HI - Hillenbrand: Remaining On The Sidelines

2023-08-30 05:15:27 ET

Summary

• Hillenbrand has seen good revenue growth driven by strong demand and recent acquisitions, but organic growth is expected to slow down.
• Organic Backlog for both segments has been sequentially decreasing, indicating a potential slowdown in organic revenue growth in the coming quarters.
• The upcoming acquisition of Schenck FPM business will increase the company's leverage and limit the potential for inorganic growth.

Investment Thesis

I last covered Hillenbrand ( HI ) with a neutral rating in March this year. The stock has remained flattish since then validating my stance. Looking forward, while the valuations are cheap, I see headwinds to the company's performance due to a sequential decline in backlog in both the segments. Further, the company's net leverage will increase beyond management's target range of 1.7x-2.7x post the upcoming acquisition of Schenck's FPM business limiting the potential for inorganic growth. Margin outlook is also mixed given the tough macros which might impact pricing. I would prefer to wait on the sidelines for fundamentals to bottom before taking a more positive stance on the stock. For now, I have a neutral rating despite the cheap valuation.

Revenue Analysis and Outlook

Hillenbrand has seen good growth over the last couple of years driven by strong demand in its end markets. In the third quarter of FY23 , the Company posted a solid 24% Y/Y increase in total revenues from continuing operations (i.e. ex Batesville). This performance was driven by 5% Y/Y organic growth as well as contribution from recent acquisitions. Segment Wise APS (Advanced Process Solutions) segment posted a remarkable 50% Y/Y growth driven by acquisitions, favorable pricing and strong aftermarket parts and services revenue. On an organic basis the growth in this segment was 14% Y/Y. On the other hand, MTS segment's revenue declined 7% Y/Y primarily due to lower injection molding and hot runner equipment sales, partially offset by growth in aftermarket parts and services revenue, as well as favorable pricing.

Looking forward, I expect the company's revenue growth to slow. A company's backlog is the leading indicator of its revenues and its organic backlog for both segments has been decreasing sequentially for the last couple of quarters.

The Company is seeing a prolonged customer decision process and delay in awards of projects due to macroeconomic uncertainty. It is not unusual for clients to delay projects for several quarters during an uncertain macroeconomic environment and given the prevailing high interest rate environment, I won’t be surprised if many of them are re-accessing the return profile of their investments.

Further, management noted that the Chinese market, which showed some initial strength post Chinese new year has slowed down since then. China is an important market for the company and Hillenbrand derived ~20% of its net revenue from this market in FY22. A slowdown in this market is a negative for the company.

So far, the pricing has held up and helped Hillenbrand's revenue. However, given the slowdown in end-market demand, there is a possibility of increased competition which might put some pressure on pricing as well.

Hillenbrand has benefited from inorganic growth in recent years. The company recently announced acquisition of Schenck's Food and Performance Materials (FPM) business which is expected to be completed by the end of this quarter. This should help revenues. However, post the completion of this acquisition the company's leverage will increase to ~3.2x which would be higher than management’s 1.7x to 2.7x target net leverage ratio. So, I expect a near to medium term pause in M&As post this acquisition.

Overall, I expect a moderation in both organic and inorganic growth over the coming quarters.

Margin Analysis and Outlook

Hillenbrand demonstrated good margin performance in Q3 FY23 and its adjusted EBITDA margin improved by 20 bps, reaching 17.6%. The company's margin benefitted from effective pricing strategies, heightened productivity and increased volumes in APS (Advanced Process Solutions) segment which were partially offset by the impact of cost inflation and lower MTS (molding Technology Solutions) segment volumes.

Segment wise, APS segment's adjusted EBITDA margins improved by 60 bps to 20.1% driven by favorable pricing, operating leverage from higher volumes, and enhanced productivity which were partially offset by cost inflation and dilutive effect stemming from recent acquisitions. MTS segment's adjusted EBITDA margin was stable around 20.2% despite lower volumes thanks to the company's effort to manage cost and drive productivity.

Looking forward, the company's margin outlook is mixed. On the one hand, the company is doing a good job managing costs and improving productivity and realizing synergy savings from the recent acquisitions. On the other hand, tough macroeconomic conditions and declining backlog may put pressure on volumes and pricing going forward which might negatively impact margins. Further, the acquisition of Schenck Food and Performance Material business should negatively impact the margins in the near term as it has lower margins compared to Hillenbrand's APS segment. Eventually, after the company realizes synergy benefits, margins should see some improvement in the medium to long term. However, for the next few quarters, this acquisition should be dilutive to the margins. So, I am not optimistic about the company’s near term margin prospects.

Valuation and Conclusion

Hillenbrand is trading at 12.58x FY24 (ending Sep.) consensus EPS estimates. This is less than its 5-year average forward P/E of 13.20x. The company's revenue has posted a good growth in the recent period helped by acquisitions as well as organic growth. However, if we look at the declining organic backlog and softening demand as customers delay projects due to macroeconomic uncertainties, the organic growth is expected to slow down. Further, I am not expecting much inorganic growth post the completion of the recently announced acquisition of Schenck FPM business as the company's net leverage will increase to ~3.2x post the acquisition which will be higher than the management's target range. So, I am not optimistic about the company's revenue growth prospects. Further, margins outlook is also mixed with the company's productivity and cost saving initiatives helping but upcoming revenue slowdown as well as lower margins of recent acquisitions being a headwind. I would like to wait on the side lines for fundamentals to bottom. Hence, I have a neutral rating on the stock despite low valuation.

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