Allegion: An Overlooked, Wide-Moat Former Spin-Off

Summary:

  • Allegion is a 2013 spin-off from Ingersoll-Rand that has benefited significantly from the separation.
  • As a stand-alone company removed from their former conglomerate parent, the business has received much more attention, particularly in their international segments where margins have flipped from negative to positive.
  • Organic revenue growth has compounded at over 5% per year, and when combined with the margin improvement, the bottom line has grown nicely.
  • The business is deeply entrenched with customers and has strong brands in niche security access control markets. This all cumulates in a very attractive financial profile and return on invested capital.

Introduction:

Allegion, a former activist-driven spin-off, is a global provider of access control security products and solutions for residential (~25% of revenue) and nonresidential (~75% of revenue) buildings. Their products include keys, locks, locksets, door closers, latches, deadbolts, knobs, monitoring controls, and control systems (such as biometric hand reader systems).

This “Big Company Small Company” spin-off has no pure-play US public company competitors and strong brands. Importantly, they have 30 global brands, including some of the top brands in the industry with many holding the number 1 or number 2 position in their particular category. Homeowners might be familiar with the Schlage brand which is the #1 brand for residential as well as commercial markets in the United States. Additionally, a handful of their brands have a long history with some dating back as far as the early 1900s.

They operate the business through three segments- based on geography. The Americas segment contributes the majority of the revenue and profits for the company and is the crown jewel for the business. Its segment margins are over 3x as wide as either the EMEIA or Asia Pacific segments.

Given the residential and nonresidential end markets, investors might think that it is a highly seasonal business; however, the business is very stable on a quarterly basis with each quarter contributing 23% -26% of the revenue for towards the yearly total.

Go-to-Market Strategy

They have over 10,000 channel partners worldwide through different distributors and retailers, including both home improvement stores as well as specialty showroom outlets. The top 10 customers represent ~25% of sales and no single customer represents 10% or more of total revenues.

When they sell through distributors, it is a technical and more consultative sales process. They work with a combination of end users, security professionals, specification writers, architects, and other building professionals to develop custom-configured solutions for their end-customers. Also, they work with industry associations to help elected officials, architects and builders set safety and security standards within their markets. This allows Allegion to continually bring new products to market to meet the evolving standards.

Industry Analysis

The Electronic Security Access Control market is estimated to be around $2.2 billion in market size and expected to grow 6% – 7% per year over the long-term. On the other hand, the Mechanical Security market (think traditional locks) is a bit slower growth and estimated to be a $21 -$23 billion market with a long-term growth rate of 5% – 6%. Allegion management estimates their overall global market share to be ~10% with their strongest market, the United States, leading the way with ~40% share. Industry research estimates that the Access Control market has been growing faster than other security markets such as Video Surveillance or Intruder Alarms.

The key market drivers are technological advancements, including the deployment of wireless technology in security systems. This encompasses important market adoption of access control as a service (ACaaS), mobile access control, Biometric Reader and Identity Management, and IP network systems. The other key drivers for the market are the health of nonresidential and residential new construction and remodeling markets. These drivers should be supported by global urbanization and increased safety concerns and standards. They layer new product introduction on top of the industry growth to outperform.

Allegion focuses more on the mid-tier and premium products where their primary competitors are Assa Abloy AB, dorma+kaba Group, and to a lesser extent Spectrum Brands and Stanley Black & Decker. The overall market is still quite fragmented and they encounter smaller regional players across all geographic areas. The fragmented market structure reflects regulatory requirements at the local level and more niche customer needs. The industry has historically been pretty disciplined where they can pass through pricing increases to customers to at least keep up with raw material inflation. In fact, they recently announced the largest price increase in the last 15 years and expect competitors to follow.

2013 Spin-Off from Ingersoll Rand

On December 10th, 2012 Ingersoll-Rand completed a strategic review and announced the spin-off of their commercial and residential security business, Allegion, into a new public company. Activist investment firm Trian Partners had a large stake in the company and was pushing for a breakup. The total transaction took about a year to close but ultimately resulted in two separate companies, each with distinct business drivers, margin structures, and returns on capital. Allegion made up about 14% of the total Ingersoll-Rand revenue at the time of the transaction which puts it squarely in our Big Company Small Company spin-off category.

Management’s rationale for the separation at the time was to allow each company to execute their distinct strategies by deploying resources in a more focused way. In other words, there weren’t significant synergies between the two businesses and parts of Allegion were being neglected as part of Ingersoll-Rand. This was most apparent in their International businesses where they were operating at negative margins. Furthermore, some of the new cutting-edge access control technology was not being appreciated by Ingersoll-Rand investors so a separation would create value by allowing the market to value each company separately.

Since the spin-off, the business has performed quite well with organic revenues growing at a ~5% CAGR and EBITDA at a ~10% CAGR as margins have expanded, particularly in their international segments.

Also, Allegion has benefitted from an improving economic environment over the last handful of years. The last two years have been particularly robust with revenues growing at nearly 6% organically.

Risks

Competitive Environment

Maybe more than ever, the competitive environment is evolving. Offshore private label competitors can get to market quickly due to online channels. This certainly represents a risk, but it is much more so on the residential side, which is only ~25% of Allegion’s portfolio. Beyond it being a smaller piece of the portfolio, investors need to remember that buying Allegion’s products is an infrequent occurrence where customers aren’t typically trying to cut costs, given the can’t fail nature of the product. Consumers have traditionally been willing to pay more for the peace of mind knowing that they have the best locks on their doors to stop any potential intruders. Also, this risk is mitigated by Allegion’s strong intangible value built up in the business through brands that have existed since the early 1900s, 700+ salespeople (including nearly 200 specification writers), over 1,000,000 end-user installations, channel partners that include 5,000+ architecture firms, and 9,000+ independent channel partners.

Cyclical End Markets

The business is tied to cyclical end markets, namely residential and commercial construction. While this is certainly the case, it is less cyclical than other building suppliers.

As you can see above, revenue was down ~16% in 2009, before stabilizing and growing again. While down 16% is a big number, during this period many companies driven by the same end markets were down over twice as much. The main reason for the relative stability of their revenue is due to pricing strength and significant replacement, retrofit, and upgrade business, which management estimates to be around 50% – 55% of total revenue. This portion of the business provides a nice growth tailwind as much of the activity results in sales of new, higher value technologies. See the discussion below on Allegion’s vitality index for more details on their innovations.

Financial Leverage

They are currently leveraged around 2.6x Debt/EBITDA. However, in September 2017 they were upgraded to investment grade. In the note upgrading Allegion’s credit rating, Moody’s cited their high margins and consistent free cash flow as key considerations.

Investment Opportunity

Over the coming years, the business will continue to benefit from a handful of trends- both macro and industry-specific.

On the macro front, both residential and nonresidential construction should continue to be stable to improving given the multiyear weakness during and after the financial crisis. The economic strength will be complemented by technology-driven innovation creating new products at higher price points, particularly on the Electronic Security Controls side of the business. During 2017 Allegion spent ~$48 million (~2% of sales) on research & development. This investment in innovation is demonstrated by the 600+ global active patents and the trend of continually improving the company’s vitality index, the percentage of revenue from product innovations in the last three years, from single digits in 2014 to high teens in 2016 and towards their target of 25%+ in 2019. If they can execute and the end markets continue to be healthy, they are on track to hit their target of continuing mid-single digit organic growth.

Margins should continue to be upward biased. The business generates about 40% contribution margins so as long as the economic environment remains healthy and the market structure with competitors remains intact, margins will be pressured upwards.

Also, as previously mentioned, their margins internationally are substantially below the Americas margins. There are two main reasons for this margin structure internationally. First, they just don’t have the scale that they have in the Americas. During 2017, they generated nearly $1.8 billion in revenue in the Americas, but just a bit over $500 million in EMEIA and just over $100 million in Asia Pacific. In order to generate higher margins internationally, they need to leverage those international assets over a higher revenue base. This is one of the main reasons M&A activity has been focused on international markets. They have done 16 deals totaling nearly $600M in total spent on M&A since 2014, including two European deals in 2015 accounting for nearly $440 million of it.

We can do a little bit more analysis to demonstrate the reasons for the margin differences between the Americas and two international segments. While it’s not a perfect analysis because it does not take total square footage or sales mix into consideration, we can look at the number of production facilities by region to get a sense of revenue they generate from their tangible asset base by region. During 2017 the Americas segment had 14 production facilities, EMEIA had 12, and Asia Pacific had 5. This resulted in revenue per production facility in the Americas segment of nearly 3x EMEIA and over 5x Asia Pacific.

The second reason their margins aren’t as good in EMEIA is that their brands trail competitors Assa Abloy and Kaba in Europe.

However, as long as the business continues to grow, margins will continue to expand as they leverage their asset base and other fixed operating costs.

Allegion is a great example of what we refer to as an orphan spin-off. It is a major player in a niche industry where it has no pure-play US competitors. Their main competitors are European, one of which is a Swedish company (Assa Abloy) and the other is a Swiss company (dorma+kaba Group). While they compete with US companies, they are all subsidiaries of larger conglomerates. As a result, U.S. focused analysts are not familiar with the business quality and industry structure. In fact, it can stay this way for some time as sell-side coverage will be picked up by analysts that have never analyzed this particular industry so it gets lumped in with other companies that may or may not have similar business characteristics. Alternatively, it never gets covered at all because there is not enough overlap with other companies and it may not generate enough trading commission or banking fees to justify the time spent.

As a result, these can be excellent opportunities for investors to find unique businesses that the market doesn’t appreciate. This is especially true with Allegion because their brands have been part of Ingersoll-Rand since the mid-1970s so they have never had a chance to stand alone and be appreciated by the investment community.

Overall, investors have the opportunity to purchase a competitively entrenched ‘orphan’ business with a very attractive ROIC and normalized operating profile of low-to-mid single digit revenue growth with operating leverage pushing margins up a bit over time. This is consistent with management’s targets of mid-single digit organic growth, EBITDA margin expansion, EPS growth of ~10%, and ~100% cash flow conversion. With the weak stock performance over the past year, the valuation multiple has contracted and it could be an opportune time for investors to take a hard look at the business.

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2018-09-26T13:51:07+00:00