Acuity Brands Doing More Than Just Keeping The Lights On (NYSE:AYI)

There’s no better way to quiet doubters than to consistently execute well, and despite challenges from stressed supply chains and some volatility in end-market conditions, Acuity Brands (NYSE:AYI) has been executing rather well, surpassing expectations on multiple occasions since my last update on the shares about two years ago.

AYI shares are up more than 75% since that last article, handily outperforming the average industrial stock and other industrials with significant non-residential exposure like Allegion (ALLE), Carrier (CARR), Hubbell (HUBB), Johnson Controls (JCI), and Trane (TT). Even with that strong performance, I wouldn’t necessarily say that the shares are getting their full due, as they still appear undervalued on both cash flow and margin/return-driven EBITDA.

A Supportive Environment For Growth

Acuity’s business is driven almost entirely by commercial construction (about 50/50 between new construction and renovation/replacement), and that’s not a bad place to be at the moment. Various barometers of non-residential construction, including the Architectural Billings Index and Dodge Momentum Index, indicate healthy expansion and point toward solid activity over the next 12 months.

Along similar lines, AIA revised its forecast for U.S. non-resi spending to +9.1% (from +5.4%), with particular strength in industrial (up 31%) and quite healthy growth in commercial as well (up 6.7%). While activity will probably slow some next year, the current AIA forecast of +6% (from +6.1% previously) is still quite supportive of Acuity’s business.

Between healthy demand (volume) and repeated price increases over the past 12 months (which other industry participants like Hubbell have also enjoyed), I expect another quarter of double-digit year-over-year revenue growth when Acuity reports FQ4 earnings (likely the first week of October). Frankly, given the 18% yoy growth in the last quarter and not much sign of waning activity, I could see Acuity delivering another good beat here, with improved operating leverage likely to follow suit even with ongoing pressure on gross margin from supply chain challenges.

Likely Over-Earning, But Maybe Not Dramatically So

One of the bearish concerns on Acuity right now is the question of whether or not the company is substantially “over-earning” relative to its true underlying profitability. Acuity hasn’t been immune to the component shortages/delays that have hit the sector (semiconductors being consistently the biggest bottleneck), but the company has benefited from having manufacturing operations in Mexico that have saved the company money and hassle relative to competitors with operations in China or other Asian countries.

Okay, fair enough. Acuity is likely generating better margins by virtue of its Mexican operations, but I’m not sure that constitutes a significant non-repeating benefit, and I suspect many companies could look to relocate at least some production/sourcing a little closer to home.

Likewise with the question of whether tariffs are meaningfully boosting profitability. I think it’s certainly true that tariffs have helped the business, but I haven’t seen any evidence that those tariffs are likely to go away anytime soon. Meanwhile, the company has also taken on the burden of margin headwinds from the OSRAM lighting assets it acquired from ams-OSRAM (OTCPK:AMSSY) and I expect improving profitability from this deal over time, which will help offset some of those more “one-time” benefits that Acuity is enjoying.

… And Then What?

One area where I do share some bearish concerns is whether management can create any real enduring “sizzle” to the business that makes it more than just a lighting supplier. Lighting is essential, and Acuity has done a good job of maintaining portfolio vitality, but I think the growth and margin potential here is more “good” than “great”. Management deserves credit for what it’s done to stand apart from commodity competitors (including prioritizing efficient manufacturing and distribution systems), but lighting isn’t exactly a hot sector.

At the same time, the company’s Intelligent Spaces business is quite small at around 5% of revenue. The Atrius portfolio offers IoT-based solutions for applications like asset tracking, visualization, spatial analysis, and positioning, while the Distech portfolio offers important edge functionality like sensors and controllers, as well as building control software.

I’ve spoken in the past about my belief that building automation/controls is a growth market, and I still believe that, but I’m not sure that Acuity will be able to differentiate itself in the market enough to really challenge companies like Honeywell (HON) or Johnson Controls, particularly as the Solutions component of Honeywell’s Building Technologies is about 10x the size of Acuity’s ISG (though that is admittedly a very rough, non-apples-to-apples comparison).

Still, it’s worth noting that however subscale ISG may be, it’s still generating 20%-plus segment operating margins. I think that argues for ongoing reinvestment in growing the business, and management has both the willingness and liquidity to use M&A to accelerate the growth of this business over time. So while ISG isn’t necessarily a reason to own Acuity, I think it does offer at least a foothold for some longer-term differentiation and growth upside.

The Outlook

Acuity should generate mid-teens revenue growth this year, but I expect that the company will see deceleration to mid-single-digit growth in FY’23, and I see a risk that the company could slightly underperform its end-markets as supply chain pressures ease more significantly for some of its rivals that rely more on components, assemblies, and finished products shipped from Asia. Even so, I think Acuity can generate long-term revenue growth in the neighborhood of 3%, and that excludes significant M&A (which management has identified as a priority for capital deployment).

Acuity has what I believe is an underappreciated track record of margin and FCF performance – it’s not enough to be a leader among industrials, but consistent EBTIDA margins of 15%-plus and FCF margins in the high single-digits to low double-digits aren’t bad. I expect EBITDA margins to exceed 16% in FY’22 and FY’23, and I think 17% or better is doable in FY’24. Likewise, I think low-double-digit FCF margins are possible, driving FCF growth in the 6% to 7% range over the longer term. This is definitely an upgrade relative to my prior view, as I’ve gained more confidence in management’s ability to preserve/generate higher margins despite the commodity-like aspects of much of its business.

The Bottom Line

Between discounted cash flow and margin/return-based EV/EBITDA, Acuity still looks undervalued even after this period of outperformance. If my growth projections are valid, the shares still look priced for a nearly double-digit long-term annualized total return, and even at a forward EBITDA multiple of 10x (a discount to what a company with Acuity’s margins, ROIC, ROA, ROTA, and so on would normally get), the fair value is over $200.

I do understand the concerns that Acuity’s margins are inflated and the risk that the company will struggle to maintain double-digit FCF margins over the long term. Likewise, I see some risk that investors will shy away from non-resi suppliers over concerns of weakening confidence in 2023. All of that considered, though, the shares seem to reflect a lot of those worries and the price today is more interesting than I had expected it to be.