Description

Acuity Brands Inc. is North America’s largest non-residential lighting manufacturer. About 90% of sales are made to commercial, industrial, or horizontal contractors – the balance is to residential outlets, primarily Home Depot.  The core business, Acuity Brands Lighting, (hereafter AYI) manufactures 500,000 products in 2000 product categories, in 24 plants mostly in Mexico. About half of the products are items like florescent lights and street lights (not used in residences), which are typically commodity-like, and the other half are “specialty” items, which command higher margins.  In addition, AYI recently bought a specialty lighting producer which should improve their product mix and margins.

The stock is both misunderstood and undervalued.  While only 10% of its business is to the residential market, it is perceived to be “residential” and, thus, a victim of the poor and opaque outlook for that segment of the market.  In addition, given the spin-out of an unrelated chemical producer (ZEP) on 10/31, its historical results provide clouded guidance for its future results.  (ZEP was approximately 22% of sales and 15% of operating income.)  The stock also has a limited following in the research community. In short, this is a very boring business, posting very good numbers.

AYI’s growth and profitability is driven by: (1) commercial construction/ occupancy, (2) retrofitting to save on energy consumption, (3) price increases when necessary, and thus (4) steady but unspectacular margin improvement. Typically, energy consumption in a commercial/ industrial building is 40% attributable to lighting; and newer, fuel-efficient lights save more than 30% in energy use (a three year payback). The installed base is about $120b, with a preponderance of the installations dating back more than 20 years.  Thus, higher energy costs and the “green” movement suggest that this “retrofit” market is only going to materialize sooner than later. Industry unit volume is expected to increase at 3 % p.a.; construction sq. ft. is estimated to grow at 1%; and vacancy rates in commercial buildings are generally low. Even with residential construction stagnant, unit volumes will increase at 2 %- 3%. Because AYI is the volume leader, it can also be the price leader. As of May 2007, AYI increased prices an average of 5%, with little discernable customer resistance, and competitors followed the increases.

Management are devoted business operators, very focused on a single market – commercial lighting; they are not financial specialists, or roll-up artists.  They do pursue acquisitions when they are “bolt-on” and relentlessly cut costs wherever possible. As a result, the ROA in three years has gone from 3.7% to 7.4% to 9.7%. The ROE has gone from 10.2% to 19.7% to 24.4%, while the ROC has similarly increased: 8.7%- 14.1%- 17.4%. Margins have been the driver: OPM has increased from 6.0% to 8.3% to 10.2%, mostly as a result of cost of goods sold declines: 61.2%-59.5%-57.7%. Net margins have expanded in turn: from 2.4% to 4.5% to 5.9%. All pretty respectable numbers. Additionally, free cash flow has exceeded net income, with FCF as a percentage of sales growing from 4.8% to 5.3% to 8.1%. Proceeds have been used to buy back stock, and to add to cash – which stands at $5.14 per share. By the way, future share repurchases are planned; historically FCF has averaged 160% of earnings.

With the stock currently selling at $36.37 it currently trades at 10.0x this years (8-2008) earnings, and 8.4x next years (8-2009) earnings. With a current market cap of $1.56b, total debt of $0.37b, and cash of $0.22b, total enterprise value is $1,72b. EV to ltm EBITDA is 8.2x, and price to EBITDA is 5.4x and price/ sales is 0.6x – an attractive LBO candidate if there ever was one (and one could be financed).

There are two potential surprises here (assuming they haven’t guaranteed a SIV somewhere): (1) operating profit margins expand more than forecast, and (2) the residential market (which, once again is only 10% of sales) is much worse than feared. I’m willing to bet that they can squeeze-out more than 150bp in OPM in the next twelve months (product mix, price increases, new corporate offices, new distribution center technology, no further diversion or expense from the ZEP spin-off). On the housing front, I am a pessimist on housing, but an optimist on economic growth. This is one name where the reasonable worst case scenario has been priced into a stock which has immaterial exposure to a prevalent investor fear (i.e., housing).

Catalyst