IDEX Appreciated For Its Excellent Credentials And Advantageous Market Exposures

I’ve talked about IDEX (NYSE:IEX) as a “best of breed” industrial in the past, and I continue to believe this is one of the best-run and best-positioned industrials out there. Management has shown that they can not only optimize operations but also execute successfully on tuck-in/bolt-on deals that build on existing strengths.

Since my last update, this has been one of the strongest stocks among the industrials I follow, with the shares up almost 25% and beating flat performance for the larger multi-industrial group, as well as other high-value “compounder” industrials like Ametek (AME), Danaher (DHR), Fortive (FTV), Nordson (NDSN), Rockwell (ROK), and Roper (ROP). This outperformance has been well-founded, with strong double-digit revenue growth and healthy margins, as well as broad-based strength in the business.

Valuation is my biggest issue. I realize some investors believe in buying quality and holding on irrespective of valuation, but I think entry prices matter, and it’s tough to see how IDEX is substantially undervalued even given above-average growth potential in the coming years.

A Good End-Market Mix Will Help

IDEX has a lot of positives going for it, but the company is not entirely immune from more challenging macro trends. To that end, orders were down about 1% in the third quarter and the backlog was basically flat. Unlike many other industrials, though, I think there’s a credible chance that IDEX’s orders will hold up better than most.

For starters, IDEX doesn’t have an overabundance of short-cycle industrial exposure (like, say, 3M (MMM), Dover (DOV), Illinois Tool Works (ITW), or Parker-Hannifin (PH)). Likewise, the company has minimal exposure to consumer, residential, and truck/commercial vehicle end-markets (fire trucks don’t typically trade in line with commercial vehicles). IDEX also doesn’t have that much machinery exposure.

As far as cyclical exposures go, IDEX does have a meaningful exposure to semiconductors, but that exposure is on the equipment side and fab investments should remain strong overall, while the company continues to gain share. Other cyclical markets like agriculture, energy, and mining are healthy and likely to remain so, while energy could possibly improve for IDEX as midstream projects go forward.

End markets like life sciences (particularly next-gen sequencing) aren’t likely to slow meaningfully, if at all, and I likewise see healthy ongoing trends for food/beverage. Municipal water spending seems to be picking up (helped by federal support) as well. Chemical processing is more of a toss-up now in my view, and IDEX doesn’t really have meaningful aerospace leverage.

Along these lines, I see good medium-term trends for IDEX and its precision fluidics, fluid handling, and metering businesses. Precision agriculture should be a multiyear trend, as should refurbishment and expansion of municipal water systems. Gene sequencing shows little sign of slowing, and IDEX has been winning business in semiconductors and fuel cells, as well as broadband (the company’s optics and photonics business is around 10% of the total).

Margins And M&A Can Both Expand Cash Flow From Here

IDEX management has done an impressive job of improving the business over the years. By optimizing operations, management has driven EBITDA margins from the low-20%s to the high-20%s and free cash flow margins from the low double-digits toward 20%. Management has continued to pursue an asset-light model focused on in-housing areas of real value-creation, while also focusing on highly customized and differentiated products that support healthy pricing and sticky customer relationships.

I don’t expect the same level of margin leverage from here, but I think it would be shortsighted to assume that margins will plateau. Management has built a business with relatively flexible costs and there is little need to expand the cost base to support further revenue growth, so incremental margins should be relatively attractive.

The company is also open for business where M&A is concerned. After a multiyear pause on material deals, the company has gotten back into the game, spending $577M in FY’21 and over $900M this year, including the deal for Muon Group (a manufacturer of micro-precision equipment that controls the movement of liquids and gasses). There are a lot of potential complementary bolt-on deals out there where management can leverage additional sales growth (cross-selling to existing customers) and margin synergies, and valuations have become more reasonable.

The Outlook

I continue to believe that IDEX can log healthy mid-single-digit long-term organic growth (around 5%) from its leverage to growing end-markets and its proven ability to gain share and maintain customer relationships. I also model in around 150bp of acquired growth – I don’t normally like to model M&A, but I think it’s difficult to approximate IDEX’s long-term value if you don’t at least try.

As far as margins go, I can see 30% EBITDA margins in around five years’ time and I expect free cash flow margins to move relatively quickly into the low-20%’s and improve gradually from there, driving high-single-digit FCF growth.

Unfortunately, these cash flows aren’t enough to support a particularly attractive return today through discounted cash flow modeling (even with a lower-than-average discount rate to reflect the company’s above-average attributes). Likewise, while IDEX has exceptional margins, ROIC, and so on, and those are important drivers of EBITDA multiples, the shares already trade with a robust premium built in (around 20x my ’23 estimate).

The Bottom Line

If there were an industrial stock where I felt comfortable to ignore the valuation and just buy, IDEX would very likely be high on that list. That’s not how I invest, though, and while I thought IDEX’s valuation was getting interesting back in February, the strong outperformance since then has flipped that script. This is absolutely a name I’d revisit at a lower valuation, but it’s not one I’ll be buying today.