A blue-chip engineer with the wind in its sails

This is where IMI (IMI) comes in. The bespoke manufacturer's valves and actuators (which open and close valves) are used by clients in everything from energy to biopharma. The company returned to the FTSE 100 last year, and its prospects look increasingly encouraging as margins widen and demand from key end markets picks up. Ahead of its interim results on 26 July, now is a good time to take a fresh, in-depth look at the business. 

The business model

IMI's operating structure was condensed into two core divisions last year. The automation business (which includes process automation and industrial automation) delivered 60 per cent of revenue in 2023, with the rest coming from life technology (climate control, life science and fluid control, and transport). Almost half of sales came from the higher-margin aftermarket, with IMI offering installation services, repairs and replacements via its team of "valve doctors".

Process automation is particularly focused on the aftermarket, which means that automation as a whole is the more profitable side of the group, with an adjusted operating margin of 19.1 per cent last year. Demand is also strong, with the process automation business reporting a record order book at the end of 2023. Life technology is hardly floundering, however, with a margin of 18.1 per cent, comfortably above the average for UK industrials. 

As well as serving a range of sectors, the company is geographically diverse: around 40 per cent of revenue comes from Europe, a quarter from the US, a fifth from Asia Pacific, and the rest from locales including the UK and the Middle East and Africa. Over the past decade, the company has increased its relative exposure to the US and cut its business in Asia Pacific, which has supported higher margins.  

Ultimately, however, IMI is still a cyclical business, directly exposed to the ups and downs of its end markets. While organic revenue rose by 4 per cent in the first quarter of 2024, certain sub-divisions struggled. Industrial automation, for instance, was down 5 per cent on muted industrial activity, while climate control (energy efficiency products for buildings) was down 4 per cent on weaker European construction levels. 

Over the longer term, IMI has also disappointed from an organic sales growth perspective, lagging the UK industrials sector by 2.7 percentage points, according to investment bank Berenberg. 

IMI has taken several proactive steps to improve its performance, however. Industrial automation, which is very cyclical, now generates a smaller proportion of group revenue than before, and there is more focus on the aftermarket and IMI’s life science and fluid control business. Clients include ventilator and food and drink manufacturers.

Analysts at RBC Capital Markets think that around a fifth of IMI’s revenue would now face significant cyclical risk in a downturn, compared with 60 per cent in 2008. The bank adds that the company's operating margins have "been much more resilient than average in widespread cyclical downturn phases". 

Meanwhile, the balance sheet is improving. The company has a manageable net debt position, with the £640mn balance at the end of 2023 made up of interest-bearing loans and borrowings, lease liabilities and a bank overdraft. 

Deleveraging is in progress, after acquisition spend raised the net debt to adjusted cash profit ratio to 1.8 times in 2022. This fell to 1.3 times in 2023, and is set to reduce further as free cash flow growth ramps up. Free cash flow climbed by 48 per cent to £234mn in 2023, and the consensus is for this to surpass £320mn in 2025. 

An improved growth outlook

IMI’s organic growth trajectory has been improving too. Average organic revenue growth was 5.7 per cent between 2021 and 2023, compared with just 0.7 per cent in the decade to 2023. This sluggishness was largely the result of a weak oil and gas market, which resulted in less capital expenditure ending up in the hands of IMI. But now things have turned a corner.  

The oil and gas sector is set for a "significant catch-up" investment period after years of undersupply, according to Berenberg. At the same time, IMI is diversifying to benefit from renewable energy trends. The energy security environment in the aftermath of the pandemic and Russia's invasion of Ukraine will only drive demand. 

The process automation business is taking particular advantage of growth in liquefied natural gas (LNG), demand for which Shell (SHEL) forecasts will rise 50 per cent by 2040. In the first quarter, energy product demand helped drive process automation revenue up 27 per cent, while underlying demand for energy efficiency services “remains strong” at climate control. 

Management has also identified reshoring as a likely tailwind. If manufacturing work moves to higher-cost economies, this will encourage companies to increase automation in their factories – and could push them towards IMI's industrial automation products and services. 

There are plenty of short-term headwinds at play, as highlighted by the latest trading and the expectation that life technology growth will come in flat in 2024. But the improved outlook is seen in the more robust ‘through-cycle’ targets set out last year for annual organic sales growth of 5 per cent, along with an adjusted operating margin of 20 per cent, a cash conversion ratio of 90 per cent and a return on invested capital of over 12 per cent. 

On a sectoral basis, the board wants to see annual organic growth of 5 per cent in process and industrial automation and climate control, 5-10 per cent for life science and fluid control, and 3-5 per cent for transport.

Whether the company can hit its 20 per cent margin target will be key. The signs are promising, based on the 4.5 percentage point improvement between 2019 and 2023. This has been driven by the 'complexity reduction' programme implemented by chief executive and former Halma (HLMA) director Roy Twite. The programme has already delivered over £100mn of cost savings.

Liberum analyst Edward Maravanyika expects the company to achieve its margin target in 2025. He added that structurally higher margins should mean "less need for restructuring initiatives and the associated one-off restructuring charges going forward", in a context where one-off charges have averaged 2 per cent a year since 2015.

Cheap versus competitors 

IMI's most relevant flow control rival is FTSE 250 business Rotork (ROR). Rotork has also enjoyed a boost from the energy market; its first-quarter update in April disclosed sales growth in the mid-teens fuelled by a strong performance from oil & gas and water & power operations. Its adjusted operating margin is higher than IMI’s at 22-23 per cent over the past few years, and it sits on a net cash pile.

Other options for investors in the UK industrials space include Spirax (SPX), Halma and Spectris (SXS). Destocking still plagues the sector, however, and a June profit warning from Spectris, flagging weaker electric vehicle and pharma demand, suggests not everyone is out of the woods yet. 

Consensus forecasts are for average growth of 5 per cent at Rotork over 2024-26, ahead of the 4 per cent at IMI. But investors need to pay a significant premium for that higher growth. A key part of the IMI bull case is the combination of an improved outlook and unfairly meagre valuation. The shares trade at 14 times forward consensus earnings, notably below peers. 

Given its valuation, growth outlook and forward free cash flow yield of 6-7 per cent, a case can certainly be made for the shares. If IMI can hit its growth targets, as seems increasingly likely, a re-rating is on the cards.