Description

Caveat: I wrote this up prior to ALLE’s Q3 earnings, not expecting the market to punish them as much as it has on the headline miss.  Nonetheless, I think a12-18 underperform thesis is intact even down here at a ~$63.00 price.   

COMPANY DESCRIPTION

• Allegion is a spin-off from Ingersol Rand in late 2013

• #2 player in $25-30 billion addressable market for locks and access control

• Assa Abloy: $7 billion; Doka+Kaba: ~$2 billion, and ALLE ~$2 billion

• Fragmented: top 5 are ~60% market share

• Mechanical security (e.g., regular door locks and metal, rectangular “push” bars) comprises ~80% of business mix (vs. 20% electronic / services)

• 50% U.S. non-resi, 20% U.S. resi, and 30% Int’l non-resi exposure.  As shown below, the U.S. segment is over 90% of the EBIT of the company.   

• Approximately 50% of U.S. business is related to new construction, with the balance replacement/retrofit

• Brands include Schlage, Kryptonite, Briton, LCN, Interfex, and Bocom

• Lots of SKUs, local safety regulations, relationships with locksmiths, builders – higher moat than you’d think

HIGH LEVEL NUMBERS

RECOMMENDATION

ALLE is a likely underperform over the next 12-18 months – with a decent chance to get crushed.  Here’s why:

• Business Fundamentals Face Huge Non-Resi Headwinds (~50% of revenue and ~66% of EBIT)

• ALLE sells mechanical locks (~80% - think very basic Schlage door locks and the push-to-open bars on office doors) and electronic locks and systems/services (~20%)

• No matter what stories the Street sells (high-tech security, expanding margins in Int’l segment), this stock is a U.S. non-resi play.  ALLE generates approximately 50% of revenue and ~66% of EBIT from U.S. non-residential construction.  This is its highest margin (25-30% EBIT+) business as well.  

• Forward looking, non-residential construction contracts turned meaningfully negative in the middle of 2016

• Running these numbers through, I see no reasonable way to hit out-year consensus figures.  For illustrative purposes, if non-resi construction declines ~10% in 2017, the company will miss EBIT consensus of $500 mm by ~13% and EPS of ~$3.70 by ~15-20%

• Valuation is Stretched and at Historical Highs

• While not apparent from ALLE’s historical multiple, given its limited trading history (spun out of Ingersol-Rand in 2013), the “security” space has seen massive multiple expansion

• Assa Abloy, the largest competitor in the space (more overweight Europe, 3x the size of ALLE), has been successfully performing a M&A roll-up story, expanding multiples itself, and by extension, the entire space, well beyond historical averages

• Assa’s historical multiple prior to 2013 ranged between 10-15x P/E.  Currently it’s multiple is well north of 20x, and ALLE is in the high teens

• These multiples could easily contract as 1) business fundamentals deteriorate across the space as organic growth normalizes to historical levels or 2) there is any sort of pause or questioning of Assa’s strategy

UPSIDE RISKS

• Buy-out potential – Horizontal guys would face anti-trust concerns.  Vertical buyers have less reason now with 1) valuation high and 2) less/no ability to work for tax inversion play

• Stories!

• Resi growth story – 20% of revenue and still growing.  Probably not enough to cushion a non-resi downturn

• Int’l margin story – Typical sell-side fluff while ignoring the (lack of) impact.  Even a 500 bps improvement in international margins is approximately a $20 mm impact (on $400 of EBIT) 

• Roll-up story – ALLE has shown no real desire or ability to do this.  I assume the market would be dubious on the prospects

• High-tech story – Hard to quantify, but some small % of sales has a tailwind from an integration of networking/locking systems.  This has the Street excited, but I don’t think it will hold water in the face of a non-resi downturn.  

• Mis-reading of non-resi downturn – While it does really appear that non-resi is set to slow over the next 12-18 months, ALLE is overweight institutional non-resi, which is slower growth, but hasn’t been seeing the same amount of decline in contract value

• Later cycle – Since locks aren’t really put on until the end of a build, it may take longer to see the weakness in the numbers

EARNINGS SENSITIVITY

EXPOSURE CHARTS

VALUATION CHARTS

ASSAB Historical Multiple – Overweight Europe relative to ALLE

Catalyst

Non-resi slowdown becomes more apparent