(08/05/11) 2 “Baby Conglomerates” to Watch

Conglomerates are usually a safe place to park money in a volatile market, and now a new class of “baby conglomerates” are becoming attractive alternatives to the big names we all know, says Daniel Holland of Morningstar.com.

The basis of any argument for a diversified firm is centered upon some core competency that filters down among its smaller business units:

In the case of Danaher (DHR), the company takes the tremendous institutional knowledge gleaned from the lean manufacturing principles of the Danaher Business System and imposes this process on every one of its segments, enhancing cash flow generation.
General Electric (GE) and 3M Company (MMM) use their massive research-and-development bases to create technologies that are not only useful for an individual segment, but implemented throughout the organization.

Finding these competencies within the smaller firms is difficult, but a solid indicator is when they find ways to creep into new end markets as avenues for growth dissipate in their current location.

For example, Actuant (ATU) pushed into energy-asset management, away from its core Enerpac hydraulic bolt tightener business. Roper Industries’ (ROP) foray into smart-card technology, away from its experience in RF identification and water-metering technology, also fits this category.

SPX (SPW), on the other hand, has struggled to integrate its businesses during the last several years, with no natural linkage among segments.

The Advantages of Being Nimble
Smaller acquisitive firms have one major advantage over larger peers: size. A $100 million acquisition is a big deal for a $2 billion firm, and coincidentally the valuations on these smaller firms tend to be more reasonable than the larger deals.

Because larger firms like General Electric and Danaher don’t get as much lift from these smaller purchases, companies like Roper and Ametek (AME) face less competition for their purchases.

Synergies are often more reliable when buying smaller firms. For example, Actuant notes that by putting acquired firms on its freight contracts, the company is able to generate better operating margins and free cash flow essentially from day one of the acquisition.

It takes several years of aggressive reinvestment to get too big to be pushed out of this strategy, giving investors ample time to take advantage of these firms’ access to more compelling acquisitions.

As always, integration risk should be a prominent concern for investors, particularly as less sophisticated targets get wrapped into a larger organization. In talking with several management teams, one difficult hurdle is simply building a strategic plan with former owners, since these smaller targets are not accustomed to projecting product road maps and doing the relevant market analysis found in larger companies.

NEXT: In Management We Trust

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In Management We Trust
As with any company, investors need to pay particular attention to the leaders of conglomerates. This is particularly relevant since these firms reinvest most, if not all, of their cash flow into the business.

Empire building is rarely a trait that we value, so it is worthwhile to ensure that management incentives have some return-based metrics as well as traditional earnings and sales growth targets. Actuant, IMI Group (IMI), and Crane (CR) stand out as having strong incentive programs aimed at driving profits and growth.

The range of return on new invested capital (RONIC) in our subset varies from SPX’s disappointing negative 1% to IMI Group’s 61%.

Also significant is the amount of cash flow that firms are using to execute their respective growth plans. For example, SPX consumed more cash flow than it generated during the period.

We often cast a leery eye in the direction of Roper, since the firm seems a bit aggressive in its growth strategy and often seeks external financing to support itself. But during the last five years, Roper has proved generated value for shareholders.

It is important to note that when looking at RONICs, significant movement in the metric can occur when a firm sells a low-value, noncontributing business. While it may skew the data, this is often the most appropriate decision.

IMI Group stands out when we look at fundamental drivers of value creation among the smaller diversified industrials. As a manufacturer of highly engineered valves for a variety of end markets as well as heating, ventilation, and air conditioning systems, IMI has benefited from both strong end-market demand and an internal turnaround effort.

The result has been earnings before interest (EBI) margin growth of nearly ten percentage points during the last five years. After going though significant savings initiatives, IMI moved from being the lowest EBI margin firm among smaller diversified industrials in 2006 to the middle of the pack in 2010.

This significantly increased returns on invested capital (ROICs) and returns on new invested capital. The company has a fair amount of capital to grow the business both organically and through acquisitions.

For investors not able to invest directly in IMI’s London shares, we also recommend equipment manufacturer Ametek. The company consistently delivers returns on invested capital above the weighted average cost of capital, and has consistently shown an ability to reinvest within its business at rates that are above the cost of capital.

Ametek is a strong operator, boasting EBI margins of 14.6% and respectable working capital turns exceeding 9 times. Unfortunately, Ametek’s shares rarely come at a discount, currently trading at a slight premium to our fair value estimate.

Closing Thoughts
Smaller diversified industrial firms offer investors more growth potential through acquisitions, though the same metrics that we apply to bigger peers are relevant as well. IMI Group and Ametek have shown they are capable of reinvesting significant amounts of capital and growing in a shareholder-friendly way.

Pruning the portfolio often provides a much-needed lift in earnings, as is the case for both of these companies, but solid bets on end-market growth also help shape the growth runway for the future.