AIMC - Regal Rexnord's Broad-Based Business Model Is Really Getting It Done

Summary

• Regal Rexnord's fourth quarter revenue performance was better than it looks, and the company outperformed on margins.
• Management guidance/commentary was surprisingly positive, with a more bullish outlook on short-cycle demand and strong confidence in later-cycle markets like aerospace.
• The AIMC deal will not only create cost synergy opportunities but further leverage the company to long-term growth in automation and electrification.
• Mid single-digit core revenue growth and high single-digit FCF growth can support a worthwhile return outlook from here.

So much for trying to time or predict market sentiment - when I last wrote about Regal Rexnord (RRX) I said that I thought the shares were undervalued but that sentiment toward businesses with short-cycle exposure could be a risk heading into a softer 2023. Up almost 40% since then, the market is perfectly fine with that short-cycle exposure, particularly as Regal Rexnord's later-cycle businesses are coming through with accelerating demand.

Even after that big move, I don't necessarily think the stock is tapped out, particularly given the longer-term potential of synergies from the Altra Industrial Motion (AIMC) acquisition (assuming it gets the needed final approvals) and the prospects for a relatively shallow and brief short-cycle correction. With a strong collection of businesses that offer "behind the scenes" leverage to automation and energy efficiency, I think this is a name that at least merits a spot on watchlists.

Better Margins Help Fourth Quarter Results

Regal Rexnord's fourth quarter results won't necessarily look all that impressive at first glance, particularly not next to industrials posting double-digit organic revenue growth, but margins were healthy and guidance for 2023 was encouraging. Moreover, looking through the headwinds created by the company's exposure to weaker HVAC markets, businesses like Motion Control kept pace with the likes of Rockwell (ROK) and SKF (SKFRY).

Revenue rose 2% as reported and 4% in organic terms, coming in trivially below sell-side expectations. Motion Control grew more than 9%, keeping pace with peers with similar end-market exposures like Rockwell and SKF. Climate Solutions revenue declined almost 11%, impacted by weaker demand from HVAC customers. Commercial Systems saw almost 6% revenue growth, while Industrial Systems was up close to 10%, with healthy demand in backup power (for data centers, among others) and end-markets like mining and oil/gas.

While revenue was a bit light, margins were better than expected. Gross margin improved about five points from last year and almost two points from the prior quarter (to 32.7%), with the company logging its eighth straight quarter of positive price/cost at a time when many companies are still struggling to recoup input cost inflation.

EBITDA rose 19%, with margin expanding a better-than-expected 310bp to 22.0%, while adjusted operating income rose 34%, with margin up 360bp to 15.2%. By segment, Motion Control rose almost 47% (margin up 430bp to 16.8%), Climate declined 22% (margin down 220bp to 15.9%), Commercial rose 60% (margin up 530bp to 14.4%), and Industrial increased significantly year over year (margin up 820bp yoy to 9.5%).

There Are Pockets Of Weakness (HVAC), But The Outlook Is Surprisingly Strong

Guidance calls like the one that Regal Rexnord made with fourth quarter earnings are certainly helping sentiment around industrials heading into 2023. While management did acknowledge some potential areas of weakness, particularly residential HVAC, business on the whole seems to be holding up well, leading me to theorize that the company is probably picking up share in some of its markets.

Management guided to a weighted-average projection of 3.5% declines in its end-markets for the year. Looking at the details, it's no surprise that residential HVAC and pool are expected to be quite weak. Trane ( TT ) reported noticeably weaker bookings in resi-HVAC in the fourth quarter, and Pentair ( PNR ) is likewise seeing pressure in its pool business. Management here is bullish on non-residential, and while I'm skeptical about the non-resi market overall, this company's leverage to commercial HVAC (Trane reported low-teens growth in commercial HVAC bookings) is a major positive.

An outlook for "flat" general industrial markets frankly looks bullish to me, but leverage to capacity growth, share gains, and automation could be driving upside. A negative outlook on food/beverage is a little surprising given the strength that Rockwell is seeing, but as I've said before, food/beverage can be a very heterogenous market. Strength in markets like metals/mining certainly fits with my view, as does the call-out for very strong aerospace (a business that has traditionally carried much higher margins for the company).

Boiling it all down, climate is weak, but doesn't seem any weaker than I expected. Short-cycle seems to be holding up really well (a 1.2x book-to-bill in the Motion Control business), and management said that they're seeing acceleration in late-cycle markets like aerospace and solar (mining/metals, oil/gas would also qualify). All in all, then, I'm not worried too much about the 10% decline in orders (driven in part by significant residential HVAC destocking), though I do still see some risks to short-cycle industrial markets through the third quarter of 2023.

The Outlook

Management expects to close the AIMC deal in the first half of 2023, and I do believe the company can reasonably expect meaningful cost savings and long-term revenue synergies. At a minimum, the deal gives the company even more leverage to the growth of automation across a wide range of markets (including factory, healthcare, and warehouse automation).

I believe Regal Rexnord can generate mid-single-digit adjusted core growth, with the company meaningfully leveraged to automation and electrification across a wide range of industries, as well as longer-term growth in markets like aerospace and renewable energy.

I think management's 25% EBITDA margin target for 2025 could be aggressive, but my estimate is in the 23%'s, so not too far off (and the company posted 21.3% adjusted EBITDA margin for FY'22). Long term, I expect low-to-mid-teens FCF margins, and while that's not going to challenge some of the best names in the industrial space ( IDEX ( IEX ), Rockwell, et al), it's still a pretty good margin for a diversified industrial.

Between discounted free cash flow and margin/return-driven EV/EBITDA, I believe Regal Rexnord shares are still undervalued, with a 12-month fair value range of $165 to $175, including the AIMC deal. Given that I'm still comparatively bearish on short-cycle and the company will have room to beat on post-deal synergies, I think my numbers are reasonable but conservative.

The Bottom Line

It's tough to buy after a stock has a big run, but it's also tough to keep seeing it head higher still over the longer term. I don't rule out a broader pullback in the first quarter as the impact of higher rates becomes more apparent, but most economic data is showing a fairly resilient economy and guidance calls have been generally as expected or better. So while I'd welcome a chance to buy these shares cheaper, I think they offer worthwhile long-term potential where they are.

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