Idex Corporation (IEX) — Q4 2015 Earnings Call Transcript

Thank you, Tim. Good morning, everyone. This is Mike Yates, Vice President and Chief Accounting Officer for IDEX Corporation. Thank you for joining us for our discussion of the IDEX fourth quarter and full-year financial highlights. Last night, we issued a press release outlining our Company's financial and operating performance for the three- and 12-month periods ending December 31, 2015. The press release, along with the presentation of slides to be used during today's webcast, can be accessed on our Company's website at www.idexcorp.com. Joining me today is Andy Silvernail, our Chairman and CEO and Heath Mitts, our Chief Financial Officer. The format for our call today is as follows. We will begin with Andy providing an overview of the fourth quarter and full-year financial results and then he will provide an update on what we're seeing in the world and discuss our capital deployment. He'll then walk you through the operating performance within each of our segments. And finally, we will wrap up with an outlook for the first quarter and full-year 2016. Following our prepared remarks, we will then open the call for your questions. If you should need to exit the call for any reason, you may access a complete replay beginning approximately two hours after the call concludes by dialing toll-free number 877-660-6853 and entering conference ID 13620002. Or you may simply log on to the Company's homepage for a replay of the webcast. As we begin, a brief reminder. This call may contain certain forward-looking statements that are subject to the Safe Harbor language in today's press release and in IDEX's filings with the Securities and Exchange Commission. With that, I will now turn the call over to our Chairman and CEO, Andy Silvernail.

Thanks, Mike. Good morning, everybody. I appreciate you joining us here for the fourth quarter call. A year ago when we were on this call, we talked about there being a difficult macro environment and the headwinds that really lay ahead for 2015. Those conditions played out, and in fact played out a little bit more difficult than we had anticipated. The reasons for it, I think everybody is aware of, and they did not escape us. We had the strong U.S. dollar which hit us significantly in the year. The impact of energy prices rippled through much of the industrial economy. There were low crop prices that hit farm income and ultimately hit the ag market. Those factors really played out in two major markets, in the U.S. industrial and in the Chinese industrial markets. I think the conditions we're seeing here today, that we saw in 2015, and the conditions we expect to see in 2016 are really impacted by that. That being said, the strength of our diversified and balanced portfolio and the quality of our teams demonstrated themselves throughout the year. I'm very proud of the execution of the teams through 2015, and our expectations are for continuing to drive strong performance operationally in 2016. We saw this play out in the numbers in a handful of ways. Year over year, our gross margin was up by 60 basis points and our operating margin was up by 30 basis points. We had an 80-basis-point improvement in operating margin at HST and an impressive 120-basis-point improvement in operating margin in fire safety diversified. We also generated $322 million of free cash flow; that was 114% conversion. We got aggressive on restructuring in the back half of last year when we saw the softening happen in the second quarter. We spent about $11 million in restructuring, and we're going to save about $12 million in total, $10 million incrementally in 2016. The other part of our strategy that really plays itself through and, I think, allows us to differentiate in this kind of environment, is our value-centric approach, a very thoughtful approach to capital deployment. In this past year, we completed three acquisitions. We spent about $200 million. We retired an $81 million euro note. We also divested a small product line, our Ismatec business in scientific fluidics and it had a pretax gain of about $18 million. Additionally, we bought back 2.8 million shares, spending just over $200 million to do so. As I look at the year ahead, frankly, I think that 2016 is going to look a lot like 2015. The near term environment is one of slow growth overall, potentially negative growth. But our business fundamentals remain outstanding. If you look at the critical nature of our products, the large installed base, and the high replacement costs, none of these things have changed. The moats around our businesses and our capability of driving very high returns in these businesses remain the same. We will continue to focus on where we have strength in 2016 around operational improvement, around our positions in the marketplace, and around productivity, while of course putting money to work intelligently for you, our shareholders. Before I get into the results for the year and for the quarter, let me take a second and just tell you what we're seeing in our markets and in regions around the world. First on the market side, if you look at energy and chemical, everyone is painfully aware of the difficulties in the energy market. We certainly have felt the impact of that in our energy business, BAND-IT and sealing solutions. As you know, we don't have a lot of exposure upstream. We do have some, but the bigger impact now is really the rippling CapEx effects as it moves through the industrial economy. The chemical side is expected to be lower growth than it was last year, but we still expect it to be a good news story in 2016. Industrial is really around the U.S. and China. If you look at industrial distribution in North America, it started softening in the second quarter of last year, and that continued through the balance of the year. We do not think that gets worse in 2016, but we do expect it to continue to be soft relative to history. On the ag side, the ag markets have been hit hard. Overall, farm income is down and we certainly see that play out for the OEM orders in the marketplace. But our position is very niche-y with our Banjo brand. We have outstanding positions; it is a terrific business. We just continue to ensure we're in the right places when a rebound does happen. Scientific fluidics and really the life-sciences businesses in general continue to be a bright spot. They were in 2015, and we expect it again in 2016. We really have terrific positioning in analytical instrumentation, bio, and IBD. As I look at the new products that are coming to market, we know what our positioning looks like there, and overall that is a good news story. Municipal is also a bright spot. We had low single-digit growth in 2015. We expect that momentum to continue into 2016 and we're seeing nice opportunities to penetrate markets. Regionally, I really have touched on this already, but just quickly - North America, the story is really around two different worlds. One is industrial, which is very soft; and the other is municipal and life-sciences, which is solid. Europe - Western Europe is actually stable and in decent shape. We think the conditions will remain the same in 2016. Asia, which is driven by China, no doubt, is in an industrial recession; it has been here for some time. We have certainly felt the pinch there. But it's important to note that we view the long-term opportunity in China with our business as being very good. As we've said many times in the past, as things cycle downward, we often find ourselves being much more aggressive to grow our business long-term and take advantage of when others are being hesitant. The other part of our strategy and how we differentiate is around capital deployment. I already noted some of the things we've done in 2015, but we're going to continue this four-pronged strategy that we've laid out over a number of years. We're going to fully fund organic growth and continue making growth investments in good times and in challenging times. We're going to pay a consistent and robust dividend. We're going to buy back shares when we believe they are below intrinsic value. Finally, we're going to execute on M&A. We have done all of these things for the last several years, and we're going to continue to ride that strategy. On the organic growth front, we have continued to focus on markets and customers where we believe we can significantly differentiate and grow highly profitable business. Some examples of that from 2015 that will carry into 2016 include the launch of our StrongArm and our rescue business and the terrific success of our fluidic systems in life sciences. In terms of dividends and share repurchase, we returned about 34% of net income last year. In dividends, we grew that by 14% in 2015, and we also bought back 2.8 million shares for $210 million in 2015. You should expect those trends to remain relatively the same in 2016. On M&A, as I mentioned before, we bought three companies last year for about $200 million - Novatima, Alfa Valvole, and CiDRA Precision Services. In 2016, we anticipate significantly exceeding this level. We have a great balance sheet, terrific cash flows, and an overall nice pipeline. This will be an important part of our strategy going into this year. Let's turn to the full-year results. I'm on slide 4. Just as a reminder, these results exclude the impact of restructuring in both the full year and the fourth quarter, and the gain from the sale of the Ismatec business that we had last year. In 2015, we had revenue of $2 billion; that was down 6%, down 4% organically. We also had orders of $2 billion, which was down 5%, down 2% organically. Orders and sales continued to be soft in 2015, really pressured by the impacts I mentioned before - the oil and gas and the ag markets and the overall slowing of North American industrial. The good news story was an operating margin of 21%, up 30 basis points year over year. I'm very proud of the team's focus on driving productivity and margin expansion even in a tough top-line environment. Free cash flow was robust at $322 million or 114% of net income. GAAP EPS for the year was $3.62, and adjusted EPS was $3.55. The 7% positive gain was primarily due to the restructuring actions and the gain from the sale of Ismatec. For the quarter, orders and sales decreased 4% organically. Adjusted operating margin increased 40 basis points over the prior year to 21%, driven by strength in FMT and diversified, which were up 40 and 280 basis points, respectively. Free cash flow was strong at $88 million or 130% of net income. Please keep in mind that we had a $2.6 million benefit, or about $0.03 a share, from the decrease in the Italian statutory rate in late December. So we ended up with $0.94 a share, which was up 6% from the prior year. Now, let's turn to the segment discussion. I'm on slide 5. As always, we'll start with fluid metering. FMT closed out the year with a 1% increase in organic orders in Q4 and a 1% decline in organic orders for the full year. Sales were down 5% for the quarter and 2% for the full year. Operating margin was up 40 basis points in the quarter but down 20 basis points to 24.6% for the year. There was solid execution in our energy business, driving productivity and maintaining strong margins in the segment. In water services, the North American and European markets performed decently with low single-digit growth, and we expect that to play out again in 2016. I have discussed the industrial markets already. They were a significant headwind for FMT in 2015. Very low CapEx spending on projects primarily attributed to the impact of oil and gas spending rippling through the marketplace was evident. While I expect the top-line pressures to continue, they are flattening out. Our recent acquisition, Alfa Valvole, has seen very solid performance in 2016, and the integration has gone well. In our energy business, there was some top-line softness affecting upstream oil and gas, but the efficiency gains and margin expansion offset this impact. In 2016, we anticipate similar headwinds, and while we also have a truck business affecting our mobile meters, our aviation business should help mitigate the downside. Finally, in agriculture, I have already mentioned that we predict softness in 2016, but certainly expect a bottom this year. Next, let’s discuss health and science; I'm on slide 6. Overall results in the quarter for health and science were driven by strength in life science markets, offset by weakness in industrial. There were also some impacts from poor mix. In the fourth quarter, orders were down 6% and sales were down 2%. For the year, HST had a 2% decline in orders and a 1% decline in sales. Margins decreased by 60 basis points in the quarter but rose 80 basis points for the year. The overall marketplace for scientific fluidics remains strong, and we expect to continue that trend in 2016. End-market demand, whether it is analytical instrumentation, bio, or IVD, all remain nicely positive, allowing us to maintain strong positioning and innovation in this area. Sealing solutions tell a different story: the oil and gas business has been soft, and while the semiconductor market has remained good, that has shifted some of our profitability due to a mix effect. Overall trends remain the same concerning our expectations for 2016. Optics and photonics were stable in the quarter. End markets like industrial and laser optics were weaker, but the strength in life sciences supported profitability there. HST industrial faces similar headwinds to FMT. We have made great progress in driving productivity, but are certainly experiencing overall industrial pressures. Material process projects globally were largely put on hold in 2015, with no anticipated bounce-back in 2016, although we are targeted on specific projects that will bolster our ability to improve in this sector. I'm moving to our last segment, diversified; I'm on slide 7. This segment has had significant swings, driven by large orders leading to losses, but has seen solid results due to fire trailer sales. Organic orders were down 6% for the full year, while organic sales fell by 10%. Operating margins improved in the fourth quarter by 280 basis points and were up 120 basis points for the year, so another impressive result, albeit stemming from a soft comparison due to the fourth quarter of 2014. Dispensing grew very well in 2015. Core markets in North America, Western Europe, and India showed impressive growth that we expect to continue in 2016. Sales of our X-SMART product have been terrific, driving top-line and bottom-line improvement; overall, our new product pipeline in dispensing is robust. In fire suppression, the North American and UK markets performed solidly, and we expect stability in 2016. The rest of the world remains choppy, with tight budgets influencing the emerging market's capacity for fire safety needs, which is also affecting the rescue business. We saw very strong North American sales from our eDRAULIC 2.0 and the launch of StrongArm. However, this is our most global business and has been impacted by tight budgets in emerging markets. BAND-IT remains a profit engine for IDEX, but oil and gas exposure has created challenges. Yet BAND-IT continues to maintain strength in the transportation sector, a business we will continue to invest in and aggressively grow over time. Two more slides to cover; let's discuss overall 2016 guidance. I'm on slide 8. For the year, we expect organic growth to be down 1% to positive 1%, which fundamentally reflects macro conditions affecting our markets. We expect to outgrow market performance, but anticipate relative softness throughout 2016. Price fluctuations will reflect a $0.10 headwind to a $0.07 tailwind at either end of that range. As for FX, we are mainly affected by fluctuations in the Euro, Canadian dollar, and pound. The impact on 2016 is expected to be much more modest than 2015, approximately $17 million, equating to about a $0.03 headwind. Acquisitions from Novatima, Alfa, and CiDRA are expected to enhance the business's performance, but the sale of Ismatec will offset some gains; net sales benefit is around $0.04, and we expect $21 million in total sales for the year. We estimate a tax rate of about 28.5% for the year, which will increase from last year due to changes in the Italian statutory rate, resulting in around a $0.03 headwind relative to 2015. Our share buyback program will continue in 2016, with plans to repurchase about 2% of our shares, contributing roughly $0.07 to 2016. The impact of our restructuring will yield about $0.10 benefit in 2016. We anticipate productivity to fully offset wage and material inflation, costing about $0.03. As I said before, we will continue to invest, so our growth expenditures could hit a $0.10 impact for the year. I’m on slide 9 now, our final slide. Let's bring it back to Q1 and a few more items about the full-year guidance. For Q1, we're estimating $0.80 to $0.82, with operating margins of approximately 20%. The Q1 tax rate will be 29%, and we estimate about a 1% top-line sales impact from FX. A couple more items for the full year. For full-year revenue growth, we expect negative 1% to positive 1% organic growth; operating margins will exceed 21%. The full-year CapEx will be about $50 million, and free cash flow will be another strong year at 120% of net income. We expect to repurchase about 2% of our shares. As always, this guidance excludes the impact of M&A or costs related to acquisitions. With that, Tim, I’ll stop here and turn it over to questions.

Let's start with the guidance. Could you just talk a little bit about how you think the cadence runs through the year, Andy? It feels like it might be slightly back-half loaded. Maybe you could just talk about your underlying assumptions for improvement in the environment as you work through the year versus comps and what you see in your order pipeline.

Sure. Well, first of all, at your conference last year we talked a lot about the realities of the first half of the year. I think I said the year is going to be negative 2% to plus 2%. As we look at it today, we think the year is now negative 1% to plus 1%, so it has tightened a little. The tougher comps were going to come into the first quarter. Also, the first quarter typically has more general expenses than you see in other parts of the year. We're not calling for a big second-half rebound, Mike, just some modest recovery is expected. We could go through all of 2016 with it being a tough year; that is our expectation. As we have said in the past, we're a business that can respond very rapidly on the upside. We don't need much direct labor to increase - or to tackle the increasing order book. Nonetheless, we want to ensure our high-variable margins don’t feel heavy costs going into tougher times. Heath, do you want to touch on that?

Sure. Mike, as normal, Q1 earnings are typically lower than the rest of the year due to comparable sales, given some Q1-specific expenses like stock compensation. So that is not uncommon. There is natural seasonality from Q1 to Q2. We know where some projects line up, influencing the timing of revenue. All that was taken into consideration when developing this guidance, leading to lower Q1 expectations compared to the confidence we have for the rest of the quarters.

Are you suggesting that if you go to negative 1% organic growth, compare that to the plus 1% at the high end, that the low end does not assume any real fundamental improvement over the year while the high end assumes some modest improvement in those stressed markets?

I think that's a fair assumption. I mean, obviously we touch a lot of end markets with our diversified portfolio.

On the acquisition side, your comments are more bullish than you've made in the last couple of years. Can you discuss what gives you confidence? Are these opportunities that have just been in the works for a while and are now coming to fruition? Is the market getting more conducive? Talk about the confidence factor.

There are no significant changes in the M&A market. Things are consistent with the last 12 months. We understand what’s in our pipeline. We have had many irons in the fire, and things are progressing well. At the same time, opportunities can fall through. We've been close to many acquisitions and are optimistic about our current standing.

Andy, I know you discussed the acquisitions, but I'm trying to understand that pipeline a bit more. You mentioned no changes to the market, but has there been anything fundamentally done differently over the past few years that could build up the pipeline with higher quality deals?

Yes, Allison, about two years ago we positioned more resources towards M&A. That has contributed significantly. If you look at what we did last year, spending $200 million, I believe we will beat that this year. It comes down to where we're putting time and focus. These are acquisitions that hit right in our target areas. This process isn’t a science; it’s a balance of art and science, and it’s playing out favorably right now.

On the energy side, with crude at $30, are energy constraints expected to worsen or there should be stability even at this low level?

I don’t think so. Knowing where we operate in the market, we believe the ripple effects won’t worsen at the current rate. The majority of our business is midstream; however, we may see some incremental negativity in our liquid controls business that primarily touches mobile applications on trucks. The truck builds are projected to taper in 2016, but we should be significantly offset by where our aviation business is positioned.

Could you help clarify Q1? Is the calculation roughly negative 1.5% organic? Is that with the implied nature of my math?

You are in the ballpark. We're looking at low single-digit organic, but not significantly different from where Q4 came in.

When you say you are not assuming a second-half ramp, is anything in the assumption based pointing at something getting distinctly better during the year or is it merely comp-based?

Let me clarify. There is certainly some sequential uptick from Q1 to Q2 due to seasonality and project activity that is aligned with our backlog for the back half of the year over standard daily book rates. However, year-over-year, comps will ease after Q1.

That's right.

Regarding current exposure, if I add up industrial at about 18%–20%, oil and gas at about 11%–15%, and ag at 2%, does that mean about a third of the portfolio is impacted right now?

Your generalization is on track. Approximately 30% of the portfolio is in life sciences or municipal, while 70% is industrially based. The 11%–15% for energy is correct. Agricultural is closer to 4% or 5%. The parts being negatively impacted align with your comments.

On the M&A front, what is the category of your pipeline now? Are you willing to go larger due to market dislocations?

Our funnel looks reasonably spread across the three segments, which is encouraging. We don’t wish to increase cyclicality, and we focus on how we moderate it. Industrial pricing is reducing slightly, but it still remains competitive. Scientific businesses generally have more robust multiples than industrial businesses. However, our sweet spot is usually in the $30 million–$250 million range. We would explore larger options if they exhibited significant value creation potential.

I want to focus a bit more on the longer-term outlook for M&A. Given your successes in the recent years, what about adding another leg to your portfolio? Is that something you are contemplating?

At this point, we have extensive opportunities within our current businesses and near-adjacent markets to double our size. Adding further legs is not our primary focus. We've analyzed several industries and sub-segments, and some may fit nicely into our model, but those are not our priority right now.

You mentioned you intend to significantly increase M&A spending. If I find that upper end, after dividends and share repurchases, I presume I can arrive at $500 million–$600 million available for capital in 2016. Is that in the ballpark?

That is a fair number. We could stretch it further in this environment, given our balance sheet.

Can you share expectations regarding that?

Expectations are significantly above last year.

On the topic of China, can you provide more insights into what your people on the ground are seeing over there?

Two years ago, we began discussing softness on the ground compared to broader perspectives. The main issues are overcapacity and overbuilding across industrial sectors in China. The situation will require time to adjust, and 2016 will likely mirror 2015. We will continue investing for the long term as we see profitability opportunities.

Andy, regarding your comments on M&A, you’ve mentioned opportunities across segments. You have high shares in fire safety and diversified; what is the M&A focus on adjacencies?

There are solid adjacencies in diversified. We have allocated more resources over the last 12-18 months and discovered promising adjacencies that have similar economics and leverage. Our focus will remain close to home.

About growth priorities for 2016, you are investing $0.03 to $0.10. What are your priorities here? What will you scale back in the current environment?

High-level, our business model hinges on aggressive segmentation. We have continually segmented and favors high-margin profit pools, removing structural costs that do not contribute to growth. In the last two years, we have walked away from around $50 million of revenue to refocus resources. We're moving investments to franchises with solid prospects; they include the positive displacement pump franchise, scientific fluidics, the optical fluidic engine, and notable investments in India and China for long-term growth.

Can we delve into dispensing for a moment? Growth seems solid there; could you elaborate on specific areas this growth stems from beyond geographical comments?

Certainly. Growth is evident in three areas: two driven by market trends and one by product development. In the U.S. market, we have positioned ourselves strongly, allowing us to capture a significant share. Growth has been noticed in big boxes, as well as other outlets critical to the market. Western Europe’s recovery has benefited us, and our X-SMART product, launched in India, is gaining traction and poised for success in advanced markets as we transition the product into the U.S. and Europe.

On HST, could you comment on channel inventories? How do you see your orders developing now?

I don't see any concerns regarding channel inventories currently. Numerous product launches occurred early this year, and we'll keep close watch on that. For the investment cycle, we opted for a longer product innovation cycle—this may take two or three years to fully develop but can result in significant returns.

Do you expect a favorable impact from budget agreements, especially related to the NIH budget?

The medical device tax will not yield any direct impact for us. Regarding the NIH budget, while it influences innovation across the industry, the financial size is comparatively small to the life science industry. Nevertheless, these budget enhancements are positive for us in an indirect manner.

Lastly, can you elaborate on BAND-IT’s performance outside of energy?

BAND-IT's performance has been quite stable and generally flat. While the transportation side has shown consistency, industrial sales are concerning. We're seeing growth from product launches, but the general industrial market remains somewhat stagnant.

On pricing and cost, just to clarify, the bridge arriving at $0.03 – considering that you expect a point of price with inputs possibly decreasing, shouldn't you see a greater amount carried through?

Let me clarify. The pricing reflects our organic volume estimates. When considering productivity, we expect to offset $20 million–$25 million in inflationary pressures, primarily labor. Thus, while pricing shows a point of increase, these costs are embedded in our organic calculations.

To confirm, the productivity is expected to counteract inflation?

Correct, across wage, material, and burden inflation.

On restructuring, can you explain how that affects segments? Do you see specific areas to cut if we experience weakness in 2016?

We've already been aggressive in the back half of 2015, leading to about $12 million savings expected in 2016. If market declines, we are ready to adjust. Some cuts may also stem from volume-based expenses, and we constantly address smaller facility consolidations that take time to execute. These actions are a routine part of our operations.

Outside of M&A, how do you contemplate your view on internal growth spend? Are there projects that could be postponed if necessary, or would the variability depend on top-line implications?

Yes, some spending plans are already in motion, but we could hold back on certain headcount plans if conditions worsen. We aim to limit delays in strategic investment and want to make efforts if the markets hold steady. We have inherent flexibility in our spending strategy.

If M&A doesn’t align with your expectations, what ranks higher between internal investment and share buybacks?

Organic growth and dividends are dialed in at this point. We see no reason to divert cash away from these initiatives. Our focus is finding shares trading below intrinsic value, allowing us to rebuy as needed. Strategic M&A leads our cash usage, but if divestitures do not align, expect increased shares repurchased.

Regarding midstream operations, it appears downstream capital projects may be cut. Could you clarify the situation?

Yes, the upstream CapEx cuts are indeed having ripple effects through the rest of the value chain. However, if demand increases, we may see expansion in infrastructure again. At the moment, we're dealing with negative impacts resulting from capital caution.

Regarding SSD orders, considering a $98 million revenue from $97 million orders, those are the lowest figures since 2011. How do you characterize the orders for the segment?

BAND-IT and rescue have been impacted, and we had substantial orders for fire trailers last year, which have since normalized. The base business of fire is doing well, but the pressures stem primarily from BAND-IT and rescue.

Can you differentiate the orders in HST between life sciences and general industrial? Any insights into order rates in this regard?

The industrial side has been faced with more challenges, including the sealing products constrained by oil and gas exposure. The weak industrial demand has yet to reveal a strong recovery, making it imperative to connect life sciences with more substantial growth potential.

Additionally, do you feel customers in distribution have finished adjusting their inventory levels? Was the adjustment completed towards the end of 2015?

As I mentioned earlier, the topic of destocking has come up frequently. We do have minimal exposure to commodity distributors; our focus lies with value-added distributors who carry less safety stock. The key issue is end-market demand, adjusting inventory when necessary, thus triggering a modest restocking upon demand upticks.

How is channel inventory holding up in HST? Is mid-single-digit growth in scientific fluidics reasonable, or is that a longer-term expectation?

I don't have any concerns regarding channel inventories to report. Several product launches occurred recently. As for growth expectations, we're looking at steady improvements in 2016 but recognizing that some projects may take longer to materialize.

Will you see benefits from the NIH budget increase, or is that correlation lacking?

Outside the medical device tax, we've seen few distinct impacts from the NIH budget. While its contribution to the industry is positive, the relative size is small, with some impacts benefiting us indirectly over time.