Established as a spin-off of Danaher Corporation in September 2019, Envista Holdings Corp. (NVST) is a leading global dental manufacturing company. Under its Specialty Products & Technologies Division (49% of revenue), Envista offers dental implants, orthodontic traditional bracket and wire systems, dental lab products, and more innovative aligners. Additionally, the company offers digital imaging systems, impression materials, bonding agents, and infection prevention products under its Equipment and Consumables Division (51% of revenue).
Solid Competitive Advantages
Though the global dental industry is highly fragmented, Envista’s reach includes more than 1 million dentists in over 150 countries. Furthermore, the company offers a broad product portfolio, covering approximately 90% of clinical needs for dental treatment. This strength and product breadth allow the company to boast a high-recurring revenue stream with approximately 70% derived from consumables, services and spare parts. A continued focus on innovation further enhances the company’s competitiveness, utilizing approximately 6% of revenue for research and development. Finally, Envista’s tenured management team of operating executives and leaders have a long history in the dental industry.
Favorable Growth Drivers
Envista is positioned to capitalize on dental market trends to accelerate growth. First, the industry continues to experience favorable demographic shifts. The aging population is significant since older individuals have a higher dental expenditure per capita. Second, new studies continue to link dental health to overall health, which could help drive dental care to become part of a larger focus on preventative healthcare over time. Third, development outside the United States boasts higher growth dynamics, with the company generating 24% of revenue from emerging markets in 2019. Fourth, cosmetic dentistry continues to experience increased demand and is particularly attractive since it focuses on more profitable product offerings. Finally, after a pause taken to focus on internal operations, Envista will complete tuck-in acquisitions, thereby enhancing its growth trajectory.
Significant Margin Upside Potential
Company operations are based on the Danaher operating culture, Envista Business System (EBS). Since 2015, Envista has invested heavily and rationalized product/brand lines, reducing manufacturing sites by 25% and other locations by 40%. Furthermore, imaging/treatment brands were rationalized from 11 to 6, and the company consolidated back-office functions. We believe management is focused on further cost savings such as additional manufacturing site reduction and product streamlining. In our view, the company will rapidly expand margins at a higher rate versus Wall Street expectations.
While it may be a recently acquired portfolio company, Envista is certainly not a new name to Ariel. In 2006, Danaher Corporation acquired Sybron Dental, an Ariel portfolio company at that time. A large portion of the Envista product portfolio is represented by the former Sybron Dental. In this current, unchartered COVID-19 environment, the American Dental Association, along with other global regulatory bodies, have informed the dental community to see patients on an emergency-basis only. However, we know people will once again visit dentists for their bi-annual dental cleanings and necessary follow-up procedures—the only uncertainty is when. As long-term investors, this temporary slowdown has provided us with a once-in-a-lifetime opportunity to invest in a high-quality company trading at a significant discount to its private market valuation of $35.71.
Kennametal, Inc. (KMT) is one of the world’s leading manufacturers of durable cutting tools. Customers rely on its products in general engineering, transportation, aerospace, agriculture, road construction, mining, and energy. Founded in 1938, Kennametal has helped customers improve manufacturing productivity for over 80 years. With so much attention given to COVID-19, the marketplace appears to be overlooking that Kennametal is more profitable than it was a few years ago. Since the last downturn in 2015-2016, Kennametal has simplified and modernized its production. We expect the company’s improved cost structure will help lead to profitability for many years to come.
High Value Proposition For Customers
The strong value proposition of Kennametal’s cutting tools and the high barriers to entry help preserve pricing power over economic cycles. The importance of avoiding malfunctions in heavy equipment such as commercial aircraft greatly outweighs the costs of these highly specialized cutting tools, such that customers are willing to spend what is necessary. Given this dynamic, one would expect many companies will rush to meet the demand. However, new entrants are not expected to flood the marketplace because of the substantial investment required. Serving cutting tools customers requires extensive materials science, engineering, sourcing, manufacturing and a technically-proficient sales force.
Resilience Through Cycles
Many of Kennametal’s end markets, most notably automotive and energy, were already experiencing production downturns in late 2019. Now with the COVID-19 outbreak, end markets that were doing well, namely aerospace, are being affected. While COVID-19 is unprecedented, in our view, investors should always, as a matter of discipline, look to the normalized earnings power of any business when calculating intrinsic value. On this count, we believe Kennametal is being priced as if the extreme downward pressure on its end markets will persist indefinitely. However, this franchise will endure because it adds substantial value for its customers. Those customers will likely be ramping up production as soon as the pandemic subsides, and Kennametal will be well positioned to serve given its essential role in the production process.
Looking Through the Windshield vs. Rear View Mirror
In addition to maintaining our disciplined focus on the long term, which we think is being neglected by many market participants at this time, we also believe many are not fully appreciating Kennametal’s improved cost structure. In the past, Kennametal allocated resources to serving many small and medium-sized clients, keeping the company’s cost base higher than it needed to be while also diverting resources from improvements that larger competitors made years before. Today, Kennametal has efficiently and strategically deemphasized smaller accounts where appropriate, resulting in decreased fixed costs. Accordingly, the company has used the excess capital to automate and modernize its factories.
A Patient Approach
Even during Kennametal’s period of elevated fixed costs, the company never sacrificed its scientific expertise and materials acumen. Improving its economies of scale by removing redundancies and automating production should enable it to remain the strongest player in the Western Hemisphere. Due to the deterioration of Kennametal’s end markets in the face of the COVID-19 shock, the benefits of management’s actions may not immediately translate to profits. However, once we return to a normalized operating environment, Kennametal’s improvements will shine through for patient investors.
Founded in 1937 and based in Mayfield, OH, Progressive Corp. (PGR) is one of the largest property and casualty automobile insurers in the U.S. With specialization in the personal auto segment, Progressive also maintains a solid position in the commercial auto market. As background, Progressive distributes its policies primarily through its digital direct-to-consumer (DTC) channel and network of over 30,000 independent agents. The company entered the homeowners’ insurance space in 2014 through the acquisition of American Strategic Insurance Corp., which strengthened its competitive positioning by facilitating a home/auto bundled solution. Additionally, it is gradually expanding beyond autos to other small commercial lines which it views as a long-term growth driver.
Competitive Advantage Driven by Data, Marketing and Innovation
Brand strength, scale, and underwriting prowess differentiate the company from its peers in a highly competitive and relatively commoditized industry. Progressive maintains a sizeable marketing budget—illustrated by the public’s familiarity with “Flo” from its television commercials. This type of brand support gives the company an advantage, especially in the DTC channel and makes it difficult for smaller players to keep pace. Underwriting is supported by superior data analytics and innovation. Now an industry norm, telematics—the integrated use of communications and information technology to transmit, store and receive information—was first developed and employed by Progressive in an effort to inform pricing decisions. Progressive’s data superiority allows the company to better assess risk factors when determining competitive policy rates, which leaves the riskier driver pool and higher payouts for its competitors. This creates a virtuous cycle. Specifically, industry participants increase rates in response to greater underwriting losses, which in turn promotes further Progressive market share gains. The company’s advantages are substantiated by best-in-class loss ratios and return on equity.
A Shift In the Global Operating Environment
Prior to the pandemic, Progressive investors had been focused on the possibility of accelerated underwriting margin degradation as a result of increased competition and an uptick in accident frequency and severity. We believed loss trends would normalize at a more gradual pace given Progressive’s competitive positioning and pricing acumen. However, the emergence of COVID-19 dramatically altered the global operating environment and understandably shifted the focus to the public health and economic implications of the virus.
A Promising Outlook In the Face Of Uncertainty
While the company’s shares have not been fully immune to market volatility, it has outperformed its peer set. Auto insurance is a non-discretionary expense and drivers need it regardless of how much they drive. Shelter in place designations across the country will likely translate into fewer miles driven and should lead to lower claims rates. While the low interest rate environment will remain a headwind for Progressive, it is important to remember the vast majority of its revenues are derived from earned premiums. Collectively, we like the company’s positioning regardless of the macroeconomic backdrop and expect its brand and data-driven culture to fuel growth and share gains in the long term.
Investing in small cap and mid cap stocks is more risky and more volatile than investing in large cap stocks. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market.
On this page, we candidly discuss three individual companies to illustrate our investment process. These companies are current holdings of certain Funds, one of which was a top performer for the quarter, one was a new addition to a Fund, and the other was, in our view, undervalued by the market. The information and our opinions were current as of December 31, 2018, but are subject to change. The information shown does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. These securities do not represent all securities purchased, sold, or recommended to investors during the period. Investors that were not invested in a Fund that held each stock for the entire holding period shown will not have experienced the performance shown. Past performance does not guarantee future results. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of any Fund or of any particular Fund itself. Portfolio holdings are subject to change. Click here for the top holdings of the Funds.