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Claim (NYSE: ALL) has shown resilient growth amid increasing economic headwinds. The company is optimistic of growing its organic revenue in the mid-single digits in 2023. But the economy is likely to continue to deteriorate, which could put pressure on the company’s growth and cash flow margins. The market overvalues Allegion, leaving the company no room for error in executing its growth strategy.
Allegion’s growth could face headwinds.
Allegion significantly outperformed its Q1 2023 earnings estimates with a big gap. The company reported revenue of $923 million, which was $76.7 million ahead of expectations, and its GA` EPS was $1.40, which beat expectations by $0.12. The company’s revenue growth was 27% in the first quarter, driven primarily by acquisitions. The company raised its sales and earnings estimates for the remainder of the year. It now expects organic sales growth of between 5.5% and 7.5% and EPS of between $5.95 and $6.15. The company beat EPS estimates in the last four quarters.
The company attributed this significant revenue and EPS growth robust demand in its North American non-residential business and strong global demand for its electronics solutions. The company attributes its improved cash flows and earnings per share to solid market demand in its non-residential markets, improving supply of electronic components and strong pricing. The company also sees the transition of security and access control demand to smart electronic hardware, driving revenue growth.
Since June 2020, the company has increased its sales by 56%, mainly due to acquisitions (Exhibit 1). The company is close to $1 billion in quarterly revenue after reporting $923 million in the first quarter of 2023 (ended March 2023).
Exhibition 1:
Allegion Quarterly Revenue, Gross, Operating Income and Margins (%) (I’m looking for alpha, author’s compilation)
Exhibition 2:
Allegion Annual Sales, Gross, Operating Profit and Margin (%) (I’m looking for alpha, author’s compilation)
The Company’s quarterly average gross margins as of June 2020 are 41.8%, compared to an annualized average of 42.6% over the past decade (Annexes 1 and 2). But improved supply chains, resilient demand, lower inflation, and higher prices have helped the company push its gross margins closer to its annual average in March 2023. The company’s GA` gross margins improved 184 basis points in Q1 2023 compared to Q4 2022.
Over the past year, I have been surprised by the pricing power of many companies in the industrials and consumer staples sectors. Most companies saw volumes fall on the back of double-digit price increases, but price elasticities were less than even management had anticipated. In the case of Allegion, the company’s volumes increased by 4.4% on a price increase of 10.6% (Figure 3). However, the company’s growth was driven by its Americas segment, which grew revenue by 42%, while its international segment saw revenue decline nearly 10% and a significant drop in margins.
Exhibition 3:
Allegion revenue results for the first quarter of 2023 (Allegion Investor Presentation)
Cash flows are impacted due to high inventories.
Although the company posted record earnings and cash flows, its operating cash flow was weak due to increased inventories due to increased safety stocks. Quarterly operating cash flow and margin were $69 million and 7.4%, respectively (Figure 4). The company has averaged a 16.3% operating cash flow margin since June 2020. The company’s increased inventories contributed to a decline in operating cash flow. The company had 84 days of inventory at the end of the March quarter, compared to an average of 67 days over the past decade (Figure 5). Inventory levels are beginning to decrease compared to late 2022. That drop in inventory levels should translate to better cash flow generation for the remainder of 2023.
Exhibition 4:
Allegion Operating Cash Flow (find alpha, make calculations)
Exhibit 5:
Allegion Day’s Sales in inventory (find alpha, make calculations)
The company hopes to meet its projected growth targets for 2023. While the company is optimistic that it will meet its growth targets for the year, it is facing mounting headwinds. The international segment has been weak and demand may fall further. commercial real estate is under severe pressure in North America and may weaken further if unemployment rates rise. The commercial property market segment is seeing higher vacancy rates putting pressure on rents, while the cost of capital for these businesses has risen exponentially. Any slowdown in growth could slow inventories and give the company lower-than-expected cash flows.
High rating
The company’s current valuation does not offer a buffer against any uncertainties that could negatively impact its business in 2023 Shares trade at a forward GA` PE of 17.6 and a PEG ratio of 3.2x, a high multiple. It trades at a forward EV-to-EBITDA multiple of 13.5x, compared to the industry median of 10.4x. A reasonable valuation for the stock would be close to 10 times the EV-to-EBITDA multiple. A 10x EV-to-EBITDA multiple will take the stock around $90. It may not be a coincidence that the stock’s 52-week low was $87.33. Valuation metrics seem to indicate that the stock is overvalued.
A discounted cash flow model estimates the equity value per share at $105 (Figure 6). This model assumes a revenue growth rate of 4%, a free cash flow margin of 13%, and a discount rate of 8%. These model assumptions are reasonable for the company. The company has a debt to EBITDA ratio of 2.5x, not excessively leveraged.
Exhibition 6:
Allegion discounted cash flow model (find alpha, make calculations)
This model assumes lower 2023 sales of $3.4 billion compared to a consensus estimate of $3.69 billion. If the model is based on 2023 sales of $3.69 billion, its equity value per share is $115, about 4% above its current price of $110.48. The company’s projected higher growth rate may not be sustainable over the long term, so a 4% assumption may be reasonable. The US Economy only increased by 1.1% in Q1 and expected to grow optimistically less than 4% for the rest of the decade. At a growth rate of 4%, the company would grow faster than GDP. Investors need a margin of safety when valuing stocks, and Allegion is no exception. The stock is now fully valued and investors might consider investing in it when it returns in the mid-1990s.
Low dividend, bad buybacks, but excellent dividend growth.
The stock yields a 1.6% dividend, which is low compared to U.S. Treasury yields. The company has a conservative payout ratio of 27% and has grown its dividend by 19% over the past five years, an excellent growth rate. The company has spent $588 million on share buybacks since September 2020, reducing its share count by 4.3 million at an effective repurchase price of $136 (Source: Seeking Alpha, Author Calculations). The company may have overpaid for its buybacks, considering its intrinsic value is closer to $90 per share.
Economic growth is slowing globally, with recent US GDP growth pointing to a dramatic slowdown. Stock market volatility as measured by the S&P VIX Index (VIX) is 15.7, showing complacency. These market conditions can change at lightning speed. Long-term investors looking to buy Allegion may regret buying Allegion at current prices. A further slowdown in the US economy and increased volatility could present a better opportunity to buy this stock at a lower valuation.
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