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I’ve liked Rexnord (RXN) as an under-the-radar play on automation and institutional/industrial water for a little while, and while I thought the valuation on the shares was equivocal back in January, the stock has continued to outperform the larger industrial sector – even though “outperform” in this case means “declined less than the others”. At this point, I still see attractive automation-oriented opportunities in its process and motion control business, and I believe its water business may hold up better than non-residential construction in general. I likewise still see longer-term margin/cash flow improvement opportunities as the company moves toward mid-teens FCF margins.
With ongoing outperformance, it is perhaps not so surprising that the valuation isn’t outstanding. I believe Rexnord is priced for high single-digit returns at this point. That’s okay, but I typically favor higher hurdle rates and I consider this more of a hold or a buy-the-dip idea than a “buy now” idea.
Better Than Expected Results In The First Quarter
For a company with meaningful “industrial” exposure, Rexnord’s results held up well in the company’s fiscal fourth quarter (the March calendar quarter). Where the average industrial/multi-industrial reported 4% organic revenue contraction, Rexnord reported 1% overall growth and an overall result that was about 2% better than expected. Margins in the industrial business undermined some of this outperformance, though, and EBITDA was “only” in-line with expectations.
Revenue rose 2% as reported in the quarter, or 1% in organic terms. The Process & Motion Control (or PMC) business saw a little more than 1% organic revenue contraction, a little worse than expected, as aerospace and consumer-facing businesses generated growth, but more industrial-oriented businesses contracted. The Water business reported 7% organic growth, about 6% better than expected, echoing generally healthy reports from other industrials leveraged to water management/control products.
As-reported gross margin improved significantly (up about two points) as the company benefitted from lower material costs and initiatives designed to improve the product mix (which means forgoing sales in some cases). Adjusted EBITDA rose 3%, with margin up 40bp, adjusted operating income rose 4% (margin up 40bp) and segment-level profits rose 2% (margin flat). At the segment level, PMC’s 4% profit decline and 30bp margin contraction were somewhat worse than expected, while Water saw 18% growth and 110bp of margin expansion.
Although Rexnord ended the quarter with ample cash (over $573 million) and manageable debt maturities for fiscal 2021 ($76.5M), management chose to draw down $325 million in available liquidity in a “better safe than sorry” move that many companies have taken.
Management also announced that it would be transitioning the company to a calendar fiscal year. While this doesn’t change the business and shouldn’t factor into valuation, it will create some modest modeling/reporting challenges, including a nine-month “stub” for 2020.
Challenging Near-Term Industrial Trends, Tempered By Longer-Term Opportunities
Like most industrial companies, Rexnord saw a sharp shift in its business as COVID-19 shutdowns began to bite. Orders in the PMC business excluding aerospace declined 24% in April and were down around 20% through mid-May (when the company reported). Aerospace was far worse, with orders down more than 50%.
About a third of the PMC business consists of “general industrial” customers, including auto, truck, and heavy machinery companies, and it’s no surprise those are weak. Likewise with energy/power gen and some bulk handling markets (like cement and metals/mining). Food/beverage has generally held up better across the sector, but again, this is a very eccentric market where trends for one machinery/components manufacturer don’t necessarily tell you anything useful about the others.
Beyond this lousy 2020, I have mixed-to-positive feelings about the PMC business. I do think that some heavy machinery categories could remain weaker for longer, and I’m not positive at all on the outlook for oil/gas-related spending for a couple of years. Aerospace, too, I think is looking at a multiyear recovery cycle. On the positive side, though, I think the COVID-19 outbreak has underlined the importance of automation and I see significant long-term opportunities for the PMC business as an automation-enabling supplier.
Rexnord’s significant exposure to water management – about one-third of sales, mostly institutional, commercial, and industrial – is also a plus for the time being. I expect water to hold up a little better over the next year or so, with a healthy contribution from replacement/retrofit. While I am concerned about Rexnord’s exposure to what I expect will be a multiyear downturn in U.S. non-residential new-builds, I believe the downturn will be less significant in institutional and industrial markets, allowing Rexnord to fare a little better.
The Outlook
I’ve discussed Rexnord’s serial operating/cost improvement initiatives before, and I won’t rehash that much here. Management has its “SCOFOR 3.0” plan in place now, and past accomplishments give credibility to further improvements – Rexnord’s FCF margins have improved from around 6% in 2010-2015 to over 9.5% in recent years, and I believe further restructuring (and mix optimization) can drive FCF margins towards the mid-teens, with operating margins moving towards the 20%s. In the near term, management is looking for $51 million in cost cuts across the remainder of 2020 as they attempt to offset the business impact of the COVID-19 outbreak/recession.
Rexnord could be a beneficiary of manufacturing reshoring, though I don’t really expect that to become a meaningful trend. I do expect more impact from automation adoption, though, and I do also see opportunities for Rexnord to grow its exposure to more attractive end-markets like biopharma/life sciences. All of that said, I don’t want to get too far ahead of reality – this isn’t a growth company, it’s an industrial company that can still grow. To that end, I’m looking for long-term revenue growth around 3%, though further M&A could add to that. With the aforementioned margin improvements, I think mid-single-digit FCF growth is a credible expectation.
The Bottom Line
Neither discounted cash flow nor margin/return-driven EV/EBITDA suggests that Rexnord is dramatically undervalued now. Both suggest that high single-digit annualized returns are available, and while that’s not bad, there are high-quality industrials out there that offer better prospective returns. I wouldn’t be in a rush to flip this position into something else if I already owned Rexnord, but I also don’t see the valuation as so compelling that it’s a “must buy now” idea.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
