Description

Investment Thesis

After a transformative merger in 2021, we believe shares in Regal Rexnord (NYSE:RRX) represent an extremely compelling investment at current valuation levels. 

In February 2021, it was announced that Regal Beloit would combine with Rexnord’s Process & Motion Control Segment (PMC) via a Reverse Morris Trust. With significant product overlap, the merger came with significant synergy potential that should be realized over the next couple of years.  To put the synergies in perspective, the transaction valued PMC at 14.2x 2020 EBITDA but that moves down to 9.7x when full run-rate synergies are included. We think synergy targets are conservative and that this merger will prove to be an incredible transaction. 

As part of the merger, legacy Regal Beloit shareholders received ~61% economic interest, while Rexnord shareholder received the other 39%. The merger was approved by shareholders and closed in October 2021. Upon closing, management issued 2022 guidance of $5bn in revenue, over $1bn in adj. EBITDA. This guidance was subsequently been increased to 2022 revenue guidance of $5.2bn with an adjusted EPS range of $10.10-10.70/share (increased from $10-10.60). 

The merger arrived with $120 million in expected synergies over 3 years and PF leverage of only 1x. After-tax integration costs for the $120 million in synergies are under $100 million over the next 3 years.  The company is targeting an impressive 500 bp expansion in adj. EBITDA margin by 2024 due to synergies and continue operating leverage. Recent management commentary suggests that integration and synergy realization are well ahead of schedule. The company has announced that they will hold an investor day in September, and we expect them to increase synergy targets and guidance by a significant amount.

On FY2022, we see RRX trading at ~11x EPS, ~8x EBITDA, and 12x FCF. These numbers are prior to realization of the majority of guided merger synergies that should be seen over the next few years. We see this valuation as extremely cheap for a high-quality industrial company that has a strong position selling mission-critical products that represent a small portion of overall end-product costs for their customers.  As noted above, the company’s balance sheet is still relatively un-levered, and they are currently buying back shares in the open market with $320 million remaining on the program at the end of Q1. 

Company and Merger Overview:

The merger of Regal with PMC is compelling due to the fact that there is significant overlap in products, yet it also fills holes in both companies to offer a more complete (i.e., higher margin) solution. Management has called out significant cross-selling opportunities. The merger presentation includes significant detail on the pro-forma company.  Here is a good example of the company’s complementary products:

The merger also increased the company’s end market and geographic exposure as follows:

Post-merger, RRX has split its business into 4 segments:

Motion Control Solutions

• ~45% of pro-forma revenue with 25% EBITDA margins

• This segment produces bearings, mechanical power transmission drives and components, gearboxes and motors, aerospace components and various other systems

• End markets include food and beverage, warehouse distribution, energy, aerospace, and general industrial. 

Commercial Systems

• ~23% of pro-forma revenue with 23% EBITDA margins

• This segment produces AC and DC motors, variable speed controls, and fans/blowers for commercial applications.  

• End markets include commercial HVAC, pool and spa, irrigation, agriculture, and general commercial equipment.   

Climate Solutions

• ~21% of pro-forma revenue with 21% EBITDA margins

• This segment produces motors and air moving solutions   

• End markets are focused on residential and commercial HVAC, water heaters, and commercial refrigeration    

Industrial Systems

• ~11% of pro-forma revenue with 8% EBITDA margins

• This segment mainly produces motors, alternators, and switchgear

• End markets served include agriculture, marine, mining, oil & gas, food and beverage, data centers, healthcare, standby power, and general industrial equipment   

Financials and Valuation

The company recently provided updated guidance for 2022. This includes ~$5.2bn in revenue with an adjusted EPS range of $10.10-10.70.  We think this guidance is conservative and we expect a further increase at the investor day in September.  However, even on these headline numbers, the stock is cheap at ~11.5x EPS with an un-levered balance sheet (~1x by EOY) that is being driven by FCF conversion of over 100% on adjusted net income.  We expect mid-to-high organic growth over the next couple of years with significant margin expansion due to planned synergies and operating leverage.  

In FY2023, we see revenue of over $5.5bn with adj. EBITDA of ~$1.23bn (22.5% EBITDA margins) and EPS of over $11.50/share. Our model assumes no acquisitions (the company did spend ~$300 million on Arrowhead Systems in November) and continued debt paydown.  

Under these assumptions, we see RRX trading at ~10x FY23 EPS, ~7.5x FY23 EBITDA and ~10x FCF. We think this valuation is way too cheap and will not remain at these levels for long.  As management continues to tell the story of the company transformation and opportunity set, we think the stock has ~50% upside on valuation alone. This upside should be further enhanced as synergies are increased and accelerated.   

Major Risks

• General raw material inflation is clearly a ST risk, but we think the PF company has stronger ability to pass along these price increases than the legacy companies.  

• The company becoming too aggressive on future acquisitions. We feel comfortable that management has proven to be disciplined and will be patient for the right opportunities

Catalyst

- Investor day in September should result in increased synergy guidance and longer-term guidance that should significantly exceed current estimates