Alphyn Capital Management, an investment management firm, published its first quarter 2021 investor letter – a copy of which can be downloaded here. A return of 6.8% was reported by the fund in the Q1 of 2021, outperforming its S&P 500 TR benchmark that delivered a 6.2% return in the same period. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.
Alphyn Capital Management, in their Q1 2021 investor letter, mentioned Colfax Corporation (NYSE: CFX) and shared their insights on the company. Colfax Corporation is a Annapolis Junction, Maryland-based welding, air and gas handling equipment, and medical devices manufacturing corporation that currently has a $5.8 billion market capitalization. Since the beginning of the year, CFX delivered a 13.52% return, impressively extending its 12-month gains to 89.40%. As of April 09, 2021, the stock closed at $43.41 per share.
Here is what Alphyn Capital Management has to say about Colfax Corporation in their Q1 2021 investor letter:
“Colfax was established in 1995 to reproduce Danaher’s success of acquiring and improving good industrial businesses. By 2017 the business had three main divisions, Fabrication Technology (welding), Air & Gas Handing, and Fluid Handling. While the Fabrication business benefits from access to end markets with secular growth opportunities, the latter two were cyclical businesses, selling to customers in such industries as power, oil & gas, and mining. In 2015, Colfax installed Matt Trerotola, a Danaher veteran, as CEO and embarked on a major restructuring. In 2017 it divested its Fluid Handling business, in 2018 it divested is Air & Gas busines, then in 2019 it acquired DJO Global, which sells orthopedic products, from private equity firm Blackstone. Under Blackstone, DJO had been weighed down by debt which severely restricted its ability to invest in growth. Colfax saw an opportunity to apply its CBS process to an otherwise attractive business.
Today CFX comprises 2 segments, ESAB (fabrication/welding), and MedTech (orthopedics).
ESAB is the second largest player in the $30bn global fabrication technology industry. Its major competitors are Lincoln Electric and the welding subsidiary of ITW. 30% of sales are from selling equipment and almost 70% of sales are from selling consumables, which generates a stream of repeatable revenues. The company provides a suite of software products to help customers manage maintenance programs, comply with extensive documentation & certification requirements, and monitor weld quality including tracing weld operators and part numbers in order to correct errors. This positions ESAB as a solutions provider and not simply a materials supplier, which increases customer stickiness. While welding might at first sound like a cyclical industrial business, a large proportion of ESAB’s sales are directed towards more attractive general fabrication, infrastructure, healthcare & laboratory, renewables and defense industries. Furthermore, 50% of sales are to emerging markets which benefit from secular growth drivers, and the company has acquired capabilities in the faster growing programable robotic welding segment.
MedTech derives 75% of sales from Prevention & Recovery, which largely comprises knee, ankle, and wrist bracing in which it is global leader with leading industry brands such as DonJoy and Aircast. 25% of sales are from surgical reconstruction, with a focus on extremities, such as “reverse shoulder” implants in which it is global leader, with further products in knees and ankles etc. MedTech will benefit from the industry tailwind of a 70% increase in the number of joint replacement procedures over the next decade, driven by an aging but active population. Most procedures currently take place in hospitals, but the proportion of procedures taking place in ambulatory surgical centers (ASCs) and outpatient settings is expected to increase to approximately 50%. This works to MedTech’s advantage as its bracing products are deeply penetrated into ASCs, and its digital solution are integrated into many workflows, which help ASCs manage insurance reimbursement and remote patient monitoring. These existing relationships should help MedTech compete more effectively in reconstruction against large and well-managed companies, such as Stryker and Zimmer Biomet.
Earlier this year CFX announced its intention to split its 2 businesses, as they have little overlap with each other. ESAB, which has been managed by Colfax for many years, will stand on its own under existing leader Shyam Kambeyanda. At MedTech, current DJO CEO Brady Shirley, who is a Stryker veteran with 26 years industry experience, will remain as President, but will be joined by Colfax’s current CEO, CFO and head of business development, who will continue to apply their CBS expertise. Importantly, Danaher/Colfax founder Mitch Rales will remain as Chairman of the Board for both ESAB and MedTech. He will step down from the board at Fortive (a larger Danaher spin out) in order to free up his time to do so, and I read this as a strong indication of his commitment to the success of the future Colfax businesses.
Based on management comments, I estimate that Colfax can grow to a $25bn business, from approximately $6bn today. ESAB had 2020 revenues of $1.9bn with 16% EBITDA margins. MedTech had 2020 revenues of $1.2bn with 18% EBITDA margins. With mid-to-high single digit organic growth, combined with diligent application of the CBS process, including operational improvements and acquisitions, management are aiming to grow each business to $3bn in revenues, with 20% EBITDA margins for ESAB and 25% margins for MedTech. These businesses can convert 90% – 100% of EBITDA to Free Cash Flow. Working through the math, this implies future combined FCF of approximately $1.3bn, compared to approximately $200m today. The publicly listed comps trade at around 20-30x multiples, implying a $25bn+ value. Even if this takes 10 years to achieve, our investment could still compound at 15% IRR from today’s market cap of $6bn.
Much of the thesis relies on an assessment of management’s ability to live up to their comments. For this I believe it is worth discussing some of the Danaher Business System, as it is central to the Colfax story. Danaher was established in 1984 to buy businesses and improve them. The initial businesses were of variable quality and included one called Jacobs Engine Brake, which suffered from low productivity and poor quality control. The Rales brothers hired an engineer and former green beret named George Koenigsaecker, who had previous work experience in Japan, to manage the business. As the story goes,6 frustrated by the issues at Jacobs, he brought in two of the architects of the Toyota Production System to overhaul the company. This was such a success that the company rolled out Lean manufacturing and kaizen (continuous improvement) processes across all their other businesses. DBS has evolved over time beyond the manufacturing floor, and encompasses all aspects of business including supplier, customer, sales, corporate, and even investor relations functions.
DBS is integral to the way Danaher conducts its business, from defining high level core values to providing comprehensive processes and tools to enable employees to execute on strategic plans, with an emphasis on Lean manufacturing, Growth, and Leadership. DBS lays out 5 core values: “The best team wins” – Danaher emphasizes employee selection and leadership development. “Customers talk we listen” – focus on identifying and solving for unmet customer needs. “Kaizen is our way of life” – continuous improvement, eliminate waste. “Innovation defines our future” – drive breakthrough ideas for technology, products, solutions and processes. Finally, “we compete for shareholders” – deliver best-in-class results to consistently attract and retain loyal shareholders.
Danaher deploys these core values through a set of results-driven practical processes and tools, which are applied rigorously and unemotionally. For example, when integrating a new acquisition, Danaher undertakes a comprehensive assessment of managerial talent both at the interview stage, and a few months post-acquisitions after observing managers in operation to sort those who are unlikely to succeed or to fit with the Danaher culture. Danaher creates a three to five-year strategic plan at each operating company. The goal is to identify true breakthrough opportunities for performance and competitive advantage. This is monitored through a Policy Deployment process, where the long term targets are broken down into annual objectives that would need to be achieved along the way. Specific processes improvements required to meet these targets are prioritized and are tracked against specific, quantifiable targets. The appropriate DBS tools (there are over 50) are deployed to address the improvements, and progress is measured monthly and annually. Any shortfalls are highlighted and tackled through a formal Problem Solving Process. As with most things DBS, the Problem Solving Process has a comprehensive set of tools designed to get to the root cause of an issue, and a variety of tools to map out potential solutions.
There is an extreme focus on process, with the overarching goal to identify standard work and maximize workflow through repeatable and measurable functions. The company weeds out people who do not conform to this world view7 and goes to some lengths to train employees. For example, new managers are required to undergo a 2-3 month DBS immersion program before they are allowed to start their jobs. This involves several “kaizen events,” which typically take place at the manufacturing floor and involve a specific target such as halving the floor space required. There is accountability at the highest levels. The belief is that having the president of the company “put on jeans and work boots and get involved with a broom on the shop floor can be powerful in setting expectations.”
Furthermore, DBS emphasizes measurement, through the following 8 core metrics:
• Financial: Core Revenue Growth, Operating Margin Expansion, Cashflow / Working Capital turns, Return on Invested Capital
• Customer: Quality, On-time delivery
• Talent: Internal Fill Rate, RetentionThe Talent metrics are a good example of how Danaher tangibly applies its “the best team wins” core value, as managers, even good operators, who fail to internally develop their team are eventually shown the door. As an example of the way numbers drive processes at Danaher, the former head of logistics at Leica Biosystems (acquired by Danaher in 2006) described in an interview9 his experience with the Operating Margin Expansion metric and the need relentlessly to cut costs by 5% a year, every year. After a few years of successive 5% improvements, he ran into an issue when dealing with a 3rd party logistics (3PL) partner. The 3PL company operated at sub 5% profit margins, so attempting to negotiate better terms to achieve the 5% margin improvement eventually became untenable. Under pressure from his superiors who would not accept failure to cut costs, he eventually used Danaher’s version of Value Stream Mapping10 and Dynamic Pricing tools to overhaul the entire process of working with this 3PL partner, to reduce costs by 50%.
During Larry Culp’s tenure as CEO from 2001 to 2014, Danaher reinvented itself and transitioned from cyclical industrial businesses to more stable, higher margin and faster growing businesses in the healthcare, dental and testing equipment industries. The company learned that its DBS operating improvements had greater impact on businesses with higher gross margins and a big spread between gross and operating margins, as there was more opportunity to take out operating costs. Moreover, a focus on companies with better growth meant less need to resort to layoffs, which would cut people the company had taken the trouble to train. Finally, steadier businesses suffered less during a recession, which would otherwise reverse hard won margin improvements. As a result, Danaher found it could support more debt at cheaper rates to accelerate acquisitions and be more highly rated by the market, which was of enormous value to shareholders over time.
As the late venerable Clay Christiansen noted in his essay “The Big Idea: The New M&A Playbook,” there are two reasons to acquire a company. The first more common one is to boost current performance by attempting to cut costs. While “the second, less familiar reason to acquire a company is to reinvent your business model and thereby fundamentally redirect your company. Almost nobody understands how to identify the best targets to achieve that goal, how much to pay for them, and how or whether to integrate them. Yet they are the ones most likely to confound investors and pay off spectacularly.”
Colfax today, following its purchase of DJO and prospective split, has successfully redirected its growth prospects in a somewhat parallel setup to Danaher under Larry Culp. It is using the DJO business, with its strong positions in bracing and shoulder reconstruction, as a platform to expand into new verticals such as foot and ankle reconstruction and has already executed 6 bolt-on acquisitions in the last 12 months.
Moreover, CBS implementation has already begun to bear fruit. At the March investor day management disclosed:
• Core Revenue Growth: doubled from 2-4%
• Margin Expansion: from 19% to 22% (EBITDA)
• Innovation: the percentage of revenues from new products (“vitality” score) increased from 7% to 11%. The number of new products launched increased from 8 to 32
• Continuous improvement: backorders reduced by 56%, held orders improved by 29%
• Talent: 20% improvement in associate engagementI believe our investment in Colfax has the potential to compound at attractive rates for many years. We are aligned with successful operators who have established highly effective processes for growth via acquisition. As founder Mitch Rales said “the real game here is thinking about the next 10 years and what we can do by compounding off of a very small base… I just think it’s a lot easier to move the needle off of these bases and double the size of the business in the years to come than it is for a larger scale company.””
Goran Bogicevic/Shutterstock.com
Our calculations show that Colfax Corporation (NYSE: CFX) does not belong in our list of the 30 Most Popular Stocks Among Hedge Funds. As of the end of the fourth quarter of 2020, Colfax Corporation was in 36 hedge fund portfolios, compared to 45 funds in the third quarter. CFX delivered a 9.57% return in the past 3 months.
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Disclosure: None. This article is originally published at Insider Monkey.
