Description

We propose buying Assa Abloy (B shares) trading below 175 SEK per share.

Background:

Assa Abloy is the world leading manufacturer of door locks and lock solutions. Its competitors include Dormakaba (German-Swiss), Allegion (USA), and Hörmann (German), but Assa Abloy is about 3x larger than their next biggest competitor. It had a profit warning 2 weeks ago mainly driven by a write-off in their China business, after which the share price dropped just a under 10%. Its shares have been fairly stagnant in the last 3 years although earnings and revenue has grown in that time and we believe will accelerate in growth going forward. 

Business Description and Segmentation:

Assa Abloy manufacturers and distributes door locks including both traditional mechanical locks and newer electro-mechanical locks. On the whole, they assemble their locks and are mostly not involved in the heavy manufacturing part of the locks. 

A few important segmentations of the business as as follows:

Segmentation by New Built vs. Aftersales

                                                                                    % of Revenue 2017

a)    Aftersales/Replacement                                              67%

b)    New Construction                                                        33%

About 2/3 of their sales are for replacement components sold mostly to locksmiths or installers for maintenance/upgrading/replacement. While 1/3 of their sales are sold in new building projects where specifiers, architects, and consultants are invovled. On average the replacement sales is more profitable and has contributed to the relative stability of revenue and earnings in the underyling business (it didnt have a signficant decline in revenue or loss in the previous economic downturns including 2008). In some regional markets like China, sales are skewed to new construction.

Segmentation by Customer Segments  

                                                                    % Revenues               

a)    Commercial/Institutional                              75%                             

b)    Residential                                                       25%

About 75% of sales are primarily products that go into public administrative buildings, offices, malls, stores, educational buildings. These are mostly complex projects and Assa has contact points with many stakeholders across the value chain. Distribution and installation are usually handled by installers, system integrators, and locksmiths. 

In the residential area, we are talking about apartments mostly and homes, where Assa cooperates with door, window, and specialist smart home distribution channels like locksmiths and home improvement stores. 

Geographical segmentation/Business segments

                                                    % of Total      % of Total      

      Business Unit                         Revenues        Op. Income                Growth in 2017         

a)   EMEA                                          23%                             24%                 7%, 4%, 16%

b)   Americas                                     23%                             30%                 8%, 4%                       

c)    APAC                                          11%                             7%                   1%, 4%

d)   Global Technologies                 14%                             15%                 -

e)    Entrance Systems                   29%                             24%                 -

Total                                       SEK 76.1 bn                        9%                                  

This is a bit of a mix between geographical and specific businesses. About 30% of revenues are in Entrance systems, which is different from door locks in that they are comprehensive solutions going into building projects from entrances to large skyscrappers to metro stations for example. EMEA, Americas, and APAC are then the divisions for the regional sale of locks, although there are some differences in that Assa owns the distriution mostly in Europe but not in the Americas. 

Customer Interface

Assa Abloy tries to involve their specialist sales people at the early stage of large projects – specifiers provide expertise and digital tools (teaching) in planning, specification, and design of door solutions for projects. Distributors then provide key role in support after installation. These are mainly security installers and specialist distributors. 

Often Assa specifiers, which are becoming more important, work with architects, building consultants, security consultants, and building standards agencies. They use building information modelling (BIM)

Competition 

The main international competitors are Dormakaba (German-Swiss), Allegion (USA), and Hörmann (Germany). Some of these are more focused on the residential market. 

Overall, this is generally a stable industry where its hard to steal customers, but also quite sticky once you have them. Assa Abloy has some scale, especially around product development, which is important, but otherwise there is an element of good execution. 

Manufacturing

Assa Abloy has over the years converted their heavy manufacturing towards assembly. Product assembly is done close to the customer primarily in mature markets. Strategic components such as cylinders, rim locks, and some electromechanical products are concentrated in the company’s own manufacturing plants in low cost countries.  

R&D

Assa Abloy spends 3% of sales on R&D and also measures a KPI which I think is very important - % of sales from products developed in the last 3 years. This is > 25% in the last 5 years. In 2017 the figure was 28%. In total, AB has 2000 people working on R&D across 114 regional competence centers close to the customers. They spend SEK 2200 million on this. Given that digitization is increasingly important in the area of locks, smaller competitors simply will find it more and more difficult to compete on the front of investing in new developments especially when it comes to software and hardware interfaces. 

Why invest?

1. Assa Abloy has historically generated good growth (around 9% p.a. for revenues and earnings in the last 10 years) from a combination of organic (approximately 4%) and value accretive acquisitions (apporximately 5%). The orgnic growth is mostly due to the underlying market growth of high quality lock solutions and the trends of urbanization that should continue well into the next decades. On the acqusition front, Assa has strong track record for many years of making highly accretive acquisitions where they are meaningfully able to increase the margins or acquire technology that drives growth. Assa's management has repeately stated that they aim to and could achieve around 10% p.a. growth from 5% organic and 5% acquisitions. The market has clearly lost faith in the company and does not believe the management can achieve this. Partly due to their recent issues in China, but we believe having looked into that situation that it does seem more like a one-off than a structural problem with their acquistion strategy. The valuation suggests that investors do not believe that returns for the company can sustain at historical levels, which we do believe they can. 

2. In fact, we believe that growth very well may accelerate in the next years due to the strong growth in electro-mechanical locks (including smart locks and number locks). There are a lot of reasons why electro-mechanical locks are growing quickly (> 10% p.a.). One reason is simply convenience and security. Another reason is that with sharing models like Airbnb being more common, a solution that doesnt require transfering of keys but that is also secure is essential. All in all, you can already see this growth today, and we believe this will only accelerate going forward. Assa Abloy is the company we believe is the best placed to capture this as they control the hard-ware/software edge especially for the larger projects/solutions, where one simple standard solution is insufficient. What is happening is that smaller competitors increasingly find it difficult to provide compelling electro-mechanical solutions - and even when they do, its almost impossible for them to continue investing enough into innovation to stay ahead. They simply do not have the scale. Even on the residential side, where smaller players can compete you see that the top brands Yale (owned by Assa) and Schlange (owned by Allegion) are gaining market share. 

3. Electro-mechanical devices and solutions offer more add-on items and more frequent replacement cycles, which in the long run should mean higher revenues. Although this is still to be seen, there are indications that whether smart sensors or interconnected services there are potential new revenue sources for Assa that can be sold for the new electro-mechanical solutions. From some of their cases, there is also some evidence that people tend to upgrade these solutions more frequenlty - maybe every 10 years - instead of purely mechanical locks - every 25 years. All in all, there is a potential for higher revenues on the same customer base longer term.  

All in all, we believe that Assa Abloy is a high-quality business with high returns on capital and high single digit revenue growth that can meaningfully accelerate in the next decade. A poor acquisition in China which we feel is a non-structural problem and the large write-down after the previous CEO had suggested the business in China was getting better has led investors to lose confidence in this business and the management team. We believe, however, that this has to do with house-cleaning as a new CEO has joined and wants to set up his legacy with a clean slate. We think the prospects of the company are in fact better in the next 10 years than in the last 10 years, and that even if they could replicate their level of success in the last 10 years, this investment would be a fantastic one. 

Lastly, we feel that with its moderate leverage and its high % of sales from replacement parts that are necessary for their customers, the business should also be a bit more protected than most companies in case we have an economic downturn. 

Catalyst

Profit warnings/poor earnings due to a temporary solution. A good company with good prospects that is a bit out of favor.