Resideo Technologies Inc (REZI)

Price:  $14.00

Mkt Cap: $1.7BN

Ent Val: $2.8BN

EV / Sales:  .6x

EV 19E /20E EBITDA:  6.5x / 5.9x

MC / 19E / 20E FCFE: 12.0% / 15.7%  

Price Target:  $22 (trading), $30+ (transaction)

Situation Analysis

·        Resideo Technologies Inc. (“REZI” or the “Company) is a provider of residential comfort care and safety solutions in its Products Segment ($2.5BN of sales) as well as a wholesale distributor of security / low voltage products with over 2000 locations in 17 countries ($2.6BN of sales).  REZI manufactures Honeywell branded products.

·        REZI products are installed in 150MM homes globally and growing by approximately 15MM installs each year.  80% of installs are related to repair and remodeling while 20% are levered to new construction.   

o    REZI commands significant market share in categories including thermostats (Honeywell brand commands upwards to 60% share), boiler controls and security in the Do It for Me (“DIFM”) market.   

o    REZI is dominant in the professional installation channel with generational relationships with over 100K professional contractors and installers providing REZI with unique industry insight and trends.

o    As a result of being over indexed to repair and refurbishment along with an increase in the age of the housing stock, the business is not overly cyclical as other housing related companies.  Management approximates that every 100K move in housing starts affects ~$7MM, or a 1.5% of total earnings.

o    REZI’s business is a capital efficient one with high returns on invested capital and strong FCF generation.

·         REZI was spun from Honeywell (Hon) in October 2018 at $28 and the stock currently trades at $14.   

·     In recent weeks, REZI’s stock has been left for dead exacerbated by uneconomic selling pressure (forced liquidation of spun shares out of the Honeywell pension  account).

o    This is the most important point of this write up.  According to management, there were potentially 4MM shares of REZI stock that were forced liquidated from the Honeywell pension account (if no action was taken by HON employees) staring at the end of July – 9 months post-spin.

·      Last quarter, management reported a solid quarter and cited momentum in the business while reiterating the top end of their EBIITDA guidance for the year with a  positive outlook for 2020.

·       Like many SpinCo’s, current research coverage exceptionally weak with confused analysts.  At the same time, REZI shareholders are facing an identity crisis as heritage industrial and cash flow investors are unwilling to underwrite growth opportunities ahead for the Company while growth investors want to see growth.  

·         In aggregate, we think the Company is exceptionally cheap trading at a 12%-15% FCF yield to the equity while levered 1.9x.

·         Fair trading value for REZI shares is $20-22 (40-50% higher) and substantially higher ($30+) as management executes on its plan.

Business Overview

·         2018 sales of $4.8BN Geography:  68% US, 24% Eur, 8% Other.  10% supplier exposure to China.

·         Two divisions:  Products and Systems (“P&S”) and Global Distribution (“GD”). 

o    Replacement demand drives 80% of REZIs products. 

·         Products and Systems (45% of revs / 72% of EBIT)

o    Leading provider of residential comfort and security solutions.  Licensing agreement to use the Honeywell Home brand for 40 years. 

o    150MM installed base of products, 15MM solutions installed annually.  REZI estimates that ~5.6MM customers are connected allowing consumers to monitor and maintain products from a third-party device.  Partnerships with Apple HomeKit, Amazon Alexa, Google, Samsung.

o    3000 patents, 1,300 engineers – Key products include thermostats, humidifiers, interior and exterior cameras, security panels, smoke detection, gas valves.

§  Competes with Nest, Ecobee, tado, Hive, Emerson, GLAS (Johnson Controls), Lennox, Carrier, Alarm.com, Tyco.

o    Residential Thermal Solutions (“RTS”) represents approximately 1/3 of segment sales ($500-600MM) Defensive business with a non-discretionary demand profile (replace when broken).

§  Water heater / furnace replacement should grow at a 2.5-3% CAGR even in light sluggish new/existing home sales environment.

§  Through its installed base (110K) of contractors, there are significant opportunities to land and expand with new behind the wall products that include smart sensors for water heaters, boilers, furnace and leak detection, etc.

§  Management estimates that currently approx. 10% of its thermostats are connected and expects a faster replacement cycle (twice as fast as the last one) for its “on the wall” products as the technology and functionality is meaningfully improving.

o    Segment growth profile is MSD% growth with LDD% EBITDA margins (after reimbursement payments to HON).  Management is investing in new products (next generation product launches) which while will lead to short term margin headwinds, drive growth from a 2-5% rate closer to 7-10% over time.

·         Global Distribution (55% of revs / 27% of EBIT)

o    ADI Global has a customer base of over 100K contractors and installers.  85% of sales are third party products offering over 350K SKUs.  Security represents 70% of sales, while fire, life and safety represent 30% of sales.  Roughly 80% of sales are attributable to the Americas with the remaining 20% coming from EMEA / other (primarily India).

o    REZI believes it has a third market share in the US, low teens in Europe and approx. 20% in India. Two thirds of net sales are attributable to non-residential end markets with the remaining in residential.

o    Segment growth profile is MSD% with LSD – MSD % EBITDA margins.  While margins are below Earlier in the year, management decided to pull forward investment from 2020 to introduce new products to the market, some of which will be released by the end of this year. 

o    corporate average the business is highly cash generative.  Two years post-spin, it is possible that REZI spins or sells this segment but at present, management is happy to own it due to its capital efficiency and favorable cash flow profile.

WWhat is of Value? / Investment Case

·         Resilient Market Fundamentals, Strong Market Share, Large Installed Base of Products

o    80% levered to repair and replacement and the Do it For Me (“DIFM”) category.  Does not compete in Do It Yourself (DIY). Product replacement and repairs drivers for demand.

o    Well-known brand (Honeywell) in the DIFM category with defensive market characteristics (replacement cycle). 

o    Age of housing stock increasing, consistent LSD% growth in demand for replacement and refurbishment as well as 25%+ growth in connected devices.

o    More than 80% of sales are in North America which mitigates international uncertainty.

·         Post Spin-Optimization Opportunities

o    Management has flagged $50MM run rate 2020 cost takeout opportunities in the business and is on track to attain $10MM of those savings this year with lower corporate overhead and SG&A.

·         New Product Launches and Connected Home Opportunity

o    REZI has opportunities to leverage its installed base of 5+MM connected users as well as introduce new products to the market and is adding functionality through tuck in M&A to enhance its existing portfolio:  https://investor.resideo.com/Acquisitions/Index?keyGenPage=1073754162

o    On its Q2 call, management cited momentum in this product strategy and was optimistic about launching new products at the end of 2019.  

§  Longer term, management believes it can accelerate growth from 2-5% closer to 7-10%.

o    Instead of undertaking large scale M&A, REZI has decided to embark on a tuck in strategy to add functionality to its current product portfolio.

·         Strong FCF Characteristics and Favorable Valuation

o    REZI’s business generates significant cash flow even after considering its environmental remediation expense to its parent (highlighted later in memo).

o    In aggregate, REZI trades at 6.5x EV / EBITDA net of its HON reimbursement agreement payments.

o    Product peers trade in the 9-12x range while industrial distributors trade in the 8-9x range.  Given REZI’s strength in its product portfolio as well as cash flow characteristics, the stock is incredibly mispriced. 

What Went Wrong / Why is the Stock Mispriced?

·         Recent Forced Sale of Shares

o    For HON 401K participants that did not act on keeping their spun shares in GTX or REZI nine months after the spin, SpinCo shares force liquidated by the fund nine months after the effective spin date (10/28) or the of July. 

§  Management estimates that this may have been up to 4MM shares of supply into the market.  Coupled with general market volatility, this could be attributable to the stocks precipitous decline in recent weeks.

·         Shareholder Base in Transition

o    Post spin, management lowered their EBITDA outlook from $465-475 to $410-430 to reflect a pull forward of 2020 spending on products and technology into 2019.

o    While the revision is not catastrophic and a positive for the longer-term growth prospects, it created uncertainty especially among the heritage industrial / cash flow investor base. 

o    Given the transition of the business from a traditional to a connected one, siloed industrial vs. growth investors are having difficulty underwriting an investment thesis for their strategy.

·         Overblown Fears of Housing Cycle and DIY Segment

o    While REZI does have some exposure to housing starts (approx. 30%), the main driver of its business is repair and refurbishment.  As houses and equipment gets older and thermostats, HVAC units and water heaters break down, REZI will be a beneficiary.

o    Everyone is aware of smart home products (NEST) and DIY security (Ring, etc) but it is important to delineate that REZI dominates the DIFM channel. REZIs strength lies in professionally installed systems and behind the wall products not off the shelf systems.

·         Understanding the Honeywell Reimbursement Agreement

o    In connection with the spin, HON saddled REZI with a stream of mandatory payments of max $140MM a year for 25 years to pay for environmental remediation related to Honeywell.

o    This is not a contingent liability for REZI.  Honeywell retains liability and is responsible for management and remediation.  Cash payments are subordinated to all material indebtedness.

o    We view this as a below the line expense (preferred stock dividend) rather than a liability for REZI.  Regardless, it does confuse investors and management has mentioned they may try to find a way to clear up the confusion.

o    $140MM represents a maximum capped number.  All cash flow and valuation figures contemplate this payment. 

·         Poor Research Coverage

o    At present, there are three analysts that cover the stock:  BofA, Oppenheimer and Imperial.  While all analysts are constructive on the outlook for the Company and the quality of the business, at this point, none are wiling to stick their necks out to defend the stock.  All are currently in “show me” mode but collectively have a $22 price target for the stock.

What Needs to Go Right?

·         Company needs to better highlight the strength of its existing business while articulating growth opportunities and how that translate into future cash flow.

·         Hit numbers and cast favorable guidance to establish credibility with its investor base.

·         Better research coverage and investor awareness.

·         Re-rate to a multiple comparable to peers (8-10x EV / EBITDA).

Risks

·         Inability to execute.  Mgmt still in show me mode.

·         Competitive landscape / mindshare.

·         Tariffs – China represents approx. 10% of sourcing.  Some manufacturing in Mexico.

·         Management screws up but they seem capable.

Management Overview

CEO Mike Nefkens

·         Fmr EVP and GM of HPE responsible for $20BN P&L, 110K employees – turned around business to record operating profit for 14 quarters.

·         Led spin-merger of that business into DXC. 

·         Drove successful turnaround of multiple businesses around the world.

·         Authority on transformation and cybersecurity.

CFO Joe Ragan

·         Fmr CFO of Ferroglobe, CFO of three public traded companies prior.

Chief Innovation Officer Niccolo de Masi

·         Expertise in mobile aps, software, hardware, B2C.  Fmr Chairman and CEO of Glu Mobile. 

Capitalization and Valuation

 Tried to paste tables but to no avail.  Sorry.  1.7BN Cap, 2.8BN EV 1.9X TD / EBITDA.  Trades at 6.5-6.8x 2019 EV / EBITDA and 5.9x 2020 EBITDA

·         Absolute Value Considerations

o    On 2019E numbers (net of the reimbursement payment to HON), REZI trades between 6.5-6.8x EV / EBITDA (2.2x levered) or at a 11.3-12.2% free cash flow to the equity.

o    On 2020E numbers, REZI trades at 5.9x EBITDA and at a 15.7% FCFE yield.

o    A business of this quality and cash flow characteristics should trade at least at an 8% yield ($20-22).

·         Relative Value Considerations

o    REZI is dirt cheap on all metrics.  I would argue that Products should likely trade around 10x while Distribution should trade at least 8x which would likely equate to a 9-9.5x multiple for the entire business.  Regardless, at current levels this doesn’t really matter too much.

Catalysts

·         Better research coverage

·         Management communication

·         Fixing the HON mandatory repayment issue

·         Acceleration of growth and cash flow generation