2023-09-19 04:32:30 ET
Summary
- MSA Safety has positioned itself through product innovation, strategic pricing, and premium branding, with key growth drivers in firefighter safety, gas detection, and industrial PPE product lines.
- Weakened demand from non-residential construction and adverse economic changes have affected the business. So, it focuses on cost optimization to deliver profitable growth.
- Negative cash flows are a concern for investors; however, it has refinanced debt to lower debt financing costs.
MSA Keeps It Together
I have been discussing MSA Safety Incorporated ( MSA ) in the past, and you can read the latest article here . In 2023, the company has positioned itself firmly through product innovation, strategic pricing, and premium branding. The key growth drivers are firefighter safety, gas detection, and industrial PPE product lines. The Bacharach acquisition has also expanded its addressable market.
However, weakened demand from non-residential construction, adverse industrial employment, and general economic changes affected the business. Its debt-to-equity ratio is higher than some competitors, coupled with negative cash flows, which can aggravate investors' concerns. However, it has addressed the issues by refinancing debt and reducing costs to improve cash flows. The stock is relatively overvalued. I suggest investors "hold" the stock for moderate medium-term returns.
Backlog And Strategy
In my opinion, MSA's near-to-medium-term outlook would depend largely on the backlog and the dynamics of the industry drivers. In 1H 2023, its book-to-bill ratio was 1x, indicating sufficient future visibility. With a steady commercial pipeline, it actually reduced its backlog sequentially in Q2 to reflect the improvement in its supply chain. Year-over-year, its orders increased by "high single digits" in July.
In August, the ISM Manufacturing PMI remained nearly unchanged at 47.6 compared to July. This indicated continued contraction in manufacturing activity and a rapid decline in new orders. On the other hand, production stabilized, and input prices remained subdued. However, a reverse in the input cost (i.e., a rise) is possible in the medium term. A rise in cost and an economic slowdown can adversely affect MSA's outlook.
MSA primarily focuses on cost optimization in this environment. It aims to deliver profitable growth and generate strong cash flow. Given the recently acquired momentum, its management expects the topline to grow by "mid-single-digit" in 2H 2023. Q3 should account for the majority of the expected growth. In FY2023, its revenues can grow by "low double digits" compared to FY2022, estimates the company.
End Market Outlook And Challenges
In a product-wise breakdown of its outlook, the breathing apparatus accounted for 23% of its Q2 sales. Here, the company received large orders in the West Midlands and California. The company's firefighter safety has been steady over the past several years despite the various supply chain challenges in the recent past. Demand for these products typically comes from the federal, state, and local governments. In Q2, firefighter helmets and protective clothing increased by 36%, while breathing apparatus saw a 10% topline rise.
Improved labor and material availability have brightened the outlook of firefighter and protective apparel businesses. MSA has developed a connected product ecosystem to help protect firefighters. This includes innovative solutions like LUNAR a (handheld wireless device), FireGrid (a cloud-based software platform), ULTIMA X5000 gas monitor, and portable gas detection.
Although the company's industrial PPE business grew in Q2, macroeconomic variances fluctuated among the end markets. While the demand for process industries and utilities remained stable, demand from non-residential construction weakened. Adverse industrial employment and general economic changes affected the business in Q2. The business will likely remain soft in the near term.
Acquisition And Future Drivers
MSA has invested ~$400M in M&A over the past four years to enhance its market position and expand the addressable market. It continues to benefit from the Bacharach acquisition (completed in July 2021). Bacharach provides gas and leak detection technologies for heating, ventilation, air conditioning, and refrigeration markets. It supplemented MSA's HVAC and refrigeration product lines. In addition, the demand from the food retail and quick service restaurant sectors benefited the company. It has recently signed a $25 million multiyear contract with the U.S. Navy.
The Key Drivers
Geographically, year-over-year revenues in the Americas surpassed (with a 22% rise) sales in international territories (16% up). Adjusted operating margin in the Americas was 30.7%. Higher volume and disciplined cost management resulted in margin expansion in Q2. The International segment expanded its operating margin by 140 basis points over a year ago. Pricing initiatives and improved operational productivity led to margin growth.
MSA's gross profit margin inflated by 360 basis points in Q2 compared to a year ago. The company's earnings per share increased by 42% in Q2 2023 compared to a year ago. Higher operating profit in both its operating segments was mitigated by higher interest expense in Q2.
Cash Flows And Debt Level
In 1H 2023, MSA's cash flow from operations turned steeply negative – a sharp deterioration compared to a year ago. Although revenues increased during this period, the $341 million contribution on divestiture of MSA LLC affected cash flows adversely. Free cash flow (or FCF) also turned negative in 1H 2023.
MSA has a much higher debt-to-equity ratio (1.1x) than some competitors (GRC, BRC, TNC). Its liquidity (cash & equivalents plus available borrowings from a revolving credit facility) totaled $635 million as of June 30, 2023. Under the current high-interest rate environment, it has refinanced debt, which helped it reduce the share of floating rate debt while extending the maturity date into 2028.
Relative Valuation
MSA's forward EV/EBITDA multiple expansion versus the current EV/EBITDA contrasts with its peers because its EBITDA is expected to decrease versus an increase in EBITDA for its peers in the next year. This typically reflects in a lower EV/EBITDA multiple than peers.
However, its EV/EBITDA multiple (17.1x) is higher than its peers' (GRC, BRC, and TNC) average of 10.6x. So, the stock is relatively overvalued. It is also trading at a slight discount to its past five-year average. Given the near-term drivers, I think the stock may slide slightly (5%-10% downside potential), but with strengthened strategic positioning, it should back up to yield positive returns in the medium term.
Wall Street Rating & Target Price
In the past 90 days, two sell-side analysts rated MSA a "buy" (including "Strong buy.”) One of the analysts rated it a "hold," while none rated it a "sell." The consensus target price is $183, suggesting a 5% upside at the current price.
Why Do I Upgrade MSA?
In my previous article, I expressed my suspicion over MSA's ability to rebound in the short term. I noticed the effects of supply chain disruptions in electronics and the global economic slowdown that can hamper its sales growth. While the supply chain issue did play out, the economic recession did not pan out as I imagined. It is unclear whether the economy has managed to soft-land or we are just kicking the can down the road. In any case, the stock rebounded and produced excellent returns over the past six months. I wrote :
the ISM Manufacturing PMI went down recently, suggesting an industry activity contraction. The specter of the world economic recession looms large over the outlook of the providers of safety products for infrastructure and many industries like MSA.
After Q2, the company appears to be on a firmer footing as its book-to-bill ratio has been steady. Many of its product lines have a brighter outlook for the rest of the year. MSA's cost management strategy has played a vital role in steadying margins. Although not all the parameters have improved (e.g., negative cash flows), it is convincing enough to turn my call in favor of a "hold" from a previous "sell."
What's The Take On MSA?
MSA has recently received large orders for breathing apparatus in West Midlands and California. Improved labor and material availability have enhanced the outlook for firefighter and protective apparel businesses. The Bacharach acquisition continues to strengthen its HVAC and refrigeration product lines. The company's recent foray into the restaurant sector and another large order from the U.S. Navy will propel it forward over the medium term. So, the stock outperformed the SPDR S&P 500 ETF ( SPY ) in the past year.
However, it will likely face challenges in the industrial PPE business, especially in non-residential construction. Cash flows turning negative is another concern for the investors, although MSA LLC divestiture-related issues primarily contributed to it. So, I expect cash flows to improve in 2H 2023. The company has robust liquidity. It has refinanced debt to reduce debt financing charges. Given the stretch in relative valuation, I think the stock is apt for a "hold."
For further details see:
Product Line Growth Will Hold MSA Safety Steady (Rating Upgrade)