Company Overview:

I recommend a long investment in Allegion (NYSE: ALLE). Allegion is a leading global provider of mechanical and electronic security products that include key systems, exit devices, and other access control solutions. The business was part of Ingersoll Rand, before being spun-off in late 2013. The company generated $2.1B of revenue in 2013, with the majority of its exposure coming from US non-residential end-markets where it is the #2 player behind Assa Abloy. ~53% of revenue is estimated to come from remodels and rebuilds with the remainder form new construction. The Company also skews towards non-resi construction with ~half of total sales coming from North American non-residential construction, ~31% from RoW non-resi construction and the remainder from (mostly American) resi construction. The Company is in a position with alot of levers to pull to help improve margins and lead to signficant earnings growth.

Business Description:

• Americas: ~72% of revenue and ~98% of EBIT.
  • Company manufactures access and security systems including locks, door access points (hinges, exit bars, frames etc) and related products under dozens of brands via 10 production facilities.
  • NA segment mostly US (~64% of total sales) although LatAm is growing
  • As the largest access and mechanical security company in the US, Company realizes advantages from scale and has EBIT margins +25% in the region, despite soft construction environment.
• Europe: ~20% of revenue and breakeven EBIT
  • Company has performed poorly in Europe and margins there are flat to slightly negative v historical average in m/HSD and peers in the region in double digits.
  • European construction market has obviously been weak which has created a persistent headwind to leveraging volumes.
• APAC: ~8% of revenue and ~1% of EBIT

Variant Perception:

• Significant opportunities across geographies:
  • North America
    • Residential and commercial security business had been run separately within IR (they were in different divisions within the co). Arguably running them together ought to create some synergies
    • High incremental margins means recovery in non-resi construction spending should drive earnings in NA
    • On the commercial side of the business, almost all their revenue goes through distribution, with architects and consulting engineers specifying the access control system. This combined with varied and stringent municipal and state building codes as well as a high level of buildable combinations significantly reduces the amount of price pressure in the market.
      • Europe
        • Europe should be a significant margin opportunity with identifiable self-help drivers. As context, this segment is breakeven today compared to historical averages of 8-10% and current peer margins (ie Assa Abloy) of up to 17% in Europe. The key issue is that while the company’s Southern European end-markets are down 40%+ from the peak and unclear if the cost structure changed at all. This creates a large opportunity for overhead savings that current management is already executing on after it was ignored as part of Ingersoll. In addition, the same LEAN team that improved US margins from the low 20s to the mid/high-20s is just now getting started in Europe. There should be a real efficiency opportunity here given Europe is 20% of sales yet represents ~55% of the business inventory.
          • The co has 6 plants in Europe (v 5 in NA despite NA sales being ~4x higher) which means much lower fixed cost leveraging.
          • Additionally, European volumes have been challenged by macro situation in Europe and should benefit as volumes increase in a less bad economic environment.
          • Management is targeting 4% EBIT margins in ’14 and 10% by ’16 which doesn’t include footprint rationalization or material volume increases.
    • Tax rate opportunity:
      • Irish domiciled co paying 37% tax rate is clearly an outlier relative to other Irish domiciled industrial cos (ETN ~9%, Wolseley ~15% and IR ~25%. % of sales in US may help explain some of this, but not all as ETN has ~50% of revenue from US while IR and ALLE are both ~70%-at the very least ALLE should be able to reach IR’s current level)
        • Already on track to lower rate to 31% in FY14 and targeting mid 20’s by ‘16
        • Lower tax rate also provides a strategic advantage as the Company becomes an advantaged acquirer
    • Capital Allocation/M&A opportunity:
      • M&A can help create growth and improve margins (a la Assa Abloy). The Co is guiding for 50% of FCF to be used in M&A and strategic growth initiatives (~15% for dividends and ~20% for buybacks) and mgmt. has indicated they believe current leverage ~3x is an appropriate target (2.75-3.25x range)
      • Security market remains fragmented despite recent consolidation in the industry (most notably on Assa Abloy’s part) with the top 5 global manufacturers having 57% combined share. 20MM SKUs (according to Bernstein) and very rapid cycle time plus >150 turns/year help explain barriers to entry to the business.
        • Assa made 100+ acquisitions over past decade which drove growth in ne geographies/products and they also consolidate operations to drive margins. The Co spent 65% of cumulative OCF on acquisitions from ’00 until ’13 (3x capex over that period). Assa’s ability to acquire businesses at undemanding multiples, leverage the acquired brand and raise margins through cost rationalization helped the EBIT margins expand ~600 bps over past decade.
        • Demand for security products is very localized and brand loyalty/recognition is non-negligible which makes acquiring sales growth a much faster way to enter and expand into a market rather than attempt to grow organically. 
        • During investor day, CEO mentioned they would be willing to flex leverage up to 4x if there is an attractive M&A opportunity and as long as they felt comfortable they’d be able to be back closer to 3.25x within 12-18 months but only if all the stars align and they had conviction that they see a real opportunity
          • Also mentioned $60-80MM/year in target M&A for bolt ons
          • Co estimated industry overall is $25-30Bn addressable market for locks and access control

Risk/Reward:

• Base case of $75 (18x multiple on ‘17E EPS base case EPS of $4.12)
• Upside to $95 (20x  ‘17E bull case EPS of $4.77)
• Downside to $42 (15x multiple on ‘16E EPS of $2.69)

Pre-mortem:

• Company not able to restructure Europe to get margin improvements.
• Revaluation of Venezualan Bolivar could be $0.11-0.13 headwind if VZ earnings booked at SICAD 2 instead of official rate
• Construction remains weak

Mgmt:

• Chairman/CEO was previously CEO at Quanex where he successfully implemented an M&A strategy and saw the stock price double over his 5 year tenure.
  • When he came on to ALLE they brought in McKinsey and spent 2 months looking at different levers they could pull in terms of both organic and M&A growth opps in order to craft credible objectives.
  • CEO mentioned he asked entire leadership team to read “The Outsiders” so that they understand the focus on capital allocation to drive shareholder value
  • Lead director was Chairman and COO of Cooper which was one of the earliest companies to successfully invert to Ireland. He also led the sale of the co to ETN in ’12.
  • Guidance seems perhaps conservative (note that if you look at their EBITDA margins collectively across the globe at 20%, that’s on a revenue base that is 20% lower than peak revenue in ’07) so there does seem to be the possibility of margin expansion if volumes accelerate
  • Compensation:
    • Long-term performance metrics earned over 3 year period; paid out as mix of PSUs, RSUs, and options based on TSR relative performance (top 100 people in the co are eligible for the plan)