Colfax Corporation (CFX)

October 2, 2019

Colfax Corporation (CFX)

A criterion of our process in evaluating great businesses for our Undiscovered Compounder strategy involves the concept of a repeatable business model. A repeatable business model is a simple set of constructs that drives successful execution of each strategy, in all markets, in all parts of the business cycle. In the same way that success in any skill-based competition is often predicated upon prior incremental improvements over time that build and strengthen the relevant neural pathways for the said skill, a repeatable business model rests on well-defined core principles that are repeated consistently over time. These well-defined core principles ensure that team members understand company goals and how their own individual responsibilities push those goals forward. This alignment of incentives across the organization then ensures that the flow of information is fast and accurate, which in turn enables management and front-line employees to anticipate customer needs and remain one step ahead of competitors in sourcing future growth opportunities.

 

Danaher Corporation’s system of continuous improvement, the Danaher Business System, is an apt representation of a repeatable business model. The Danaher Business System provides the constructs from which all employees meet quality and cost benchmarks as they deliver superior customer satisfaction and profitable growth. The continuous improvement mindset then reverberates across all aspects of the business, from cost efficiency in production, to new product development and marketing and sales execution. The end result is market share gains and sustainable earnings growth over time.

 

Investing in Colfax today is like investing in Danaher in 1991. In 1991, Danaher was a little over a year into a portfolio transition in which CEO George Sherman repositioned the portfolio into less cyclical businesses. Sherman did this by divesting business lines that sold to troubled, cyclical industries. The high-quality remaining businesses then operated as platforms from which Danaher executed bolt on acquisitions. Bolt on acquisitions built scale, which created operating efficiencies and pricing power that strengthened Danaher’s strong positions in growing, niche markets. The end result was three decades of 20%+ annual shareholder return.

 

Today, Colfax is at the end of a multi-year portfolio transformation that repositioned the portfolio from cyclical businesses to businesses with recurring revenue and secular growth tailwinds. The new Colfax consists of two segments; Fabrication Technology and Medical Technology. Fabrication Technology develops consumable products and equipment used in welding applications. Medical Technology is a developer, manufacturer, and distributor of medical devices for use in injury prevention, surgical repair, and rehabilitation. With any business that we invest in, we look for multiple ways to win. With Colfax, there are five.

 

First, we see opportunity in the analytical complexity of Colfax. Colfax’s two-year portfolio transformation began in 2017 with the divestiture of the Fluid Handling business. 2018 was defined by bolt on acquisitions to strengthen and diversify the Air & Gas segment. 2019 is defined by further complexity from the acquisition of medical device company DJO Global, and the recent divestiture of the Air & Gas segment. The goal of the transformation process was to create a fast growing, high margin company that generates cash consistently throughout the business cycle. Strong cash flow throughout the cycle then feeds a long runway of tuck in acquisitions and high return on invested capital investments that support faster innovation and strengthen the business. This transformation has made Colfax an orphaned equity. What many know of Colfax is the old Colfax, a Danaher relative with end market exposure to oil industry capital expenditures, coal fired power plants, and the cyclicality of the macro economy. The new Colfax is a high-quality business with over 90% of sales from recurring run rate products, long term secular growth tailwinds, a significant runway for bolt on and adjacent acquisitions, and a proven, repeatable business model to execute over the long term. The new Colfax does not yet have a dedicated analyst base or investor base, and this orphaned equity status and analytical complexity has created a valuation discount of over 50%.

 

Second, we see opportunity from an upcoming inflection in earnings. Shortly after the DJO Global acquisition closed in February 2019, Colfax management undertook a large restructuring plan. Investments in DJO Global were made to strengthen the businesses foundation to support scalable, long term growth. As the capex cycle rolls off, margin expansion will come from process improvements in the supply chain, procurement gains, improvements in the reimbursement cash cycle, and the scalability of volume growth from recently released products.

 

Third, we see opportunity in the long-term secular growth tailwinds driving the DJO Global business. DJO Global's product line of braces, artificial shoulders, knees and hips span the spectrum of injury prevention, surgical repair, and rehabilitation. As product innovation is supported by secular tailwinds from increasing orthopedic injuries in an active and aging population, leading market positions are set to grow. Additionally, as reimbursement shifts to an outcome focus, and treatment shifts to outpatient post-operative rehabilitation, there is an increased need for connected medicine to enable remote patient monitoring to ensure treatment compliance. DJO Global is in pole position to derive outsized value from these long-term secular growth tailwinds.

 

Fourth, we see multiple platforms within the Medical Technology segment. The Danaher and Colfax playbook entails building platforms with sufficient market size in fragmented industries with core market growth and a long tail of subscale participants that can be acquired through a low risk, repeatable, tuck in acquisition process. In Medical Technology, we see at least two platforms in Orthopedic Solutions and the broader medical technology business. From this footprint, Colfax will use its repeatable business model to make bolt-on acquisitions that provide synergies, and to make acquisitions in adjacencies that then function as standalone businesses. This represents a longer-term opportunity, that, due to typical time arbitrage dynamics, is not reflected in the valuation.

 

Fifth, we see Colfax eventually splitting into at least two companies. Colfax's segments in Fabrication Technology and Medical Technology do not make a lot of business sense as a combined entity. We believe that as Fabrication Technology and Medical Technology continue to scale their businesses, Colfax will eventually follow the path of Danaher and split into at least two separate companies.

 

All told, we get these five legs to our investment thesis at a valuation discount of 50% to Fabrication Technology peers and Medical Technology peers. We are underwriting 100% upside in the medium term, and multiples of that in the out years. As margins expand, earnings grow at a double-digit rate, and internally generated free cash flow feeds the tuck in acquisition machine, we believe the continuously improving repeatable business model will compound over the long term.

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