THE SECRET PM: BUY IMI
From 37,000 feet managers of manufacturing businesses have three tools at their disposal to increase business value.
First, management can devote resources to develop more bespoke and customer-valued products, these command higher prices and generate higher gross margins. Second, management can improve operating efficiency by closing high-cost capacity and holding less inventory, in so doing converting more gross profit into operating free cash flow. Third, management can re-invest this cash flow back into new even higher margin products and new even more efficient capacity, thereby compounding the company’s cash flow growth. Repeating this cycle over many years can result in exceptional share price performance.
A poster-child for compounded shareholder value growth is US “off-price” retailer TJX. TJX’s main businesses are the retail stores TJ Maxx and Marshall’s. In 2004 TJX reported an average gross profit per store of $1.6mln and average post-tax cash flow per store of $0.27mln. By managing inventory per store down, from $1.04mln in 2004 to $0.95mln in 2014, management ensured its stock of merchandise was “fresh” and fast-moving. This meant fewer markdowns and more frequent customer visits. In other words, higher gross profit per store and higher revenue per store. By 2014 TJX posted 27% more revenue per store and $2.45mln gross profit per store, leading to post-tax cash flow per store of $0.65mln – a 140% improvement in 10 years. So, you suppose the market value of TJX increased 140% too, from $12bn to 29bn? No. As well as improving the profitability of the business the management of TJX re-invested in new capacity, growing the store base from 2224 to 3395, thereby compounding the growth in shareholder value. TJX ended 2014 value at $48bn.
IMI is a British business that makes “engineered” products that control the movement of fluids and gases. IMI is a business where Martin Lamb, CEO from 2001 through 2013, did a good job employing the first two tools of shareholder value creation, in so doing growing IMI’s market value from GBP 1bn to GBP 3.5bn. But he failed on the third. Mr Lamb was never bold enough in allocating the company’s capital toward re-investment.
At the end of 2010 Mr Lamb articulated four strategic priorities for IMI. Two of these were: “… to increase investment in sales and engineering resource” and “… use balance sheet to fund further acquisitions.” Yet in 2011, 2012 and 2013, IMI spent a total of only GBP 159mln out of GBP 677mln operating cash flow on capital investment, an amount less than 2.5% of revenue and just 70% of depreciation. Moreover Mr Lamb spent less than 20% of available cash flow on acquisitions. It should come as no surprise then that operating profits (at its fluid handling businesses) have been roughly stagnant for the past four years: GBP 308mln, GBP 300mln, GBP 322mln, GBP 298mln.
At the end of 2013 Mr Lamb stepped down as CEO. He was replaced by another industrial-company veteran, Mark Selway. Mark has what Martin lacked – the courage to invest. As CEO of Weir Group, from 2001 until 2009, he upped capital investment from 2.2% of revenues in 2001 to 4.2% of revenues by 2007, and spent GBP 460mln of GBP 520mln available cash flow on acquisitions. The key move being the GBP 328mln purchase of Texas-based SPM flow control, which leaped Weir into a dominant position in the US energy market. Mr Selway’s aggressive investment saw Weir’s profits grow from GBP 31mln in 2000 to GBP 200mln in 2010, and its market value increase from GBP 480mln to GBP 3,800mln. Mark Selway has a track record of compounding his shareholders’ capital. Moreover he already knows what is “missing” at IMI, in an interview with the FT he described IMI: “… this is a business that needs to be invested in.”
Mr Selway has made his goals for IMI public: “The review which I initiated shortly after my arrival, has now been largely completed. Using the information gathered through this process we have developed a five year plan to harness the Group’s full potential to deliver sustainable accelerated growth and shareholder value. The opportunities are significant and that is reflected in our ambition to double the Group’s 2014 operating profits by 2019.”
In 2014 IMI reported operating profits, before restructuring charges, of GBP 298mln. Mr Selway therefore targets 2019 operating profit of around GBP 600mln, which in turn would mean over GBP 400mln in free cash flow, enough to easily sustain a market cap over GBP 6bn. Today IMI is valued at GBP 3.5bn. IMI could thus be one of the very few opportunities in Europe where investors have a reasonable chance to double their money over the next five years?
Given Mr Selway’s track record at Weir you would expect the market to anticipate some success. Instead IMI’s share price has fallen from GBP 18 to GBP 12 since his appointment was announced. Perhaps the reason for this is that investors look at IMI’s own history of growth and remain sceptical about improvement: IMI reported revenues and operating cash flow of GBP 1,619mln and GBP 170mln in 2001, not very different from the GBP 1,686mln and GBP 190mln reported in 2014. Such a conclusion, however, ignores the huge changes that took place at IMI from 2001 to 2014. Indeed, to better understand why Mr Selway believes he inherited a “good set of cards… that has so much upside,” we need to go back to 2001 when Martin Lamb was appointed CEO of IMI.
Martin Lamb did not inherit a good set of cards. In 2001 39% of IMI’s revenue came from selling building products, including plastic pipes and copper tubes. At the time highly-engineered products used in “critical” applications at power plants and petrochemical facilities – these are applications where potentially corrosive liquids are at extremely high temperatures, pressures, and velocities – was IMI’s smallest revenue division. Mr Lamb was quick to identify the need to exit the building products business owing to growing threats from low-cost, emerging market competitors. He realised, correctly, that “knowledge-based engineering” could provide a defendable profit source.
Between 2001 and 2005 all the various building product divisions were sold. This shifted the company’s mix toward higher value-add products and was reflected in rising gross margins: from 36% to 40%. Even with GBP 300mln less revenue in 2005 IMI reported higher total gross profit. The smaller business asset base demanded less capex: capex of GBP 42mln in 2005 compared to GBP 66mln in 2001. Improved free cash flows together with disposals meant IMI moved from a having GBP 400mln net debt to a net cash balance sheet and over GBP 100mln in annual free cash flow, giving Mr Lamb lots of opportunity to invest back into the “realigned” business.
During 2006 and 2007 Mr Lamb started to pull the trigger, spending GBP 170mln on three acquisitions aimed at growing the engineered products businesses. Total capital employed by the business (excluding goodwill) grew 50% from 2005 to 2008. Mr Lamb was doing the right things to improve profitability and compound shareholder wealth. Growing revenues resulted in cost efficiencies – revenue per employee rose 20%. Operating profit margins rose from around 10% to over 13%. This 30% improvement in profitability coupled with the 50% growth in capital employed resulted in profit growth of roughly 100% over those four years. Everything was going well! Then the recession hit in 2008 and 2009.
Mr Lamb’s response to the recession was to play defensive, perhaps spooked by the 22% decline in IMI’s cyclical “precision” valves business, which sells to automakers. 15% of the workforce was let go. Capex was cut to GBP 37mln, down from GBP 50mln in 2007, and IMI’s acquisition strategy started in 2005 was put on pause. Such a response at the time is totally understandable and actually worked to further improve cost efficiency when the recovery started. By 2011 IMI was doing GBP 2bn of revenue with 14k employees compared to GBP 1.6bn of revenue with 19k employees when Mr Lamb took the reigns in 2001.
As the economic recovery became more entrenched Mr Lamb again started to invest back into the business, spending GBP 117mln to buy Zimmerman & Jansen, further boosting the critical products division. IMI made a further acquisition in 2012 and then something changed. Growth at IMI’s critical product division, which sells to power plant operators and petrochemical facilities, slowed as the rampant pace of industrial infrastructure construction in many emerging markets cooled. Maybe Mr Lamp was bitten by the “double dip” bug and once again IMI went into retrenchment mode. Capex of GBP 83mln combined in 2012 and 2013 was close to the lowest ever spent in any two year period by the company, and just 68% of depreciation. Despite an increase in R&D it is hard to argue Mr Lamb was acting on the strategic priorities he outlined at the end of 2010: “… to increase investment in sales and engineering resource” and “… use balance sheet to fund further acquisitions.”
It seems Mr Lamb’s focus was rather on a further disposal. In 2014 IMI sold its “retail dispense” division. Systems used to dispense beverages from fountain machines at restaurants are clearly not a critical component of restaurants’ business process and thus such systems do not command the same profit margins as IMI’s other products. The decision to stop investing precious capital into that division was probably a smart one. But nonetheless Mr Lamb never used the disposal as an opportunity to push more investment into the company’s highly-engineered products divisions.
So this is the IMI Mark Selway inherits. All the low-margin, non-customer-critical divisions have been sold – about GBP 1.4bn of revenue . The workforce is down to less than 12k – the lowest in over 25 years. As Mr Selway said in his FT interview: “What I’ve got left is pretty much a flow control related business. At the maximum there’s about £100m of non-core assets in the business so it’s a great place to start. You don’t have to worry about all that portfolio fixing.”
Mr Selway quickly understood a key reason why IMI had not been very successful in deploying capital, particularly in 2012, 2013 and 2014. IMI evolved as a set of diverse acquired businesses, each with autonomous decision-makers. The company had no group-wide IT systems or shared facilities. IMI was operating as a mini-conglomerate, which made allocating capital difficult.
This “siloed” approach had the added cost of poor inventory and asset management. Without an enterprise resource planning (ERP) system and shared facilities even division at IMI had to operate with lots of redundant capacity and lots of excess inventory. The CEO could not “see” beyond two weeks of sales. Industry peer, Emerson Electric, carries about 50 days of inventory compared to over 90 days at IMI. That is equivalent to GBP 100mln of unnecessary capital. Mr Selway is not wasting time addressing these issues: an Oracle ERP system is being implemented and in June 2014 a new global intranet was launched. Almost everyone across the business now knows the company’s strategy and its progress against that plan.
IMI’s engineered products divisions reported combined operating margins of around 17.5% over the past seven years. These are similar margins to peer, Emerson. However Emerson carries a low profit “network power” division. Comparing the companies on a like-for-like basis shows Emerson with operating margins around 19% compared to IMI’s 17.5%. In fact, best in class peer, Rotork, thanks to its lean, outsourced production model has operating margins over 25%. The difference between IMI and its peers is not in product set or market position, it is in operating efficiency. Both Emerson and Rotork report operating costs around 22% of sales versus 27% at IMI.
Mr Selway earned his stripes in “lean manufacturing” techniques while working at a Toyota supplier. At Weir Mr Selway used these techniques to take operating costs from 23% of sales in 2002 to 19% in 2007. He now sees even more of an opportunity at IMI, from the FT: “I think the impact of lean will probably be more substantial than they were even at Weir because they are highly repetitive businesses operating on a global scale.” He has benchmarked the operational performance of every business at IMI. A world class operational performance score is 85% or more. Not one of IMI’s 59 facilities achieved this on first measurement, with the highest scoring only 54%. Mr Selway is a “details” guy – page 17, 18, 19 in the 201 annual report show the scores and targets for every single IMI facility. Mr Selway is aiming for world-class scores by 2018. Better capacity utilisation and leaner inventory will generate the cost savings needed to push up IMI’s operating margins. 20% is a first target. Rotork shows 25% is a possibility. Through his efficiency drive there is no reason IMI cannot at least match Emerson’s comparable operating margins of 20%.
The most important change from Mr Lamb to Mr Selway is not operational efficiency but increased investment. IMI has set a public target of increasing R&D from 3% of revenues to 5% (In 2011 under Mr Lamb’s watch R&D expenses were less than 1.8% of revenues). Capex will increase from 70% of depreciation to 200% with the aim of driving 6% plus organic growth. To benefit from this investment a new, group-wide, standard product development process was launched. From the annual report: “A crucial element of the process is the creation of a cross-functional team under a project manager involving representatives from all necessary functions including sales, R&D, engineering, procurement, operations and finance,” in order that products are produced at the right quality, on time, and at cost. A doubling in internal investment, all else equal, should lead to a doubling in organic growth. Over the past cycle IMI recorded 3% organic growth. If growth can average 4-6% over the next five years that means nearly GBP 500mln extra revenue.
Under Mr Selway IMI will follow-through on building the business through acquisitions. Mr Lamb spent around GBP 500mln on acquisitions during his 13 years as CEO, less than 30% of free cash flow. Mr Selway believes he can double the group’s addressable market through acquisitions in adjacent non-valve businesses. This is the exact strategy he delivered at Weir when he purchased SPM. Peer Rotork is currently executing the strategy too, proving there are available targets . Mr Selway has acted fast, in November spending about GBP 130mln to buy Bopp & Reuther in Germany, which makes safety valves that can be sold to IMI’s existing power plant customers. Mr Selway targets net debt of around 2x operating profit, and together with GBP 100mln of inventory reduction implies around GBP 400mln of acquisition firepower today. IMI intends to continue to pay a growing dividend, which currently consumes about 50% of free cash flow. Thus every year IMI will generate over GBP 100mln in cash post-dividends that can be used for further acquisitions. Over five years: debt headroom, working capital reduction, and free cash flow add up to around GBP 1bn of capital that Mr Selway can deploy. At an acquisition multiple of 2x revenue that GBP 1bn is good for buying GBP 500mln of revenue.
From 2001 to 2013 at IMI Martin Lamb streamlined IMI to focus on bespoke and customer-valued products, which command higher prices and generate higher gross margins. Gross margins of 45.5% compare to 37% when he took the helm. Mr Lamb made some strides improving operating efficiency but as new CEO Mark Selway has learned capacity is still significantly under utilised costing the company 200bps – 500bps in lost margin every year. Most importantly Mr Selway demonstrated at Weir he can deploy all of a company’s free cash flow into smart acquisitions, thereby compounding the company’s cash flow growth. Increased investment internally and through acquisitions can credibly add GBP 1bn to revenue over the next five years. By 2019 IMI can thus report revenues close to GBP 2.7bn. At an easily achievable 20% operating margin that means operating profit of GBP 540mln. If margins can get to 22% – still short of peer Rotork – operating profit will reach GBP 600mln.
Mr Selway targets 2019 operating profit of around GBP 600mln. That is clearly a tough target but not an unrealistic one. IMI has the margin potential and the balance sheet to get there. GBP 600mln operating profit would produce over GBP 400mln in free cash flow, enough to easily sustain a market cap over GBP 6bn. Today IMI is valued at GBP 3.5bn. IMI is indeed one of the very few opportunities in Europe where investors have a reasonable chance to double their money over the next five or so years!