update -- DCI, APH, IEX, ADBE

Wow, I apologize -- didn't realize that the last post I made was last Tuesday -- I swear I wrote another piece since then but its not on the site so it doesn't count.

Been doing lots of reading -- more than I should have about various stocks -- mostly industrial types like Donaldson (DCI), IDEX (IEX) and Ametek (AME) as well as many others. I was looking for a consistent grower with good return on assets that had strong free cash flow as well as high international sales that also wasn't just an acquisition story. Didn't really find one yet. I would say I like the ECL story better than all of those others.

Donaldson (DCI) really looked good until I looked at the cash flow. Here are the numbers -- free cash flow (cash flow from operations minus cap ex) and net income.

2002 $107 mill (vs. net income of $86.9 mill)
2003 $99 mill (vs. net income of $95.3 mill)
2004 $70 mill (vs. net income of $106 mill)
2005 $87 mill (vs. net income of $110 mill)
2006 $79 mill (vs. net income of $132 mill)
2007 $40 mill (vs. net income of $150 mill)

The decline in free cash flow is both due to lower cash flow from operations (higher receivables and inventories) and increased cap ex. Notice the progression from more FCF than net income in 2002 to FCF of barely more than 25% of net income. This sure implies that earnings quality is poor and that the reported EPS are overstating the profitability of the company -- not that you would notice from the stock, which has done well. I would touch it myself -- it may work through this with no trouble or it could blow up hard with a huge earnings miss -- not worth the risk.

APH -- hugely successful over the last few years with much faster growth and much higher margins than its peers -- its all about management focus and execution. The management is focused on the higher margin products and on adding new product areas to drive growth. They are less than $2 bill in sales amongst a $40 bill industry -- very low market share. However they are earning 20%+ operating margins vs. others in the industry closer to 10% at most. That's great, I love managements that focus on profitability and not just growth. They also have great return on assets -- 12-14% so its not just margins but they also know how to manage assets too. What concerns me are 2 things -- 1. is the valuation/stock performance and 2. just how much of the industry is 20% margin business?

The stock has done really well over the last several years -- remember its the future that matters -- but you have to have confidence in the business and what it is likely to do to make sure you are not buying in at the top. I guess I just don't have that confidence, given the second point. There is $40 bill in industry revenues but how much of it is 20% operating margin business? To earn twice the industry average you have to find niche areas that have much less competition. Either these are technically very difficult or they are small volume customized deals or they are protected in some other way from price competition. So how much of the $40 bill is high margin? tough to say but it means their market share is higher than it first appears. Say the high margin part is 20% of the total -- that's $8 bill and that means they are at 25% market share rather than the 5% you first thought. I'm sure they have plenty of room to run for at least the next couple of years but at some point they are going to hit a wall and either have to accept lower margins or slower growth.

APH has some good secular growth parts -- electronicization of more products (i.e. increased electronics content in more products) has been going on uninterrupted for about 50 years. That should drive industry growth of high single digits. I will definitely keep a watch on this one but I'm nervous at these valuation levels.

I was reading something on real money last Friday and it got me thinking about ADBE again. I have watched this one from a distance for many years but never bought any or really understood its position. I spent some time over the weekend in between the Greek festival and my church's annual picnic reading up on ADBE -- its a great story but I'll save the details for the next note.....