The following segment was excerpted from this fund letter.
IDEX Corp (NYSE:IEX)
One of Ensemble’s newer positions is IDEX Corporation. IDEX is not a well-known company, and we believe it has the chance to be recognized as one of the next great serial acquirers like past Ensemble holdings TransDigm Group (TDG) and Heico (HEI).
One of the reasons IDEX is not well-known is because it sells decidedly mundane products, under many different brand names – mostly to distributors and other product manufacturers. It is highly diversified and owns over 50 subsidiary companies; these businesses typically sell niche parts and technology that help larger systems run smoothly in industrial and healthcare end-markets.
One of IDEX’s products is its Systec OEM MINI Degassing module. This module removes gases from fluids and can improve the accuracy of liquid chromatography equipment used to analyze the chemical composition of drugs in the pharma industry, for example. It is sold within IDEX’s Health and Science Technologies (‘HST’) segment, 40% of revenue. Another is its Sandpiper Heavy Duty Flap Valve Pump sold by its Warren Rupp business, counted within its Fluid and Metering Technologies (FMT) segment, 38% of revenue. The pump can be used in a larger Dissolved Air Floatation system that factories use to treat industrial wastewater. Its StreamMaster Fire Monitor is installed on fire trucks and used as a water cannon to extinguish fires. It is sold by the Akron Brass business within IDEX’s Fire and Safety / Diversified Products (FSDP) segment that is 22% of revenue. Flashy Ferraris these are not.
IDEX has been acquiring businesses that sell niche products like these for over three decades. In the last two calendar years, five acquisitions totaled over $1.2 billion. But why would we want to own a company that does so many acquisitions, when acquisitions so often fail, and for so many reasons? Roger L. Martin estimated in his 2016 Harvard Business Review article that “M&A is a mug’s game, in which typically 70- 90% of acquisitions are abysmal failures.” Some famous M&A failures include AOL’s $165 billion combination with Time Warner, Daimler-Benz’s $37 billion deal with Chrysler, and Sprint’s doomed $35 billion merger with Nextel.
There are many ways for an acquisition to fail, among them for an acquirer to overestimate strategic fit, to overpay, and to not recognize conflicts in business cultures or technologies. We believe, however, that IDEX is among a class of companies that can outperform via acquisitions, because acquisitions are its bread-and- butter. As opposed to an online service provider like AOL or a car company like Daimler-Benz overestimating the synergies of one big tie-up, acquisitions are what IDEX specializes in. Serial acquirers can be similar to great equity investors who have a disciplined process of buying good businesses at reasonable prices and do so repeatedly and at growing scale over time, much like Ensemble aims to do.
A strategy of serial acquisitions can compound above-average returns for decades if done right. Examples of successful serial acquirers include Constellation Software (CSU), TransDigm (TDG), Heico (HEI), Danaher (DHR) and Illinois Tool Works (ITW), all of which have outperformed the S&P 500 over the last 15 years.
IDEX’s stock has outperformed as well, with a 15% annualized total return since its IPO in 1989, about 4.5% above the S&P 500’s return over the same period.
IDEX’s path to its IPO started 10 years prior in 1979 as the first major leveraged buyout (‘LBO’) by famed private equity firm KKR. At the time it was a 50-year-old auto parts company called Houdaille Industries. Houdaille was taken over by the British-based TI Group PLC, which spun off several businesses it didn’t want into an entity that was again LBO’d by KKR in 1988. The resulting company was named IDEX – an acronym for Innovation, Diversity and Excellence, headquartered in the Chicago area. The LBO left IDEX with a pile of debt to pay off; according to Donald Boyce, the first CEO of IDEX, “It made us focus on cashflow.” Since 1990, IDEX’s operating cash flow has grown at a double-digit pace of 11% annualized, according to data from Bloomberg.
We attribute IDEX’s success to three things: Its 1. Discipline 2. De-centralization and 3. Scale.
IDEX is disciplined in the types of investments it targets and in its financial management. IDEX generally acquires businesses that have #1 or #2 share in small, fragmented markets uninteresting to larger competitors. The businesses IDEX acquires typically sell components or technology that are small portions of the overall cost of their customers’ systems, but that also must be counted on to work. For example, its BAND-IT fasteners, such as steel bands and clamps, are used to hold together objects on everything from ships to aircraft where the cost of failure could be disastrous. These types of parts, once trusted to work and to be supplied quickly and reliably, create a switching cost for customers who don’t want the risk or inconvenience of designing such a part out. This gives IDEX pricing power with its customers.
Management also has a minimum financial return it expects to achieve on its capital invested by year five after an acquisition, and regularly passes on deals that are too expensive. There is a minimum incremental EBITDA margin target of 25% for IDEX that discourages a lot of dilutive acquisitions, and it aims to consistently pay out 30-35% of its net income in dividends.
A second key aspect to IDEX’s success is its decentralization. Unlike the rationale for most acquisitions talked about in the press, IDEX does not expect much synergy between its businesses. While IDEX does buy businesses in certain areas it calls its “business platforms” — such as pumps, valves, water, scientific fluidics & optics, and fire & safety, these businesses are not usually integrated with each other. IDEX gives its general managers performance targets specific to their business and enough leeway to empower them to achieve its goals. It is the antidote to micromanagement.
Lastly, we believe IDEX is successful because it operates at a scale that’s differentiated. It has gained talent, experience, and capital the last 35 years. Acquisitions have been part of IDEX’s DNA from the beginning, having got its start as a collection of businesses spun off from private equity firm KKR; KKR’s co-founder Henry Kravis served on IDEX’s board for the first 14 years (1988-2002.) In the last several years, IDEX has built up a team that specializes in sourcing deals for each of its segments, and in greenfield areas.
The company has also been influenced by the culture of Danaher, another successful serial acquirer whose stock price has returned almost 20% annualized the past 15 years. The past three CEOs of IDEX have been Danaher alums, including current CEO Eric Ashleman and the previous CEO Andrew Silvernail who adopted the “IDEX Difference” that is similar in concept to the Danaher Business System (DBS.) Danaher calls DBS a process for continuous improvement, lean manufacturing, and innovation. The IDEX Difference is a strategy with three pillars – Great Teams, Customer Obsession, and Embracing 80/20.
IDEX helps its general managers apply its 80/20 system of optimization upon acquisition and over time. IDEX’s 80/20 system asks the managers to focus on the 20% of causes that lead to 80% of the desirable outcomes. An example of 80/20 optimization would be to concentrate resources like money, time, and talent, on the 20% of products that account for 80% of profits. This is a simple and well-known principle used for over 30 years also by Illinois Tool Works (ITW), another serial acquirer whose stock has returned 18% annualized the last 15 years. David Parry, the former vice chairman of Illinois Tool Works, has served on IDEX’s board of directors since 2012 and we believe was influential in bringing this system to IDEX.
While IDEX mostly operates as a de-centralized entity, with each business having its own HR, finance, and marketing teams, for example — IDEX does offer some services at the corporate level that add value versus a simple holding company. IDEX has an office of business optimization that implements the 80/20 processes, and a talent academy to train and promote leadership internally. The talent academy gives employees opportunities for career growth not usually available within smaller firms. IDEX also supports its businesses’ growth initiatives, giving them access to IDEX’s large pool of capital if a project is considered worthy.
So what are some of the risks we face as shareholders of IDEX? Like with any serial acquirer, the company must continue to find acquisitions to execute, while being prudent in the quality and valuation of deals. We also expect IDEX to monitor shifting technologies and trends, and to respond appropriately in its capital allocation priorities, for example via divestitures and acquisitions. The company seems to be doing so by investing in faster growing areas recently like medical applications, optical devices, and specialty materials over traditional industrial pumps.
And what are some potential positive catalysts? IDEX has proven its ability to generate attractive returns from acquisitions in the past, and this could bode well for its chance to further compound shareholder value. We think IDEX could ramp the cash it deploys into acquisitions and it has gained the ability to do bigger deals. It generated over $600 million in free cash flow in 2023, and we think it could add significantly more debt to its balance sheet without damaging its creditworthiness. IDEX could also report improving sales growth as its customers are mostly through their de-stocking phase from inventory built-up amid the pandemic. Along with a new CFO, Abhi Khandelwal, who re-joined IDEX in November 2023, we think IDEX might be ready to fire on all cylinders.
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