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- [00:00]
A
Finley is a debt capital management software that I wish I had during my private credit days. Finley is also today's sponsor of business breakdowns and it's a company that's solving a pain point near and dear to my heart. In my credit days, we spent way too much time coordinating diligence trackers. The internal versions, the external versions, the banker versions, and our borrower management operations always felt like they were the same as they probably were in 1996. And and I know it wasn't specific to us. Regardless of what other funds we were working with on these projects, it was always the same. Just ask around and you'll find that nearly every operator or investor has experienced the operational nightmare of managing debt capital. The reason? Most corporate loans come with hundreds if not thousands of pages of reporting requirements and gotchas. And historically there's been no way to avoid the tedious back and forth of lender borrower interactions. Finley translates these unstructured credit agreements into code, it puts every party on the same page, and then it streamlines the credit management life cycle. So you can think about covenant reporting, interest and fee tracking, portfolio analysis. If you have a revolving credit facility, the ability to borrow. All of this is sped up. Borrowers like RAMP and INOVA rely on Finley to track and automate reporting requirements for hundreds of millions of dollars in debt capital. And then you have lenders like Trinity Capital Valley bank using Finley as a command center for debt capital data, workflows and analysis across all their transactions. So that's gonna include fund finance, securities based lending, syndicated loans, the full gamut. So if you are on either side of the table here, you can learn more and request your demo today@finleycms.com this.
- [01:56]
B
Is business breakdowns Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you. To find more episodes of breakdowns, check out joincolasis.com all opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.
- [02:44]
A
This is Matt Russell and we are replaying one of our favorites today, our breakdown of Ametek with Nail Fakhri, co CIO of Osterweis Capital Management Growth and Income Strategy. Now, Ametek is a really nice pairing with last week's episode on Jack Henry. These are two businesses with very long track records executing a playbook. For Ametek, they are a serial acquirer but unlike many other with that classification, their playbook is to target markets with 200 million to 300 million in total addressable market. They aim for mission critical components which make them a must buy. It gives them some pricing power, but the smaller size of that overall market insulates them from having new competition come in. Ametek is number one or the number two player in the markets that they operate and they maintain 25 to 30% market share. All of these things are very specific to their playbook and like many high performing conglomerates, they run a decentralized model. The overall employee base is over 21,000 employees, but just 150 sit at HQ. So Neil gets into all of this and much more throughout the episode. It's an excellent discussion in terms of some of the qualitative dynamics of their strategy, but also the quantitative numbers to bring it home. It's one that left me reading much more and more about Ametek over the past year. If it's your first time listening, enjoy. And even if you have listened, I think it's worthy of a revisit if you so please enjoy this breakdown on Ametek. All right, Nayal, thank you for joining us. To break down Ametek, I thought just to kick this one off, they're self described as this manufacturer of high tech industrial solutions. But I thought maybe you could help us come up with a better way just to describe as simple as possible what Ametek does that and then we'll jump into the meat of the conversation from there.
- [04:42]
C
Sure. So the way I would describe Ametek on a one line basis is that it's a niche manufacturer of highly engineered products across a very broad range of end markets. It's not just one product or one set of products. In fact, you've probably never heard of most of these products, but they play a really critical role across a bunch of industries.
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A
Can you talk maybe just about those end markets? Are there specific ones that dominate the revenue pool? Anything that you can share there on the end markets to give us a better picture as well?
- [05:16]
C
The way the company describes it is that there are a handful of end markets that dominate. The largest is Medtech. That's a little more than 20% of total revenue. And then you have aerospace and defense, military, that's a little under 20%, about 18 19% of revenue. The power market, the serving utilities and others, that's another 10%. Automotive is another roughly 10%. And then you have semis, R and D and then just other industrial. There are four or five markets that are 50 to 60% of sales, but those are the major end markets.
- [05:51]
A
It's quite a diversification of end markets there. Is there something that's unifying what they're actually selling? You gave us some sense in terms of how highly engineered products, manufactured products, but is there something that's kind of unifying all of those products across those end markets?
- [06:08]
C
Yeah, what I would say is. So first of all, there are probably tens of thousands of components and parts and products that they sell. Because if you look up any one business unit within AMETEK and there are over 40, you'll find that that one business unit might sell couple, three, four or five thousand parts. So it's a really broad array, but I think the one unifying factor across products is that they are mission critical. They're really important to the operation of some larger system, but the costs are actually usually really small relative to the overall cost of the system. So think about a component that goes into a part on a commercial jet. That one component is very low cost, but it plays a really important role. And the jet might cost tens or even hundreds of millions of dollars. Or a subsystem in a manufacturing line for semiconductors, or an underwater electrical connector for a submarine.
- [07:09]
A
Usually in the history of doing the show and looking at businesses leads to some type of pricing power as well, whether the company decides to take it, but that representing a small percentage of the overall cost, but being mission critical is usually a good formula that leads to pricing power, in my experience.
- [07:25]
C
Yeah, exactly. And that's the case here.
- [07:28]
A
Would you say there's anything unique about these various end markets that they're targeting? Anything that they try to do that might unify their strategy in terms of how they're approaching it?
- [07:39]
C
Yeah, I would say it's not necessarily the specific end market. I mean, they do obviously have a focus on certain end markets they find more attractive, but it's the structure. So if you talk to the company or if you talk to former employees, you get a very consistent message that Ametech tends to be number one or number two. They're always going to be the dominant player. They want to be in really small markets. So on average, the market size, the whole market is about 2 to $300 million in size. And they tend to have, on average, it's a Very broad sweep number, but it's about 25 to 30% share on average in each market. They will actually avoid markets that are really large in size, say a billion dollars or more, because they don't want to attract competition from the larger players that are seeking growth. So they don't want to be in really huge profit pools, which is actually smart because while hard to grow in that, it just avoids competition. So typically you'll see 1, 2, 3 global players that are dominant. Ametek is one of them, typically one or two number one or two. And the rest of the market is very highly fragmented among a bunch of mom and pops. And the other thing about their end markets is they tend to be highly regulated. So if you think about what we've talked about, Medtech and Power, these are really highly regulated markets. Products tend to be specked in and therefore are pretty sticky.
- [08:59]
A
Yeah, it's subsegments of bigger end markets, but very interesting. Just in terms of running counter to the traditional example of going after a big tam. Can you talk a little bit about where their products or where their manufactured parts might be showing up in meaningful projects or anything that might resonate with a listener?
- [09:22]
C
I think that's actually a really good way to frame it because their products tend to be ones you've never heard of and they're components in larger parts. So, for example, NASA, you know, they launched a rock into space a few years ago to basically study an asteroid belt. And they used the solar X ray monitor that amatech, which is an amatech company, produces, and they used it to basically measure the spectrum of the X rays reaching the asteroid and therefore map the asteroid. So it's obviously very unique, very differentiated. NASA's not going to just choose any supplier. And another interesting one, actually close to home here in the Bay Area is Lawrence Livermore Laboratory. They've been doing fusion energy research for decades, actually. And basically what they do is they bombard a pellet of hydrogen plasma with the world's largest laser and create a nuclear fusion reaction. And to do that, they actually have to use really highly specialized optics. And they actually use Zygo, the optics produced by Zygo for research on fusion energy. And Zygo is an amatech company. So it gives you a sense of this is really highly engineered, highly specialized type of stuff that Ametek is producing. Those are really on the EIG side of the business if you shift to emg, something that I think is equally important but probably a lot less sexy and a little less interesting. But I Think equally important is powdered metals. They do the shape wire. So SMP Wallingford, which is an amatech company, does the shape wire for the push pull mechanisms in flight control on commercial jets. So these are wires basically that are 4/100 of an inch in diameter. So really small, really important, they fit into this much larger jet to actually help control it. So again, this is a really broad range of products serving all kinds of customers. But that's the bread and butter of what they do.
- [11:14]
A
Thinking about how this all came together, so much of what we look at now is either a single product, product business, or something that's focused in a specific sector. So just bring us back in time a little bit in terms of how Ametek came to be, whether those individual divisions grew up organically together, whether they were acquired, whatever you think are some of the key moments in the history bringing us to where we got to today.
- [11:39]
C
It's kind of interesting because I got to know the company almost 20 years ago. I worked at American securities, which is a private equity firm. And the first deal that they ever did was a company called Katima. They lbo Katima, which was a spinoff of Ametek. It's the only spinoff they've ever done. And that deal basically enabled American securities to become the private equity firm that it is. Latest fund was $9 billion, become a pretty sizable player. And one of the co founders, American securities, was on the board for 35 years at AMETEK. So I kind of studied Ametek for years because it was considered the model company to acquire. They sell these kind of niche products where they really dominate this small market that they're in. And each of these products generate lots of cash and then can go and use that as a platform to acquire other adjacent products and businesses. In terms of the history of the company itself, the predecessor was a company called Manhattan Electric Supply Company and actually went bankrupt in 1929. And then the company emerged from bankruptcy in 1930. It was called American Machine and Metals at the time, and it was actually just a producer of commodity industrial parts for laundry machines and a bunch of other things, but over time gradually became more profitable and by 1944 was actually able to acquire a company called US Gauge for about $3 million. And that is a pressure and temperature gauge business. Amatec actually 80 years later, still dominates that market. So this gives you a sense of kind of the origin of the business. And then 1955 is when William Rosenwald, he invested a significant stake in American Machine and Metals his dad was Julius Rosenwald. And Julius Rosenwald had bought a controlling stake in Sears Roebuck, built the Sears catalog that we've heard of, and turned Sears into the Amazon slash Walmart of its generation. So William Rosenwald, his son, was really just trying to kind of diversify, bought this company and pushed it into continuing to do even more niche products. And that year 55 is a seminal year because they acquired Lam electric for about $34 million and really focused on these kind of precision components, niche electric motors for small appliances. And today Lam Electric, if you look it up, it's a really dominant brand by the biggest brand within vacuums, other applications, basically. The company eventually named itself Ametek and continues acquiring through the 60s and 70s. By 1980 was doing about $400 million of sales of these very kind of highly engineered parts. And by 1988 they realized, okay, we have some businesses that we've acquired that are a little slower growth, they're not as niche. And so that was Katima, which is actually Ametech spelled backwards. And it was 14 different business units that they spun off. And again, like I said earlier, it was LBO'd by ultimately LBO by American securities after they were spun off, because the Rosenwald family, they owned 20% of Ametek at the time. And so they received a commensurate stake and really obviously were familiar with this spun off business. And then in 1990, Walter Blankley, he became CEO and he was actually an engineer at Amtech for 30 years and laid the foundation for what would become the Amtech growth model. New product development, operational excellence, global and market expansion, then M and A. And his goal was double digit annual earnings growth and achieving what he called superior roic. So he was trying to systematize the continued growth of the business. And he was really independent. I mean, he at one point cut the dividend by 2/3 and bought back a third of the company over three years because he thought it was undervalued. He really focused on we have to own and build and buy differentiated businesses. So he actually separated the water filtration business in the late 90s because he thought it was overly commoditized. And then you get into the 2000 period, this guy, Frank Hermance became CEO. He'd been at Ametek for about 10 years and he basically took the blankly model and just applied it going forward. So lot of M and A and really big focus on margins, that operational excellence and the earnings compounded about 15% until he left in 2016. And you get to the present. David Zapico is the current CEO. He's an engineer by training. He'd been at Amtech for 27 years. So you see this recurring theme of people who are engineers who have really dyed in the wool Ametek employees and understand the Ametek growth model. The two things that he's done that have been a little bit unique have been. One, he sold Reading Alloys, which was a little bit of a commoditized specialty metals business that was tied to oil and gas. And he's really focused M and A on these niche growth businesses to try to increase the future organic revenue growth. So obviously there's always been this focus on these differentiated businesses, but he wants to own businesses that have a little more growth and that's really worked well because you've seen the organic revenue growth of the business pick up since he took over about seven years ago. So I think the last thing is if you go back to 1955 and it's a long history, but it's actually kind of amazing. Revenues have compounded at anywhere from 7 to 9% annually. To get that kind of high single digit revenue growth through the cycle, obviously not year in and year out, but through the cycle is pretty, I think, amazing and speaks to the durability of the business over time across different leaderships.
- [16:50]
A
Yeah, it's quite a unique history. I mean, just the various things that you mentioned there. It stands out to me that the engineering focus and the advanced, very, very mission critical parts has always been core to the DNA. But certainly over the last 30 plus years that capital allocation as well. I think when you see these businesses, sometimes we'll often cover them. The conglomerates or the mixed end markets tend to end up spitting out and almost becoming just more focused on a single product line. As a shareholder or as an investor who's looked at this name for a while. When you balance that niche market along with the capital allocation, where do you put management in terms of capital allocators and ranking them? Like how do you think about them in that regard? Because that's something that's certainly standing out to me in that description of the history.
- [17:46]
C
I think that management has been really effective over time and really introspective and thoughtful about allocating capital. They've never actually had a write off of goodwill in the history of the company. So this is a company that dates back almost 100 years now and they've obviously done hundreds of acquisitions over the history of the company. And even reading alloys, you know, that was a company that was purchased in 2008 for $110 million. Viewed as not the most successful unique business, they sold it for $250 million in 20, 20, 12 years later. So I would say management is really competent and thoughtful and I think a lot of that ties into their compensation. I mean, it's not the most unique compensation incentive scheme, but they do focus on the short term organic revenue growth, earnings growth, margins and free cash flow that's part of their annual comp. But then longer term there's a return on tangible capital and relative shareholder return metric that they're also compensated on. And I think that balance of those factors is really important because if you're incentivized to grow revenue, you're going to grow revenue. If you're incentivized to expand margins, you'll do it at all costs. The balance of organic growth, margin expansion, free cash flow generation and returns on capital, I think that's worked out really well. And I don't think it's a coincidence that the business has done what it's done over time.
- [19:06]
A
Yeah, I think your point there and look at that incentive schedule and what they're prioritizing and that's usually where you'll find the company prioritizing their focus. I do want to get into the segments, at least in terms of the way that the company presents them. It breaks out. The Electronic Instruments Group, the Electronical Mechanical Group. Do you view those as separate? I mean, the size is certainly different, but when you look at the margins, 25% versus 28%, there's a lot of similarities. Just when you approach looking at this business, do you separate those significantly?
- [19:43]
C
Yeah, I mean, only because they separate them. It's just easier, you know, that's how the management team looks at it.
- [19:49]
A
You're right.
- [19:49]
C
They're kind of hard to really penetrate when there's generic names. Electronic Instruments Group and Electromechanical Group. But the one way to divide it is that the eig, Electronic Instruments Group, it serves the process, the power, industrial and the aerospace markets and the EMG, the Electromechanical Group, which is 30% of sales, serves A and D medical, automation and other industrial markets. So I think using that set of parameters helps separate the two.
- [20:17]
A
Yeah, and markets. And they certainly both sound niche just from the cheap seats over here. It's always interesting to see how management will split those things out. We talked a little bit about the Ametek growth model which incorporates many different things, but maybe we could just start with the top line. How do you think about what goes into top line growth, which has been, based on those statistics that you just provided, quite impressive over the years. But when you think about organic growth versus what they're acquiring and how those two things go and trend over time, how do you think about that for.
- [20:52]
C
Ametek, I think that's the right way to think about it because you can't really look at this because of the question you just asked. You can't really look at this at a unit level because you have so many different products across different divisions. So you kind of have to look at it on an aggregate basis. And the other thing you have to keep in mind is it is a cyclical business. It's an industrial cyclical. So you have to look at it kind of through the cycle. So through the cycle, organic revenue growth is roughly 4%. Now, part of that is because of the acquisitions that have made over the last several years, which just structurally are growing faster. I think under David's Pico, the organic growth used to be closer to 2 to 3%. But I think 4% through cycle is a reasonable algorithm to think about the top line growth. And it's primarily price led. There's some volume growth that comes in year in, year out. But pricing is important. So, for example, this year the company thinks they can do about 3% pricing probably will be a little bit better is my guess, but I think that's a good benchmark. And then acquisitions represent another roughly 4% through the cycle. That'll vary obviously year to year. At the end of last year, they just completed their largest acquisition in the history of the company. But I think the 4% organic plus the 4% acquisition gets you to 8%, which is right in the middle of that 7 to 9% historical growth rate that they've generated.
- [22:09]
A
And on the organic growth makes sense that they would have the ability to increase price on the volume side. Is this all the original equipment that they're manufacturing the parts for? Is there anything regarding replacement? Just thinking about that trend line over time.
- [22:27]
C
Again, it's so many different end markets, but I think it's primarily aftermarket parts. They do do OEM as well. They'll supply to oem, but aftermarket is the primary source of demand for their products. And they don't disclose this, but periodically, if you talk to the company or if you talk to actually former employees and competitors, it's something like 30% of their revenue is really recurring. It's just a replacement part and you need to replenish it every few months or every year or something like that. And that used to be 15, 20% years back. So they've tried to increase it and I think they have but broad sweep across the whole business. It's about 30%.
- [23:04]
A
And one interesting data point that I saw was that 25% of sales in. Can't remember if it was 20, 22 or one of the most recent years. 25% of revenue came from products that were released in the last three years. That would indicate to me that innovation is key here. Is there anything else that you would point to in terms of what's driving that new product representing that high percentage of revenue?
- [23:34]
C
Yeah, it's 25% of sales, I think in last year were produced from products that were released in the last three years. That's part of their Ametek growth model. Your listeners are probably familiar with Danaher. They have the Danaher business system and Ametek has Ametek growth model. And new product development is actually one of the four pillars of the Ametek growth model and that innovation. A couple things I would say the CEOs are. David Sapico is an engineer. He's been with the company for years. They have 2900 engineers on staff here in the US and outside the US and they invest about 6% of sales in research, development and engineering. And that's actually increasing over time. That 6% is pretty significant. It's actually in line with Danaher I just mentioned significantly higher than Honeywell or Illinois Tool Works. And so that is a core part of their Ametek growth model because they've acquired some of these businesses literally going back to the 30s and 40s. And so you have to invest in the products and innovate and work with your customers so that you can remain kind of leading edge and maintain your dominant position. Because they're in these niche markets. But there is competition. And so that's a really core part of what they do. And I think it's important to driving the organic revenue growth and driving those volumes because you can obviously get lazy and juice your margins by not investing. But I think they realize that that's not a sustainable approach.
- [24:54]
A
Yeah, it acts as a unique marketing tool in some ways I think as well, because it points to how much they are releasing new products. And I'm sure when there's competition in end markets, that's consistently important.
- [25:06]
C
I would say just in terms of price. If you're telling your investors, hey, we're raising price in excess of cost by 50 base points, 100 basis points, you have to Be able to turn to your customers and say, well, we're also investing for this product innovation that we were telling you about. I think there's reality to it. I don't think it's just marketing, but you're right, it is marketing as well. I think it's important.
- [25:25]
A
Yeah, absolutely. Works hand in hand. And before we get to the margins, one other thing that stood out in terms of the revenue is that 50% is coming from outside of the U.S. was the international growth story an actual thing or was this always kind of a globally diversified business where a large chunk of sales were coming from outside.
- [25:47]
C
The US I think that was an intentional development as the business grew. And again, that's part of the Ametek growth model is product and market expansion. That's one of the four pillars. That's a separate pillar. Because as the business grew, and especially Asia grew economically and grew in importance as a customer base, you had all these new end markets where there was all this manufacturing. And if you're a supplier of these niche components, you have to be in these markets. And so as demand there grew, they intentionally expanded there. They've done acquisitions to serve customers that are outside of the United States and they're also in Europe and I mean, they're all over the world. But that was, I think, an intentional part of their approach. And if you look at what they do today, if you talk to the former employee there, one of the consistent themes that'll come up is that that product and geographic expansion, market expansion is key because you may acquire a business that has no sales and in some geography or to some customer base, but this other business at Ametek has really strong sales there. And they can use their relationship and their scale and leverage to expand into that market. And that's beneficial for everyone. It's beneficial for the acquired company and it's beneficial obviously to the customer who has an additional supplier.
- [27:03]
A
And on that point, it was something that I wanted to get to a bit. Just in terms of the synergy potential with any of these acquisitions, is there a lot of cross selling going on? Is there anything that they point to? Just in terms of when we have a salesforce in this existing region or in this end market, we find that a large percentage of what we acquire can get a revenue opportunity that they didn't already have. Is there anything unique about that? Just in terms of the synergy potential and what you just mentioned before, I.
- [27:31]
C
Don'T have a statistic in terms of their success in cross selling, but. But again, if you Talk to the company, you talk to for employees, you talk to competitors. You definitely hear that it's a key part of what they do because they view it as basically a platform of company they might have in a market. And to the extent that they can add a product line and sell it and lock themselves in more with that customer, it's beneficial obviously to them.
- [27:56]
A
And the last point on the international markets, I think it's always interesting. You see a lot of US players try to implement their business model abroad. Walmart, UPS, FedEx. Oftentimes there's a big learning curve where it's not just an apples to apples thing. It sounds like there's a little bit more natural growth or extension abroad here with what they're making. Is that fair to say?
- [28:21]
C
Yeah, I think it's completely natural for what they do because like I said, so much of the manufacturing is done abroad that if you're selling a critical component to a customer that's already abroad, they're likely to use you for a new product. The other thing is that huge portion of their engineering staff is in India. And so a lot of the research and development that they're doing is coming from outside of the United States. So the knowledge and expertise and they're working with other companies is happening abroad. And so I think this expansion abroad has been a very natural kind of expansion of the business. Haven't heard of any sort of big blow ups that they had over the last 20, 30 years by expanding abroad. The way you have heard from many companies over time who try to do kind of a single big push. This has been more organic.
- [29:09]
A
That makes sense. Transitioning a bit to the margin profile of the business. We touched on it a bit before. 25% operating margins in that electromechanical group, 28% on the EIG group. Impressive margins for manufacturing business and industrial business. Can you talk just a little bit about how that's trended over time? I love in industrials you get to talk about the incrementals and the decrementals through cycles. So any color you can give there would be useful.
- [29:38]
C
The way management thinks about margins, they look at the op margin of the business. So if you just go from that, they generate about six and a half billion of revenues. An annual basis, 26% EBIT margins on a consolidated basis for the company. That was last year. If you go back to 2005, they were doing 16% margin. So you went from 16 to 26 over that 18 years. That's a really significant amount of margin expansion. And so the question is, how did you do that? And your point actually is right. So their incrementals, if you look at their incremental margins, typically they're about 35%. It's a cyclical company. So some years during a soft patch, they're not going to put up those types of incrementals, obviously, and they'll have decremental margins. But over time they've consistently generated about 35%. Last year they had over 40% incremental margins. As I think about it, that is a reasonable benchmark to think about it, because you're consistently generating those types of incremental margins. The business should be headed in that direction. So we can talk about some of the drivers of that.
- [30:40]
A
You've jumped me on my next question, which was going to be where they're getting that leverage and that margin expansion, whether it's the labor line or anything else.
- [30:48]
C
If you just look at the P and L, you can see we talk about roughly 8% revenue growth historically annually. But the gross margins have grown at about 10% annually and EBIT operating profits grown about 12%. So clearly you're getting some improvement at the cost of goods level and then some fixed cost improvement as well. And I think there are a handful of things going on. So first of all, the Ametek growth model, which again I keep coming back to, but it's something that's been ingrained in the company for decades now. And it's one of these things where again, you talk to former employees, they'll tell you that's kind of what you live by. The first leg of it is operational excellence. It's kind of the cornerstone of the business. And what does that mean? It means they are constantly trying to figure out how to pull costs out of the business and do things more efficiently. This is not about constant headcount reduction.
- [31:38]
A
Or anything like that.
- [31:39]
C
It's more about we are trying to improve our manufacturing process. What are the best practices if we get a new company that we've acquired, what have we been doing in this division or this business unit to produce things more efficiently? They're doing all kinds of Lean and Six Sigma and other things, but they're also using their scale to procure inputs at a better cost. And the greater scale they have, the greater leverage they have to improve their costs. And then they're operating in these niche markets, especially as they acquire new businesses and as they cross sell, as we talked about earlier, and expand, they have more and more leverage and they can price. And so they typically, if you go back to say 2017 when they started disclosing this, they price ahead of cost inflation by anywhere from 50 to 100 basis points. So if you're constantly trying to improve your operational efficiency and your manufacturing and use your scale and procurement and you can actually get price ahead of cost by 50, 100 basis points, that's a really good recipe for margin expansion. And even the pricing alone, I mean I've seen it across other companies. When you can get pricing ahead of cost by that level, it doesn't seem that impressive. But you do that year in, year out, it's going to add up. And I think that combination of factors is what's really driven the gross margin expansion. And then if you think about sga, this is a business where you acquire a new business and you put it on the platform. They have a very decentralized approach. They're not adding a ton of headcount at headquarters, they're just adding another business. And so you get this SGNA leverage to as you sell through distributors and even through your existing salesforce.
- [33:13]
A
Yeah, I think the Ametek growth model, depending on which business it is, oftentimes you hear them. In this particular case, I think you can point to the performance of the business and get an understanding of the credibility that goes into that growth model there. Where for others it might be just more show here. I think there's a case to be made that is a very big part in terms of how they work now they operate. I did want to get into that operational approach and when you're managing all these different businesses with all these different product lines, you tapped into it a little bit there in terms of that decentralized approach. Is there anything unique there? I think talked about Danaher, there's some other great examples of businesses that transdig try to make sure that they're incentivizing the individual business units. What does Ametek do?
- [33:59]
C
Yeah, both those companies actually come to mind as good analogs to what Ametek does. This is one of the two things that really differentiate the business in terms of having a decentralized approach and wrapping the Ametek growth model into it. So in terms of decentralized approach, they have about 21,000 employees at the company, but only 150 are actually at corporate headquarters in Berwyn, Pennsylvania just outside of Philadelphia. So you think about there's a small corporate headquarters, but all the decision making is pushed down to the business unit level. So they have 42 different business units that roll up into 11 divisions that roll up to four, group presence who report to the CEO. But those business units, those 42, that's where everything is really going on in terms of the operations of the business. So each of those business unit managers has PNL responsibility. That's what they're doing day in and day out is they're trying to improve that PNL for that business unit. This is from again, talking to former employees. About 75% of the comp is at the business unit level. The manager of that business unit really cares about what he or she is able to do to maximize profitability and grow that business over time.
- [35:09]
A
Very interesting to see how these businesses that come together through acquisitions are worked through. Is there anything else regarding the integration of new businesses into the business model that we haven't talked about that you think is interesting?
- [35:23]
C
Yeah, I would say what's really important here, actually, this kind of touches on the last part of the Ametek growth model, which we didn't talk about, which is acquisitions. That's the fourth leg of stool. So it's operational excellence, the new product development, the global market expansion and acquisitions. And the end goal of all of it is that double digit earnings and revenue growth, significant free cash flow, and then strong and improving returns on capital. Acquisitions are this really key component because they acquire a business about half the time that acquisition is coming from the business unit level. So a manager will say, hey, if we were to acquire this adjacent product line or business, it would really improve our position with our customer. And by the way, to the extent that business that's acquired is helpful, it's going to help the business unit manager. And if it's not helpful, the business unit manager doesn't want to own that business. So they're constantly looking at these acquisitions to kind of improve their offering. And then they can use their operational excellence and develop new products and expand into new markets with that acquired company and therefore drive margins, which drives higher free cash flow, which enables you to kind of do this all over again. So it's this virtuous cycle and I think the acquisitions really tie it all together.
- [36:38]
A
I don't know if you have any color on this, but it's interesting to me whether it's former employees who may have mentioned something. But when you have these models, the upside is all great. Sometimes though, the reality is having businesses that maybe could cannibalize one another or maybe it would be better for the overall business if there was things bundled together and that might impact pricing a bit and look negative at the unit level or the business unit level. Have you come across any downsides to the operating model like that or challenges that they've had to work through?
- [37:10]
C
I think periodically what's happened, this is more historical, is that you see that they can acquire businesses that generate lots of cash but don't have a ton of growth. The cash flow generation is a really important part of what they do. And if you overemphasize that, you. You get into end markets that potentially aren't that great and therefore you have slower growth. It's a fine balance because you obviously want a company that generates cash, but you also want some growth because ultimately that's what generates future cash. So I think that's where they've had issues in the past and you've seen the actions they've taken is that's what Katima was. When they had those really slow growth business units, they spun them off because they said it's not core to the business or reading alloys. In 2020, it was tied to oil and gas. It was just cyclical, generated lots of cash. But it just wasn't something that made sense from a growth standpoint. So I think to me that's where they've kind of run into issues in the past, is sometimes overemphasizing cash flow. And frankly, if that's a mistake you're going to make, I'd much rather make that mistake because a business that generates lots of cash theoretically has more downside protection as long as you're not wildly overpaying.
- [38:20]
A
Yeah, I would imagine it makes for an interesting acquisition target too. Divested from the portfolio. And it all points back to them being very interesting capital allocators where you often hear of great purchases. It's equally important to make great sales. And I think that it's harder and harder to find management teams that want to focus on that side of running the business or at least focus on conglomerates and thinking about it through a portfolio approach rather than focusing on one specific product. One of the data points that was really interesting was that 75% of free cash flow over the past decade has gone to acquisitions, which is an incredible number. And I think split the remaining 25% split between dividends and buybacks. One of the challenges that many of these businesses run into as they grow is that it gets harder and harder to find acquisitions that move the needle. You mentioned they just made their biggest acquisition ever. So full falls in line with the need to acquire bigger businesses or bigger assets. But how do you think about that? Whether it represents A risk or the Runway opportunity in terms of the businesses that are out there that they could acquire. Knowing how important that acquisition growth is to the overall model, I think you.
- [39:34]
C
Hit the nail on the head. To me that is actually the single biggest risk as I think about the future of the business. So Paragon Medical was a business they acquired for a billion nine at the end of last year. They actually acquired it from American securities, funny enough. So it all comes full circle. It seems like a fits right in. You know, this is a med tech type business. So they're selling these kind of highly engineered components and instruments for medical devices that are used in surgeries and all kinds of things and orthopedics in particular. And they paid a billion nine for a business that is generating about 150 million in EBITDA translates to about a 12 to 13 times EBITDA multiple. Now historically they paid 8 to 10 times. They've been creeping higher over time. So 8 to 10 times as years back, it is a higher margin business, it's a higher growth business should grow 10 to 11% over time. But when you're acquiring a business of this scale, if you have a mistake, if there's a blow up, it'll just have a bigger impact potentially to Ametech creates a distraction for management to fix this thing. And it just raises the stakes in general. You know, if you look, you point out the statistic of 75% of the capital. So the average deal historically was roughly $200 million in revenue. So this $500 million is more than double what their historical rate has been of acquired revenue. So I think that to me is the biggest risk. Now if you have a business that has been growing for decades, it's just natural that they're going to be new larger deals over time. But you do have to trust management more in terms of their diligence.
- [41:06]
A
And is there anything based on their track record of when they've made bigger acquisitions of those working out or not working out, Is there anything historically? I mean ultimately it just comes down to the next deal.
- [41:18]
C
Just curious, over time you've seen these larger deals do just fine and there just haven't been blow ups like we talked about earlier. They've unwound some deals, but there have not been any really big blow ups. And this question comes up every few years as they gain more scale and then have to look at bigger deals. But I think the discipline of incentives, that's where this is really important. Because if you're focused on improving organic revenue, these deals make a difference because they start filtering into organic revenue. If you're incentivized to improve earnings per share, but also margins and free cash flow, that's a good check. And if returns on tangible capital are a key to your long term incentive comp in addition to shareholder returns, all of that ties in as a check on how these deals go. So I think they understand that the stakes are raised, they completely get that. But just natural that they're going to look at bigger deals as they gain scale. And you've seen this at other businesses as well where there have been deals that have gone wrong with other businesses as they get larger, but there have also been deals that have gone really well. And this is just kind of a natural organic evolution.
- [42:26]
A
Another evolution might be the pricing of these deals you mentioned kind of in the low teens or 12 to 13 times EBITDA for deals, even 8 to 10 times. I think that's probably realistic in terms of what most businesses are paying for deals, but they'll often reference six to eight times. But I would say it screens as certainly not cheap for a lot of those assets. And that's pre synergies, I'm sure. But can you talk a little bit about the valuation point? I think you dove into it a lot there, but it does seem to stand out just as maybe their willingness to pay higher prices for some of these acquisitions.
- [43:00]
C
Yeah, I think as they've gained deeper expertise at integrating businesses and cross selling and pulling out costs and all the other things that they do that are part of the amtech growth model, they feel more and more comfortable that they can pay these multiples. And I would raise two other points. They've been able to extract or generate higher organic revenue growth under David Spico, as he's done deals that are a little more expensive, but the payoff has been there. And meanwhile they've still expanded margin significantly and generated much higher free cash flow and improve the returns on capital. And so I think if you just look at their history over the last seven years as they've shifted a little more to these types of businesses, it's worked. The other thing is that a core part of their M and A strategy, and this has been true for years, is that deals have to be immediately accretive and they have to achieve a 15% minimum IRR using reasonable assumptions. Now you're relying on their judgment obviously and their analysis, but that's really all you can do. And you have to base it on what they've done historically.
- [43:59]
A
I guess certainly tracking the movement in the underlying financials. Over time you're going to get a lagged indicator of whether it's working but seems to be working on the funding of M and A. Certainly cash is a big percentage of this from the business, the free cash flow. Are they using equity or leverage debt financing where they're making these acquisitions?
- [44:20]
C
Yeah, so they don't use equity. If you look at share count, it's been flat for about 20 years now. And like you said, they spend about 10 to 15% of their capital on share repurchase. They're pretty opportunistic about share repurchase actually. If you look at when they've done it, they've really increased it during periods of turmoil for the broader market. They really do view it as an alternative use of capital right side by side with M and A. And if you think about how they've financed their deals historically, they use free cash flow primarily. Their leverage is only. It's under one and a half times on a net basis even after the Paragon deal, which is the largest deal ever. And so they do use a little bit of debt. But I would argue they're significantly under levered now. They don't want to use a ton of leverage. Probably can tell based on the history of the company. They're not a really aggressive company when it comes to M and A and using leverage and financial engineering, that's not what they do. They're trying to buy businesses that can grow over time and where they can improve them. So to me it's a really important, especially in a roll up because this is arguably a roll up. For decades they've been acquiring other businesses. They generate tons of cash. The free cash flow conversion net income is about 115% if you look at it over a long period of time. And then the leverage is I think very conservative, under one and a half times, especially if you're relative to peers. And so they're very thoughtful about how they fund these deals and they don't want to be going out and just issuing shares to do deals. It's not their M.O.
- [45:48]
A
At all. Yeah. On the debt point I think certainly screens is under levered. One of the points you were making earlier was that this is a cyclical business. So you do see some swings. Do you have a sense of historically, whether it's the 1516 industrial recession or 2020, maybe with the EBITDA line did in terms of declines. I think your point on it being a roll up and you have to be very, very thoughtful about how you're using leverage in a roll up is an important one.
- [46:18]
C
It's definitely a cyclical business. And the best I think precedence to understand the cyclicality in a typical slowdown would be in 2001 and then the industrial recession like you mentioned, 2015, 16. In both those cases, revenue was down in 01, revenue was down 1%. In 15 and 16, revenue was down 1% and 3%. Those are total revenue numbers. So not much. But if you look at 15, 16 I think is a good one. Just because it was across two years, the mix of businesses was pretty similar to what we're seeing today. EBITDA was actually slightly up in 2015 despite the revenue decline. And then in 16 it was down about 8%. So you had a decline, but it wasn't a dramatic decline in profitability. In 2009, revenues declined 17%, EBDA was down 13, so a little less. And then obviously in Covid revenues were down about 12% that year and EBITDA was actually up low single digits in 2020. And so I would say there are a couple takeaways. One, the business is cyclical. So you see the top line compression. But EBITDA doesn't compress probably as much as you might think. And the second point which I think is really important is that the snapback in profitability within a year or two is really significant. They quickly are able to exceed, meet and exceed prior levels of profitability and then get larger. And this is something we talk about, I like to touch on is that the companies like Ametek that are, I think really high quality cyclicals tend to do better in these periods of slowdown. And they actually will take share from these small mom and pops and they'll just grow and improve their cost structure. And not only that, they'll actually be able to take advantage of M and A. So evaluations get compressed. They can actually buy companies at a time that everyone else is stepping back. And Emetech is the permanent, you know, in many ways ideal home for other companies that want to sell because it's not a highly transactional business in terms of buying and then selling. They want to hold these companies forever. And actually in some cases, like we talked about in history, literally these companies go back decades.
- [48:23]
A
Yeah, opportunistic acquirers of their own shares certainly have a case to be made there, I think for being potential winners over the long run during those periods. Before we close out on the capital allocation section, just the dividend, it seems like something they are paying. There was that cut which was notable but anything you would point to there in terms of relevance with the dividend.
- [48:46]
C
I think that cut back then was justified. That was, you know, in the 90s, in the early 90s. It made sense at that time because of the broader reality of the shares being undervalued. But they've been paying, they pay a small but growing dividend. So it's about 10 to 15% of their free cash flow generation that they spend on dividend and they consistently grow it roughly in line with their free cash flow per share and earnings growth. To me, I think that's a really good position to be in because it tells me that they have higher and better uses of capital, primarily M and A. And then periodically they'll do share repurchase. And the dividend is kind of the output with the excess capital. But it also, at the same time it creates some discipline. I think this is true across a lot of different companies. When you have these small growing dividends, it does create some discipline. We have to meet this obligation over time and it's more a signal to investors than anything. And meanwhile they can retain internal capital to actually go out and buy companies rather than going out and issuing excessive amounts of leverage or like you were asking earlier, issuing equity, which would be kind of last thing I'd want them to do.
- [49:49]
A
One point that you mentioned earlier, just in terms of the valuation of the deals that they're acquiring and those ranges, I'm just curious how Ametek has trended over time. Valuation methodology you would use as an investor to look at this business, assuming it's some type of EBITDA multiple, but just where it's ranged over time and just general framework for that would be useful.
- [50:13]
C
I look at it both on an EBITDA basis and on an earnings and free cash flow basis. Everyone kind of talks about earnings for this company. The reality is free cash flow conversion is significantly higher. But if you look at it over time on an earnings basis, it's traded in that 20 to 25 times range, which given the returns on capital, returns on capital were back in 2005 or something in the 35, 36% range on returns on tangible capital. Because they do a lot of acquisitions. They're now 80% as of last year. Not only are they really high, but they're improving. And I think improving returns on capital, that's one of the single most important indicators of value creation for shareholders. And so it's not a cheap multiple just in absolute terms, but relative to the quality of the business and proving returns on Capital, I don't think that that's crazy at any one time, but obviously you want to buy it when it's cheaper. And then from an EBITDA perspective, it kind of trades in the mid to high teens. Obviously you have to take into account a bunch of different things. Rates are rated. They are. Now, the market is trading at bit of an elevated multiple at the moment relative to history. Historically. You can think about those earnings multiples over time.
- [51:27]
A
Yep. If you said the market traded and used to be in that 15 to 16 times, but let's say 15 to 20 times. For a business that converts earnings into cash flow above 100% and has those returns on capital, I think getting some premium to that is certainly not unreasonable and why the market would trade it there. A completely fair case. We talked about the risks associated with bigger acquisitions to some extent, cyclicality. Do you think there's anything else that you would point to as a key risk or maybe that other investors suggest is a major risk for the business?
- [51:59]
C
I think one conversation that you'll hear, and I think it's a legitimate question, is around the organic growth of the business. They've achieved high organic growth over the last several years. How sustainable is that? And is the volume growth large enough? Are they capturing these large, growing, structurally growing areas of the economy? They'll talk about automation, they'll talk about renewables, they'll talk about medical device. And semis is a big theme that they play into. But are they really capturing all of that? And my answer to that is one, it's a very good question. It's a fair question. If you look at the organic revenue growth pre 2016, it was that 2 to 3% range through the cycle, which isn't that inspiring relative to nominal GDP growth of say, 4% in the US over time. My answer to that is I think you've now had seven years roughly of evidence that the organic revenue growth is picking up because of the nature of the focus, the business, the separation of some assets that were just lower growth. But I would point to that as the key question that I look at routinely. And like you pointed out, the acquisitions, that's something that definitely you have to focus on and think about and talk to them about. Because if anything changes there, it's not something you can ignore.
- [53:18]
A
Absolutely. This has been a fascinating conversation. We covered the business and the segments and just how they operate the business just as much. And I think some of those are the most fascinating companies to cover. We close out with the lessons that you can take away in this case, Ametek, what would you point to? You've had quite a bit of experience looking at this name over two decades. What would you say stands out as a lesson from looking at Ametek?
- [53:45]
C
I'd say there are two big lessons for me. One is that when you have a company that has very long duration growth and a little bit of margin expansion, that combination is extremely powerful. And it's hard to overstate how powerful that is. You know, they've grown revenue at a 7 to 9% CAGR for almost 70 years now. And that doesn't sound really exciting. You're not necessarily talking about all the latest technology trends, but over time that can be really powerful. And I think that's what's helped lead the company to perform so well from a shareholder standpoint. So that long duration growth, to me, with a little bit of margin expansion, that's a really important lesson, something to anchor on. And then the second big takeaway for me is just to keep it simple. When I first looked at the business almost 20 years ago, it was what I understood was that it's this really simple, repeatable model and it worked. And if I think about over that timeframe, there have been so many distractions and they've stuck to these niche businesses, they improve them, they buy them and they do this year in, year out and they've made improvements, they've made course corrections. But when a business has a really intelligent strategy that's working, adhering to that strategy can be as powerful over time as the long duration growth. And you combine those two, they're tied at the hip. But I think those two lessons for me are really important from studying Ametek.
- [55:04]
A
Absolutely. No, I think it was very well said and I think you offer some unique perspective on this name given the relationship that you've had with it over the years. So thank you Neil for joining us. It was a pleasure.
- [55:15]
C
Thanks Matt. Appreciate the time.
- [55:17]
B
To find more episodes of breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out joincolosis. Com, that's J O I N C O L O ss u s dot.
- [55:33]
A
Com.