2023-08-22 23:10:32 ET
Summary
- IMI's first-half results were slightly better than expected, with revenue growth and improved margins, driven largely by the company's leverage to the long-cycle refining, petrochemical, and oil/gas markets.
- Destocking and cautious capex is hitting short-cycle industrial and life sciences markets, including automation, but IMI is also benefiting from investments in new areas like LNG.
- IMI plc looks undervalued for investors willing to withstand cyclical ups and downs, with exposure to growth opportunities in green energy, automation, and life sciences.
I can understand why investors would be nervous about companies that depend significantly upon longer-cycle process end-markets like oil/gas, refining, and so on. These markets have held up quite well as shorter-cycle markets have started to slow, but sooner or later these markets will likely follow suit and history suggests the peak-to-trough moves will be more dramatic.
Even so, I think IMI plc ( IMIAF ) (IMI.L) may still be undervalued here for investors willing to hang on through the cyclical ups and downs. I do see some risk of negative earnings revisions in the second half of 2023, but trading below 8.5x forward EBITDA, the share price already seems to anticipate that. What’s more, I think the market may be ignoring the company’s longer-term leverage to growth opportunities like green energy, including renewables and hydrogen, as well as automation and life sciences.
A Decent Beat, But Not Thesis-Changing
IMI managed to do slightly better than expected in the first half of 2023 (IMI, like many British companies, reports on a semi-annual basis), with the main drivers of the good and bad news not really out of line with the broader trends in the industrial sector. Namely, there is ongoing evidence of destocking and order weakness in many industrial markets (including industrial automation), while autos and trucks hang in there on improved supply chains and process industries like oil/gas and refining continue to perform quite well.
Revenue rose 12% as reported and 7% in organic terms, good for a very modest beat versus expectations, though the organic growth rate was over a point better than expected (with the Street underestimating the negative impact of currency). Process Automation grew 15%, Industrial Automation grew 2%, and Climate Control grew 5%. Life Sciences and Fluid Control contracted 3% and Transportation was up 6%.
Gross margin improved 90bp to 47.1%, and I think that strong gross margin is worth noting again as it does reflect (in my view) high value-add for the company’s products and good manufacturing efficiency. Adjusted operating income rose 21% (13% in organic terms), good for a 4% beat versus sell-side expectations. Margin expanded 140bp to 17.8%, beating by 60bp, and incremental margin of 31% is pretty good all things considered.
Waiting For The Process Market To Turn
Broadly speaking, IMI’s results weren’t surprising relative to other industrials. One of the most apparent themes coming out of the second quarter is the significant level of customer destocking that industrial companies are seeing.
What is still very much up for debate is how much of this is normalization in the wake of improving supply chains (companies were socking away components in inventory in response to shortages/supply chain interruptions) and how much of this is running down inventory ahead of a downturn in demand. Manufacturing PMIs are below 50 in all the major regions (China, the EU, and the U.S.), but end-customer demand still seems to be holding up better than some had feared earlier this year (myself included).
Like many, IMI is seeing more weakness in shorter-cycle industrial markets, including automation, where many companies have seen significant weakness in orders as many customers hold off on capex spending amidst a great deal of uncertainty over end-user demand in 2H’23 and into 2024. That puts management’s comments about “uncertain” markets squarely in line with many other industrials ( Dover (DOV), Eaton (ETN), Parker-Hannifin (PH), et al) and some tougher year-ago comps in areas like life sciences aren’t helping.
In contrast, most process automation end-markets remain strong. Markets like refining and downstream oil/gas remain healthy, and IMI saw almost 9% year-over-year growth in its refining/petrochemicals business, as well as 46% growth in oil/gas. Autos and trucks are more like hybrid markets at this point, with both getting a boost from improving supply chains though with weakening demand outlooks. Last and not least, climate remains a healthy end-market on the commercial side as customers continue to look for energy-saving opportunities (which IMI targets).
At some point these longer-cycle markets are going to turn (they always do…), and there is some risk that such a downturn will coincide with a short-cycle market environment that seems unlikely to see a sharp drop but could see a more prolonged “bumping along the bottom” troughing cycle.
Still, while I don’t like to understate the risk that negative earnings revisions could be on the way, I do think there are IMI-specific opportunities and drivers that offset this risk to at least some extent. In my opinion IMI has undervalued exposure to growth opportunities in cleaner energy, including LNG (strong right now) and hydrogen. It certainly remains to be seen how much of the eventual decline in oil, gas, and petrochemical capex can be offset by greener opportunities, but I think we’re also a long way away from leaving hydrocarbons behind.
The company has also been investing in growing its portfolio of solutions within Climate (including the Heatmiser acquisition) and Life Sciences, both of which I see as attractive long-term growth markets. Last and not least, IMI remains leveraged to the ongoing growth of industrial automation, including still-underpenetrated markets like food/beverage and general manufacturing.
The Outlook
I understand taking a cautious approach here given sub-50 global manufacturing PMIs and the likelihood (if not certainty) that longer-cycle markets aren’t going to get stronger from here in this phase of the cycle. It remains to be seen whether the U.S. economy can “thread the needle” and avoid a recession, but there are definite signs of a slowdown across Western Europe and the U.S., and China’s economy has likewise been looking quite a bit softer lately.
As I said, I think there is some risk of a downward revision cycle for IMI (and the larger sector) in the second half of 2023. Moreover, given how companies will often hit “pause” on spending in election years given uncertainty in economic policies/incentives, that weakness could linger throughout 2024, particularly for capex-heavy categories. Should 2023 revenue growth come in closer to 4% and 2024 revenue growth closer to 1%-2%, there’s definitely some near-term risk for the shares, but I still think IMI would achieve its 5% longer-term revenue growth target, as I continue to expect meaningful investment in industrial automation, climate renovation, clean energy, and energy infrastructure in 2025 and beyond.
On the margin side, again, there’s near-term risk if the economy turns more sour than I expect, but I think mid-20%’s EBITDA margins are achievable in 2025 even if 2023/2024 end up weaker than the Street currently expects. Longer term, I expect free cash flow margins to improve toward the mid-teens. Management has already executed on a lot of self-help projects, but I see the company continuing to use M&A and internal R&D to drive a richer product mix both in terms of growth and customer value-add (meaning higher margins).
On the basis of discounted cash flow, including 2023 and 2024 estimates that are below the Street, I believe IMI is priced for a high single-digit long-term total annualized return, which I consider pretty attractive for a company with IMI’s qualities (including a mid-teens ROIC). I also consider the current sub-8.5x forward EBITDA multiple to be too low; even accounting for near-term cycle risk and longer-term risk from overexposure to fossil fuel power generation, petrochemicals, and oil/gas, I think a sub-10x multiple is too low and I think the shares could be at least 20% undervalued on that basis.
The Bottom Line
As is usually the case with quality companies, potential bargain hunting comes with risks – in this case the near-term risk of a downturn in longer-cycle industries and a sharper downturn in short-cycle markets and the longer-term risk that the company is too dependent on the traditional hydrocarbon economy. I think those risks are more than priced into the shares, though, and I think this is a name worth considering for investors who can stomach shorter-term volatility in the pursuit of longer-term gains.
For further details see:
Even Accounting For Risks In Process End-Markets, IMI Seems Undervalued