ITW - The Middleby Corporation: Reiterate Hold Given Visible Headwinds

2023-07-04 00:05:21 ET

Summary

• Management's comments on normalized lead times are a sign of declining order demand, in my opinion.
• Despite expectations of weaker growth in RK and CF in the next 1-2 quarters, there is potential growth for the latter towards the end of the year.
• Investors should wait for clear visibility on the recovery of the Residential Kitchen segment before increasing any existing position.

Thesis

The Middleby Corporation ( MIDD ) designs, manufactures, markets, and services a broad line of equipment for use in cooking and preparing food. Within the business, there is a portfolio of leading brands within three highly synergistic business segments: Commercial Foodservice [CF], Residential Kitchen [RF], and Food Processing [FP]. As I expected , my previous coverage was right that the uncertainties revolving the business has led to the stock being rangebound. Even with the latest update, uncertainties remain. I believe that investors interpreted the remarks made by management regarding standard lead times as an indication of a decrease in the demand for orders. The confirmation of inventory accumulation in the CF and RK divisions appeared to support this perception. Thus, I restate my hold rating given the headwinds are still up ahead; however, I do believe there may be opportunities to start accumulating position when valuation touches 12x forward PE, given the current valuation that MIDD is trading at. That said, investors should only size up when there is clear visibility to RF recovery.

Demand outlook

Most factories have returned to normal production times, according to management. This, I believe, implies a normalization in order trends (i.e. less demand compared to last year's elevated orders driven by advance orders in the face of a supply situation), which will generate additional uncertainty among investors. Which means, MIDD is likely going to see weaker growth in the next 1 or 2 quarters in the RK and CF segment. That said, while I anticipate RK to remain weak due to weak consumer spending, I expect CF to grow relatively better as the year winds down due to the back-loading of chain activity. This growth expectation is further affirmed by what Illinois Tool Works ( ITW ) management is saying as well.

Institutional end markets were up more than 50%, with particular strength in education and lodging." ITW 1Q23 earnings call

This is an area we talked about backlog earlier where the backlog is 2 times our normal levels, which gives us a little bit more visibility than what we normally were used to" ITW 1Q23 earnings call.

For more information on why I think the near term for RK is bleak, see my previous post. However, once the inventory issues have been resolved-which should take a couple of quarters-I anticipate growth to resume. Despite MIDD's forecast of flat sequential sales in 2Q23 due to continued grill destocking and softer UK conditions, things could turn out better than I anticipated. Notably, growth on a % basis could see acceleration in 2H23 due to easier comps - which might just be the required headline figure to kickstart a positive momentum around the stock. I would expect a positive narrative somewhere along this: "RK recovering from excess inventory issues and against easy comps, coupled along with a strong Commercial market, should help elevated MIDD overall growth in 2H23.". This should screen well and appeal to investors.

Valuation

MIDD valuation remains low in comparison to history, with a wider discount to ITW. There are a couple of reasons why I believe the valuation has reached these levels, which I believe will continue to limit how much the gap can be closed. For starters, MIDD leverage has increased significantly since the acquisition of the outdoor grills businesses . Second, the sharp rise in interest rates has increased MIDD's cost of equity and interest expense. Finally, there is concern that the macroeconomic environment will worsen in 2H23, further depressing consumer spending. I'd like to also point out that Home Depot's management (in 1Q23 earnings call) has forecast negative SSS (-2 to -5%) for 2023, which is clearly not a good sign for home improvement trends.

While I believe the MIDD valuation is unlikely to return to its average given these headwinds, if we run a scenario analysis based on a range of multiples, the risk/reward appears to be acceptable in my opinion. For my earnings assumption, I used consensus estimates in my model and valued it using four different scenarios.

1. MIDD trades at 7x, which is the trough multiple that MIDD has ever traded (due to covid), we would see a 40% downside. I believe this scenario is highly unlikely given that covid was an outlier
2. MIDD trades at 12x-14x, which is where the stock was trading at just a few weeks ago. As investors digest and mild over the decision to stay on the sidelines or hold on to the stock, due the visible headwinds, we could see multiples bouncing in between this range. At this range, the stock is fair-valued to having 18% upside
3. Positive momentum returns to the stock due to earnings margin growth and lapsing of inventory issues, the stock is now valued at 16x earnings, a 4x discount to its average. A discount is warranted here given there high leverage profile and cost of equity.

The takeaway is that as long as MIDD does not trade below 12x earnings, the risk of losing money is low because MIDD should continue to grow earnings as it resolves the inventory issue and benefits from the commercial tailwind. As a result, my advice is to accumulate small positions if it reaches 12x earnings (the low end of the 12-14x range), but to only size up to a maximum position once we have clear visibility on RF recovery.

Risk

The prolonged impact of rising input costs and ongoing supply chain difficulties could exert downward pressure on profit margins for an extended duration, particularly as the company fulfills an exceptionally high volume of pending orders that cannot be adjusted in terms of pricing.

Conclusion

The uncertainties surrounding MIDD and its stock have hindered positive share price performance. For instance, Investors perceived management's comments on normalized lead times as a signal of declining order demand. Given the upcoming headwinds, I maintain a hold rating on MIDD. However, there may be opportunities to accumulate positions when the valuation reaches 12x forward PE, considering the current trading valuation. Investors should exercise caution and wait for clear visibility on the recovery of the RF segment before increasing their position. Despite expectations of weaker growth in the RK and CF segments in the next 1-2 quarters, growth prospects in the CF segment towards the end of the year and easier comps in 2H23 could potentially generate positive momentum.

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