Description

Recommendation: Short HI

HI is a low-quality industrials roll-up where management has been pitching an ongoing “transformation story”, which really just means buying top-line growth in the PEG segment while running the Batesville business for cash flow. With a combination of anemic organic top-line growth potential and a margin structure that is proving to be increasingly fragile, HI is not well-positioned, especially given largely cyclical end market exposure in PEG and negative secular trends in Batesville. FY18 top-line growth at PEG is unsustainable, driven by the confluence of FX tailwinds (which is now being lapped) plus backlog momentum that will not recur in separation equipment (longer than expected proppants cycle which now tapered off) and unusual strength in large plastics projects. Meanwhile, Batesville is struggling as elevated supply chain and commodity costs have hurt margins on top of deleverage from lower sales volume, with management conceding that holding margins will be difficult going forward given the high fixed cost nature of both manufacturing and distribution. Management’s FY20 guide provided at Investor Day last December of 2-4% y/y total organic revenue growth and 5-7% y/y adjusted EPS growth is not impressive and doesn’t justify HI’s valuation at >18x P/E and >10x EV/EBITDA on consensus FY19 profitability metrics that look too high. With tough comps in FY19, I see limited risk of upward EBITDA/EPS revisions in FY19-20, and misses could drive multiple compression given a forward P/E currently near the high end of the historical range. At $45, shorting HI offers a 2.0x risk/reward in my assumed FY19 base case, with a trading range of $37 by $49.

Business Description

HI consists of two segments: Process Equipment Group (PEG) and Batesville. PEG sells products and services globally (EUR exposure with Germany sales at ~30% of total revenue) in compounding, extrusion, screening/separating, and flow control to a variety of industrial end markets. Management views PEG as a growth platform to opportunistically bolt on acquisitions in various industrial/manufacturing products and services. The “crown jewel” of the PEG segment is Coperion, a business acquired in late 2012 that established HI as a leader in high-performance compounding and extrusion systems. PEG’s product sales are supplemented with a captive replacement parts and service (P&S) business that represented 33% of segment revenue in FY18 (FYE 9/30/18). While PEG’s product sales are generally susceptible to cyclical pressures, P&S serves as a stable base of revenue with more predictable margins. PEG represents 70% of HI’s total revenue and 60%+ of EBITDA (pre-corporate). Batesville is a leading North American provider of funeral products such as caskets. This segment is in secular decline given an ongoing shift in consumer preferences towards cremation rather than burial, so management treats it as a cash cow business where margin and cash flow preservation is of paramount importance. Batesville contributes the remaining 30% of revenue and 30%+ of EBITDA.

Stock Opportunity/Debate

HI is a sleepy stock, underfollowed by the sellside and underowned by hedge funds, so there isn’t an active bull/bear debate as far as I’m aware. Following management’s narrative, however, the theoretical bull case would be that management is building a diversified industrials platform and using its Hillenbrand Operating Model (HOM) framework to drive efficiencies across all of its assets. This should result in management’s FY20 guide for organic total revenue CAGR of 2-4% (4-6% at PEG, (1)-(3%) at Batesville) and 5-7% organic adjusted EPS CAGR (double-digit including acquisitions) being achievable. Embedded in this guidance is 250bps of EBITDA margin improvement at PEG, driven by assumed procurement efficiencies at Coperion. If you’re bullish, you likely believe that there could be upside to these numbers as after all, it’s inevitable that management will continue juicing top-line growth through acquisitions and then use its HOM principles to try and eke out margin improvement over the long term. Coupled with buybacks, this should theoretically produce the double-digit EPS growth that management guides to pro forma for potential acquisitions. Given management targets converting 100%+ of net income to FCF, bulls could take comfort in valuation support despite meager earnings quality.

The structural debate in my view is around what the long-term growth algorithm really is given the different moving parts in end market cyclicality at PEG (which produces a good amount of unpredictability in top-line and margin trends), plus the terminal trend line for Batesville given the secularly declining nature of the asset. In the immediate term, looking at FY19, it’s clear that the debate is what will happen to top-line growth now that HI has to lap the outsized growth comps from last year and whether the unfavorable product mix shifts and other margin headwinds (such as commodity inflation at Batesville) are more long-lasting in nature than bulls believe.

Why Now?: Top-line growth comps are tough throughout FY19 given non-recurring positive contributions from FX and the strength at PEG from an extended proppants cycle that will not benefit FY19. While management believes the plastics end market remains very strong and therefore it’s possible that large deals could continue showing up in FY19 backlog and work through PEG’s revenue line in FY19 and for some time thereafter, growth should still decelerate meaningfully from FY18. Further, PEG’s EBITDA margin comps are also exceedingly tough in H1’19  Finally, Batesville also has tough H1 revenue growth comps and it’s unlikely that recent weakness in both volume and ASP are going to sequentially reverse. Putting all of these headwinds together, it appears that the Street is probably in-line on revenue and too high on EBITDA/EPS, setting up near-term numbers favorably on the short side.

Headline PEG Backlog and Top-line Growth Metrics Are Misleading

Following management’s commentary from the last four earnings calls, it’s clear that PEG’s sudden backlog growth during FY18 is unsustainable. Bridging both backlog and PEG revenue to reveal underlying organic growth effectively shows the entire picture.

As a general note, management doesn’t disclose quarterly backlog contributions from acquisitions, so I’ve just assumed zero contribution (which isn’t correct but can be revisited after further work). Revenue contribution from acquisitions, however, is provided on a quarterly basis. From the above, it’s clear that FY16 PEG numbers were influenced in an outsized way by both FX and acquisition contribution. On an organic basis, revenue was -6.5% y/y, forming an initially easy base of comparison. Then in FY17, backlog growth started accelerating meaningfully in H2’17 due to strong demand for proppant separation product and process equipment like precision feeders and small extruders. This supported revenue growth through H1’18, still against very easy comps, and then large plastics deals started kicking in by Q3’18. This strength from plastics continued in Q4 and should persist into part of FY19, but my view is that the drop-off in the rest of the business will result in future top-line growth at PEG downshifting absent a sudden and meaningful pick-up in organic demand in other end markets (which seems unlikely). The Street is likely a little too low in the very near term on overall top-line growth as I think analysts may be underestimating the strength in the plastics end market that management has spoken to. However, this should also normalize moving through FY19 so by the time HI approaches H2’19 and FY20, my revenue number is in-line with the Street (which could ultimately prove too bullish).

EBITDA Margins Have Underappreciated Headwinds

There are a few things going on with HI’s EBITDA margins that are worth highlighting and can help argue the case that Street estimates are too high. Going back to H1’18, the demand environment was robust (supported by global PMI being at the highest level in 7 years) and PEG was able to sell a large amount of smaller extruders and plastics equipment, which have good margins. This strength was further helped by proppants separation momentum, also presumably at strong margins. However, in H2’18, PEG started seeing large system projects in plastics flow through its backlog; these are typically fulfilled over 12-18 months and a part of this revenue comes from third-party sourced products with minimal markup. Due to the bulk of backlog/revenue upside coming from these projects at lower margins, PEG’s overall EBITDA margin was significantly diluted in H2’18, with a total of ~40bps of y/y improvement for FY18 (vs. guide of 30-80bps). The end result is that H1’19 EBITDA margin comparisons at PEG are terribly difficult, which should be a meaningful drag on estimates for FY19.

The other piece of this argument is Batesville, which seems to be in a disastrous state for a few reasons. Firstly, management basically conceded on the Q4’17 call that it’s becoming increasingly difficult to hold margins in this business due to the high fixed costs inherent to both the manufacturing and distribution sides. The underlying issue here is that Batesville is finally seeing real deleverage in its cost structure due to lower sales volumes. There is no fix for this given it is the direct result of permanent changes in consumer attitudes towards burial vs. cremation. If Batesville continues to post the midpoint of the (1)-(3%) of the long-term top-line guide (or worse), I can argue that EBITDA margins should be structurally lower going forward. While FY18 also had some impacts from higher commodity costs and these headwinds will be lapped to some extent in FY19, there is the ongoing risk that tariffs on steel and other commodities may have lingering impacts on Batesville’s cost structure. Given the current political climate and the fact that hedging is largely ineffective against tariff action, HI can only really offset the impact through raising prices or realizing supply chain efficiencies. While the latter may be possible, raising prices is probably not a winning strategy for a business already seeing volume declines. Overall, Batesville just appears to be in a tough spot with little to provide confidence in long-term margin recovery.

Understanding the dynamics behind EBITDA generation at each segment and then looking at consensus numbers should illustrate why I am skeptical. The Street is assuming consolidated company adjusted EBITDA margin goes from 16.6% in FY18 to 18.2% in FY20 (160bps of total improvement). Let’s first handicap the likelihood that PEG can hit its long-term margin target. Management has guided to 250bps of total margin improvement by FY20 at PEG (from FY17), so this would take PEG EBITDA margin from 17.3% in FY17 to just shy of 20% in FY20. As I said above, PEG EBITDA margin improved ~40bps in FY18; this leaves two years to get the additional 210bps of improvement in the FY20 guide. With the tough PEG margin comps in H1’19, realistically this leaves only 1.5 years. For a business that has averaged ~50bps of y/y EBITDA margin improvement the last several years, I don’t see this happening, irrespective of the planned procurement initiatives at Coperion. Furthermore, even if PEG can achieve the 210bps of margin improvement, the total bridge to solve for implied by Street numbers is 160bps. This implies that Batesville would have to see EBITDA margin deteriorate only by 50bps; the natural deleverage on lower sales volumes alone should make this impossible. In all likelihood, I believe HI’s consolidated EBITDA margin is likely to be flat to down over the next two years.

Estimates

There aren’t many reliable individual analyst models, so I can’t do a thorough consensus analysis with underlying assumptions for both PEG and Batesville. However, to reiterate, my high-level view is likely to slightly beat or do in-line on revenue but miss on both EBITDA and EPS estimates. It’s also important to call out that I’m assuming HI can buy back a significant amount of shares in both FY19 and FY20. Management has stated that when leverage (total debt / EBITDA) falls below ~1.6x, share repurchases are a priority for capital return. Given how weak core adjusted net income growth is in my model due to the top-line and margin headwinds underpinning my short thesis, the number of shares repurchased actually doesn’t move the needle for EPS that much, so basic financial engineering is highly unlikely to help HI show upside to the Street.

Valuation

On my numbers, HI looks expensive on a growth-adjusted basis looking at both EV/EBITDA and P/E, especially as I believe consensus is too bullish on the profitability profile of the business going forward. I value HI primarily using P/E and triangulating with EV/EBITDA. An asset that grows EPS organically in the LSD-MSD% range with potential cycle/recession risk should not get a premium P/E. I believe a mid-teens P/E would be appropriate on FY19 numbers, as this would contemplate core LSD-MSD% EPS growth rate plus potential upside from share buybacks and some embedded assumption that the HI could potentially be acquired or undertake some strategic alternatives to enhance shareholder value.

Risk/Reward: 2.0x on short side in base case (FY19 EPS)

·          Upside: 17.0x consensus FY20 EPS of $2.93 (which I view is a best case scenario) = $49 (+9%)

·          Downside: 15.0x my FY19 EPS of $2.51 = $37 (-18%)

Entry Point: HI is currently trading at 18.0x P/E and 10.6x EV/EBITDA on consensus NTM numbers. For context, it appears that HI’s P/E bottomed near 10.0x in 2012 and hit a high of close to 20.0x earlier this year. From a technical standpoint, the stock has basically been flat YTD. Overall, the entry point is favorable for a short.

Risks/Pushbacks

HI is very likely to make an acquisition soon. With leverage below the low end of management’s guardrails of 1.6-2.8x, over two years passing since the last set of meaningful acquisitions with Abel and Red Valve in H1’16, Moody’s upgrading HI’s senior secured rating, and hiring a new SVP of Strategy & Corp Dev in Q3’18, all signs point to HI actively seeking acquisition targets. Management has particularly called out pharma/food as a vertical to build out more within PEG. These end markets tend to be a lot less cyclical than the others HI serves, so to the extent an acquisition is made here, positive revisions could be meaningfully accretive to pro forma financials and less prone to boom-and-bust dynamics.

FCF generation provides capital allocation upside and valuation support. HI is very efficient in converting net income to FCF, and this translates into a ~7% FCF yield on even my first cut of the numbers. Naturally, I don’t believe this FCF really can grow sustainably and given the inferior underlying asset quality, future FCF numbers could have downside. That said, investors could support the stock for long periods of time even in the face of secular/cyclical headwinds if the business manages to hold decent FCF conversion (and therefore “screens cheap”).

HI could explore transformational strategic alternatives. A potential medium-term risk is that HI could decide to split up the business to try and unlock shareholder value. There is no obvious synergy potential to keeping PEG and Batesville together as a combined entity, which could also catalyze activist investor involvement. In some ways, this parallels the Manitowoc situation from a few years ago. While I don’t think this is an immediate risk given management uses Batesville’s cash flow as a means to fund growth at PEG, it is worth considering in the position sizing decision.

Catalyst

Earnings, industrial data releases (PMI, etc.)