AYI - Acuity Brands Dimmed By Softer Non-Residential Markets

2023-10-17 16:05:12 ET

Summary

• Acuity Brands' non-residential markets have weakened, with both new-build and retrofit activity slowing more noticeably in recent months.
• Q4'23 results showed a decline in revenue, but gross margin exceeded expectations, continuing a multi-quarter trend of softer revenue and better margin.
• Management guidance for FY'24 is better than expected, but the outlook for end-user demand is uncertain and I see some downside risk.
• Building out the ISG business and adding more control functionality to its core platform could improve the long-term revenue growth outlook, but at the risk of near-term dilution.
• Acuity shares look undervalued and are worth monitoring as the non-residential cycle goes through its paces.

Writing about Acuity Brands ( AYI ) back in January, I cited the risk of a weaker non-residential market in 2023 as a prime risk for the company and stock, and that has indeed come to pass. At the same time, institutional markets haven’t provided the offset that I’d hoped, and the company’s building controls business is just too small to fully offset that pressure.

These shares are up a few percentage points from my last update , disappointing relative to the broader market, but actually better than a fair number of other stocks leveraged to non-resi activity (like Assa Abloy ( ASAZY ), Allegion ( ALLE ), Otis ( OTIS ), and Johnson Controls ( JCI )). Looking into the new fiscal year, I’m not feeling that bullish about the end-user demand situation, or at least not until the second half of calendar 2024. While the shares are still modestly undervalued, I think this will be a tough place to generate alpha until the outlook for non-resi improves.

FQ4’23 Results Outperformed A Lowered Bar

Acuity reported respectable fiscal fourth quarter earnings against sell-side expectations, but it’s worth noting that numbers declined throughout the year, so the company ultimately passed a lowered bar. Still, it’s better than the alternative.

Revenue fell 9% in the fourth quarter, missing by about 1% and marking the third straight quarter of below-expectation revenue. Acuity Brands Lighting (or ABL) posted a greater than 10% decline in revenue, missing by 3%, with the Independent channel down 8% yoy (after a 5.5% year-over-year decline in the prior quarter) and Direct down 5% (up 8% in the prior quarter). The Intelligent Spaces Group (or ISG) business grew 17%, beating by 6% and likely helped at least in part by an acquisition closed earlier in the year.

Gross margin has exceeded expectations going back into calendar 2022 and this quarter was no exception, with the 340bp yoy improvement (to 45.1%) driving a 100bp beat. Operating income fell 5% on my adjusted calculation (keeping amortization and stock expenses), with margin up 60bp to 14.1%, while company-reported adjusted operating income fell 4%, with margin up 80bp to 16.1%; both reported adjusted operating income and margin beat expectations (by 1.5% and 40bp, respectively).

At the segment level, ABL earnings declined 2% (margin up 150bp to 16.8%), beating by 1%, while ISG profits fell 3% (margin down 410bp to 19.7%), beating by 3%.

Reassuring Guidance … If They Can Achieve It

Management guidance for FY’24 wasn’t exactly robust, but it was better than expected. Management guided to a revenue range of $3.7B-$4.0B, with lighting down low-to-mid single-digits, and that compares reasonably well with the prior sell-side midpoint around $3.8B and the EPS guide was about $0.50/share higher (or 4%) at the midpoint.

It’s fair to question whether management can hit this target. Recent revenue trends have been running below expectations, and I don’t see near-term improvements in the company’s key markets.

While new construction held up pretty well throughout the year, it has been softening more noticeably in recent months as higher credit costs and more economic uncertainty take hold. With that, put-in-place activity should be weaker next year. Meanwhile, retrofit activity isn’t strong either – unless you’re talking about top-quality properties, building owners are reluctant to reinvest in properties today, and particularly in the retail and office spaces.

There are some more positive potential drivers to consider. First, management has been delivering on past pledges to drive increased product vitality; the company refreshed about 20% of the product portfolio in 2023 and new products have been good for market share (offsetting market weakness) and pricing/margin. Also, the company could still get some boost from institutional activity, as federal stimulus dollars should be more visible in 2024 (and contractors will have more capacity with the declines in other non-resi categories). Last and not least, the company has been building up its capabilities in the industrial and data center markets, and these are still among the strongest spaces in the non-resi space and likely to remain so.

Can ISG Become A Real Driver?

Regular readers know that I’m pretty bullish on the long-term opportunities in building electrification and automation, and control systems figure prominently in that ecosystem. Acuity competes here with its Distech controls business and its Atrius cloud/IoT platform, but the business is still rather small – generating less than 10% of overall revenue and segment profits.

Management did make an interesting acquisition earlier this year. I’ve previously said that this business needed to expand beyond its core lighting roots to really thrive, and the company acquired KE2 Therm (for what appears to be around $35M), a manufacturer of commercial refrigeration controls, earlier this year. While there’s only so much that this addition will do in the short term (it offers a more complete portfolio offering for a select group of Acuity customers), I like the overall direction.

The question is whether the Street will support a more aggressive move in this direction. Control, sensor, and software companies don’t generally come cheap, and I’m not certain that the Street will welcome near-term dilution even if it promises stronger long-term positioning in a growth business. Despite that risk, I expect further investments in this direction; Acuity has a clean balance sheet and generates good cash flow and can afford to deploy more toward M&A while also increasing returns to shareholders.

The Outlook

I’m bullish on what the ISG business could become, but I’m not modeling on that basis. With what, I’m looking for a soft FY’24 ($3.7B in revenue), a modest recovery in FY’25, and a stronger recovery in FY’26. I’m concerned that margin improvement will be more challenging given those revenue headwinds, but Acuity has shown some strength here of late and I’m modeling a little more than a quarter-point of EBITDA margin improvement and further improvements in the coming years.

Over the long term, my estimates work out to around 2.5% revenue growth, though there is upside here on the controls side. Looking at margins, I expect free cash flow margins to stay in the low double-digits, gradually improving toward 13% over time and driving a little upside to revenue growth.

Between discounted cash flow and margin/return-driven EV/EBITDA, Acuity still does look undervalued. I can get a fair value over $190 on discounted cash flow, while a 9.5x forward EBITDA supports a fair value of $183.50. I’d note that the actual “fair” multiple on the basis of margins and returns ((ROIC)) is actually closer to 10.5x (a $203 fair value); I’m using a 1.0x discount to account for the near-term risks in the non-resi market and the low growth of the underlying lighting market.

The Bottom Line

If you have a materially more bullish outlook on non-residential activity in 2024, this is a name to consider. My near-term concerns are that this is a value trap and that non-residential activity could be even weaker in 2024, driving more downward revisions and keeping the shares under pressure. Still, with the valuation where it is relative to what I think are realistic to conservative estimates, this name is worth monitoring.

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