HI - Hillenbrand: Not A Buy At Current Levels

2023-03-07 14:53:06 ET

Summary

• In the near term, the company is expected to benefit from record backlog levels.
• However, the macroeconomic slowdown should impact order growth.
• Margin outlook is mixed with challenging near-term and good long-term prospects.
• Valuation is higher than historical average.

Investment thesis

Hillenbrand ( HI ) is expected to benefit from the conversion of its record-high backlog into revenue in the coming quarters. However, due to the macroeconomic slowdown, order growth should slow and start impacting backlog and revenue in the medium term. The leverage also is on the higher side which should impact inorganic growth prospects.

On the margin front, the company should experience a decrease in EBITDA margin due to the dilutive impact of the price/cost equation, volume deleverage in the MTS segment, and the dilutive impact of lower margin acquisitions in the APS segment. However, in the long term, margins are expected to improve as the company realizes synergy benefits from these acquisitions and focuses on growing aftermarket business.

The company is currently trading at a higher than historical valuation. While I like the long-term prospects, mixed near-term outlook and higher valuations keep me on the sidelines.

Revenue Outlook

Hillenbrand experienced good revenue growth post-pandemic, driven by healthy demand in end markets such as automobile, construction, medical, and electronics, for both short-cycle and long-cycle projects. This momentum continued in early FY22. However, in the second half of FY22 and 1Q23, the company started seeing some weakness in the MTS segment’s orders due to the macroeconomic slowdown.

Source: Company data, GS Analytics Research.

Looking ahead, the company’s revenue growth outlook is mixed. While the record backlog is expected to drive revenue growth in the near term, weakening order growth should start to impact backlog and revenue growth in the medium term.

Hillenbrand's backlog has reached a record high of ~$1.95 billion, which includes ~$240 million of backlog from recent acquisitions. The strong order growth and supply chain constraints in recent years were the primary reasons behind this record backlog. Although some supply chain problems persist, particularly in electronic components and chips, they are generally improving. I believe that these supply chain issues will continue to improve throughout FY23, resulting in a higher backlog conversion rate and benefiting the company's top line in the near term.

In the medium term, the recent macroeconomic slowdown is expected to result in weak order growth for Hillenbrand in the coming quarters which should eventually start impacting backlog and revenue. During 4Q22 and 1Q23, the MTS segment witnessed lower demand from short-cycle projects due to weak macroeconomic conditions, resulting in project delays and a sequential decline of 13.3% and 6.1% in the segment’s backlog for 4Q22 and 1Q23, respectively. While the APS segment has fared much better till now due to continued strength in long-cycle projects, if the current slowdown is prolonged, it may result in order slowdown in this business as well.

The company’s growth in recent years also has been aided by M&As. The acquisitions of Linxis, Peerless, Gabler, and Herbold expanded the company's presence in the high-growth recycling and food industry and grew the company's revenue from these end markets from ~$100 million to ~$530 million. The acquisition of Herbold expanded the company's recycling capabilities, making it a turnkey service provider in the plastic recycling space, while the acquisitions of Linxis, Peerless, and Gabler expanded the company's capabilities in the food processing end market.

However, this inorganic tailwind also is likely to be subdued over the next couple of years. The company's net debt to EBITDA ratio is currently ~2.6x, near the upper end of management's target range of 1.7-2.7x. Given the high debt level and uncertain macroeconomic conditions in the near term, it's unlikely that management would pursue further acquisitions in the near term.

While I like the company’s long-term growth story around the increasing use of engineered plastic in various industries to cater to increasing demand from the growing middle class especially in Asia, its near to medium-term revenue outlook remains mixed.

Margin Outlook

During 1Q23, the company experienced a 40 bps YoY decrease in adjusted EBITDA margins to 15.4%, primarily due to the dilutive effect of price/cost. On a segmental basis, the APS segment witnessed a 10 bps YoY increase in adjusted EBITDA margins to 17.3%, primarily due to productivity improvements, partially offset by dilutive mid-teen EBITDA margins from the acquisitions. On the other hand, the MTS segment witnessed a 310 bps YoY decrease in adjusted EBITDA margin to 17.7%, primarily due to inflation and volume deleverage.

Looking ahead, the company's EBITDA margin is expected to be impacted by several factors, including dilutive price/cost, volume deleverage in the MTS segment, and the dilutive impact of acquisitions in the APS segment.

The company has been dealing with higher input costs due to rising inflation. While the company has been able to increase product pricing to offset the rise in input cost and maintain the gross dollar level profitability, the net impact is dilutive to the margins, resulting in a 10 bps YoY margin headwind in the first quarter of FY23. This trend is expected to continue throughout the year, with price/cost remaining a headwind for EBITDA margins.

In addition, the MTS segment's EBITDA margins are expected to be under pressure due to volume deleverage. The segment has reported a decline in the backlog for two consecutive quarters, and the sluggish demand is expected to continue resulting in a volume decline for the year. Management anticipates that the decrease in volume will impact the segment's EBITDA margins, which are expected to decline between 70bps and 170 bps YoY. Furthermore, the inclusion of lower-margin business in the APS segment is expected to impact the segment's adjusted EBITDA margins, with management forecasting a YoY change of -60 bps to +40 bps.

Over the medium to long term, the company's EBITDA margins are expected to benefit from an increased mix of aftermarket revenue and synergy benefits arising from recent acquisitions.

The company sells capital equipment that can have a life of up to 30 years. However, this equipment needs to be serviced from time to time, creating a stream of aftermarket revenue for the company, which comes a substantially higher margin. The management plans to grow its aftermarket revenue from $730 million to $900 million by 2025. This business is expected to grow faster than the capital equipment business growth, as the company is focused on improving servicing ability, designing products that have higher aftermarket potential, and offering service contracts.

Moreover, the company's EBITDA margins are expected to improve due to synergy benefits from recently acquired companies. LINXIS, Peerless, Gabler, and Herbold had a combined EBITDA margin of ~15%, which is well below the 19-20% EBITDA margin of the APS segment. The company has previously realized significant synergy benefits from acquisitions, such as the Coperion acquisition, which saw a 700bps margin improvement post-acquisition, and the more recent acquisition of Milacron business, which saw a 200bps margin improvement post-acquisition. Similar synergy realization is expected from the recent acquisitions.

So, the long-term margin outlook is good but there are some challenges in the near term.

Valuation

The stock is currently trading at a forward P/E of 15.19x based on the FY23 consensus EPS estimate of $3.14, which is higher than its five-year average of 13.75x. The company has mixed revenue and margin outlook. While revenue should benefit from a healthy backlog and faster backlog conversion in the near term, the order rate should slow due to challenging macros eventually impacting backlog and revenue in the medium term. Margins should be under pressure due to negative price/cost and recent low-margin acquisitions in the near term. However, in the medium to long term, as the company realizes synergy benefits and increases aftermarket sales, we should see margin expansion. Given the mixed outlook, I don't think paying higher than the historical average P/E multiple makes sense. Hence, I prefer to be on the sidelines and have a neutral rating on the stock.

For further details see: