ALLE - Allegion: Despite Strong Growth Outlook Share Price Lacks Margin Of Safety

2024-01-01 21:50:52 ET

Summary

• Allegion plc specializes in security products and solutions, with historical financials showing accelerating revenue growth and robust margins.
• The company's investment in AI video surveillance and growing core physical security is expected to drive future revenue growth.
• Despite a positive growth outlook and outperforming competitors, the current share price lacks a margin of safety, leading to a hold rating.

Synopsis

Allegion plc ( ALLE ) is a company that specializes in security products and solutions, including electronic and mechanical locks, door closers, exit devices, and biometric access control systems.

ALLE's historical financials have shown accelerating revenue growth after 2020, which was impacted by COVID. Despite fluctuations in revenue growth, its margins have remained robust and stable, resulting in an annual increase in diluted EPS.

In the long term, ALLE's investment in AI video surveillance is expected to bolster its future revenue, as this market is poised for exponential growth. Additionally, ALLE's core business in physical security is also expected to see robust growth in the foreseeable future, further enhancing its revenue prospects. Its deleveraging move is expected to free up additional capital for investment in these fast-growing markets.

Despite outperforming its competitors, the current share price relative to my target price lacks a margin of safety. Therefore, I am recommending a hold rating for ALLE, despite its positive growth outlook.

Despite outperforming its competitors, the current share price relative to my target price lacks a margin of safety. Therefore, I am recommending a hold rating for ALLE, despite its positive growth outlook.

Historical Financial Analysis

Over the last four years , ALLE’s revenue growth trend has shown signs of recovery from the impact of COVID-19. The revenue growth trend is also accelerating. In 2019, it grew by ~4.48%, and by 2022, it had increased to ~14.11%. In 2020 , revenue growth declined due to the severe impact of COVID-19 on the global economy. Since then, revenue growth has recovered and is accelerating.

Despite fluctuations in revenue growth, its margins have remained robust over the years. However, I did notice a slight contraction in its Gross Profit Margin [GPM] from 43.88% in 2019 to 40.42% in 2022, mainly driven by rising inflation. Despite this, its Operating Income Margin [OIM] and Net Income Margin [NIM] have remained relatively flat throughout these years.

ALLE achieved this by actively managing and reducing its SG&A expenses to combat the rising COGS. Based on the 'SG&A % Revenue' chart, its SG&A has been consistently decreasing over the years. In 2019, it accounted for ~24% of total revenue. By 2022, this had decreased to ~21%. This 3% decrease was sufficient to offset the rising COGS, thus allowing the company to maintain its OIM and NIM.

As a result of its revenue growth combined with robust margins, ALLE managed to grow its diluted EPS annually. In 2019, diluted EPS was $4.26, and in 2022, diluted EPS increased to $5.19, representing a growth of ~22%.

Analyzing ALLE’s 3Q23 Results

For 3Q23 , ALLE’s revenue grew a modest 0.5% year-over-year to ~$917.9 million, up from 3Q22’s ~$913.7 million. The modest revenue growth is attributed to strong growth in electronics and access technologies, offset by softness in the residential sector and some international markets. Organic revenue declined by 0.6% year-over-year, and management attributed this to the challenging comparison with 3Q22, when organic revenue grew by 18.6% year-over-year.

Based on the following chart, it's clear that ALLE managed to expand all of its margins in 3Q23. The GPM expanded by ~4% to ~44%, up from 3Q22’s ~40%. OIM expanded by ~3% to ~21%, up from 3Q22’s 18%. Lastly, NIM expanded by ~4% to ~17%, up from 3Q22’s ~13%. Overall, the growth in margins is looking strong and robust. The margin expansion is mainly driven by a contraction in COGS. SG&A expenses remained relatively flat year-over-year. The contraction in COGS can be attributed to cooling inflation since the beginning of 2023.

Although revenue growth for the quarter was flat, the margin expansion allowed for an increase in diluted EPS. For 3Q23, diluted EPS was reported at $1.77, compared to $1.30 in 3Q22, representing a growth rate of ~36%.

ALLE's Strategic Investment in Ambient.ai to Capitalize on the Fast-Growing AI Security Market

In October 2023, ALLE announced its investment in Ambient.ai , marking a significant move in the field of physical security and AI-powered solutions for the company. Ambient.ai specializes in AI Computer Vision Intelligence [CVI]. Currently, most security cameras operate on very rudimentary functions, and it aims to disrupt this market with its AI-powered CVI technology. The collaboration is anticipated to enhance ALLE's product offerings and tap into evolving customer needs in physical security.

Based on the following chart , it's clear that the global AI video surveillance market is anticipated to grow at an exponential rate. In 2022, it was valued at ~$5 billion, but by 2028, it is expected to reach ~$16.3 billion. This represents a CAGR of ~23.7% and provides ALLE with ample opportunities for growing its business. I believe this collaboration will allow ALLE to tap into this fast-growing market, thereby boosting its future revenue growth outlook.

Expanding Physical Security Market and Deleveraging Will Support Future Growth

The objective of physical security measures is to protect equipment and structures. While network and cybersecurity are crucial, safeguarding the physical assets that house these technologies and data is equally important.

According to the following diagram , the global physical security market is expected to grow in the foreseeable future. From 2023 to 2031, this market is anticipated to grow at a CAGR of ~4.6%. Apart from the AI surveillance market discussed earlier, ALLE’s core business is expected to continue growing robustly, which I believe will bolster ALLE’s revenue growth outlook.

Additionally, management stated during the earnings call that it has managed to reduce its debt back to pre-acquisition levels of Access Technologies. I believe this deleveraging move has not only stabilized ALLE’s finances but also created a conducive environment for directing resources towards revenue growth and market share expansion, including the investment in Ambient.ai. With more financial resources on hand, ALLE is better positioned to capture the anticipated growth in the global physical security and AI video surveillance markets. Overall, this appears to be a win-win situation for ALLE.

Quote : “Please go to Slide 5. I'd like to turn to our capital allocation priorities. When I joined Allegion, we had just announced the acquisition of Access Technologies.”

How about management’s revenue guidance?

For the full year 2023, management has reaffirmed their previous revenue growth guidance. The growth rate will be in the range of 11.5% to 12.5%. In my opinion, this guidance is strong because it maintains double-digit growth rates, although it is slightly lower than 2022’s growth.

However, considering that 2022 was a tough comparison period, this growth rate is very impressive. Additionally, it is still well above its 4-year revenue CAGR of ~3.47%. in terms of organic revenue growth, it will be in the range of 5.5% to 6.5%. In terms of EPS, management has also reaffirmed its previous guidance of $6.10 to $6.20.

Overall, this reaffirmation of previously provided guidance of double-digit revenue growth and EPS reflects management’s confidence in ALLE’s business and its growth outlook. Therefore, it provides strong support for the growth catalysts I have discussed above.

Comparative Valuation Model

Based on my valuation model, it's clear that ALLE has outperformed its competitors in terms of growth outlook and profitability, despite being similarly sized. In terms of market size, ALLE’s market capitalization of ~$11.2 billion is ~1.15x larger than the median of its competitors, which is ~$9.7 billion.

Despite being slightly larger, ALLE's forward revenue growth rate of 9.47% is significantly better than the median of 1.75%, indicating that ALLE’s growth rate is 5.41x larger than the competitors' median.

In terms of GPM TTM, they are aligned; ALLE’s GPM TTM is 42.78%, compared to the competitors' median of 40.95%. However, ALLE’s NIM TTM significantly outperforms its competitors. Its NIM is 15.41% vs the median of 6.90%, which is 2.23x higher.

Currently, ALLE’s forward Price-to-Earnings [P/E] ratio of 18.67x is higher than the competitors’ median of 17.21x. Given its superior performance in growth and profitability, I believe the higher P/E ratio is justified. Moreover, the premium is ~8% over the median P/E, which is reasonable.

The market revenue estimate for ALLE is projected to reach $3.66 billion in 2023 and $3.76 billion in 2024. The market estimate for ALLE’s 2023 EPS is $6.83, and for 2024, it is $7.08. Given my discussion on ALLE’s financial strength and growth catalysts above, these revenue and EPS estimates are well supported. Additionally, these market estimates align with management’s guidance, further bolstering their credibility.

By applying ALLE's current P/E ratio of 18.67x to its 2024 EPS estimate, my price target for 2024 is $132.18, representing a modest upside potential of ~4%. Despite acknowledging ALLE as a high-quality company, the lack of a significant margin of safety in its share price leads me to recommend a hold rating.

Risk To My Recommendation

One potential risk associated with my hold recommendation is the possibility of ALLE exceeding market expectations in the upcoming quarters. If the AI video surveillance and physical security market grow faster than anticipated, it could boost ALLE's forward revenue. Given ALLE's outperformance compared to its competitors, surpassing market expectations would likely increase investor confidence in ALLE even more and further strengthen its premium P/E ratio. In such a scenario, the share price might appreciate.

Conclusion

In conclusion, over the past four years, ALLE has demonstrated an accelerating and recovering revenue growth trend from the impact of COVID. Despite this growth volatility, its margins have remained robust, enabling annual growth in diluted EPS.

I believe ALLE's collaboration with Ambient.ai will bolster its future revenue growth, as the AI video surveillance market is projected to grow exponentially in the coming years. This collaboration will also expand ALLE’s product range, extending its revenue avenues. Additionally, ALLE's core physical security market is expected to continue its robust growth.

To support growth in these markets, ALLE has successfully deleveraged its debt to pre-acquisition levels of Access Technologies. This move allows the redirection of capital towards capturing revenue growth. As a result, management has reaffirmed its previous guidance, signaling their confidence in ALLE’s business outlook.

Despite these tailwinds and its outperformance compared to competitors, the current share price relative to my target price shows a lack of margin of safety. With a low single-digit upside potential, I recommend a hold rating for ALLE.

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