Allegion Stock: Valuation Isn’t Compelling (NYSE:ALLE)

I wasn’t overly fond of Allegion (NYSE:ALLE) when I last wrote about this leading manufacturer of locks, door controls, and access systems, as I thought the shares were getting a bit too much credit for their end-market leverage. The shares have fallen more than 20% since then, underperforming the broader industrial space by more than 10%, as well as underperforming the shares of the company’s largest rival Assa Abloy (OTCPK:ASAZY) – all of that including a nice post-earnings kick of close to 10%.

I’m conflicted on the shares right now. I don’t really like the valuation all that much, and I don’t think my outlook for 5%-7% long-term revenue and FCF growth is exactly conservative. On the other hand, the company still has lagging price action acting as a tailwind, not to mention late-cycle exposure that investors seem to find strategically attractive today. Still, I’m concerned about the health of the construction markets that Allegion serves, and I’d prefer a wider margin of safety before investing my own money.

A Good Third Quarter Beat, As Lagging Pricing Drives Improved Results

Allegion’s third quarter wasn’t flawless, but it’s hard to argue with a combination of high-teens organic revenue growth, margin expansion, and healthy beats relative to sell-side expectations.

Revenue rose almost 19% in organic terms, more than 4% ahead of expectations, with 26% growth in the Americas business and a 1% decline in the International business. Relative to expectations, Americas revenue beat by about 6%, while International missed by 3%.

Revenue in the Americas was driven by a fairly equal mix of pricing (up 15%) and volume (up 11%), and this at least partly resolves some of my concerns about weak volumes recently. Allegion’s non-residential business was up 30%, the residential business was up mid-teens, and the electronics business was up 30% as component shortages ease. For the first time in many quarters, Allegion actually outperformed Assa Abloy in the North American market (by around 900bp).

International sales were undermined by an 8% decline in volume, which isn’t altogether surprising given the company’s exposure to Europe, though Assa Abloy outperformed here by about 500bp.

Gross margin declined 160bp to 40.3%, but operating income rose 34% year over year, beating by 13%, with margin up 100bp. The Americas business drove this, growing 45% with margin improving 50bp to 26%, while International saw a 28% decline with margin down almost two points to 9.2%.

Lagging Pricing Helping

The financial may make it seem that Allegion was slow to raise prices in response to higher input costs, but the reality is that price realizations in this business lag – there’s a standing practice of honoring prior prices, so it takes time for new pricing to work through. With that, pricing contributed 12 points to organic growth this quarter, a meaningful step up from +8 points in the second quarter. I’d also note that Allegion saw stronger price realizations than Assa (12 points versus 6 points).

Pricing should remain a tailwind into 2023, particularly as supply costs seem to have peaked. Component availability is still not normal and there is a long way to go before hitting “normal” on costs, but I think the worst is now in the books.

What happens next with pricing is a significant unknown. The market isn’t tremendously concentrated, with Assa holding about 12% share and the top four (including Allegion) holding about 25% share total, so price competition is a potentially viable strategy if and when supply costs ease more meaningfully.

Macro Trends Are Complicating The Late-Cycle Story

In past economic cycles, the investment case for Allegion at this point would be a little more straightforward – markets like residential and non-residential construction tend to be later-cycle movers, and so with the market anticipating weaker short-cycle trends (declining PMI, etc.) in the face of higher rates, it would make sense to rotate into later-cycle names. And to be sure, there has been some of that in the industrial space – particularly with companies offering more exposure to end-markets like aerospace that have ongoing recovery prospects.

I’m comparatively less bullish on construction markets at this point. The Dodge Momentum Index is still strong (up 28% year over year in October), but banks are already reporting weaker demand for commercial real estate loans and more caution on the part of prospective borrowers. At the same time, the residential market appears to be rolling over in the face of higher rates and affordability issues.

An important complicating factor here is the role of renovations in Allegion’s business. My understanding is that the majority of Allegion’s residential business is now renovation/remodeling, and that market is more idiosyncratic. So too with non-residential and institutional, where retrofitting schools, hospitals, and other facilities with hands-free and/or electromechanical is still a meaningful opportunity.

Likewise, indicators like the Dodge Momentum Index are leading indicators, and often run a year or more ahead of underlying trends. In other words, while the overall trend for non-residential construction can still be positive, there can also still be an “air pocket” in 2023 (and plans can change or be delayed in response to changes in the economy).

The Outlook

I believe Allegion could still be in a position to deliver revenue beats through mid-2023, but I’m concerned about negative revisions for the back half of 2023. Relative to my prior estimates, my revenue estimates for 2022-2024 are higher (by 4% to 9%), but largely due to pricing, and I do still have my doubts as to whether pricing power will endure. Longer term, I’m looking for revenue growth in the 5% to 6% range, currently closer to 6%.

Modeling out the margins gets interesting. If input costs ease off in 2023 and 2024 but pricing somehow stays sticky, Allegion could see some meaningful margin re-acceleration. Again, I don’t think pricing will be that sticky, and if input cost inflation remains high, I expect the Fed to continue pushing rates higher (which will destroy demand for Allegion). I think EBITDA margins will move back up to 23% over the next couple of years, and with that, I expect FCF margins to move back into the mid-to-high teens, and eventually reach 20% over time. That, in turn, should drive FCF growth in the range of 7% to 8%.

The Bottom Line

Neither discounted free cash flow nor margin/return-driven EV/EBITDA suggest to me that Allegion is significantly undervalued. Discounted cash flow suggests a long-term annualized return in the range of 7% to 8%, which certainly isn’t bad but also not exactly compelling. Using my margin and ROIC/ROA assumptions for the next 12 months, I think a 12x multiple to EBITDA is fair, supporting a high-$90’s fair value. If Allegion can get back to mid-teens operating margins, the fair value would jump above $110.

All in all, I think Allegion is an okay prospect, but not compelling to me given my concerns about weaker than expected trends in non-resi and residential construction. I could certainly be wrong there, and likewise pricing could be stronger for longer than I expect, but I find other industrial names more interesting today.