AYI - Acuity Continues To Execute But Weaker Non-Resi Trends Seem To Be Weighing On Shares

Summary

• Acuity posted a modest beat relative to sell-side expectations, with better revenue and gross margin partly offset by higher commission spending.
• I see a real risk that non-residential spending could disappoint Street expectations in 2023, but Acuity's leverage to institutional customers is a relative positive.
• Acuity generates respectable margins and returns (ROIC, et al), but a fundamental lack of revenue growth remains an issue when making the investment case; investing to expand ISG could help.
• I believe Acuity shares are undervalued even with the risk of a weaker non-resi end-market, but low revenue growth and limited margin leverage potential may limit the upside.

One of the more frustrating investment situations to be in is to see a company executing a little better than expected, but see the shares drift lower anyway. Such is the case with Acuity Brands ( AYI ), where two decent quarters (relative to sell-side expectations) and inline guidance for FY’23 hasn’t been enough to maintain investor enthusiasm. Down about 5% since my last update on the company, Acuity has modestly outperformed the S&P 500 but underperformed the broader industrial space, including other non-resi-skewed comps like Allegion ( ALLE ), Hubbell ( HUBB ), Johnson Controls ( JCI ), and Otis ( OTIS ).

I’ve written in the past about the risk of “boredom” with this stock; it’s not well-covered and the long-term growth potential in the core business (lighting) isn’t very exciting. Still, while recognizing risks like increased competition from overseas lighting manufacturers and overpaying for growth-oriented M&A (for the Intelligent Spaces Group, or ISG), not to mention my weaker-than-the-Street outlook for non-resi activity in 2023/24, the share price does look too low to me and this may be a name for value-driven investors to consider.

Another Modestly Better Quarter

Acuity’s fiscal first quarter results were modestly better than Street expectations, with not too many areas of meaningful concern.

Revenue rose 8% from the year-ago quarter, beating by 2%, with most of that driven by price after multiple price hikes in 2022. The ABL lighting business grew 7%, beating by 1%, with strong 18% growth in its direct channel (about 11% of segment sales) and 6% growth in the retail and independent channels. ISG posted 22% growth, beating by 8%, with management calling out customer wins for both Atrius (IoT) and Distech (sensors and controls).

Gross margin was steady on an annual and sequential comparison (at 41.7%), modestly beating expectations, and management did note improving component availability. Adjusted EBITDA rose 4% and adjusted operating income rose 5% (GAAP operating income declined 5%), with the latter beating expectations by a little less than 2% as margin (14.0%) came up about 10bp short and declined 40bp yoy and 130bp qoq, largely on higher commissions in the ABL business.

By segment, profits were basically flat in the ABL business (with margin down 90bp to 14.7%) and up 100% in the ISG business (with margin up more than eight points to 21.3%).

Acuity ended the quarter with a relatively clean balance sheet (about $200M in net debt on quarterly adjusted EBITDA of 153M), and the company repurchased another $78M of shares in the quarter.

Non-Resi Could Be A Little Shaky In The Near Term

I’ve been on record for some time now in expecting a weaker environment for non-residential activity in 2023 than most of the Street seems to expect. While 2022 activity was healthy and there will be some spillover into 2023 from orders that couldn’t be fulfilled in 2022, I do expect higher rates and weaker business confidence to translate into lower activity.

To that end, the Architectural Billings Index has begun to contract, with both October and November below 50 – November’s reading was 46.6 and December’s reading should be available within a few days of this writing. Institutional remains relatively healthier (an ABI of 47.7), while Commercial/Industrial (44.2) and Multi-family (46.1) have posted three straight sub-50 months.

I’m not expecting a bad year, but rather just a more challenging one with weaker growth. I had previously expected around 5% year-over-year revenue growth for Acuity, which I’ve since revised down slightly (4% growth) in response to management’s guidance and what I see as building evidence of that slowdown in non-resi activity. I do believe that institutional/infrastructure should hold up comparatively better, and this is around one-quarter of Acuity’s business in a typical year. I’d note that the commission expense adjustment seen this quarter was explained as related in part to positioning the company for future infrastructure business wins.

I think the ISG business is well worth watching over the next few quarters. This is still a small business for Acuity (only a little more than 10%), but I’m curious how the IoT part of the business will fare given weaker guidance from many semiconductor companies in the IoT space tied to “inventory adjustments” at customers. On a more positive note, the company seems to be having some success expanding its addressable markets for Distech, and I believe the business should get a boost from government-subsidized efforts to enhance building energy efficiency (likewise for larger rivals like Honeywell ( HON ) and Johnson Controls).

Another potential driver to watch in 2023 is M&A. Management made comments that valuations are getting more reasonable and the pipeline of potential M&A projects is getting more attractive. I would expect M&A activity to be centered around adding scale and/or enhanced capabilities to the ISG business, and particularly the controls side.

The Outlook

I’ve modestly reduced my revenue expectations for FY’23 and FY’24 (by about 1%-2%), but Acuity should recapture most of that with a stronger FY’25 as non-resi spending improves. Long term, I expect around 2% to 3% annualized revenue growth.

I would describe the rest of my modeling changes as “tweaks”, as I’m still expecting adjusted EBITDA margin of around 16% and mid-teens adjusted operating margin in FY’23 and FY’24. I’m still looking for long-term free cash flow margins in the low double-digits, and long-term FCF growth a bit above revenue growth.

Acuity shares end up looking undervalued today on discounted cash flow with a potential double-digit long-term annualized return. The shares likewise look undervalued on margin/return-driven EV/EBITDA. I can understand assigning a discount to Acuity’s valuation for its lower growth prospects, but even with a 10%-20% haircut driving a 9x-10x forward EBITDA multiple, the shares look potentially 5% to 20% undervalued.

The Bottom Line

I do see a risk that Acuity could become a value trap. Underlying demand growth for non-residential lighting just isn’t that robust, and it remains to be seen if management can build ISG into something that can contribute meaningfully to long-term returns. On the other hand, management has a good execution track record here and the valuation is just not demanding. With that, value-driven investors may still find something to like here.

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