Summary
- Vertiv’s recent pricing power should provide a solid foundation for FY23 operating profit and free cash flow dynamics.
- Forward valuations remain cheap whilst the working capital position will improve.
- Vertiv’s order book looks set to slow and the E&I integration is causing some challenges.
- The risk-reward on the charts does not look appealing.
Introduction
Vertiv Holdings Co ( VRT ) has built a name for itself by providing hardware, software, and support services in the digital infrastructure space. Even though it offers its expertise to communication, commercial, and industrial entities across the world, its services are predominantly used in the data center space.
Bullish View
Vertiv has been witnessing strong pricing power ($365m of pricing benefits seen in FY22) for a while now, and I don't believe this will abate any time soon as management reiterated that the pricing environment remained favorable across many of Vertiv's product segments. In effect, in FY23, the company expects to extract another $275m of pricing benefits. Despite Q1 traditionally being a seasonally weak quarter, things this year should be strong enough, with Vertiv now expecting pricing to boost the topline by 9% (which is similar to the 9-10% range seen in Q3 and Q4). You would think that higher pricing would dampen demand volumes but that is hardly the case with Vertiv as volumes are poised to pick up even further from the 12% run-rate seen in Q4 (a large part of Q1 volumes will be driven by the low base effect where Q1-22 volumes were down by 3%).
Vertiv Quarterly Presentation
Given the low EPS base in FY22 ( $0.20 ), one shouldn't get too excited about earnings growth in FY23, but if you stretch the horizon to FY24, consensus numbers still suggest solid enough earnings growth for VRT. According to YCharts, VRT could deliver FY24 EPS of $1.43 which would imply annual earnings growth of 21% . At a forward P/E of just 11x (15.8/1.43), that implies a very compelling Price/earnings to growth ratio) of less than 1x. Also note that the P/E of 11x would represent a massive 57% discount over the stock's long-term average P/E.
In the short term, I believe the most promising facet of the Vertiv story will be linked to FCF improvements as management has made this the top priority for FY23. As you can see from the image below, in recent periods, Vertiv hasn't done a great job in converting its inventory to sales (typically Vertiv converts its inventory by 8.8x , currently it is at 5-year lows. This was driven by heightened inventory builds related to supply chain uncertainty, which will now ease.
In addition to that, the COVID effect in China has also impacted the efficiency of their collections, with the receivable turnover at 5-year lows.
The working capital build has weighed heavily on Vertiv tilting the FCF position into the red.
Looking ahead to FY23, management believes one will see a very different narrative with expected positive FCF to the tune of $350m driven mainly by $370m worth of working capital improvements YoY.
The strong FCF generation this year could be very useful in bringing down Vertiv's heightened leverage ratio of 5.8x (+ 3bn of net debt over $ 0.53bn of EBITDA) which is still well below the company's long-term net leverage target range of 2-3x . Combine the convalescing FCF narrative with over $330m of potential operating profit improvements in FY23, ( 82% of FY23 operating profit improvements will be driven by pricing), and we could have a situation where Vertiv finishes close to the higher end of its net leverage target range.
Bearish View
Investors ought to embrace the fact that going forward, the pace of growth of Vertiv's order book will continue to slow as the buying cycle normalizes on account of reduced lead times and lower supply chain challenges. Order cancellations could also be another emerging theme in the quarters ahead (in Q4, Vertiv was subject to $170m worth of order cancellations from a large hyper-scale entity). All in all, in Q4-22, Vertiv's orders declined by 15% YoY, and in Q1-23 the YoY decline is expected to persist at the double-digit levels, augmented also by a higher base effect where things had grown by 34% in Q1-22!
Vertiv intends to make a mark in the switchgear and busway market over time and acquired E&I Engineering in 2021 as it thought its modular power solutions would give it an edge here. Unfortunately, the E&I part of Vertiv's portfolio is causing some challenges as it has faced execution issues and project cost overruns on several large projects , which will likely increase the reputation risk of Vertiv. Management noted that more tactical work would need to be carried out here to get better visibility on costs.
In Q4-22, the favorable movements of the Euro, Pound, and Yuan against the dollar helped generate a $30m tailwind on Vertiv's group topline. However, I believe things could be a little more challenging in Q1-22. This month we've already witnessed a 4.3% appreciation in the dollar index, and if it stays at these levels, expect FX to become a headwind once again.
Besides, if we shift to the dynamics on the charts, we don't think it makes a great deal of sense to stage an entry in Vertiv at this point, particularly as the stock has already delivered healthy returns of 33% over the past six months, even as the broader markets have been flat.
If one looks at Vertiv's own weekly price imprints, we can see that for over a year now it has been trending in the shape of a rising wedge pattern . Last week, the stock looked on course to break past the upper boundary of the wedge but failed to witness any momentum, leading to the formation of a bearish pin bar candle.
One could have made the case for Vertiv as an ideal mean-reversion candidate within the mid-cap space sometime towards the start of H2-22, as the relative strength ratio was only half as much as the mid-point of the long-term range. However, since then, the relative strength ratio has clawed back and is now not too far away from the mid-point.
Closing Thoughts
At this juncture, we are conflicted on VRT and feel there are compelling reasons for both the bulls and the bears. The stock is a hold .
For further details see:
Vertiv: Bullish View Vs. Bearish View