Description

RXN/RBC merger - Buy RXN to get exposure to both

Price: $51

Target: >$65 by 2021YE

Market Cap: US$6.1B

Liquidity: $44MM per day

Trader Talk: Recent RMT transaction that is trading “cheap” on a SOTP basis, both pieces are interesting, and the Remain Co is a potential high business quality, long-term compounder at large discount

Thesis

RXN is an underfollowed stock with a long, pretty mediocre history that recently culminated in a long overdue value creation event. I believe the transaction has created two different yet compelling ideas - a large, reasonably priced general industrial entering an upswing and a smaller, very high quality non-residential construction business -  which can be purchased at a large discount on a SOTP basis. I’ll give info on both businesses, but my focus will be on the smaller Remain Co. as I think it is the more interesting piece.

The stock IPOed in 2012 as a “mini-Danaher” and was a roll up of two core businesses, Process & Motion Control (PMC) and Water Management (WM), with numerous 2008-2011 acquisitions. The company even has the Rexnord Business System, a not so subtle nod towards the Danaher Business System. Given the comparison and supposedly strong PE firm backing, the stock initially traded at a premium >20x EPS multiple, despite 5x net leverage. After the IPO, the stock almost immediately hit the skids. It turns out many of those 2008-2011 acquisitions were duds and the business had significant exposure to previously hot sectors that became challenged such as mining and energy. Apollo exited their stake in 2015 and a new board, though not a new management team, was brought in and the company spent the next five years cleaning up the mess. Here’s a few examples of just how bad certain acquisitions were:

It’s worth noting that since Apollo’s exit, the new board has done an admirable job of biting the bullet to clean things up and generally have been good stewards of capital. Net leverage has fallen to a manageable 2x level, margins have improved, and RXN handled the covid recession well. 

The five or more years of work recently culminated in a large, value creating event - the sale of PMC to Regal Beloit (RBC) via a reverse morris trust (RMT.) The transaction should close in Q4 2021, and investors now own two businesses. The PMC/RBC merger is highly synergistic and plugs key strategic holes in each business. RBC is trading ~14x PF 2022 adjusted FCF/sh., the deal is a strong strategic fit, and the underlying business has recently seen sales and margins inflect. The smaller Remain Co. stub is trading ~15x PF 2022 adjusted FCF/sh. I believe Remain Co. is a potential compounding “gem.” WM has grown sales at a ~6% CAGR since 2015 while improving EBITDA margins to ~27%, despite divestitures and RXN’s previous focus on dividend/buyback rather than M&A. The business has only had two quarters in the last 10 years with negative organic growth and is a share gainer. Now that Remain Co. capital allocation will focus solely on WM, I believe RXN could become a HSD to LDD topline growth story with light cyclicality and high margins. Further, Remain Co.’s comp group will be several water-focused “ESG plays,” such as WTS and XYL, which trade at >30x EPS multiples. 

Combined, I believe RBC/PMC and Remain Co. can reweight to at least 18x and 25x 2022 FCF/sh., respectively, yielding a $65 SOTP valuation.

Catalysts

Closing of the Merger

Continued Operating Momentum in Core RBC and PMC Segments

Management Highlighting the M&A Opportunity at Remain Co.

Risks

Non-Residential Construction Slowdown - Remain Co.’s end market is ~95% North American non-residential construction and the recent recession is likely to be a headwind for a few years

Pull Forward of WM Sales from Touchless - Efforts to increase covid sanity drove WM’s sales of touchless products, such as motion-activated hand dryers and faucets, to ~100% y/y growth in 2020. While RXN’s backlog for touchless products indicates strong 2021 growth again, this may simply be a pull forward in demand and make a “tough comp.”

Deal Math

As an RMT transaction, the deal is signed but the tax side of the RMT is not finalized. Depending upon RBC and RXN’s ownership overlap, RBC expects a cash dividend of roughly ~$7 which RXN shareholders will not receive and to issue ~0.22 RBC for every 1.0 RXN share. However, the math is not finalized and you won’t know the outcome for a few more months. For a variety of reasons, I personally am unhedged, despite my preference for Remain Co. The deal is a ways out, and I don’t want to tie up a lot of capital isolating Remain Co. when I think both are cheap. My personal plan is to remain modestly sized and add 1) in a pullback or 2) as we get closer to the separation.

PMC/RBC

The PMC/RBC merger creates a leader in drive automation technologies. Think things like bearings, gears, chains, etc. that are used in a variety of industrial end markets with no particularly substantial end market exposure (“General Industrial” is 26% of sales and Food and Beverage is 18%) and most are sub-10%. The deal actually plugs several strategic holes and, despite making similar products, has less SKU overlap than one would expect. Margins are expected to reach ~21% in 2022 and management has hinted upside exists. Per GS following RBC’s recent “virtual bus tour:”

Due diligence work underway and management sees savings opportunity beyond the $120mn synergy target. RBC noted that integration remains a key priority for the company and it’s already progressing further on the due diligence front. Both RBC and RXN are pulling together integration teams with an integration leader from RBC. They are also leveraging a third party consultant to manage the process. Management highlighted visiting six RXN sites recently, and they feel they have a clear mapping of the footprint consolidation opportunities. On this front, management believes that RXN’s PMC business probably has more footprint optimization opportunities than RBC as it has more sqft/sales. Another opportunity exists in terms of business unit rationalization where both RBC and RXN each have 4 business units (the goal is to go to 5 total). Lastly, management noted that it will not stop at the $120mn synergy goal and will continue to drive savings post that, similar to how it has been leveraging the various decentralized businesses groups to drive the current 300bps savings goal in the business. On the base RBC business, management noted it is sees a clear path for each of its segments to attain the high end of the margin goals provided at investor day.

Assuming the RMT tax status goes well, the PF company should have ~1x net leverage on 2022 EBITDA. However, there is a chance the dividend must be upsized which could drive leverage closer to ~3x, which management believes could be reduced to 1.5x in two years.

It’s also worth noting RBC and RXN’s PMC segment have both been recently beating on operating margins with RBC’s topline inflecting positively in Q4 and easy comps in H1 2021. RBC’s operating margins trended from 9.4% to 10.8% from 2014 to 2020, yet have inflected higher to ~12.9% in H2 2020. This is despite -2% topline in Q3 2020. PMC, after a lot of pruning, has also recently improved from 20% to 23% EBITDA margins. 

The RBC presentation and call is a good overview of deal: 

https://regalbeloit.q4cdn.com/342045820/files/doc_financials/2020/q4/RBC-RXN-Investor-Call_FINAL_02.16.21.pdf

I think PMC/RBC is a decent, interesting idea. It’s basically a cheap stock entering a cyclical upswing (like every industrial really…) where synergies are likely low balled (60% achieved in Year 1) and the deal is a pretty good fit. My only real knock is neither business is really “awesome” and the PMC segment was where the majority of RXN’s issues were historically.

Remain Co.

By far, Remain Co. is my favorite part of the deal. I think it’s an opportunity to pay a reasonable price for a very high-quality company that might turn into the next SMID cap industrials compounder. It’s the old Jacuzzi Brands non-residential plumbing business, acquired in 2006, with its primary banner the Zurn brand. It’s worth noting that through all RXN’s issues, the WM segment actually performed fairly well.

If that’s hard to see, it’s an older KeyBanc model, but WM has grown from $100MM in 2011 EBITDA to ~$200MM today, despite divestitures. WM has also only had two negative organic growth quarters in the last ten years. WM also posts 27% EBITDA margins with ~1% capex/sales due to its exceptionally high market share of narrow market verticals and strong sales execution.

WM’s specializes in commercial plumbing solutions:

The key to their success is that they have large market share in “less expensive” categories where labor is 50% of the construction cost. By working with architects, engineers, and contractors, WM can work less on simply being the cheapest priced widget but more on a lower overall total cost of construction. For instance, a floor drain in a bathroom is pretty much as “who cares who manufacturers it” commodity as it gets. However, designing an installation system that means the contractor does not have to break up and then repour the concrete if someone screws up is a huge deal and definitively non-commodity. RXN has repeatedly executed and has clearly grown share at the expense of competitors such as WTS. Here are the CEO’s comments on the most recent call:

On Page 6, the items on the left side of the page really are what creates the competitive advantage that we have. Spec driven, broad portfolio, lowest total cost of ownership and an increasingly strong presence in and around e-commerce. And what that does, it really creates this machine that we can continue to grow through cycles, take share. And I think if you look at us relative to some of our competitors, it's -- I think it's abundantly obvious that we are taking share.

And slide 6:

https://s1.q4cdn.com/233624116/files/doc_downloads/2021/02/4QCY20-Earnings-Call-Slides-FINAL-Corrected-ROTF-Pic-022321.pdf

Further, RXN has been in “we are a cheap stock that needs to divest” land for the better part of the last decade. Now, as the transaction unlocks value and WM emerges as a standalone entity, the Remain Co. is in a position to pivot towards inorganic growth, particularly if shares trade at a multiple in-line with water-focused, ESG peers. (I’ll comment on whether ESG peer comps make any sense at the end of this segment.) Management is highlighting this opportunity as they roadshow the new company, though I expect little on this front in 2021.

For 2022, Remain Co. is expected to earn ~$220MM in EBITDA and be ~2x levered, which management believes should convert to ~$150MM in 2022 FCF/sh vs. 123MM shares outstanding. WTS is the cleanest comp, RXN has been stealing share from them, and currently trades ~30x 2022 EPS. Other comps such as XYL and BMI trade at substantial premiums as well. On ESG, frankly, I couldn’t care less about the trend, but I’ll happily participate if Remain Co. rallies upwards on index buying. Regardless of whether RXN “deserves” an ESG multiple, I think the core WM business has a very real chance to average HSD-LDD topline and EBITDA growth going forward and at ~15x underlying FCF/sh. think that is a very fair multiple with a clear series of catalysts for shares to reweight (deal closing and RXN laying out an M&A story).

Catalyst

Closing of the Merger

Continued Operating Momentum in Core RBC and PMC Segments

Management Highlighting the M&A Opportunity at Remain Co.