Summary
- Allegion had a better than expected quarter, helped by strong price realizations and improving supply chains.
- There is increasing evidence of a turn in non-residential construction, but Allegion's specific exposures (retrofits and a large institutional customer base) should drive relative revenue outperformance in 2023.
- Allegion's idiosyncratic cycle/customer exposure is interesting, as are margin leverage opportunities, but the valuation isn't all that exciting.
Following the twists and turns, each economic cycle interests me greatly, and it’s even more interesting when companies have their own idiosyncratic drivers. Such is the case with Allegion ( ALLE ) today. Although I don’t love the valuation, I do find the company’s later-cycle leverage and margin opportunities intriguing, and I think management is making broadly good decisions with the business.
These shares are up around 5% from the time of my last article , basically tracking the broader industrial sector, though modestly underperforming Assa Abloy ( ASAZY ). I do think that Allegion’s business could stay stronger for longer, at least compared to other multi-industrial mechanical/electrical companies with significant non-residential exposure, but despite an outlook for double-digit long-term FCF growth, I don’t see compelling value here.
A Quarter Above Expectations, But Still “Mixed” In Some Respects
Allegion had a pretty good fourth quarter, but came up just a bit short of “excellent”, subjective as that may be, and guidance for the next year was a little soft.
Revenue rose a little over 11% in organic terms, good for a nearly 2% beat versus the Street and putting Allegion just over the line for “better than average” growth among multi-industrials this quarter. As has been the case for most companies, price was the overwhelming driver, with price contributing over 12% to growth (with volume down about 1%).
The Americas business posted 18% organic growth, modestly beating expectations, with price up 15% and volume up 3%. Non-residential remained strong (up mid-20%’s), while residential slowed from up mid-teens in Q3 to up low single-digits, and the electronics business was up 50%. Allegion once again outperformed Assa Abloy in this region (+18% versus +11%) after Assa enjoyed several quarters of share gains as Allegion struggled with supply chain issues.
In the International business, revenue declined 4% despite 6% price growth, but that was still good for a 6% beat. Given how the businesses overlap (or rather, don’t), comparisons to Assa are less useful here.
Gross margin improved 30bp yoy and 40bp qoq, but still missed by about 40bp – misses at the gross margin line have been common this quarter. Management noted improvements in the supply chain for its mechanical components, but the electrical side still remains problematic.
Operating income rose 44%, beating by 4%, with margin up 310bp to 19.5%. Segment profits rose 39% (with margin up 280bp to 21.8%), with Americas up 56% (margin up 290bp to 24%) and missing by 1%, while International fell 21% (margin down 90bp to 13.1%), beating by 41%.
Guidance calls for 3.5% organic growth at the midpoint, with the Americas business up 5% (light of sell-side expectations closer to 7%), and International down 1% (better than the 3% decline expectation). The midpoint of the EPS guide ($6.40) was about 1% below expectations ($6.46).
Business Is Going To Slow … But How Much And How Quickly Are Key Questions
There was nothing surprising to me about management pointing to signs of a softening market in the residential business; this has been my expectation for 2023 for some time, and companies like Fortune Brands Innovations ( FBIN ) and Masco ( MAS ) are already seeing it. New construction is likely to fall at a high-teens rate this year, with renovation probably down somewhere in the mid-to-high single-digits; the latter being more relevant to Allegion (it’s more leveraged to the repair/replace market than new construction).
Likewise, news of slowing demand in the international residential business is not surprising, as Europe seems to be slowing more noticeably than the U.S. and China remains rather weak.
Non-residential is more complicated. Leading indicators like the Architectural Billings Index (or ABI) have been weakening for a little while now, but the key there is “leading” – it can take a year in some cases for weakness in indicators like the ABI or Dodge Momentum Index to show up “on the ground”. Still, there have been some signs of weakness in companies exposed to early-cycle non-resi.
How this will impact Allegion isn’t completely clear to me at this point, but I think that Allegion could do better than average. First, the company was supply chain-constrained previously and is now able to ship to demand, so it’s plausible to me that regaining share could help offset some underlying weakness. I also believe Allegion’s business is later-stage and could allow for continued outperformance versus non-resi businesses at companies like Eaton ( ETN ), Trane ( TT ), Acuity ( AYI ), Johnson Controls ( JCI ), Hubbell ( HUBB ), and so on.
Another factor skewing the results is Allegion’s exposure to institutional business (government buildings, schools, health care facilities, et al) and retrofits. Institutional construction activity tends to be driven less by the economic cycle, and Allegion is benefitting from a cycle of retrofits to convert to hands-free and/or electromechanical entry systems.
The Outlook
I still remain concerned about the broader economy. Inventories are at a decade-plus high and leading indicators like loan officer surveys are pointing to reduced C&I lending activity. Along these lines, high inventories and high inflation going into a corrective cycle have been predictors for longer, more serious corrections in the past. While Allegion would see the impact later than most, it would still ultimately impact non-residential activity.
I do see elevated uncertainty over the next 12-24 months, but I think Allegion will be a relative outperformer on revenue growth as it leverages supply chain improvements and past pricing actions. I do expect a slowdown in 2024 and 2025, though, and while I expect 6% or better revenue growth in FY’23 and FY’24, my model works out to long-term revenue growth a bit below 5% on an annualized basis.
Growing electronics, controls, and service businesses should be beneficial for margins over time, and management is taking other steps to boost margins. A new plant in Mexico will shorten supply lines (replacing products sourced from Asia), but margin benefits likely won’t materialize until 2024/25. Even so, I’m looking for EBITDA margins to reach the mid-20%’s over the next three years, and I expect free cash flow margins to improve from the low-to-mid-teens to over 20% across the next 10 years, driving FCF growth around 10%.
Neither discounted cash flow nor margin/return-driven EV/EBITDA suggest that the shares are significantly undervalued to me today. At best, if I give credit today for the margin improvements I expect over the next few years, I can support a 14x forward multiple, which would get me to around $120 on my ’23 EBITDA estimate.
The Bottom Line
Valuation doesn’t constrain stock behavior all that much – expensive stocks can still go up a lot and cheap stocks can still go down a lot (at least in the short term). Given what I see as superior exposure at this point in the cycle, Allegion could outperform a bit longer, though that could also mean that the company starts seeing weakness at a time when others are closer to bottoming/rebounding. In any event, while there are certainly positives to this story, the valuation just doesn’t work for me today.
For further details see:
Allegion: Interesting Later-Cycle Exposure, But Less Interesting On Valuation