AZZ - AZZ: Low Valuations But Potential End-Market Weakness Keeps Me On The Sidelines

Summary

• The company’s revenue should be impacted due to the moderation in non-residential, residential, and industrial end markets.
• The margins should benefit from the pricing actions, operational efficiency, and improvement in productivity.
• Valuation is low but I prefer being on the sidelines till the fundamentals bottom.

Investment Thesis

AZZ Inc. ( AZZ ) has seen good growth so far but leading indicators for its end markets indicate weakness ahead. The company’s revenue outlook is mixed. While organic growth is expected to be under pressure given the moderation in construction and industrial demand, the company should benefit from the recent Precoat business acquisition. The company’s margin should benefit from the pricing actions, and increased productivity and operational efficiency at its Metal Coating plants. While the valuation is cheap at 10.90x FY24 earnings, I prefer to wait on the sidelines till the end-markets bottom and hence have a neutral rating on the stock.

Business Basics

AZZ is a global provider of galvanizing and a variety of metal coating solutions to a broad range of markets. The company has two operating segments: the AZZ Metal Coatings segment, which contributes 42% to the total revenue, and the AZZ Precoat Metals segment, which contributes the remaining 58% to the total revenue. The AZZ Metal Coatings segment provides hot-dip galvanizing, spin galvanizing, powder coating, and other metal coating applications, whereas the AZZ Precoat Metals segment provides advanced applications of decorative and corrosion-protective coatings and related value-added services.

The company underwent two transactions last year as a part of its strategy to become a pure-play metal coatings company. First, AZZ acquired Precoat Metals for a purchase price of $1.28 bn in May 2022. Precoat Metals is the leading independent provider in North America of value-added services and pre-painted metal coil coating with diverse end markets.

Further, in June 2022, AZZ entered into a transaction whereby it contributed its AZZ Infrastructure Solutions segment to the AIS Investment Holdings ((AIS)) Joint Venture and sold its 60% interest in the AIS JV to Fernweh Group. AZZ retained a 40% interest in the JV, which is now accounted for under the equity method of accounting. The company utilized the proceeds received from this sale to reduce its debt by $230 mn and bring down its net leverage to 3.4x at the end of Q3 FY23 from 4.3x at the end of Q1 FY23.

Revenue Analysis & Outlook

The company saw good growth in Q3 FY23, helped by strong performance in the Metal Coating business as well as benefits from the acquisition of the Precoat Metals business. The Metal Coatings segment’s revenue grew 17.2% Y/Y in Q3 FY23 to ~$158 mn, driven by value-based pricing initiatives, the complete integration of its previous acquisitions (DAAM and Steel Creek), and an increase in volume for hot dip galvanizing due to healthy demand in some of its end markets including renewables, utility, OEM, and non-residential construction. The recently acquired Precoat Metals business contributed ~$215 mn in sales. On a pro-forma or comparable basis, the sales in the Precoat Metals segment increased 14.8% Y/Y, driven by value-based pricing initiatives and stable volumes from the non-residential construction market. The company is improving its service levels to provide better value to its customers and charge more for its services.

AZZ has a diverse end market with exposure in the construction, industrial, transportation, consumer, and utility markets. Within the construction end market, the demand in the non-residential market should moderate in 2023, as the Architectural Billing Index ((ABI)), which is the leading indicator of non-residential construction activity, is currently below 50, indicating contraction. In the residential construction market, the company should face headwinds as demand is weakening due to rising interest rates and affordability concerns. The story is similar on the industrial side as well, and the U.S. manufacturing PMI was at 46.8 in January 2023, indicating declining demand.

In the consumer market, the company is seeing healthy demand due to the secular growth trends in the container market, primarily beverage cans. Many beverage companies are shifting to aluminum cans/bottles from plastic due to sustainability and consumer packaging preferences. However, this business is just ~9% of revenue and should not be enough to offset the decline in other end markets.

So, I am not too optimistic about near-term organic growth prospects. However, inorganic growth should help, as Q1 of the current year only had two weeks of sales contribution from the recently acquired Precoat Metals business, while Q1 FY24 should have a full three months' contribution from this business.

Margin Outlook

In Q3 FY23, the Metal Coatings segment’s adjusted operating margin declined 330 bps Y/Y to 21.2% due to inflationary pressures, particularly in zinc, and investments in productivity initiatives in the Surface Technologies business. The adjusted operating margin of the Precoat Metals segment declined 150 bps sequentially to 13.5%. In addition to seasonal volume decline vs. Q2, inflationary costs, and labor shortage, margins in this segment are also getting impacted by unusually high customer-owned inventories at AZZ’s warehouses, which caused inefficiencies and increased costs. Precoat Metals provides warehousing for steel and aluminum for its customers. However, due to the supply chain disruptions, Precoat’s customers had increased their safety stock. This has led to higher-than-normal inventory levels at its warehouses, which is impacting the productivity and efficiency at AZZ's warehouses due to the logistics and training required to get things moved around and stored.

Looking forward, in the Metal Coatings segment, the company should benefit from its investment in the Digital Galvanizing System ((DGS)), which is driving both productivity and improvement in customer service quality. The DGS technology is helping the company receive data at its plants without having to contact its drivers, delivery people, or suppliers (i.e., in a touchless way). While zinc prices are difficult to predict, I expect them to cool down given the potential slowdown in the global economy thanks to rising interest rates. So, zinc prices should be less of a headwind for this segment looking forward.

In the Precoat Metals segment, the company is taking action to improve its inventory situation and is focusing on improving productivity at several plants. The company has made some leadership changes at several of its plants, which should help drive better performance. The management is anticipating that the customer inventories will reach their normalized levels over the next couple of quarters at the majority of its plants. Apart from this, the company is also taking pricing actions to offset the inflationary material costs and higher logistical costs.

The company’s margins should also benefit from an optimized cost structure post-AIS divestiture, as the company now focuses only on coatings businesses. So, I am optimistic about the company’s long-term margin prospects.

Valuation & Conclusion

The stock is currently trading at 10.90x FY24 consensus EPS estimate of $3.83. The company has seen good growth in FY23 (ending Feb) so far, but I believe FY24 might be more challenging with a potential slowdown in end markets. While the full-year inclusion of Precoat business should help revenues and the long-term margin outlook is also positive, I would like to wait till organic growth headwinds fade and end markets bottom before becoming more optimistic on the stock. Till then, I would like to wait on the sidelines and have a neutral rating on the stock.

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