Idex Corporation (IEX) — Q3 2019 Earnings Call Transcript

Thank you, Doug. Good morning, everyone. This is Mike Yates, Vice President and Chief Accounting Officer for IDEX Corporation. Let me start by saying thank you for joining us for our discussion of the IDEX third quarter financial highlights. Last night, we issued a press release outlining our company's financial and operating performance for the 3 months ending September 30, 2019. And later today, we will file our 10-Q. The press release, along with presentation 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 Bill Grogan, our Chief Financial Officer. The format for our call is as follows: we will begin with Andy providing an overview of our operating performance in the quarter, Bill will then discuss our third quarter financial results and walk you through the operating performance within each of our segments. And finally, Andy will wrap up with an outlook for the fourth quarter and full year 2019. Following our prepared remarks, we'll 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 the toll-free number 877-660-6853 and entering conference ID 13684164, or you may simply log on to our company's homepage for the webcast replay. Before we begin, a brief reminder. This call may contain certain forward-looking statements that are subject to the safe harbor language in last night's press release and in IDEX' filings with the Securities and Exchange Commission. With that, I'll now turn this call over to our Chairman and CEO, Andy Silvernail.

Thanks, Mike. Good morning, everybody. I appreciate you joining us to discuss our 2019 third quarter operating results. In the challenging macro environment, I'm extremely proud of my team. As you know, I've had concerns about the overall demand volatility and the potential for further erosion. We have a short-cycle business. We go into any given quarter with only about 50% of the quarter booked. We were prepared. We got ahead of the challenges, and we're executing. In the quarter, the team delivered outstanding margin expansion, hitting all-time highs for gross margin and operating margin. The healthy margin expansion helped us deliver another record quarter of adjusted EPS, and we reduced working capital to drive another record quarter of free cash flow. The results were achieved in a decelerating commercial environment. Organic sales were flat in the quarter. The global demand for industrial products definitely weakened in the third quarter with manufacturing contracting for the first time since 2016, and we're certainly feeling it. Lingering trade tensions and uncertain trade policy have weighed on global growth with customers and business leaders hesitant to spend. This has led to a slowdown in most geographies. With that said, we remain confident in our ability to thrive in this environment. We're executing the playbook we've spoken about to you all year. We're being prudent about costs, and we're focusing on productivity while continuing to invest aggressively in our exceptional long-term growth prospects. We've built IDEX to perform throughout a cycle, and we're doing the things that make IDEX different. We're investing in great teams who focus on the critical few priorities within our outstanding businesses, all of which is in service to our customers. This is what separates IDEX from our competition and allows us to deliver for our customers, employees, and shareholders regardless of the macro environment. We're fortunate that our durable, diversified business model produces exceptional free cash flow, and we have an outstanding balance sheet. These facts allow us to have abundant capital to both invest aggressively in organic growth and drive returns through capital deployment. Let me take a moment to talk about capital deployment before turning it over to Bill for some color on the financial results. The integration of Velcora is going extremely well, and the teams are delivering on the key value drivers. And as we get inside the business, I'm even more excited about the possibilities that Velcora brings to our Sealing platform. M&A continues to be a top focus for us but remains a challenge in the current environment due to valuation. Our teams are hard at work on both the cultivation and evaluation of several deals. With nearly $2 billion of capacity based on existing cash, availability under our revolver, and a very healthy balance sheet, we have the capacity to support the right opportunities while remaining disciplined within our return framework. We will only move forward on a deal when the target fits the IDEX criteria. Along with the acquisition of Velcora, we returned $38 million to shareholders via dividends in the quarter. With that, let me pause here, and Bill, I'll turn it to you for a discussion on financial results and the segment details.

Great. Thanks, Andy. I'll start with our third quarter financial results on Slide 4. Q3 orders of $586 million were down 5%, both overall and organically, driven by softness across all segments and tough comps versus last year. Q3 sales of $624 million were flat overall and organically. We did see growth in FMT and HST, but it was offset by a decline in FSD that was primarily driven by project timing. We expanded gross margins in the quarter by 20 basis points to 45.2%. However, excluding the $3 million fair value inventory step-up charge related to the Velcora acquisition, adjusted gross margin was at an all-time high of 45.7%, up 70 basis points. This was primarily due to strong price capture and productivity initiatives partially offset by continued investments in engineering related to new product development. Q3 operating margin was 22.7%, but adjusting for both the fair value inventory step-up and restructuring expenses, adjusted operating margin was 25.2%, an all-time quarterly high for IDEX and up 120 basis points compared with the adjusted prior year period, mainly driven by our gross margin expansion and lower SG&A costs, which were driven by decreased variable compensation expenses and tighter cost controls across the business. Included in the restructuring charges was an approximate $10 million impairment charge related to the wind down of a small business line within HST. Our Q3 adjusted effective tax rate was 19.1%, which was lower than the 20.3% in the prior year period mainly due to changes in U.S. Treasury regulations as well as the mix of global pretax income among our jurisdictions. The adjusted ETR of 19.1% was also 340 basis points lower than our previously guided ETR due to a higher excess tax benefit from greater-than-expected stock option exercises as well as a favorable impact from the 2018 income tax return to provision adjustment. This lower ETR provided $0.06 of EPS favorability in our quarterly results compared to our previous guide back in July. Q3 adjusted net income was $117 million, resulting in a record adjusted EPS of $1.52, up $0.11 or 8% over prior year adjusted EPS. Finally, free cash flow was very strong at $146 million. It was up 28% over last year and 125% of adjusted net income. This was our highest free cash flow of all time. I'll now turn to the segment discussion. I'm on Slide 5, starting with Fluid & Metering. Q3 orders were down 1% overall and flat organically, mainly driven by softening demand in the industrial market and continued declines in agriculture. Q3 sales were up 1% overall and up 2% organically, attributable to the growth in our pumps, valves, and energy businesses due to strong performance around our targeted growth initiatives but partially offset by the slowdown in the industrial short-cycle book-and-turn activity during the quarter. The municipal water business remains solid, with stable spending projected for the remainder of '19. In regards to the agriculture market, the market dynamics remain unchanged due to continued tariff pressures and depressed commodity prices, which has put pressure on the Banjo business all year. Preseason orders are flat compared to the prior year period, and we are not forecasting any near-term change to the U.S. agriculture market performance. Finally, operating margin was outstanding at 32.2%, up 270 basis points over the adjusted prior year quarter, mainly due to a widening price-cost spread driven by the team's ability to continually capture value for their products and deliver on their productivity initiatives. FMT really executed during the quarter. Let's move on to Health & Science, turning to Slide 6. Q3 orders were down 4% overall and 6% organically mainly driven by continued market pressure in semicon and automotive as well as the industrial slowdown impacting about 1/3 of the sales in HST that are industrially exposed. Orders were also impacted by timing as a few large life science blankets got pushed into the fourth quarter. From a sales perspective, Q3 sales were up 3% overall and 1% organically driven by strength in the life science business as they continue to experience growth tied to new product development and collaboration with our key customers. At Gast, we continue to see MPT project wins, but as discussed earlier, we started to see challenging market conditions in the third quarter due to weakened North American industrial distribution demand. For MPT, strong results in Q3 were driven by shipments of some long lead time projects, reversing the negative trend we experienced in the first half of the year. We're seeing positive momentum within key pharma markets, and our commercial funnel continues to grow. Expectations are to deliver positive growth for the year. Finally, within Sealing, pressure across the semiconductor, industrial, and auto markets continue. Although we're beginning to see signals of reaching the bottom of the semi decline, their orders and sales are still challenged. From a margin perspective, excluding the fair value inventory step-up charge and restructuring expenses, operating margin increased 30 basis points to 23.8%. This was primarily due to the higher volume and price capture, partially offset by higher growth investments and amortization related to the Velcora acquisition. I'm now moving to our final segment, Diversified. I'm on Slide 7. Q3 orders were down 10% overall and 9% organically mainly driven by pressure on the projects side of the business as customers remain cautious around making large investments, as well as tough comps in dispensing and rescue to large project orders in the prior year period. Both dispensing and rescue orders were down over 20% organically in the quarter. Q3 revenues were down 5% overall and 3% organically, and I'll provide a little bit more color on that in a minute. Adjusted operating margin of 27.2% decreased 50 basis points in the quarter. This was mainly due to the reduced project volume. Sequentially, the segment was up 10 basis points versus the second quarter. FSD's performance was mainly driven by the following: on the fire side, core OEM and municipal markets continue to perform well. We're experiencing steady growth across our product offerings as well as continued momentum around our new SAM product launch. Turning to rescue, sales declined mainly due to project delays associated with political uncertainty, coupled with a tough comp from the prior year period. U.S. performance was slow due to a delay in FEMA spending, but expectations are that we'll see a rebound in the fourth quarter. BAND-IT performance remained strong based on wins with our targeted growth initiatives. Even as we see general softness in the auto and energy markets and pressure within the industrial space, BAND-IT continues to take share and grow in these areas. Finally, the dispensing story remains similar to the first half of the year due to a tough comp against some large project wins in 2018, with no new projects occurring this year. As such, the business was down double digits compared to the prior year, but we do expect to cycle back to growth in 2020. I will now pass it back to Andy to provide an update on our 2019 guidance.

Thanks, Bill. So let me wrap things up, and I'll provide some details here regarding 2019 for both the fourth quarter and the full year. I'm on the last slide, that's Slide 8. In Q4, we're projecting EPS to be in the range of $1.33 to $1.35 with flat organic revenue. Operating margin should be about 23.5%. We're estimating about a $0.01 top line headwind from FX based on the September 30 rates. This translates to about $0.01 on the bottom line EPS headwind. The Q4 effective tax rate should be about 22%, and corporate costs in the fourth quarter will be around $18 million. If we look at the full year 2019, we're projecting full year EPS of $5.80 million to $5.82. Full year organic revenue is projected to be about 2% with operating margins at approximately 24%. We should have about a 2% headwind from FX based on the September 30 rates. The effective tax rate for the year to be about 20.5%. CapEx is anticipated to be about $55 million, and free cash flow should be about 105% of net income. And finally, corporate costs will be about $73 million for the year. As always, these earnings guidance expectations exclude anything from acquisitions or restructuring. With that, Doug, let me turn it over to you, and we'll open it up for questions.

So let's start with the underlying trajectory, what you're seeing right now. Lots of puts and takes in the order numbers. SMT is flattish, which is typically a more cyclically sensitive business. The other pieces had some project timing-related things. So maybe you could just talk about what you're seeing as like the core underlying demand characteristics today. What that trajectory looks like through the fourth quarter? And then maybe some puts and takes on how you're looking at growth for 2020.

Sure. Mike, that's a great question and definitely the main focus for us. If we break down the factors involved, here’s my perspective: we faced some project timing difficulties. Last year, we experienced a notably strong third quarter in our rescue and dispensing services, along with some significant orders in our life science blanket orders that we usually see in the fourth quarter. If we neutralize these factors and evaluate the core run rate of the business, it appears to be essentially flat or down by about 1%. When looking specifically at the underlying day rate businesses, it's approximately a 0.5% decline, which aligns with our previous observations. As we approach the fourth quarter, additional factors are likely to influence the day rate business. Thus far in October, our performance is aligning with our expectations entering the quarter. Currently, we seem to be stabilizing around this flat to down 1% trajectory regarding core order rates. I don't foresee any significant deviations from this trend moving forward. However, the fourth quarter does present an easier comparison than last year, while the first and second quarters of next year pose considerable challenges. Assuming no changes in trajectory, I think a flat revenue growth outlook for the fourth quarter makes sense, with more difficult comparisons occurring in the first and second quarters, followed by a likely improvement in the third and fourth quarters of next year. This is more or less our assessment. While it’s still early to project 2020 due to the nature of our short-cycle business, my initial analysis suggests we might face a tougher first half and a more manageable second half, potentially bringing us between plus 2% to negative 2%. However, it’s still quite early in the process. We are currently refining our annual plans for 2020, but that's a preliminary overview.

No. That makes a lot of sense. And then on the margin side, very strong execution this quarter. Walk through any puts and takes you think that might help us on a forward basis to figure out sustainability at this level. Were there anything on the incentive comp that's different? Any other kind of one-off things that would move this around one way or another?

No. Yes, I think overall, obviously, with the revised results for the full year, there's a decrease in some of the variable compensation stuff. I think fundamentally, obviously, FMT's margins were really strong. That's where we're going to see probably the most decline is if we are in this industrial softness here recently, and they'll delever probably more than the other businesses. So that'll put more pressure. I think for the third quarter, we guided around 23.5%, which is probably what you'd see going forward at a consistent revenue run rate.

Andy, I appreciate your earlier comment about signaling a slowdown. You were one of the first senior leaders at the EPG Conference in May to mention that a slowdown was occurring, so no one should be caught off guard by this. As order rates decline, I understand you're dealing with shorter cycles, but you mentioned that customers are hesitant to spend. What is the current discussion regarding their willingness to commit capital? How do the order rates look for the fourth quarter? Are we going to continue to see negative trends or is the situation worsening compared to the start of the third quarter?

I don't currently see any worsening, but I want to address the hesitancy. As mentioned at EPG, the main issue is that there is significant reluctance due to the uncertainty in the marketplace. There aren't any major demand issues or sudden downturns outside of the previously discussed human-made challenges worldwide. However, this uncertainty is causing people to hesitate in terms of spending and hiring. We're observing more layoffs in the manufacturing sector than in a long time. Unfortunately, this uncertain environment is likely to persist for a while. There is ongoing back-and-forth regarding trade tensions, and those engaged in these discussions remain skeptical about any substantial positive developments, aside from perhaps a standoff where the situation doesn’t get any worse. Additionally, as we approach the election cycle next year, it’s evident from conversations in the field that people are postponing significant investments in hiring or capital during these unpredictable times. I believe the situation will remain challenging for some time.

All right. So the macro commentary is really helpful, but let's pivot now into your end markets. And if we just go back to the second quarter when we talked about where the softening was showing up, it was auto, it was semicon, it was ag for you guys. And that was like 10% of the portfolio. It really does sound like that's still the kind of ground zero of where you're seeing the slowing. Has that spread to these any other verticals?

I believe that the change in the third quarter reflects my previous concerns about ongoing struggles in certain areas. The industrial sector has begun to decline, particularly with FMT, which makes up a significant portion of our industrial exposure. Although FMT remains relatively strong compared to global trends, it's still experiencing challenges. I anticipate these conditions will persist for a while. The negatives include a general slowdown in the industrial sector, which is likely to present challenges at least until the second quarter of next year. It seems unlikely that things will improve sooner. Additionally, there's uncertainty over whether agriculture and semiconductors have reached their lowest point. The automotive sector appears to be nearing a bottom in China, but expectations for auto production are down for next year, which might result in additional pressure. Overall, these sectors are likely to continue struggling until we see some recovery in semiconductors. There are indications that semiconductors may be stabilizing, while agriculture remains uncertain due to trade tensions. The municipal and health of science sectors are expected to remain stable.

Yes. That's exactly what we'd expect. And look, you cannot control the slowing on the end markets, but you're obviously doing a great job on margins and cash flow, so congrats on that.

Well, thanks, Deane. I think the important thing there is controlling our own destiny. We've talked to all of you guys about the playbook. We've looked at it in a slowing environment. We're certainly working that. We know how to deal in those environments and make sure that we deliver for our customers, our people, and certainly our shareholders.

Come on, Andy, control the end markets. Question on working capital. I mean it looks like you guys managed inventory really well in the quarter in the face of probably some slower revenue that you were anticipating. Maybe you can talk about whether you need to reduce your inventory levels here in the face of this lower demand environment, whether you can generate some cash over and above what your excellent free cash flow conversion normally is here in this environment?

Yes. I think, Nathan, so first of all, this is something from a business model standpoint we've talked about a lot that even in times where you're getting pressure on the top line of the business and pressure on margins that the balance sheet delevers really nicely. And so from a cash EPS perspective, that will hold up well. I expect we'll see more delevering in the fourth quarter. And then we'll kind of see where we are in terms of what we're planning for next year. But certainly, in the fourth quarter, I expect more delevering.

So you're not in any kind of heavy downturn here. You're talking about flat 4Q, kind of plus 2% to minus to 2% 2020 outlook. Are there any meaningful cost action plans that you take here? Are there particular businesses where you're seeing worse demand where you think you need to take some cost actions, and maybe what those would be?

Yes, you absolutely do. To clarify, in this environment and for IDEX overall, these situations are not widespread. We are not a company that implements significant reductions across the board. The key to navigating this environment is, first, investing in elements that promote long-term, sustainable competitive advantage and value. For us, this boils down to two main areas. The first is our people, whom we consider central to our business model; they are what drives scalability in the company. Therefore, we will continue to invest in leadership development and remain focused on that. Second is innovation in our core markets. When you consider the segmentation we do regarding profit pools, you need to make growth bets moving forward. Beyond those core strategic areas, you need to be prudent. There are areas where we are already implementing targeted cost reductions, and we may need to do more if we observe any weakening; this is essential for the long-term competitiveness of the company. We're following this strategy while looking ahead. My expectation for the current environment is that 2020 will present a challenging comparison in the first and second quarters, followed by a more manageable comparison in the latter half, leading to an overall outlook of plus 2% to minus 2%.

A couple of questions. First, can you maybe give a little bit more geographic granularity in terms of incoming orders and organic performance in the quarter?

Yes, Matt. Bill, you want to tackle it?

Yes, sure. I think Europe will continue to maintain the lower levels we've observed over the past few quarters. The significant declines were primarily in North America, which is where we noticed a broader drop in order numbers. We did perform a bit better in some emerging markets, but compared to the fundamental macroeconomic situations in India and China, our teams effectively executed their growth initiatives and achieved growth in the upper single digits in those regions.

Yes. So the incremental softening, Matt, has really been around North America.

Got it. Regarding FMT margins, there was an increase of $270 million year-over-year and $170 million sequentially, despite lower revenue during that time. Could you discuss whether you are increasing prices in that business or if your input costs are significantly decreasing? Please clarify how you are achieving that margin and what the expectations are for FMT margins moving forward, especially in what you refer to as a more subdued general industrial environment for that business.

Yes. I would say 30% is probably closer to what its normal run rate is. Those businesses, even on lower volume, are running lights out with the remaining projects that they had. And then the input costs have decreased. I think the teams, as they looked at where they're getting some pressure from tariffs, they've been able to come up with some supply chain solutions to reduce the impact of those. And the pricing that we put out last year in Q3 to offset some of those just levered better within the quarter.

Just wanted to come back to price cost. It sounds like you got a very good price traction in the quarter. You do start to lap a tough like-unlike price in Q4 next year. But given the moderating commodities, does price start to flatten out as we get into 2020? Or do you still think you can achieve positive price in some of those businesses?

Brett, we'll get positive price in 2020, I feel very confident in that. The nature of the business model, the nature of our competitive positioning, it'll be lighter than certainly in 2019, there's no doubt about it, but I don't see any reason why we won't sustain that kind of 30 to 40 basis points price cost leverage that we've gotten in the past. Bill, anything else you'd add to that?

Yes, I believe the spread as we enter the latter half is higher than that. However, next year, as we adjust our 2020 pricing actions, it will decrease somewhat. Nonetheless, as Andy mentioned, I still expect us to maintain a significantly positive price-cost differential.

Yes. In regard to rescue, there are two main observations. First, globally, we've experienced this before; sovereign governments purchasing our products can pull back when financial situations tighten. We're seeing some relief now because we maintain strong relationships with our customers and are aware of when their funding might improve. We feel optimistic about that. Second, as Bill mentioned, there has been an unusual situation with FEMA funding getting delayed during the third quarter, but it seems to have been released. We have no reason to believe that this issue will persist.

Can you provide more details? You mentioned that you believe semiconductors are showing signs of bottoming. Could you remind us how significant that is as a percentage of your sales currently? Also, what leads you to that conclusion? What specific indicators are you observing?

Yes. It's not a significant portion overall, accounting for about 3% of the business. The largest effect is in our Sealing segment, along with a smaller pump business that is also affected. Although I mention bottoming or inflecting, there’s no indication that there's going to be a dramatic increase. However, we've received strong signals from several key players indicating a forecast of higher demand. This is somewhat balanced by some signs of softness they are observing. Nonetheless, we are gradually converting many customers over time, which represents a gain in market share in addition to market conditions. In simpler terms, Andrew, we are getting direct feedback from customers about the need to prepare our supply chains for increased demand. However, I want to emphasize that we should not be considered a leading indicator for the semiconductor market. We aren’t the ideal source for insights on that front.

Got it. Okay. I know people are asking this question a bit, but your sales are only about 2% for this year, and you achieved an impressive incremental margin from that. This follows strong incrementals from the previous year. So the question is, how long can you maintain this if you are implying around 2% plus or minus for the top line in 2020? It seems unrealistic that expansion is likely.

Yes. There are a couple of important points to consider. First, the overall top line is crucial; I consider 2% to be a tipping point. At 2%, you're covering inflation and can achieve some incremental margins. When you exceed 2%, reaching 3% or 4%, you really start to achieve those incremental margins in the 30% to 35% range. However, 2% is where you begin to offset the normal inflation in the business. So that volume figure is significant. Secondly, the relationship between price and cost is essential; if we can maintain that at 30% to 40%, it will contribute to the first point and enhance any expansion we aim for moving forward. If growth rates are below 2%, it will be challenging to achieve any expansion, and we are focused on maintaining stability. Conversely, if we surpass 2%, we will certainly see expansion driven by the typical contributions and the price leverage we experience.

Okay. It seems unlikely that margins will decrease significantly, if at all.

Let's consider another scenario where we may experience a decline next year. We've discussed our approach to that situation, and I want to share our perspective. In a typical recession, we anticipate a decline of about 5%, which translates to a $125 million decrease in revenue, leading to around $75 million that would affect our bottom line. Our aim would be to counteract this by implementing approximately $25 million in cost reductions, and the math on that is straightforward. In such an environment, we will be very strategic. While it is possible to make deeper cuts and we have done so before, we prefer not to go that route. As I've mentioned previously, if this scenario occurs, we will continue to reinvest in the business aggressively. The $25 million target is manageable without making very difficult compromises. We will remain focused on our key priorities, particularly regarding our workforce and the promising businesses where we can innovate within profitable segments. This is our general approach to navigating these challenges.

Apologies in advance, you might have covered this. I got disconnected for a little bit in the beginning of the Q&A here. But when I look at your CapEx, generally, it scales up in the second half of the year. Clearly, you have some markets moving other ways and you're being cautious, but how should we think about that level for the rest of the year and into next year?

Yes. So we're going to be at about $55 million, which is about $5 million less, and that was not our intention. It's a matter of timing and the ability to actually get some stuff in within the fourth quarter. So that $55 million, $60 million range, that's a healthy range with our business right now, and I would expect that to be similar going into next year, plus or minus.

Okay. Is the order decline in your fourth quarter related to timing, and will it directly impact the revenue number you expect for Q4?

I don't believe it will have a significant impact. It's primarily about the timing of that order; these items are for future delivery. Therefore, I don't think it will materially affect the fourth quarter.

Yes. I mean, OEMs, when they place it, we've had some volatility between Q3, Q4, and Q1 that have created some noise in the comps there.

Okay. Can I clarify something, Andy? In your downside analysis regarding a 5% decline, did you mention that $75 million would be deducted directly from the bottom line for a $125 million decline? Am I understanding that correctly?

Yes. I'm just saying that if we do nothing, it results in what we refer to as material margin. So, material contribution or value added would be the outcome if we took no action. This would represent 50% of the company's contribution margins.

Thank you very much, Doug. I appreciate it and I want to thank everyone for joining us on the call. In this volatile environment we have all been navigating, I couldn’t be prouder of our team for their execution and dedication to our customers, our employees, and you, our shareholders. We're excited about that and grateful for the support from the investment community. With that, we will say goodbye and we look forward to speaking with you again in 90 days. Take care.