Allegion exceeds low expectations for 1Q22 but faces many challenges (ALLE)

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Allegation (NYSE: ALL) is a leading supplier of locks and doors with a wide range of products ranging from simple mechanical assemblies for individual doors in single-family homes to complete high-tech solutions for large buildings. To position yourself well across this wide range of products and customers, the company uses 23 brands, eight of which are dedicated to products intended for non-residential customers.

Ingersoll Rand plc, an industrial conglomerate spun off from ALLE in 2013. ALLE has two divisions – Allegion Americas (Americas) and Allegion International (International). Allegion International sells its products on four continents and has manufacturing facilities in 10 countries.

ALLE’s 1Q22 results beat analysts’ expectations but illustrate lingering challenges

ALLE reported adjusted EPS of $1.05 versus analyst estimates of $0.98. The favorable performance compared to expectations is most likely explained by higher than expected price increases. CEO Dave Petratis attributed the 4% revenue growth to a 6% price increase, with a secondary benefit coming from a modest volume increase in the non-residential and international segment in Americas, partially offset by exchange rate headwinds.

ALLE badly needed a significant price increase after inflation eroded its margins in 2021. The table below shows that ALLE exercised pricing power while effectively controlling its costs, which improved its results in 2017-2020. This has changed drastically in 2021.

Impact on operating profit

2021

2020

2019

2018

2017

Pricing

1.8%

1.0%

1.8%

1.6%

1.8%

Excess COGS inflation

-1.2%

-0.2%

1.6%

-0.1%

0.4%

Excessive inflation of general and administrative costs

-0.5%

2.3%

-0.4%

-0.4%

0.6%

Source: SEC Filings

Unfortunately, the sharp rise in prices put an end to the good news for 1Q22 results. ALLE’s operating margin further compressed to 16.2% from 18.9% in 1Q21. According to ALLE’s 10-Q, inflation accounted for 2.1 percentage points of the erosion of 2.7 percentage points. Therefore, it appears that management still has not aligned ALLE’s pricing with its costs despite the significant price increase in 1Q22. On the earnings call, CEO Petratis said the company has advised customers of price increases for 2Q22, but margins may not improve until 3Q22.

ALLE will need to show improvement throughout the year to reach its 2022 Adjusted EPS guidance of $5.55 to $5.75. The chart below suggests that 1Q21 should have been an easy comparison for 1Q22 given that ALLE’s gross margin and operating margin both declined in 2021. A few analysts who participated in the call on results appeared to note that 1Q22 adjusted earnings of $1.05 were below the quarterly rate needed to meet ALLE’s full-year targets. CFO Mike Wagnes said around 60% of revenue will be generated in 2022.

Gross margin and operating margin of ALLE

Chart created in Excel

Gross margin and operating margin of ALLE (SEC Filings)

Source: SEC Filings

Supply chain issues AND rising inventory?

Over the past year, many companies have blamed supply chain issues for negatively impacting their revenue. The media has documented this global macroeconomic problem with particular attention to the problems at two Californian ports. ALLE’s continued assertions of supply chain issues hampering revenue are puzzling as its inventory level increased throughout 2021 and into 2022. The graph below shows that the number of days inventory on hand (DOH) at ALLE increased to 84 at the end of 2021 after remaining in a narrow range of 62-67 since 2015. DOH inventory increased another 3 days in 1Q22 to reach 87 on 31 March 2022, i.e. 19 days longer than on the same date in 2021.

ALLE Inventory and Available Inventory Days

Chart created in Excel

ALLE Inventory and Available Inventory Days (SEC Filings)

Source: SEC Filings

The increase in DOH inventory would make sense if the supply chain problem was centered on logistics and the goods remained on ALLE’s balance sheet because they were stuck in the delivery process. However, that is not how CEO Petratis portrayed the problem in recent earnings calls. Instead, he focused on input shortages.

Poor international results

Turbulence in Europe will only exacerbate Allegion International’s poor performance. The segment generated 27% of ALLE’s revenues in 1Q22, but only 14% of its operating profit. The chart below illustrates that 1Q22 was not an anomaly. ALLE made several acquisitions in Europe which did not develop as expected. The company recorded a charge of $99 million in 2020 for impairment of goodwill and intangible assets from its operations outside of the Americas. There was no impairment for Allegion Americas.

ALLE operating margin by segment

Chart created in Excel

SEC Filings

Source: SEC Filings

Note: Results for International eliminate the impact of the $99 million impairment charge in 2020.

Russia’s invasion of Ukraine could make a bad situation worse. The latest forecast from the International Monetary Fund (IMF) reduces real GDP growth in the European Union in 2022 to 2.8%, down from 3.9% in its previous forecast. The IMF expects Germany, one of Allegion International’s key markets, to be particularly hard hit.

Potential headwind from residential construction

Interestingly, implied management revenue stagnates in residential Americas as they highlighted international and non-residential Americas as growth drivers in 1Q22. The outlook for revenue growth in the residential Americas could be bleak over the next few years. According to the Census Bureau, new home sales fell 6% in 2021 after increasing at an annual rate of 10% between 2011 and 2020. The National Association of Home Builders’ Confidence Index fell 2 points in April , marking the fourth consecutive decline. Additionally, higher mortgage rates could dampen home sales in 2022. Freddie Mac’s mortgage benchmark recently topped 5%, more than 2 percentage points higher than the 2021 average.

Evaluation

The following valuation uses management’s outlook for 2022 and recent trends to project free cash flow (FCF), then values ​​ALLE as an increasing perpetuity. The table below presents ALLE’s FCF forecast for 2022 as well as actual figures for 2019-2021. The comparisons show that the projected 8% free cash flow growth in 2022 is reasonable. Projected free cash flow for 2022 reflects management’s expectation of revenue growth of 7.5% to 9.0% and improved operating results. As mentioned earlier, management guidance looks aggressive based on 1Q22.

($ million)

2019

2020

2021

2022 (fcst)

Revenue

2,854

2,720

2,867

3,104

Gross profit

1,252

1,179

1,205

1,273

SG&A

681

636

675

714

Amortization

15

14

12

11

EBITA

586

557

542

570

Pro forma taxes

76

72

70

74

Pro forma net income

510

485

472

496

Depreciation

47

47

45

45

Capex

78

57

32

35

D Working capital

13

3

34

20

FCF

466

472

451

486

Key indicators

Revenue increase

4.5%

-4.7%

5.4%

8.3%

Gross margin

43.9%

43.3%

42.0%

41.0%

SG&A / Sales

23.9%

23.4%

23.5%

23.0%

Tax rate

13.0%

13.0%

13.0%

13.0%

Source: company documents

It seems reasonable to value ALLE using increasing perpetuity with a terminal growth rate of 3%. Management’s forecast for 2022 includes 8% growth in free cash flow, a proxy for FCF, and analysts expect ALLE’s EPS to grow 8% in 2023. However, these rates growth benefit from comparisons with a weak FCF in 2021 and high inflation. It will be much more difficult for ALLE to systematically increase the FCF above 3% after 2023.

FCF’s rising perpetuity values ​​ALLE at $96, 16% lower than ALLE’s closing on April 26, 2022. It would be reasonable to add $1 to $3 for ALLE’s recently announced acquisition of Stanley Black and Decker’s Access Technology Business for $900 million. ALLE believes there is at least $1 per share in tax savings. Access Technology operates in ALLE’s more profitable Americas segment. Therefore, it is conceivable that management could derive additional value from the acquisition; however, it seems unlikely that the acquisition could bridge the gap between ALLE’s current stock price and the stock price indicated by the model assuming the data is reasonable.

Stock price calculation

Item ($millions)

Value

Source

(A)

FCF0

$486

Pro forma FCF for 2022 in the table above and in line with management guidance of $470m to $490m

(B)

FCF growth rate

3.0%

Selected

(VS)

Risk-free rate

2.8%

https://www.treasury.gov

(D)

Beta

1.14

Yahoo finance

(E)

Market risk premium

5.0%

Damodaran Online: Aswath Damodaran Home Page

(F)

Cost of equity

8.5%

(C) + (D) * (E)

(G)

Debt

$1,440

10-Q as of 03/31/22

(H)

The cost of debt

4.4%

Current yield on corporate debt Baa2

(I)

Effective tax rate

13.0%

Management tips

(J)

WACC

7.9%

(Cost of Equity * Market Cap ($10,110) + Cost of Debt * (1-Effective Tax Rate) * Debt) / (Market Cap + Debt)

(K)

Enterprise value

$9,918

(A) / [(J) – (B)]

(L)

Equity value

$8,478

(KG)

(M)

Outstanding shares

87.8

Yahoo finance

(NOT)

Estimated share price

$96

(G) / (M)

Sources: quoted above

Conclusion

ALLE faces a myriad of challenges. It has not been able to bring its prices in line with its costs to compensate for the rise in inflation. Rising inventory levels and supply chain issues indicate weak operational management. International’s profit margins consistently lag the Americas by a wide margin. Residential Americas seems to be slowing down after a very strong decade of growth. Against this backdrop, it is difficult to envision a combination of FCF and WACC growth rate justifying ALLE’s current stock price of $114.

Share Price Sensitivity to Key Variables

Rate of growth

WACC

7%

8%

9%

ten%

2%

94

76

63

53

3%

122

94

76

63

4%

168

122

94

76

5%

260

168

122

94

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