AZZ - AZZ Inc.: Lingering M&A Overhang

2023-05-11 10:21:28 ET

Summary

• AZZ Inc. surprised the market by announcing a huge deal early last year.
• The M&A action coincided near a market peak, adding a lot of leverage ahead of an uncertain economic environment.
• AZZ Inc. shares have come down amidst operational headwinds, for the right reasons.
• I see no reason to add to a small position here.

Over the past summer, I concluded that the risk-reward for AZZ Inc. ( AZZ ) was gradually improving. While I was not a fan of a big metal coating deal which the company announced earlier in 2022, operating momentum continued to be solid despite a volatile economy, although that leverage still came in a bit too high for me to get comfortable with.

A Recap

In the past, AZZ Inc. has been a secular grower, albeit in cyclical end markets. This meant that shares rose from single digits to a peak at $60 in 2016. Ever since, the company, which has undergone a real transition, moving away from lower margin and cyclical businesses towards higher value-added services like galvanizing, among others. Despite these efforts, AZZ Inc. shares have been trading stagnant for years now.

Pre-pandemic, the company generated a billion in sales on which the company posted adjusted earnings of $2.75 per share, with leverage being very reasonable at 2 times. Of course, the company did not repeat these results in 2020, for obvious reasons, and while 2021 results improved a bit, they still came in short compared to the 2019 results.

With 25 million shares trading at $49 per share early in 2022, the company was granted a $1.2 billion equity valuation, as that excluded about $160 million in debt. In the light of a $1.36 billion enterprise valuation, AZZ reached a huge deal early last year, as it paid $1.28 billion to Carlyle in order to acquire Precoat Metals , a deal valued at effectively the same valuation as AZZ itself.

The deal tag fell to $1.13 billion following tax synergies, as the $700 million sales number of the company was a bit smaller than AZZs sales base around $900 million at the time. An EBITDA contribution of $137 million, for margins around 20% of sales, looked quite reasonable. That said, disclosure on margins, accretion and financing was very limited.

In May of last year the company announced that pro forma leverage would come in at 4.2 times, as the company posted 2021 earnings at $3.35 per share. With pro forma sales seen at $1.6 billion, it was clear that leverage was high as shares had fallen to $42 by May. To address a $1.2 billion net debt load, the company announced the sale of a 60% stake in the infrastructure group in a deal valued at $300 million, with net cash proceeds pegged at just $228 million, reducing net debt to around a billion.

The company guided for 20% earnings growth following the Precoat deal and with earnings power pegged at $4 per share, with leverage coming down rapidly to 3 times, valuations had been reset to $40 over the past summer. If the company could execute, a re-rating might send shares higher to $60-$70 per share over time, at least that was my belief or hope.

On the back of that, I saw potential for a small position, although leverage was still a bit too high to see great appeal.

Stagnating

Since the summer, AZZ Inc. shares have largely traded in a $30-$45 range, now trading hands at $35 per share. The company has a broken book year, which means that the company posted its fiscal 2023 results in April. Reported sales rose 20% to $1.33 billion, with pro forma sales coming in short compared to pro forma results as the deal only closed during the year.

Adjusted earnings for the year came in at $3.48 per share, although that a weaker fourth quarter made that adjusted earnings only came in at $0.30 per share. For the year, adjusted EBITDA came in at $267 million as the company reported a 3.5 times leverage ratio based on the fourth quarter tally, higher than I feared amidst softening performance in the second half of the fiscal 2023.

For the fiscal year 2024 the company guided for a modest improvement with sales seen between $1.40 and $1.55 billion, with EBITDA seen between $300 and $325 million, and adjusted earnings seen between $3.85 and $4.35 per share.

Concluding Remark

The reality is that while I was upbeat on the operating performance last summer, AZZ Inc. has seen some weakness in the second half of the year. This means that earnings per share came in a bit soft, while leverage came in a bit higher than I hoped for. The fiscal 2024 guidance implies that assuming flat net debt, leverage ratios will fall towards 3 times on the back of improved EBITDA.

While I initiated a tiny position in AZZ Inc. at $40 last summer, I see no reason to add to this position again, even as shares are down a bit and the company trades at nearly 10 times earnings. While this is low, I simply think that AZZ Inc. has taken on a bit too much leverage with the deal last year, as I was surprised by such a dramatic move (certainly given the uneven track record in recent years).

Hence, I continue to hold a small AZZ Inc. position here. However, I see no reason, despite the lower price action, to get involved with a greater position in AZZ Inc. here.

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