Description

Background / Thesis

Brady Corporation (BRC) is a Milwaukee-based industrial company.  The company’s core products are labels, label printers, signs and other safety devices (e.g. lock-out / tag-out).  Prior to 2014, the company struggled with no organic growth, bloated operating expenses, and value-destructive capital allocation.  In 2014, Michael Nauman became CEO, and his entire tenure as CEO was spent (i) cleaning up the business, and (ii) navigating COVID challenges.  He retired in April 2022, and Russell Shaller (who cut his teeth at Teledyne, an industrial company with a long history of shareholder value creation) became CEO.  I believe Brady is on the cusp of accelerating its organic and inorganic growth profile, and that its current valuation (7+% NTM free cash flow yield) provides an attractive entry point that could re-rate as the growth accelerates.

Recent Company Stages / Current Setup

·         Pre-2014:  The company spent ~$570mm on 17 (!) acquisitions between 2007 and 2013.  The deals were awful, and between 2013 and 2015, the company wrote-down $400mm (yes, a full 70% of the previous 6 years of acquisition spend) of goodwill, and added over $60mm in restructuring expenses on top of the write-downs.  The final straw was a ~$300mm acquisition in 2013, which experienced a ~50% write down in the first year after closing.  Amazingly, despite the acquisition spending, revenue was lower in 2014 than in 2007.  The company had over ~$200mm of net debt, was heavily adjusting its earnings, and was strategically directionless.

·         2014-2022 (Michael Nauman era):  Michael Nauman effectively came in and fixed a broken company.  He stopped acquisitions, and in fact made several small divestitures of non-core businesses.  He consolidated the company’s facility footprint and pushed the company to GAAP reporting (no longer allowing the catch-all “restructuring” expense bucket).  Nauman eliminated waste and ran a tight ship, but did increase R&D spending, focusing on innovation in the company’s core ID Solutions segment (mostly in the label / label printers product group).  Some financial highlights of the Nauman era:

o   Organic growth was negative at the start of his tenure.  After some fits and starts, organic growth turned consistently positive in 2018, and accelerated slightly in 2019.  The company shrank by 5% organic in 2020 (COVID effect), but grew in FY 2021 despite continued COVID headwinds.

o   SG&A expenses were down significantly, from 36% of revenue in FY 2015 to 31% in FY 2021.  R&D expenses increased from 3% to 4%.  The net of this overall expense savings is consistently higher EBIT and free cash flow generation.

o   Net cash peaked at over $300mm in FQ3 2021.  Recall that there was $200+mm net debt Nauman’s start.

·         Russell Shaller (new CEO) Track Record:  Russell Shaller was one of Nauman’s first key hires, in June 2015, when he was appointed President of the ID Solutions segment (~75% of Brady revenue, and almost 90% of pre-corporate profit).  He came to Brady from Teledyne, where he worked directly for current Teledyne President & CEO, Al Pichelli (by anyone’s account, an excellent operator).  During Shaller’s tenure as segment President (2015 – 2022) at Brady’s ID Solutions segment, he led an increase in segment EBIT margin from 14% to 20%, and turned the division to organic growth.

·         The current setup: 

o   Core Business Performance:  Brady is operating well and starting to express confidence in its core business.  First, organic growth has finally inflected (post-COVID), which management attributes to product launches (after years of increased R&D spending and focus on pipeline development) in its core IDS division.  I look at 2- and 3-year stacked comps given COVID impact, and FQ3 (April 30, 2022 ended) 2022 results exhibited a positive step-change (10% 3-year stacked vs. 6% and 2% for the prior two quarters, respectively).  On the last earnings call, BRC’s CFO noted an expectation of continued strong growth in FQ4 (July ended).  Finally, I would note that over half of Brady’s recent growth has been volume driven (not overly price-driven, as one might expect considering inflation).

o   Capital Allocation: 

§  Acquisitions: After many years on the sidelines, Brady did three acquisitions in FY 2021, for a total of almost $250mm.  The businesses were strategically targeted at completing Brady’s industrial track & trace capabilities.  The company was already a leader in the barcode and RFID label industry, as well as selling associated label printers.  However, prior to the acquisitions, Brady did not sell barcode / RFID scanners (readers).  The acquisitions provide the company with this capability.  It seems like Brady is taking a page out of Zebra’s (ZBRA) playbook, as Zebra was originally a manufacturer of printers for barcode and ID card applications, before it got into the complementary handheld scanner business.

§  Buybacks: Brady purchased almost $65mm of stock in 2020, and another ~$85mm YTD (first 9 months) in 2022.

o   Leadership Focus:  In comparing himself to his predecessor at CEO, Russ Shaller said, “I would say Michael did a great job of being cost-focused… I would say I am far more growth-oriented and more about optimizing the portfolio. My track record is I worked for a number of years at Teledyne where we were very aggressive in terms of both portfolio shaping and mergers and acquisitions… So that was kind of my training and that's what I'm looking to bring to bear as CEO.”

Key company attributes

1.       Steady revenue

Despite Brady’s historical challenges with generating revenue growth, the company has demonstrated resiliency to macro headwinds.  As illustration, FY 2020 organic revenue was down just 5%.

2.       Strong ~50% Gross Margins

Gross margins have been between 48% and 50% for 7+ years.  Brady sells niche products through MRO business-to-business distributors, where price is not the key influencing variable for customers.

3.       Excellent cash conversion & capital returns

Over the past ~6 years, almost 110% of GAAP net income has converted to free cash flow.  (Note: FY 2022 FCF conversion has been uncharacteristically terrible. Management noted that they have built inventory purposely given supply chain worries, as well as freight / shipping costs. This should normalize in FY 2023, and we've seen this cycle before, as recently as FY 2021, when FCF was almost 150% of net income.) Capital intensity is quite low, as capex averages ~2% of revenues.  Returns on tangible capital are great at 50+%.

4.       Clean balance sheet

Despite spending ~$250mm on acquisitions in the past year, and another ~$85mm on buybacks, Brady still has net cash of ~$25mm.

Why now?  And Valuation

I have followed Brady for several years, and I’ve admired the improvement that Michael Nauman catalyzed, despite a difficult setup upon his arrival.  I believe recent performance trends, along with increasingly more bullish management commentary, indicates the potential for an inflection in organic growth.  As Russ Shaller said on the last call, “…we are well on our way in transforming Brady into a company that will consistently grow in excess of GDP.”

At only 13x expected NTM earnings, and with a history of ~100% FCF conversion, I believe the stock could meaningfully re-rate with an improvement in organic growth.  If that organic growth improvement does not occur, then I think the stock remains boring and relatively cheap, which limits the downside.  I do not believe that this management team will repeat the capital allocation blunders of Brady’s history.

Catalyst

1.       Continued / sustained improvement in organic growth.

2.       Portfolio changes / M&A.