the valuation reflects the quality and then some.
- Management has significant M&A capacity, and M&A has long been core to the business plan, but finding deals that meet the strategic and rate of return hurdles could be challenging.
- High single-digit FCF growth and a high-teens ROIC don't support particularly attractive fair values; the relative P/E is at the high end of its historical range.
I don’t expect the shares of quality companies to go on sale that often, and I do regard IDEX (NYSE:IEX) as a “best of breed” player in fluid management, with an asset-light model focused on multiple smaller businesses that are leaders in their markets by virtue of differentiated product design and capabilities. Likewise, the company’s 20%-plus operating margins and long track record of healthy ROICs speak for themselves.
I have no issues with the quality or growth potential of IDEX, but I am a firm believer that overpaying for even the best companies is a ticket to long-term underperformance. Since my last update, these shares have continued to rise (up another 18%), but lagged the broader industrial group by around 10%, as well peers like IMI plc (OTCPK:IMIAY) (OTCPK:IMIAF), and the valuation is still no bargain.
High single-digit FCF growth isn’t enough to support a particularly attractive return, and I’d likewise note that the P/E has crept up to a 50% premium over the S&P 500 (the high end of the historical range), while the P/E of the S&P 500 itself is close to 50% above its long-term average. None of that precludes further gains for IDEX, but I do worry about the inevitable normalization of valuations across the industrial sector (and the market as a whole).
Most Markets Are, Or Will Be Turning, Green This Year
Looking at IDEX’s primary end-market exposures, there’s a lot to like in the outlook. What’s more, IDEX is an exceptionally well-diversified company, reducing idiosyncratic risks to the busines.
The only market of any significance that I’m concerned about for IDEX in 2021 is oil/gas, where I expect weak demand and spending throughout 2021 and likely into 2022. Neither Dover (DOV) nor Vontier (VNT) have sounded all that bullish on retail fueling equipment demand in the near term, and weakness in the midstream sector seems likely to persist into at least 2022.
Marine and conventional power gen are also both likely to be weak in 2021, with IDEX more leveraged to tanker-type ships, but neither is a major market for the company.
Moving up the chain, chemicals/chemical processing may be “okay” in 2021, but perhaps not much of a growth market. Recent strong prices for chemicals should encourage producers to restart delayed projects, but these decisions take time. At a minimum, I’d pay attention to the guidance from Emerson (EMR) (among others) for signs on where this market may be heading.
While IDEX management guided analytical instruments and life sciences as “stable” in 2021, I see some potential upside here. Agilent (A) and Thermo Fisher (TMO) have both noted improving demand in their core businesses, and with only a small percentage of research labs running at pre-pandemic levels, I do see leverage to normalization as the pandemic issues fade later in the year.
As far as strong markets go, agriculture, autos, and semiconductors seem like no-brainers. Ag companies like Deere (DE) are benefiting from over-aged fleets, strong crop prices, and low interest rates, and that should continue through at least the remainder of 2021. With semiconductors, the sector is supply-constrained, and I expect that to support ongoing capex investment spending. The auto recovery will see some pressure from component shortages (semiconductors), but demand is still robust.
Food/beverage, pharma, water, and paint are also looking pretty healthy today. Food and beverage companies continue to invest in automation and capacity, with particular strength in areas like functional beverages and non-diary milks. The pharmaceutical strength is in part due to ongoing investments in capex/production capacity, while paint companies are responding to strong demand in residential markets by adding capacity.
Water could be a more exciting growth opportunity in the near term. In addition to metering technologies and products for leak detection, IDEX is leveraged to water delivery and water quality, and that is a significant area of focus within the infrastructure plan proposed by the Biden administration.
Searching For New Opportunities In M&A
Not unlike Ametek (AME), Danaher (DHR), and Roper (ROP), M&A has long been a core part of the IDEX growth plan, though the company has generally shown good price discipline over the years. The pandemic certainly complicated dealmaking, but a clean balance sheet and healthy FCF generation capabilities, I believe IDEX could deploy $1.0 billion to $1.5 billion into M&A without much strain. Of course, finding $1B-plus worth of deals is no easy feat. The company did acquire ABEL Pumps from Hillenbrand (HI) earlier this year for around $100M, but IDEX isn’t the only company looking for fluid control/management assets, and valuations across the sector are not exactly low. I do model IDEX with assumed M&A revenue, and that could actually be a modest source of downside if the company cannot find attractive deals that meet their hurdles.
As I’ve said in prior pieces, I really like IDEX. I like the broad exposure to multiple end-markets, as well as the focus on engineering-driven product differentiation. I also see arguably underappreciated growth opportunities in areas like precision/microfluidics and photonics, and I see no real threats to the strong margins and FCF generation.
I’m looking for long-term organic growth in the neighborhood of 4%, and I expect at least another 150bp of M&A-based growth on top of that. While markets like biosciences can certainly outgrow that target, other markets like slower-growing fire/rescue and chemical processing will offset that – this is actually one of the things I like about the company, as in normal economic cycles (not a pandemic-driven recession), there are natural cyclical offsets in the business mix.
I’m looking for ongoing margin improvement, with an adjusted operating margin around 25% in 2022 and heading higher from there. I expect FCF margins to move into the 20%’s over the next three years (on a sustained basis), though I think mid-20%’s would be a stretch. Combined with the revenue growth, that supports a free cash flow growth rate on the low end of the high single-digits.
The Bottom Line
Discounting those cash flows back, I see a prospective annualized return in the mid-single-digits, and that’s not all that appealing to me when I can invest in other high-quality industrials that offer 7% or better prospective annualized returns. Likewise, the shares look pricy on margin/return-driven EV/EBITDA, and P/E, though I’m really not an advocate of P/E-based valuation.
As I said before, many times before actually, I expect to have to pay up for quality. But I also know that there’s no such thing as a can’t-miss prospect, and buying the stocks of great companies at bad prices doesn’t work out over time. I’d love to own IDEX at a better forward expected return, and I’m prepared to wait to get that opportunity.
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