2023-03-14 11:21:26 ET
Summary
- Resideo Technologies is seeing improvement in inventory destocking at channel partners which should lower the volume declines in 2023.
- REZI's revenue and margin growth should be flat to slightly positive in 2023.
- Based on DCF calculations and relative valuation, Resideo stock is trading at cheap valuations.
Investment Thesis
Resideo Technologies' ( REZI ) volume decline in Q1 FY23 should be lower as compared to the second half of 2022, as inventory destocking at channel partners is nearing completion. The company's revenue in 2023 should be flat due to the impact of volume declines and moderation in demand, offset by strong price realization, acquisitions, and new product developments. The company's margins in 2023 should benefit from its cost-saving initiatives, such as reductions in the workforce and manufacturing optimization through automation, strong price realization, and the addition of new brands. However, this should be partially offset by the volume deleverage from inventory destocking and the moderation in demand and wage inflation in Mexico. Despite the weak macroeconomic conditions, the company has healthy revenue and margin growth prospects and is trading at a cheap valuation, making it a good buy.
Products & Solutions business
In 2022, REZI's Products & Solutions (P&S) segment made up around 44% of the company's total revenue. The segment saw year-over-year growth of 12.7% in 2022, thanks to the acquisition of First Alert in Q1 2022, as well as strong volumes in the first half of the fiscal year and favorable pricing across its business portfolio. REZI's investment in pricing and sales force tools and training paid off, resulting in increased average revenue generated per salesperson and strong price realization.
The acquisition of First Alert, a leading provider of smoke and carbon monoxide sensing products, has been a strategic move for REZI, as the company is continuing to integrate it into its security business portfolio to cross-sell its products and strengthen its ties with retailers.
Despite the strong revenue growth, REZI's Products & Solutions (P&S) segment experienced a decline in gross margin in 2022, dropping by 90 basis points year-over-year to 38.7%. This was due to the increased inflationary cost pressures, partially offset by the strong price realization seen across the business portfolio. The operating margin of the P&S segment also experienced a decline of 300 basis points year-over-year, dropping to 18.9%. This was due to a combination of lower gross margins and increased expenses related to SG&A, R&D, and restructuring.
The management anticipates that the inventory destocking at the channel partners, which has been ongoing since the second half of 2022, should be nearing completion in Q1 FY23. The company collaborates with and gets information from its top 26 trade customers regarding the sell-in, their point-of-sale, and their inventory levels in terms of days. REZI saw that the inventory levels at its channel partners have come down and the point-of-sale continues to hold up. Therefore, I believe the volume declines should be lower in the quarter as compared to Q3 and Q4 of 2022. Additionally, the company should also benefit from acquisitions and new product development. In February 2023, REZI completed the acquisition of Teknique , a leader in artificial intelligence-enabled video camera development and solutions. This acquisition will advance REZI's security video business and accelerate its focus on providing artificial intelligence to its end users. With Teknique's capabilities, REZI is poised to further enhance its portfolio of products and solutions, offering more value to its customers. The new product development includes water leak detection and shutoff products, T10 thermostat enhancements, an underfloor heating controller, and a Pro Series product for EMEA. Overall, I believe the segment's revenue growth in 2023 should benefit from carryforward pricing, acquisitions, and new product development. I believe the volumes should continue to improve throughout the fiscal year.
In terms of profitability, the company's cost-cutting measures, carryforward pricing, and improvements in the inventory situation should have a positive impact on the bottom line. These cost actions include a 5% reduction in the global workforce later in the fiscal year, as well as the optimization of manufacturing facilities through automation. These factors should provide some favorable support, though inflationary cost pressure in certain materials such as steel and higher wages in Mexico due to labor inflation may partially offset these gains. Overall, I believe the segment's operating margin is likely to improve by anywhere between flat and 20 basis points in 2023.
ADI Global Distribution business
REZI generates the majority of its revenue from the ADI Global Distribution segment, which contributed ~56% to the total revenue in 2022. In 2022, the segment's revenue grew 6% Y/Y due to the strength in commercial categories in North America and acquisitions. The company is continuing to expand its e-commerce and digital capabilities, which led to total touchless sales of 37% in the fiscal year. The company is leveraging its digital investments to offer customers and suppliers AI-driven analytic tools that will provide a better understanding of their sales and inventory through customized reporting. Despite the company's continued investment in digital tools and systems to drive long-term growth, the ADI Global Distribution segment managed to improve its gross margin and operating margin by 130 basis points and 80 basis points year-over-year, respectively, to 19.4% and 8.7%. This improvement is due to the segment's improved product line margin, increased private brand contributions, and strong pricing realization.
Looking ahead to 2023, the ADI segment should benefit significantly from the AI-analytic tool that was discussed earlier, creating opportunities for revenue generation through a subscription model. The segment should also benefit from the introduction of new SKUs and acquisitions. In 2022, REZI launched 250 new SKUs and three new brands: Capture Advance, Avaro for audio-visual ((AV)) and datacom equipment, and ADI Pro for wire access control and accessories. These categories contributed over $500 million in revenue in 2022, a YoY growth of 20%. REZI is continuing to expand into these markets through new brands and acquisitions. The company recently acquired BTX Technologies , a professional AV distributor with datacom capabilities, which should enhance REZI's offering in these markets. Overall, I anticipate that the ADI Global Distribution segment's revenue will grow between low and mid-single digits in 2023, driven by acquisitions, new SKUs, and healthy activities in commercial categories, partially offset by a weak residential market.
Furthermore, the segment's operating margin in 2023 should improve due to the addition of new brands, the implementation of a new ERP system, pricing actions, and growing the e-commerce business to drive cost savings.
Risks to my thesis
It is possible that the impacts of volume deleverage may not be completely offset by pricing actions, acquisitions, and new product developments, leading to negative revenue growth in 2023. This could also have a negative impact on the margins in the fiscal year, as lower revenue may lead to reduced profitability.
Valuation
WACC calculation (Created by DzD Analysis using discoveci calculator ) DF Calculation (Created by DzD Analysis using Alpha Spread)
I arrived at the conclusion that Resideo Technologies is currently undervalued by conducting a DCF analysis and using the relative valuation. In my DCF analysis, I assumed revenue would be flat in 2023 due to the volume declines from inventory destocking offset by strong pricing realization, acquisitions, and new product development. I have assumed a terminal operating margin of 11.05% for my calculation, which is 100 bps above current levels. The reason being that REZI is continuously investing in its operating facilities and automation, which should impact near-term margins but be beneficial in the long run. I used a discount rate of 7.82% (rounded off in the Alpha Spread software to 8% for a clean representation) based on Cost of Equity of 9.95%, which is below the industry levels , and arrived at a fair value of $32.42 for REZI.
Using the relative valuation, the stock is currently trading at 8.63x FY23 consensus EPS estimate of $2.00 and 7.44x FY24 consensus EPS estimate of $2.32. This is below its five-year average forward P/E of 11.22x.
Conclusion
In summary, the company's revenue in 2023 should remain flat due to ongoing inventory destocking at channel partners as well as moderation in demand. However, this should be offset by strong price realization, acquisitions, and new product developments. The margins should improve due to cost-saving actions such as optimization at manufacturing facilities, price realization, and reductions in the workforce. However, these benefits should be partially offset by inflationary cost pressures across some materials and wage inflation in Mexico.
Despite the weak macroeconomic conditions, I have a buy rating on the stock based on the healthy revenue and margin growth prospects and cheap valuations. The company's focus on expanding into new markets through acquisitions and new product developments, coupled with cost-saving measures, should drive long-term growth and profitability.
For further details see:
Resideo Technologies: A Good Buy At Current Levels