AZZ - AZZ Inc.: Low Valuation But Mixed Prospects And High Leverage

2023-10-02 05:27:28 ET

Summary

• AZZ Inc. faces headwinds from a tough macroeconomic environment, slowing its end markets and impacting its growth.
• AZZ's high debt levels and expensive interest rates on its variable debt should prioritize debt.
• While the valuation is cheap, muted growth prospects and high leverage keep me on the sidelines.

Investment Thesis

While AZZ Inc.'s ( AZZ ) valuation is not expensive, it faces headwinds from the tough macroeconomic environment which is slowing some of its end-markets including commercial and residential construction, transportation, and HVAC. The company's high debt levels and the high interest rate it is paying on its variable debt should make debt repayment a priority and reduce inorganic growth which has been a major driver for its growth in recent quarters. I prefer to wait on the sidelines till the company's end-market bottom and debt levels come down before becoming more optimistic about the stock. Hence, I have a neutral rating on the stock.

Revenue Analysis and Outlook

AZZ has undergone a significant strategic transformation over the last one and a half years. Last year, the company divested the majority stake in its infrastructure segment (the minority stake in this segment is now accounted for under the equity method) and acquired precoat business from Sequa Corporation. These acquisitions coupled with demand recovery as the economy reopened post-Covid and price increases helped the company post good topline growth in the recent quarters.

In Q1 FY24, the company posted an 88.7% Y/Y increase in net sales from continuing operations which reached $390.9 mn. This growth was primarily driven by 408.3% Y/Y growth in Precoat Metals segment revenue. Last year's Precoat sales included only the last two weeks of revenues following the acquisition of Sequa Corporation's Precoat business on May 13th, 2022. This explains the significant increase. On a comparable basis, the segment's sales declined slightly as the comparisons were difficult with last year's first quarter benefitting as the customers ramped up their inventory levels in response to supply chain disruptions. The company's Metal Coatings business, however, saw sales increase ~3.3% Y/Y to $168.8 mn primarily driven by an increase in galvanizing volume as well as improved price realization.

Looking forward, as the company anniversaries its precoat business acquisition, the sales growth in Q2 FY24 should slow significantly compared to what we have seen in recent quarters. The company's net leverage is also quite high at ~3.5x and its variable rate debt is expensive with an effective interest rate of ~9.07% on its Term Loan B and revolving credit facility as of the last quarter end.

This is what management said about interest expense on the last quarter's earnings call :

We recorded interest expense for the first quarter of $28.7 million compared to $7.5 million in the prior year due to acquisition-related borrowings, as well as the higher interest rate environment we operate in today.

Last fall, we secured a cash flow hedge of half of our variable rate debt via a swap. This fixed rate -- this fixed our rate at approximately 8.6%, and we currently incur roughly 9.5% on the remaining variable rate debt."

So, management's near-term focus is on reducing debt and I don't see any further M&As in the near term.

The company's near-term organic growth outlook is also mixed. The construction end-market which accounts for over half of the company's total sales is expected to benefit from the U.S. government's infrastructure funding under the Infrastructure Investments and Jobs Act (IIJA) but the commercial and residential part of this business is slowing. Further, the high interest rate and inflationary environment are impacting industrial and consumer business and management noted signs of a slowdown in the HVAC and transportation business on its last earnings call.

Management is controlling what it can control and trying to improve production efficiency and customer experience. While the metal coatings business is essentially a commodity business with little to differentiate, management is digitalizing its galvanizing operations to improve production efficiency and the quality and speed of its customer interactions. Around 1.5 years back, management replaced the off-the-shelf CRM tool it was using earlier with an internally built tool linking AZZ's customer relationship management to its Oracle ERP system. This eliminated all paperwork and significantly improved the quality and speed of its customer communications. Precoat business also has similar proprietary applications like Coil Zone that provide it with similar productivity improvement and enhanced customer engagement.

While I like the company's efforts, it essentially operates in a slow-growing industry with organic revenue growth largely dependent on end-market growth. With end-markets mixed and M&As unlikely in the near term due to relatively high leverage, my revenue growth outlook is muted in the near term.

Margin Analysis and Outlook

In Q1 2024, the company's margins were impacted by higher Y/Y labor and commodity costs. As a result, the gross margin declined 420 bps Y/Y to 24.8% and the adjusted EBITDA margin declined 360 bps Y/Y to 21.8%. However, on a sequential basis, the gross margin and adjusted EBITDA margin improved by 660 bps and 480 bps, respectively driven by higher seasonal sales and production improvement initiatives.

The Metal Coating segment's adjusted EBITDA margin decreased 210 bps Y/Y to 30.7% while in the Precoat segment, the adjusted EBITDA margin of 19.4% declined 310 bps Y/Y.

Looking forward, the company's margin should see a return to growth in the coming quarters as Y/Y comparisons are easing and Zinc prices have also seen some declines. Over the last few quarters, the company's margins were also impacted as its precoat client stored excess inventory at the company's warehouses while dealing with supply chain disruptions. This created some inefficiencies for AZZ and adversely impacted its margins. This inventory situation is now normalizing which should help margins in the near term.

However, beyond these near-term improvements due to headwinds easing, there is not a significant scope for margin improvement as this is essentially a commodity business and the bigger customers can always look at in-house galvanizing operations in case the company prices its services too high.

Valuation and Conclusion

AZZ is trading at 11.55x FY23 consensus EPS estimate which is a discount compared to its 5-year historical forward P/E of 15.87x .

While the company's valuations are cheap, the near-term outlook is mixed with tough macroeconomic conditions impacting some of its end customers in industries like commercial and residential construction, transportation, HVAC, etc. The company's debt level is also pretty high with net leverage of ~3.5x as of the last quarter's end. This should limit inorganic growth prospects. I would prefer waiting for end markets to bottom and debt levels to come down to more reasonable levels before becoming more optimistic about the stock. For now, I have a neutral rating on the stock.

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