Summary
- CSWI's revenue and margins should benefit from the pricing actions in Q4 FY23 and FY24.
- The moderation in inflationary cost pressure should benefit the margins in FY24.
- CSWI stock is trading at a lower valuation compared to its historical levels.
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CSW Industrials' (CSWI) revenue and margins should continue to benefit from the pricing actions taken over the last few quarters. The company's revenue should also benefit from the acquisitions of AC Guard, Cover Guard, and Falcon Stainless, as well as from healthy backlog levels in its engineered building solutions segment. These tailwinds should offset the volume decline due to inventory destocking at its channel partners. The inventory destocking is expected to be completed in the back half of 2023, which should bring the volumes to moderate levels in the second half of FY24. The margins should also benefit from the operational efficiencies at the company's facilities and a moderation in inflationary cost pressures. Overall, given the good growth prospects and the low valuation, I have a buy rating on the stock.
Business Basics
CSW Industrials is a manufacturer of mechanical products used in HVAC/R, plumbing products, grilles, registers, and diffusers (GRD), building safety solutions, and high-performance specialty lubricants and sealants. The company has three operating segments:
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The Contractor Solutions segment, which serves residential and commercial end markets;
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the Engineered Building Solutions segment, which serves commercial, institutional, and multifamily residential end markets; and
- the Specialized Reliability Solutions segment, which serves industrial, energy, mining, and rail end markets.
CSWI's segment distribution (Created by DzD Analysis using data from CSW Industrials)
Q3 FY23 Performance
Since the beginning of 2023, CSWI stock is up 20% compared to the S&P 500 index, which is up 6.25%. This was primarily due to better-than-expected financial results for the third quarter of FY23 and investor optimism about the completion of inventory destocking in the second half of 2023. Revenue increased 25.5% year on year to $171.09 million (vs. the consensus estimate of $166.70 million). Revenue growth was driven by pricing actions and contributions from acquisitions. The diluted EPS increased 71% year on year to $1.01 (compared to the consensus estimate of $0.75). The increase in adjusted EBITDA margin and lower share count benefited diluted EPS in the quarter. The adjusted EBITDA margin increased 270 basis points year on year to 18.3%, owing to pricing actions and lower raw material and freight costs.
R evenue Drivers
The Contractor Solutions segment's revenue increased 36% year on year, or $29 million, in Q3 FY23, with organic revenue growth of $17 million and inorganic revenue growth of $12 million from the Shoemaker, Cover Guard, AC Guard, and Falcon acquisitions. The pricing initiatives drove organic growth, which was partially offset by a YoY decline in unit volumes. The segment's volumes have been facing headwinds since the second quarter of FY23 due to inventory destocking at its channel partners. The revenue in Specialized Reliability Solutions increased 16% YoY due to pricing actions and strong end market demand, including energy and general industry. Revenue in the Engineered Building Solutions segment increased by 3% year on year due to healthy commercial activity.
Revenue Outlook
CSWI's end markets (Created by DzD Analysis using data from CSW Industrials)
The volume in the Contractor Solutions segment, which primarily serves residential and commercial end markets, should continue to be impacted by the inventory destocking at its channel partners in the first half of FY24. The inventory destocking at its channel partners is due to uncertain macroeconomic conditions. As this destocking gets completed in the second half of FY23, the segment's volume growth should reach moderate levels. Approximately 80% of the revenue in this segment is generated from repair and maintenance activities. Even though volume declines should impact organic growth in 2024, the pricing actions taken over the last few quarters should benefit the segment's revenue.
Apart from this, the segment's revenue should also benefit from the acquisitions made in 2022. CSWI acquired Cover Guard, AC Guard, and Falcon Stainless in October 2022. Falcon Stainless will help expand CSWI's product line with products such as water, gas, and solar connectors in the HVAC/R and plumbing end markets. AC Guard and Cover Guard acquisitions will help expand the segment's product line in the HVAC/R market through their patented enclosures for outdoor HVAC condenser units and line set covers for HVAC/R.
In the Engineered Building Solutions segment, the company has a healthy backlog level due to healthy multifamily, manufacturing, and commercial end markets in 2022. The bookings and backlog increased 38% and 47% YoY, respectively, in Q3 FY23. The trailing eight-quarter book-to-bill ratio as of Q3 FY23 was 1.19 to 1. The healthy backlog should benefit the segment's revenue over the next few quarters. The company is starting to see a slowdown in bidding for new projects, which is in line with the decline in the recent Architectural Billing Index ((ABI)) data. The ABI in December 2022 was below its optimum level of 50, which indicates weakening demand. The company is seeing a slowdown in bidding activity in certain geographies, such as the California region - especially in Northern California. This should impact the segment's order book in the near term.
The volume growth in the Specialized Reliability Solutions segment should moderate in FY24 due to weakening demand. The weak demand could be seen in the December 2022 S&P Global Manufacturing PMI numbers, which were below 50.
Overall, I believe the revenue in Q4 FY23 and FY24 should be primarily driven by the pricing actions taken over the last few quarters, healthy backlog levels, and contributions from acquisitions. Additionally, as the inventory destocking at its channel partners gets completed in the back half of 2023, the company's volume growth should reach moderate levels. CSWI's healthy balance sheet, with a leverage ratio of 1.5x, positions it well to engage in M&As and expand its product lines and geographical presence.
Margin Outlook
While the company is seeing a reduction in the cost of shipping containers from Southeast Asia as well as lower costs for certain raw materials, it is still facing higher costs for certain items, such as domestic freight. The company is successfully offsetting these cost pressures through pricing actions and productivity gains. In Q3 FY23, the gross margin improved by 80 bps YoY to 38.5% whereas the adjusted EBITDA margin improved by 270 bps YoY to 18.3%.
CSWI's gross margin and adjusted EBITDA margin (Created by DzD Analysis using data from CSW Industrials)
CSWI segment adjusted EBITDA margin (Created by DzD Analysis using data from CSW Industrials)
In Q3 FY23, the Contractor Solutions segment's adjusted segment EBITDA margin improved by 460 bps YoY to 25.4%, driven by pricing actions, a decline in ocean freight rates, and managing cost structure. The Specialized Reliability Solutions segment's adjusted segment EBITDA margin declined 130 bps YoY to 13.9% due to the investment made by the company in equipment for its Rockwall, Texas, facility. The adjusted segment EBITDA margin in Engineered Building Solutions declined 430 bps year over year to 10.8% due to higher sales of lower-margin products.
Looking ahead, CSWI is focusing on operational excellence at its facilities, which should help expand its margins. Additionally, the pricing actions taken over the last few quarters should benefit the margins in the coming quarters. The costs of certain raw materials, ocean freight, and container costs are coming down, which should be accretive to margins. These tailwinds to the margin should offset the impact of volume deleverage from declining demand. Overall, I am optimistic about the company's margin growth prospects in FY24.
Risks
If the inventory destocking at channel partners is not completed in the back half of 2023, the company's revenue should be impacted in FY24. Also, the costs of certain raw materials and freight costs are coming down. However, if there is a material shortage and a tight freight, raw material and freight costs will increase, impacting the company's margins.
Valuation
Using relative valuation, CSWI's stock appears to be undervalued. The stock is currently trading at a P/E of 22.84x the consensus EPS estimate of $6.13 for FY24, which is lower than the five-year average forward P/E of 25.03x. We arrive at a price target of $153.43 based on the five-year average forward P/E and the FY24 consensus EPS estimate.
Conclusion
The company's revenue in FY24 should benefit from pricing actions, healthy backlog levels, and contributions from the acquisitions. These tailwinds should more than offset the volume decline from inventory destocking. However, this destocking is expected to be completed in the back half of 2023, which should return the volumes to moderate levels. The margins should benefit from pricing actions, operational excellence, and declining inflationary cost pressures. Given the good revenue and margin prospects, as well as the low valuation, I have a buy rating on the stock.
For further details see:
CSW Industrials: Near-Term Headwinds, But Good Medium-Term Prospects