We assign Ametek a narrow-moat rating, although we believe the overall business is on the wider side of narrow. In Ametek’s case, however, it’s difficult to separate the horse from the jockey given the firm’s acquisition-heavy model. Nevertheless, even accounting for management’s capital allocation bias, we believe it’s likely the firm can continue exceeding its weighted average cost of capital over the next 10 years on the merits of its collective businesses alone. We believe the firm’s moat sources primarily include switching costs, followed secondarily by intangible assets, which mirrors our moat analysis in the other diversified industrials we cover.
We see switching costs related to Ametek’s mission-critical highly engineered products found in narrow, defensible niches: the high cost of failure in the vital portions of the end markets it serves; the need for customers to reliably test and measure materials based on environmental and regulatory compliance needs; and to a lesser extent, some modest multiyear contracts with appreciable recurring revenue bases. We also identify intangible assets based on: the firm’s research, development, and engineering prowess, as shown by products that yield both pricing power and premium pricing; valuable and sticky customer relationships, including with original equipment manufacturers and national governments; and to a lesser extent, intellectual property, including patents and know-how. In our view, if management were to turn off the acquisition spigot, we believe the firm’s returns on invested capital would likely rise albeit at the expense of value-accretive growth. For the consolidated business, we model midcycle ROIC including goodwill of about 15%, relatively in line with the firm’s recent historical 10-year average.
We assign EIG a narrow-moat rating, and project midcycle ROIC including goodwill in the lower midteens. EIG is traditionally Ametek’s higher-growing higher-return segment. This segment is also higher margin, owing to its comparably richer fount of direct aftermarket (parts, service, and software upgrades) revenue that we strongly associate with switching costs. Seventy percent of EIG’s mix involves sales of technologically differentiated monitors, sensors, and a plethora of test and measurement tools like spectrometers (instruments that use light to identify and quantify samples). Among a host of other products, EIG sells high-purity germanium-based, or HPGe, detectors, which according to academic papers, are widely considered the gold standard for precise gamma and x-ray spectroscopy relative to silicon detectors. User training is also offered at an additional cost to the list price of nearly $100,000 per unit.
EIG sells portable radiation detectors for U.S. customs, border patrol, and emergency services under a multiyear contract with renewal options. This contract was awarded by the U.S. Department of Homeland Security under the Human Portable Radiation Detection System. Of the five contractors initially chosen to improve and enhance their radiation identification technology, DHS recently selected Ametek to continue in the program. Ametek’s multimillion-dollar contract wins haven’t been limited to the U.S. government. For example, Abu Dhabi’s Khalifa Port, which is the pre-eminent deep-water port in the United Arab Emirates, awarded such a contract to Ametek as its primary radiation and nuclear threat inspection solution provider.
These devices are mission-critical instruments that are designed to detect and prevent the illicit trafficking of nuclear materials in the world’s largest ports of commerce. This high-resolution technology can positively identify weapons-grade nuclear or other radiological materials, even when shielded by other radioactive sources that may fool lower-resolution lower-cost silicon alternatives. We note that HPGe detectors have 20-40 times better resolution when compared with sodium iodide detectors. We also highlight that in 2011, the year of the Fukushima nuclear disaster, EIG’s sales of radiation detection equipment saw an appreciable spike, which we believe helped drive segment organic sales growth to record highs on a year-over-year basis (over 17%).
According to DHS, these types of monitors are also preferable because they provide a nonintrusive means of screening people, vehicles, or other objects when testing for the presence of these materials, saving governments time and expense. High-resolution technology also eliminates false positives that are common with lower-resolution technology. False positives can also slowdown the flow of commerce, which is yet another reason Ametek’s radiation detectors can save taxpayer money. At the same time, these monitors eliminate the need for protracted individual searches.
The high cost of failure associated with these detectors is further self-evident: if governments fail to detect radioactive materials and prevent them from entering their borders, the health and psychological well-being of their respective populaces are at stake. The only way to detect certain radioactive material is by the amount of radiation given off, specifically, gamma radiation at various energy levels. According to foreign policy experts, the threat of a crude fissile nuclear bomb in the hands of terrorists is admittedly low given the technical difficulty with manufacturing such a device, as well as difficulty gathering enough weapons-grade uranium or plutonium. What many foreign policy experts agree on, however, is the highly probable threat of a so-called "dirty bomb," whereby conventional explosives are used to disperse radiation from a radioactive source.
Regrettably, the ingredients for a radiological dirty bomb, which employs the same isotopes that are used in life-saving blood transfusions as well as cancer treatments, are located at thousands of sites in over 150 countries. From our understanding, many of these sites are poorly secured and vulnerable to theft. The biggest single theft concern would be Cesium-137. Cesium-137 is a powder that is far more dispersible relative to other agents that can be dispersed only as metal pellets. It also has a half-life of 30.2 years, meaning it remains radioactive for a long time. While few lives would be lost because of an initial dirty bomb blast (orally administered Prussian blue can be ingested to counteract the effects of radiation poisoning), a single dirty bomb using Cesium-137 could render several metropolitan blocks unusable, threatening the health and well-being of the citizenry in surrounding areas. Given lingering radioactive contamination risks, billions of dollars in damages would likely ensue.
Leveraging its R&D and intellectual property used in nuclear detection devices, Ametek also developed a chemical identification system that both rapidly and safely identifies hazardous chemicals inside munitions or chemical storage containers through nondestructive gamma ray analysis. This system is also entirely portable and works without the need for liquid nitrogen as a coolant, nor does it require the use of shielded radioactive sources. We believe few companies have the technical expertise to compete with Ametek’s brand Ortec in the radiation detection market, with only companies such as private company Mirion and narrow-moat Thermo Fisher coming to mind.
While these are only a few examples of the products available for sale through EIG, we believe many of these same competitive advantages are prevalent throughout the entirety of the segment’s portfolio. For example, in terms of R&D prowess, Ametek’s Zygo business supplies critical instrumentation and components found in the Laser Interferometer Gravitational-Wave Observatory. This observatory successfully detected gravitational waves, which was critical in three recent Nobel Prize-winning physicists’ work that proved one element of general relativity theory. As result of these factors, we believe EIG can likely generate 10 years’ worth of excess returns on capital, even when including goodwill.
We consider Ametek’s electromechanical group, or EMG, to have a narrow moat rating, and model an upper-teen, midcycle return on invested capital for the segment. We also base our assessment on switching costs and intangible assets for the EMG segment. With the exception of its aerospace exposure, EMG is the more original equipment and Tier 1 manufacturer-focused segment of Ametek’s business, which is why we posit it earns lower, albeit still strong, operating margins in the lower-20s. EMG is a niche supplier of differentiated automation solutions, thermal management systems, specialty metals, and electrical interconnects to a wide variety of end markets. Seventy-five percent of EMG sales involve automation and engineered solution sales, including specialty motors that are used in a wide variety of household and commercial appliances, food equipment, lawn equipment, as well as industrial-grade blowers. Many of Ametek’s motor contracts have inherent price escalation clauses.
Moreover, as in EIG, EMG has historically won major contracts with national governments, such as its agreement to equip submarines with interconnect systems that install cabling interconnects between the outside water and the inside of the submarine. These are highly engineered parts built to withstand high amounts of underwater pressure. In some mission-critical applications, like in the submarine example, or in Ametek’s contract to design and manufacture engine data concentrators for both the U.S. Air Force and L3 Aerospace Systems, suppliers like Ametek will collaborate closely during product development stages with its customers. Data concentrator units, for instance, are specifically tailored to avionic requirements, and support real-time conversion of aircraft sensor data into a digital format. Other examples include Ametek’s manufacturing of heat exchangers, which are found in U.S. tanks and are designed to cool the crew and electronic equipment, or its multimillion-dollar contract with Lockheed Martin for the U.S. Navy’s testing of naval avionics used in both shore-based and sea test applications. The customer costs of switching to marginally cheaper products that meet a similar reliability and performance standard in harsh and hazardous environments (for example, moisture-proof and hermetically sealed) is meaningful both in terms of time and expense.
Some of Ametek’s products are mission-critical in other ways, such as those acquired through the Rauland-Borg acquisition, which provides niche clinical communications and workflow solutions for hospital and acute-care facilities. We believe this business could benefit from value-based care initiatives because Rauland’s value proposition (and the value proposition of nearly all workflow solutions) is to reduce customer costs, as well as improve nurse productivity and efficiency. These solutions can help nursing care facilities comply with Medicare requirements, which, in theory, may lead to higher levels of reimbursement. Rauland’s solutions, for instance, also allow hospitals to share real-time data to optimize patient bed management and help reduce the time nurses spend looking for the correct patient room. According to the U.S. Centers for Medicare & Medicaid Services, healthcare costs as a percentage of U.S. GDP now total nearly 18% (over $10,000 per person), about 10 points higher than other advanced economies. Chronic disease like asthma and diabetes is on the rise, as are surgical procedures. The aging baby boomer population could provide this business with a long runway.
Other offerings in this space also have inherent high cost of failure, such as EMG’s fault recorders on high-speed rail systems. Fault recorders provide complete electric power quality trends and alarm management of all substation events providing real-time indicators, as well as high-resolution post-mortem analysis in the event of a fault. Other Ametek solutions perform similar functions, like automating crisis solutions in schools to keep students safe in the first few moments before first responders arrive. We point out that the first few moments of an emergency, whether it be in law enforcement, fire suppression, and emergency medical services, are often considered the most important. As a result, well-regarded brands like Rauland are also somewhat valuable. Relatedly, EMG's material science expertise with metal powders in oil and gas drill bits or with ceramics in aerospace sheathing applications also indicates the presence of intangible assets. Accounting for all these factors, we believe EMG will also generate over 10 years' worth of excess returns.
Ametek combines some familiar elements of wide-moat Roper's asset-light and narrow-moat Danaher and Fortive's "buy-it and fix-it" strategies within its own operations. Ametek's portfolio mostly consists of mid- and long-cycle businesses that operate in somewhat mature niche markets and where over 95% of its products compete on differentiation. Further, Ametek typically holds first or second market share positions in oligopolistic and duopolistic markets, with share typically hovering around 30% (but upward of 50% in certain precise instrumentation markets); we think this is a testament to its market segmentation strategy. At 1,900-plus global engineers strong, Ametek also allocates about 5% of sales to research, development, and engineering (about 50-100 basis points below innovative firm 3M), which allows it to yield on average about $7.30 of returns on research capital (current year gross profits divided by prior year R&D), about $1.60 below 3M but well above the $5.50 average of other well-regarded innovative companies we cover.
Ametek’s new vitality index (sales from products Ametek has introduced over the past three years) typically totals 25%, relatively in line with statistics reported by both 3M (30% over a five-year basis) and Danaher (high 20s over a three-year period). This sustained level of R&D spending also allows Ametek to take price greater than inflation (positive price inflation spread typically hovers in the 20- to 30-basis-point range), which is somewhat exceptional. In our observation, most moaty industrials typically use price to offset raw material costs and tariffs, but generally don't have greater-than-inflation pricing power. For example, net of its electronics business, wide-moat-rated 3M typically raises prices 50-70 basis points year over year (or 30-50 basis points when including electronics). Additionally, Ametek needs to spend only a near-industry low of about 1.8% of sales on capital expenditures, while working capital hovers around only 11% of sales. This allows Ametek to generate free cash flow conversion rates of nearly 120%, which, in our view, is best-in-class and toward the upper end of our diversified industrial coverage. These factors give us confidence in our 10-year horizon excess return projection.
Ametek’s returns on tangible capital impressively hover over 100% and the company's historical returns have safely exceeded our estimated, normalized WACC over the past 20 years. Even so, we still lack the requisite degree of confidence needed to award a wide-moat rating given our strict 20-year forward hurdle combined with Ametek's slimmer excess return profile, when baking in goodwill. While we don't base our moat ratings on relative assessments, we have awarded multi-industry wide moats based on similar 700-800-basis-point projected excess return spreads. Roper Technologies is one such example. However, in Roper's case, the firm's go-forward mix is evolving toward increasingly asset-light and less capital-intensive sales--only Roper's average free cash flow conversion regularly exceeds 130% in our coverage, which gave us added confidence in assigning that rating. Given the nature of its software businesses, Roper also benefits from negative working capital thanks to large amounts of deferred revenue that it can continuously reinvest at incrementally higher returns on capital, albeit Ametek's balance sheet reveals it has also begun to benefit from customer advances in 2018.
In terms of our competitive moat framework, Roper's business model is protected by a strong third moat source in the network effect, which is the rarest moat source across our coverage but traditionally the most lucrative in terms of ROIC. We note that Ametek does appear to have elements of network effect in Rauland-Borg because presumably the more hospitals that are added to the network, the better the quality of data that is shared among practitioners (and the better the corresponding quality of patient care). However, we point out this is probably not typical throughout a significant portion of Ametek's portfolio. Furthermore, 60% of Roper's consolidated business generates recurring revenue, which we believe shows even stronger, immutable switching costs. This figure stands as high as nearly 70% in rival Danaher.
Ametek’s recent acquisitions in Telular (65% recurring revenue) and Spectro (25% recurring revenue) have elements of these characteristics, but Ametek's overall business lacks these qualities. By our count, as of 2018, about 20% of its overall business portfolio has recurring, aftermarket revenue. Finally, while both wide-moat 3M and Ametek have proven track records of innovation, 3M's gross margin typically exceeds Ametek's by nearly 15 percentage points. We believe this better prepares 3M to weather economic storms, which is partially why 3M's returns historically exceeded our estimated WACC by about 3 times, even while both businesses generate similar GDP-plus organic top-line growth rates.
By contrast, we believe Ametek’s business model is inherently more comparable to narrow-moat rated Idex in terms of its preference for market adjacencies (in other words, the markets it knows best), as well as narrow-moat rated Danaher and Fortive in terms of driving continuous operational improvements. For example, we think a large part of why Ametek can achieve its M&A targets of an ROIC of 10% by year three post-acquisition is its ability to drive significant margin improvement in acquired companies (at a minimum, over 200 basis points within a short period of time after an acquisition). Ametek will typically buy moaty businesses but identify cost synergies throughout a target's supply chain. The firm relies on its own local-for-local suppliers that manufacture in low-cost regions to meet its stated acquisition goals. These are pre-qualified suppliers with skillsets ranging from circuit board construction to precision machining and casting, which can significantly drive down a target's bill of material costs--by 20% to upward of 30%. Material costs, from our understanding, are typically the highest cost found in niche industrial technology.
Other areas Ametek will drive down acquired companies' costs include shared services, such as human resources, IT, tax accounting, and legal expenses. This is a similar playbook to both Danaher's and Fortive's, which is modeled after the Toyota production system. Nevertheless, while Ametek's results are impressive, we consider this a hallmark of operational excellence and part and parcel of our stewardship analysis for the firm. A business such as Roper, by contrast, is really limited in the amount of step-up it can drive in a target's operating margins given the types of software-related businesses Roper typically acquires (implying these may be inherently moatier without managerial improvements).
Finally, while Ametek has significant exposure to highly contract-oriented industrial end markets with deep moats like aerospace and power plants, where higher-margin aftermarket revenue can easily span two to three decades, we surmise this exposure still represents a minority of its end-market exposure given the firm's preference for heavy diversification. We point out that aerospace, which is one of Ametek's largest end markets, for example, represents only about 15% of consolidated sales. For these reasons, we hold off from awarding Ametek our highest moat rating.