original blog post
Acuity Brands is one of the world's leading providers of lighting solutions for commercial, institutional, industrial, infrastructure, and residential applications throughout North America and select international markets. Acuity manufactures or procures lighting devices primarily in North America, Europe, and Asia. During 2014, Acuity manufactured 25% of their products in the U.S., 53% in Mexico, 2% in Europe, and procured the remaining 20% from other manufactures. Acuity's principle customers include electrical distributors, retail home improvement centers, electric utilities, lighting showrooms, national accounts, and energy service companies. Acuity's customers serve new construction, renovation, and maintenance and repair applications. Home Depot (HD) is Acuity's largest customer at 12% of fiscal 2014 sales. Sales originated in North America accounted for approximately 98% of net sales during 2014. Demand for Acuity's products is based on residential and non-residential construction, both new and renovation activity. Demand for Acuity's products is sensitive to the volatility of general economic factors. Lighting demand from renovation and retrofit activity in the U.S. has experienced accelerating growth in recent years.
Strength in Construction
Construction is one of the stronger parts of the U.S. economy right now. During the financial crisis, residential and non-residential construction dropped off precipitously, and the following years were a time of underinvestment. Now the construction market is coming back, and it will take several years to recoup this underinvestment.
A competitor of Acuity in the lighting space is Eaton. During Eaton's 2Q conference call, Alexander M. Cutler, CEO, acknowledged the strength in construction and lighting:
"...the strength in the marketplace is really in the lighting area, it's in residential, and it's in selective parts of the non-residential construction market..."
During Home Depot's (HD) 2Q conference call, Edward P. Decker, EVP Marketing, called out the strength in lighting.
"The departments that outperformed the company's average comps were appliances, tools, plumbing, decor, lighting, kitchen and bath, hardware and flooring.... Pro heavy categories continue to show great strength and we saw double digit comps in water heaters, power tools, commercial lighting, flooring tools and materials and power tool accessories... While cleaning, wiring devices, circuit protectors, plumbing repair parts, pipe and fittings and light bulbs all had comps above the company average. In decor categories, tile, in-stock kitchens, recessed lighting, bath fixtures, vanities, ceiling fans, faucets, interior lighting and bath accessories also had comps above the company average."
I expect strong construction activity to power economic growth in coming years, and I believe lighting will continue to be a particularly strong segment of the construction market.
Addressable Lighting Market & LEDs
Acuity estimates the fiscal 2014 North American lighting market to be $14 billion. Acuity's 2014 market share was 17.1%.
Light-emitting diode lamps ("LEDs") are disrupting the lighting market in a big way. The LED segment of lighting is the fastest growing segment of lighting. During fiscal 3Q, Acuity saw 13.2% growth in total revenue, but LEDs grew 55% and represented more than 45% of total sales. This obviously implies a significant decline in florescent lighting as LEDs disrupt the lighting market.
LED prices have dropped enough to make the payback economic in many new applications. For a modestly higher upfront cost, LED lamps offer significant energy savings. Payback periods have dropped to the 2-4 year range for many more applications, cause demand to switch from florescent luminaires to LEDs. High-Bay Lighting is used in warehouse, industrial, sporting, retail, and transportation facilities. In 2013, several high-bay LED products were launched that provide exceptional quality in a price range that allows for acceptable paybacks from energy savings.
Navigant Research forecasts LEDs to grow at a 19% CAGR from 2015 through 2024. The market for every other lighting technology will contract during this period. Due to the increased lifespan of LEDs over florescents, Navigant Research forecasts global lighting revenue to peak in 2017.
Acuity is benefiting from the disruptive LED technology. Acuity is currently experiencing accelerating revenue growth due to demand from retrofit activity as the installed base is converted to LEDs. This conversion is expected to take several more years to complete.
Acuity's purchase of ByteLight during fiscal 3Q shows Acuity's growth strategy beyond the retrofit-LED pop in demand. ByteLight combines Visible Light Communication (VLC), Bluetooth Low Energy (BLE), and inertial device sensors to transform LED lights into indoor location waypoints. This technology can be used in location-based marketing. ByteLight makes LEDs "talk" to any smartphone and tablet with a camera and/or blue tooth smart technology that opts-in to "listen".
I see Acuity generating about $260 million of free cash flow in 2016. With an enterprise value of $8.3B, the multiple to FCF is about 32x. If Acuity is able to grow earnings in the 17% range, the PEG is about 1.9x. I think the stock is fairly valued.
Acuity is in the right geography i.e. the U.S.. Acuity is benefiting from a disruptive technology, and Acuity's management is investing for the future grow of the business. I see Acuity as an attractive business at a fair price, and I advocate buying the stock.
Today's lack of volatility and stabilization in oil indicates the market is going higher in my opinion. The market has had some extremely volatile trading recently. On Monday the S&P traded in a 103 point range! Today it feels like we haven't even moved although the S&P has carved out an 18 point.
The energy sector had been leading the market lower, but bottomed and has led the market higher the past 2 trading days. Oil looks to may have bottomed, and is now more than 15% off its low.
Prior to today, the S&P had a range greater than 44 points for 6 straight days. Today's range of 18 points is chump change. Guess what money managers do after the market settles down from a big downdraft. I'm guessing they are going to buy, and that's why I think the market is going higher next week.
No China Exposure
I have been looking for stocks with no China exposure, and Alaska Airlines (ALK) fits the bill. The airline industry is benefiting from lower energy costs, but oil is now a risk if it bounces back. Capacity additions have increased competition, and fares have begun to come down since mid-2Q. I chose Alaska because many of their routes don't compete head-to-head with ultra-low-cost-carrier (ULLC's). I decided to hedge Alaska against a pop in the price of oil by adding a long WTI future hedge.
Less Competitive Routes
Alaska is adding capacity, just like most other airlines. Alaska also eliminated 5 routes recently. They freed up assets to serve new, less-competitive routes. Many new routes, shown here, do not currently have a non-stop flight or has only one carrier providing a non-stop flight.
The cost of fuel is a big issue to deal with when looking at an airline investment. Since oil has been elevator down for the past year, airline stocks have had a strong tailwind from margin expansion. But today with WTI trading with a $38 handle, I feel like the easy money has been made on the short side of the oil trade. So I decided to add a long WTI future hedge to Alaska in order to hedge the position to a snap back in oil. I calculated a bunch of different hedge ratios based on OLS and volatility ratios. The hedge ratio is somewhere in the neighborhood of 20%-50%. I prefer to err on the side of hedging too much WTI rather than too little, so I am going to lean toward the 40%-50% area. Using a 50% hedge ratio, buy 1 WTI future for every 2,000 shares of Alaska.
Alaska is an exceptionally well run airline with a shareholder friendly management team. They have proven themselves to be prudent managers of capital. I trust management will continue to maximize the FCF of the business.
I expect Alaska will generate over $500M in FCF in 2016. With an enterprise value of just below $10B, the multiple to FCF around 18x. I expect the 2016 EBITDA to be over $1.7B which puts the EV / EBITDA at 5.5x.
One could argue the airlines are experiencing peak earnings and cash flow right now, and a valuation should be done on a normalized profitability level. This is certainly a risk to any airline stock, and something to be monitored. The airline industry has been adding capacity, and ticket prices have recently exhibited downward pressure. I don't want to see this competition get out of hand, and I'll monitor this situation closely.
Home Depot (HD) reported superb total sales ($24.829B vs estimate $24.7B) as well as comp store sales up 4.2% and U.S. comp store sales up 5.7%. Home Depot also raised full year sales, comp store sales and earnings guidance. This report confirms the strength in the U.S. housing construction, retrofitting, and remodeling market. Read the full report at this link:
Home Depot 2Q earnings report press release
The conference call starts at 9am ET
Looking at the details, Home Depot seems to have some margin pressure at the gross margin line. There were a couple one-timers in the numbers which I took out. I believe the $92M charge for the data breach is in the COGS line. Even after adding the $92M back in, I still see gross margin down by 19 bps. I don't think there is a lot of discounting going on in home supply retailers, so I am guessing it's coming from the COGS, maybe some wage pressure. Home Depot should have raised prices to offset this wage pressure in order to avoid this margin compression.
Home Depot has a debt-to-EBITDA ratio of 1.1x, and this is expected to increase roughly 0.1x per quarter. The reason for this is the $7B share buyback which Home Depot is executing during calendar 2015. Home Depot has repurchased $3.085B of stock in the first 2 quarters. I am usually a fan of share buybacks, but I don't think it's a great idea to lever up the balance sheet too much to buy back stock, particularly at the beginning of a Fed tightening cycle.
At yesterday's closing price of $119.70, Home Depot is trading at 25x FCF. I think Home Depot is benefitting from a construction market which is quite firm and expected to continue to strengthen, but I don't see the stock as a great investment opportunity.
The strength in the Home Depot sales makes me think of Lowe's (LOW) and Tractor Supply (TSCO), both of which should also benefit from the strong construction market. Lowe's reports tomorrow, and Tractor Supply reports in October. This is an interesting comparison, because the valuation difference between these companies is quite significant. Lowe's trades at 18x FCF, but does have lower operating margins than Home Depot and Tractor Supply. Lowe's is also more highly financial levered than Home Depot at 1.5x debt-to-EBITDA. Tractor Supply has no net debt.
Tractor Supply trades at the highest multiple at 40x FCF, but is also growing sales at around twice the rate of Home Depot and Lowe's. The comp store sales of these three is pretty comparable. The growth from Tractor Supply is coming from geographic expansion. Home Depot and Lowe's are pretty saturated. As of the end of the first quarter, a total of 293 stores, or 12.9% of the total store count of 2,270, were located in Canada & Mexico. This leaves little room for geographic expansion in the U.S., and the U.S. construction market is what I want to get exposure to. This is just me talking, but if Home Depot started a new smaller store format, maybe they could further penetrate the home supplies market. The existing warehouse-style format is probably pretty close to saturation in the U.S., so store growth is going to approximate population growth which is below 1%. Lowe's has a similar saturation problem. Lowe's has some upside in making their operation more efficient, and Lowe's is buying back even more stock than Home Depot.
I like the growth story of Tractor Supply. They are in a non-competitive space where Home Depot and Lowe's have decided not to focus. This is a great advantage for Tractor Supply, and could help them expand their operating margins above Home Depot's 13%. I see Tractor Supply with the highest PEG ratio at 2.6 versus 2.0 & 1.4 for Home Depot and Lowe's. I am hoping for a strong report out of Lowe's, but I think their strategy to lever up the balance sheet and buy back stock is not a good fit with me. Let's wait to see what Lowe's report looks like tomorrow to make a final decision.
Snap-on (SNA) is a tool supplier with several secular trends improving its business. First, Snap-on has exposure to end-market strength in autos, aerospace and construction. Second, Snap-on benefits from commodity price weakness in steel & natural gas. Finally, China is not currently a large portion of sales, so the risk to the Chinese slowdown is limited.
The auto industry is Snap-on's largest end market. Snap-on pioneered mobile tool distribution in the automotive repair market. Two of Snap-on's business segments focus on the automotive market: Snap-on Tools Group and Repair Systems & Information Group. These two segments represent 41% and 29% of sales. So 70% of Snap-on's sales are related to auto repair and manufacturing, putting Snap-on in a great position to benefit from the strength in auto industry. Vehicle sales are strong, and trending higher. July seasonally adjusted vehicle sales of 17.6M units was higher than consensus of 17.2M.
The auto repair industry is benefiting from the secular trend of people keeping their car longer. The average vehicle in U.S. is now a record 11.5 years old, according to IHS Automotive. In addition, this trend is not expected to reverse. IHS thinks the average vehicle age will hit 11.6 years in 2016 and then 11.7 years in 2018. So the auto repair business and Snap-on should continue to benefit from this secular trend.
Snap-on has successfully diversified into markets adjacent the autos. The Commercial & Industrial Group contributes 30% of Snap-on's revenue. Included in this segment are two industrial markets also benefiting from positive secular tailwinds: aerospace and construction. Aerospace is strong as a result of the shift toward airplanes with higher fuel efficiency. Construction is gradually strengthening after years of low investment following the financial crisis. I believe these industries will maintain relative strength due to positive secular trends.
Snap-on's manufacturing costs decrease with lower commodity prices, particularly steel and natural gas. The principle raw material used to manufacture Snap-on's products is steel. Assuming steel is 10% of COGS, then a 10% drop in the price would increase net margin by 69 bps (tax rate 31.5%).
Snap-on holds 3-4 months of inventory and buys steel ahead for work in progress, so this dramatic move down steel prices should be a nice benefit to margins in the second half. In addition, iron ore has dropped back down close to it's March low, which I think indicates further weakness in steel prices is probable. I believe steel & iron ore prices will continue to be heavy, because China is exporting higher and higher volumes after the collapse in their internal demand for steel used in construction.
Geographically, Snap-on's sales are 66% in the U.S. and 20% are in Europe. Both of these geographies are currently strong relative to China. Although China is an area of growth for Snap-on, business there is relatively small. Snap-on has less than 10% of sales in emerging markets. China is Snap-on's 11 largest geographical market. There are 7 European markets larger than China as well as Canada and Japan, so I assume China exposure is less than 2% of sales. Snap-on does has four manufacturing facilities in China, but I view Snap-on's China exposure is relatively small.
Snap-on has a financing division, Snap-on Credit, which makes loans to franchisee-distributors. When I value Snap-on, I eliminate the results of the Snap-on Credit segment. I view Snap-on's credit business as a subsidy to its manufacturing business. I am not buying Snap-on for credit exposure. I don't think the credit segment has delinquency problems, so I am not assigning it a negative value.
I see Snap-on as fairly valued at 18.3x FCF and 22.5x earnings. Snap-on trades at a higher multiple than its competitors, but I am willing to pay up for the execution, strategic business plan, and secular tailwinds outlined above.
In Summary, Snap-on has exposure to the strong end-markets of autos, aerospace & construction. Snap-on is a beneficiary of lower commodity prices, particularly steel, and has low exposure to a weakening China. On the negative side, Snap-on does have some negative exposure to the stronger USD. I am avoiding investments with high foreign exchange exposure. Although I am not happy with the USD exposure, all considered, Snap-on is still an attractive industrial stock.
Michael Grove, CFA