2023-11-15 09:29:36 ET
Summary
- We are encouraged by APOG’s profitability which is showing signs of continuous improvement.
- We see scope for further margin expansion, which should push APOG towards its 10%+ operating margin target.
- We initiate with a BUY rating and a $56.50 price target.
Business Overview
Apogee Enterprises ( APOG ) is a manufacturer of architectural glass and metal glass framings. The Company also provides building glass installation services. Its four main business segments are Architectural Framing Systems, Architectural Glass, Architectural Services, and Large-Scale Optical Technologies ((LSO)). The Company undertook an extensive strategic review of its business in fiscal 2022 and since then has realigned its focus on premium offerings with higher margins and profitability. Along with premiumization, APOG relaunched Lean and continuous improvement using the Apogee Management System ((AMS)). Through the deployment of AMS, we see the potential to drive meaningful productivity gains and continued margin improvement for the next several years. APOG aims to continue its new strategy over the next several years and set financial targets for fiscal 2025, including 1) a return on Invested Capital ((ROIC)) of greater than 12%; 2) an operating margin greater than 10%; and 3), revenue growth greater than 1.2 times the growth of the overall non-residential construction market.
Apogee operates in four different segments.
Architectural Glass ((AG))
Accounting for 19% of total sales, the segment coats and fabricates high-performance glass used in custom window and wall systems on commercial buildings. Operating under the Viracon brand, the glass business has long been an industry leader. It has a reputation for quality and service, deeply entrenched relationships with customers and influencers, and a wide range of capabilities. Despite these positive characteristics, the Glass segment has long underperformed its potential. The segment’s margin performance has been historically poor, with operating margins hovering in the low to mid-single-digit range. APOG’s aim is to drive the margins between the ten to fifteen percent range.
In order to achieve this goal, the AG segment adopted a new strategy focused on the premium segment of the market. This shift in market focus has led to a more favorable sales mix, improved pricing, and new growth opportunities. Along with premiumization, the AG segment has focused on cost and productivity improvement. The progress with this strategy is evident in their financial results, as the AG segment has delivered impressive margin gains, which has positioned the business as an economic leader.
Architectural Framing Systems ((AF))
This segment is the largest contributor accounting for 45% of total sales, and is a vertically integrated provider of aluminum windows, curtain wall, storefront, and entrance systems. AF has eleven manufacturing facilities located in the U.S. and Canada but has underperformed over the past several years. APOG noted that its priority is to grow the margin profile of AF to double-digits. To support this goal, cost reduction, and realignment initiatives have been announced, and we are now starting to see positive results. As seen in Exhibit 2, the operating margin for AF has improved to double-digits, in line with management’s target range of 9-12%
Large-Scale Optical Technologies ((LSO))
The segment manufactures coated glass and acrylic primarily for use in custom picture framing, museum framing, wall décor, and other display applications. In fiscal 2023, this segment accounted for approximately 7% of total sales. The segment has shown consistent profitability over the past five years. Adjusted operating margins have been north of 20%, in line with management’s long-term target of 20%+ margins.
Architectural Services (AS)
Accounting for 29% of sales, the segment provides technical and project management services to install building glass and curtain wall systems. The integration of the Sotawall business to the AS segment from AF (Architectural Framing) is impacting margins in the near term. The Sotawall backlog includes lower-margin projects.
Investment Thesis
Apogee Enterprises is a leading provider of high-performance glass and acrylic products for the nonresidential construction market. The Company’s initiatives to improve profitability are yielding strong results. Recent Q2:24 results confirm the progress management is making to reposition the Company and improve profitability.
APOG delivered top and bottom-line growth in Q2:24, operating margins at 11.5%, and had a strong cash flow quarter, with cash from operations significantly higher than last year’s second quarter. These improved financial results are underpinned by the strengthening operational execution across all segments. The Architectural Glass segment continued its impressive momentum, with its eighth consecutive quarter of sequential margin expansion. We see scope for margin enhancement in other segments (such as Architectural Services), which could push APOG towards its 10%+ operating margin target. We expect Architectural Services operating margin to increase in the second half of the year compared to the first half, primarily due to the progression of work on active projects.
At the Investor Day in November 2021, APOG established three-year financial targets for return on invested capital ((ROIC)), operating margin, and revenue growth. The Company is well on its way to reaching each of these objectives. ROIC in FY:23 reached 13.8%, exceeding APOG’s target of greater than 12%. In fact, all four segments had a ROIC above 12%, a first for the Company in many years. Operating margin improved to 8.7%, great progress toward the 10% plus target after just one year of its three-year plan. Furthermore, overall revenue growth surpassed the growth rate in the non-residential construction market.
We are confident that APOG will be able to achieve these objectives, given its seasoned leadership. The leadership team has experienced management and a dynamic ecosystem of professionals with deep domain expertise. APOG’s balance sheet remains strong, with a leverage ratio of just 0.7x. We forecast free cash flow for 2024 at $74.7 million. Therefore, with much-improved profitability and strong cash flow, we see increasing potential for opportunistic M&A in the future.
Improving Profitability in the Architectural Glass Segment
We are encouraged by APOG’s profitability, which is now showing signs of continuous improvement, driven by several initiatives focused on optimizing the footprint, improving cost structure, and enhancing product/pricing strategy. Some of APOG’s key actions taken include site closures, integrating their supply chain, back-office consolidation, and product standardization. The turnaround, which began in 2021, is led by the Architectural Glass ((AG)) segment. In the past, the AG segment had operating margins in the low single digits. However, these margins have now moved well into the high double-digits as a result of eight consecutive quarters of sequential margin improvement. During the past 18 months, the AG segment has been repositioned and is now squarely focused on the fabrication of higher value-added/differentiated glass that commands better pricing and profitability. This strategic transformation was well evident in Q2:24 results. Revenues for AG increased over 25% to $97.2 million, and operating margin improved to 18.5% (up 1,020 basis points year-over-year). We note that the high margins for the AG segment witnessed during Q2:24 may not be sustainable, and we expect margins for AG to revert to the Company’s target range of 10-15%. This result still means significant improvement in profitability compared to 24 months ago when the margins were hovering in low single digits.
We see scope for margin enhancement in other segments (such as Architectural Services), which could push APOG towards its 10%+ operating margin target. We expect Architectural Services operating margin to increase in the second half of the year compared to the first half, primarily due to the progression of work on active projects. Although Architectural Services margins would improve through the year, management expects that they will likely fall short of the seven to nine percent target range for the fiscal year.
For fiscal 2024, we are anticipating solid gains as the company realizes more benefits from its restructuring efforts. Operating margins are expected to be at 9.7%, up from an adjusted margin of 8.7% in fiscal 2023. We believe that fiscal 2025 margins will be helped by further productivity and Apogee Management System ((AMS)) initiatives with an improved project pipeline and services and a continued emphasis on improving sales mix. However, higher interest rates, potential credit tightness, and general economic weakness continue to remain headwinds.
Growing Faster than the Non-Residential Construction Market
Most of APOG’s revenue growth will ultimately be tied to the health of the non-residential construction market. The chart below illustrates APOG’s 2015 to 2022 revenue growth versus the growth in non-residential construction spending for the U.S. The chart clearly indicates that APOG has been exhibiting greater growth than the market for most of those years. We attribute much of that better growth versus the industry to both share gains and the firm’s focus on delivering higher-performance products to a demanding customer base. APOG is aiming to improve the Company’s outperformance going forward with a target to grow at least 20% faster than the overall non-residential construction market.
U.S. non-residential construction spending has grown by 17.9% year-over-year during the first eight months of 2023. But there are expectations that it might soften for the remainder of the year. This result was reflected in the backlogs of Framing and Services, which both saw sequential declines. At Framing, the backlog fell to $197 million from $221 million, and at Services, the backlog declined to $674 million from $709 million. As such, for full year FY:24, APOG has guided for a flat to lightly declining sales growth which is not surprising given the cyclical nature of the business where downturns are expected.
Large Market Opportunity
According to FMI Capital Advisors , the value of U.S. non-residential construction is expected to reach roughly $670 billion by 2027. However, APOG is mainly focused on the glazing part of the non-residential construction industry, which is nearly $14 billion in size. But through its new strategy revealed in 2021, we see adjacent opportunities for APOG that could allow it to tap into the larger $670 billion pool. Non-residential construction can include segments like the construction of lodging, offices, commercial buildings, health care, and education. Generally, the U.S. construction industry is linked to the general economic well-being of the country.
While the overall outlook for the non-residential construction market remains soft amidst a higher interest rate environment, we believe there are individual sectors that will do better or worse than the aggregate based on their microeconomic conditions.
According to data from FMI, total non-residential construction in the U.S. is expected to increase by two percent in 2024 and then decline by three and two percent, respectively in 2025 and 2026. Within this segment, smaller sectors of private nonresidential construction have been holding up a little better than the overall category and are likely to outperform. These smaller sectors include education, healthcare, public safety, transportation, and communication.
Healthcare remains steady and is expected to continue to grow in the low- to mid-single-digit range until 2025, buoyed by the aging population. Communications are seeing a revival as faster and more reliable networks will be needed to accommodate the growing use of artificial intelligence and other cloud service offerings, Internet of Things and virtual offices, learning, and entertainment demands. Communications construction spending is expected to grow in the mid to single-digit range until 2027. Transportation is among the fastest-growing markets, with projections of double-digit growth until 2025. Rail/transit is expected to lead transportation investment growth, tied to increasing manufacturing construction and port activity. Private education has increased with private school and daycare demand increasing, which should further support construction spending growth over the next several years in the educational sector. Public safety is another area which is experiencing growth backed by government spending. In all, these sectors should buoy total private non-residential construction activity.
APOG, via its Architectural Framing, Services, and Glass segments, does serve these industries, which are growing faster than the overall market and therefore should benefit from this exposure.
Investment Risks
- The cyclical nature of commercial construction activity is a key risk. A long and substantial downturn in the nonresidential construction activity could adversely impact APOG.
- The overall outlook for the non-residential construction market remains soft in the near term amidst a higher interest rates environment which could reduce the demand for APOG’s products and services and impact profitability. We do see it as a near-term risk to our margin improvement thesis. However, individual sectors in the private non-residential market, such as healthcare, education, and transportation, are expected to outperform and could mitigate the impact of a slowdown on APOG to an extent.
- Rising raw material costs for aluminum, glass, paint, and other materials used in operations could impact margins and profitability.
- Failure to integrate acquisitions could hurt operating results. Also, rising competitive intensity could put pressure pricing and impact margins.
Valuation
We value APOG using industry peer companies (Price/Earnings and EV/EBITDA multiples) blended with our Discounted Cash Flow ((DCF)) valuation to derive a fair value target price for the Company.
For our peer valuation, we have assembled a group of public companies that are involved in supplying building products. The peer group includes Compagnie de Saint Gobain, AGC, PGT Innovations ( PGTI ), Qanex Building Products ( NX ), Jeld-Wen ( JELD ), Tecnoglass ( TGLS ), and Insteel Industries ( IIIN ). We have also included two international glass manufacturing firms - Cie de Saint-Gobain and AGC Inc. We are valuing APOG using a combination of P/E and EV/EBITDA multiples and apply these multiples to our FY:25 forecast. We value APOG at ~10.9 times FY:25 EPS of $4.65 and 6.8 times FY:25 adjusted EBITDA of $186.8 million. We note that our multiples are at a slight premium to the peer group average, given the expanding margins and improved profitability seen at APOG. This valuation results in a price target of $51.30.
We weight the other 50% of our target using our Discounted Cash Flow target. Our DCF model uses our forecasted free cash flow to the firm over one year and then grows EBIT at a 10% rate over years two to three, at a 5% rate over years four to six, and at a 3% rate thereafter. We apply a weighted average cost of capital of 9.24%. Our DCF produces a value of $61.71.
The combination of $51.30 at 50% and $61.71 at 50% results in a weighted average price target of $56.51, which we round down to $56.50.
For further details see:
Apogee Enterprises: Strong Margin Expansion; Initiating Coverage With A Buy Rating