2023-12-13 04:20:09 ET
Summary
- SPX Technologies is expected to benefit from strong demand in its end markets, including reshoring trends and federal stimulus funds.
- The company has shown improvement in margins and is expected to see further upside in FY24.
- SPX Technologies has good growth prospects driven by a healthy backlog, strong end markets, and inorganic growth opportunities.
Investment Thesis
SPX Technologies ( SPXC ) should benefit from the strong demand in its end markets fueled by tailwinds including the recent reshoring trend and acceleration in the deployment of federal stimulus funds next year. Further, a potential reversal in the interest rate cycle should also help the end-market demand and the company also has good inorganic growth opportunities.
On the margin front, the company has done a good job in terms of improving margins, and I believe the margin should further see an upside in FY24, driven by positive price/cost in HVAC segment and absence one time headwinds related to a pass through contract and supply chain issue in locator line of D&M segment. In the long term, the margin should see benefits from automation, productivity gains, and lean manufacturing.
Coming to valuation, while the company is trading in line with its 5-year historical averages, as the company settles the claims related to its legacy South African power business and continues with its good execution, I believe its P/E multiple can see a re-rating to the mid-20s in the long term. Given the company’s good growth prospects and the potential of P/E re-rating, I have a buy rating on the stock.
Revenue Analysis and Outlook
I previously covered SPXC in September with a buy rating anticipating continued strength in its business. The stock has reported better than expected Q3 results since then and the stock is up ~10% validating my bullish stance.
In the third quarter of 2023, the HVAC segment’s revenue increased 27% Y/Y benefitting from a 10.6% Y/Y increase in organic revenues and a 16.3% contribution from acquisitions of TAMCO and ASPEQ. The 10.6% organic growth was attributed to increased volumes, primarily of cooling products due to greater plant throughput, labor and supply chain stabilization, and price increases. In the Detection and Measurement (D&M) segment, revenue grew 11.8% Y/Y driven by organic revenue growth of 10.4% Y/Y and a favorable impact of FX translation of 1.4%. The Y/Y increase in organic revenue was due to higher volumes of large projects within the communication technologies, transportation, and aids to navigation businesses.
Consolidated revenue increased 21.1% Y/Y driven by a 10.5% Y/Y organic revenue growth, a 10% contribution from TAMCO and ASPEQ acquisitions, and a 0.6% positive impact of FX translation.
Looking forward, I am optimistic about the company’s growth prospects. The company posted a 1.6% Y/Y increase in total backlog at the end of the last quarter. While the backlog was almost flat sequentially versus the second quarter, management noted that it was mainly due to strong Q3 deliveries and the order trend continues to remain strong. For Q4 2023, management is expecting book-to-bill of greater than one indicating sequential improvement as well as meaningful Y/Y growth in backlog as we end FY23. This sets up the company for nice growth in FY24 as backlog is a leading indicator of revenue.
The company’s end markets also remain strong and it is seeing strong demand from end markets like data centers, semiconductor manufacturing, EV battery plants, and various other industrial facilities driven by the recent reshoring trend which should continue in the coming years. The end market demand is also catalyzed by various federal stimulus programs related to infrastructure funding, the Inflation Reduction Act, and the CHIPS and Science Act. Management expects the deployment under these funds to accelerate next year which should help the company’s growth. On its last earnings call , answering a question related to the funding under these acts, the company’s CFO Mark A. Carano said (emphasis ours),
... we have seen some benefit from some of that government funding, particularly in our transportation business. Some of those projects have already benefited from availability of that funding. And we anticipate that, next year, we will begin to see additional dollars benefit many of the businesses across the platform. We've talked about where that could benefit AtoN as well as our Location and Inspection businesses. And then, clearly, you may see some benefit from some of the HVAC businesses as well.
So we're watching that carefully. We anticipate that we'll see more of those dollars flow out. I think most people believe that the distribution of those funds has been slower than I think anyone anticipated. But we believe we'll benefit from those next year and beyond, quite frankly, for the next few years. ”
I also expect the company’s growth to benefit from broader industry recovery next year driven by potential interest rate cuts. With inflationary concerns moderating, analysts have already started talking of interest rate cuts next year. Lower interest rates improves return on investments for various industrial projects which increases end market demand for the company.
The company also has a healthy balance sheet with a net leverage of ~1.7x and management expects the net leverage ratio to reach ~1.5x or lower by the year-end. This is at the lower end of the management target net leverage range of between 1.5x and 2.5x. So, I expect the company to also focus on inorganic growth opportunities which should add to overall growth.
Overall, the company has good growth prospects driven by a healthy backlog, strong end markets, increased deployment of federal stimulus dollars, and inorganic growth opportunities.
Margin Analysis and Outlook
In Q3 2023, SPXC’s margins benefitted from a higher absorption of manufacturing costs as a result of increased volumes, price increases, and a favorable sales mix related to recent acquisitions with higher margin profile. Further, improved operational execution resulting from investments in plant automation and labor and supply chain stabilization, especially within the HVAC segment contributed to the margin growth. As a result, the consolidated segment income margin expanded by 330 bps Y/Y to 20.4%, and the adjusted operating margin expanded by 390 bps Y/Y to 16.9%.
The margin growth was led by the HVAC segment, which grew the segment income margin by 570 bps Y/Y and was partially offset by a 30 bps decline in the D&M segment income margin.
The company has done a really good job in terms of margin expansion this year and according to management guidance, it is expected to achieve the margin targets set for FY25 in the current year itself.
I see a further upside to margins next year and believe management should revise their FY25 margin target upwards. In the D&M segment, the company has a 100 bps of margin headwind this year due to a lower mix issue in the communication technologies business (where margins were impacted by pass-through content) and a supply chain issue with respect to its locator product line. These issues are temporary in nature and should not repeat, helping next year’s margins. In the HVAC business, the continued strong demand is helping pricing while raw material inflation has started easing which should help the margin. The company margins should also benefit from operating leverage given a healthy sales growth outlook. The longer-term margin outlook is also good thanks to the company’s continuous improvement approach focusing on automation, productivity, and lean manufacturing.
Valuation and Conclusion
SPXC is currently trading at a 19.08x FY24 consensus EPS estimate of $4.70 and a 17.55x FY25 consensus EPS estimate of $5.11. Over the last 5 years, the Company has traded at an average forward P/E of 18.75x.
The company has meaningfully improved its execution over the last several years. However, one of the overhangs which has impacted its valuation multiple in the past was the claims associated with its legacy South African power business. In Q3, the company finalized an agreement with Mitsubishi to settle all the remaining claims between them. There will be one final settlement payment of ~$19 mn, including related tax benefits, next year and this chapter will be closed removing residual uncertainty related to the dispute resolution process. This should help improve investor sentiments and help remove this overhang on valuation causing a potential re-rating. High-quality industrial companies with a good long-term track record of execution and following similar bolt-on acquisition strategy and continuous improvement strategy (e.g. Danaher Corporation ( DHR )) usually trades in mid to high 20s P/E multiple. I believe SPXC’s stock can trade at mid-20s P/E in the long term if it continues to execute well. This potential for P/E multiple re-rating coupled with the company’s good revenue and margin growth prospects make it a good buy.
For further details see:
SPX Technologies: Good Growth Prospects And Potential For A Re-Rating