How often do we pay attention to door locks? Probably not very often, yet we use them every day. They are crucial to the security of homes and businesses.
Introducing Allegion PLC (ALLE, Financial), a lock maker.
Background
Allegion is one of the top lock makers in the world. Its major global competitors are Sweden's Assa Abloy and Switzerland's Dormakaba.
The company has produced locks for a long time. Some of its brands, including Von Duprin, Schlage, LCN and CISA, have been in existence for more than 75 years.
Allegion is based in Ireland, but a majority of its revenue and earnings is generated in the U.S. In 2018, it recorded $2.7 billion in revenue and over $600 million in earnings before interest, taxes, depreciation and amortization.
Allegion was spun off of Ingersoll-Rand (IR) in 2013. Currently almost 40% of the company is owned by five shareholders: T. Rowe, Vanguard, JPMorgan, Blackrock and Standard Life Investment in the U.K. T. Rowe is the largest shareholder with a 10% stake.
CEO Dave Petratis came on board during the spinoff. According to a press release, he has 38 years of experience in the building products industry, successfully leading Houston-based Quanex Building Products (NX) out of the 2008 financial crisis. From 2003 to 2008, he doubled the revenue at Schneider Electric’s (XPAR:SU) American division and completed several successful acquisitions.
Why is the stock attractive as a long-term core holding?
- Secular growth in electric locks.
For several decades, we have seen electric locks in science fiction. These eLocks are centrally controlled and interconnected. People use their palms, faces or voices to unlock them. But only recently, after the birth of iPhones and Alexa, did we start to see more and more of these in real life.
The interconnected eLocks in office buildings, hospitals and schools allow people to open doors they are authorized to enter. The eLocks in residential buildings allow people to remotely control doors through their cell phones. It is a wonderful world. Finally, we can save ourselves from the troubles of misplaced keys. eLocks are part of the Internet of Things. Unlike thermostats and security cameras, they may not yet have caught our collective attention. But they are arguably one of the most important things to revolutionize.
Allegion’s CEO Dave Petratis frequently encourages people to think about this fact: Of the 40 billion to 50 billion doors in the world, only about 5% are electric and connected. In the U.S., Allegion’s key market, the penetration of eLocks for commercial buildings is only 14% and for residential buildings only 7%. Compared to the eLock penetration in Korea of 60-70%, there is a long way to go. But the adoption may happen quickly. Think about this: In 2008, 11% of cars sold worldwide were keyless. By 2018, that figure reached 60%.
Currently only 20% Allegion’s revenue is from eLocks. In its major segment, Americas, the percentage of eLock revenue is even smaller than that.
Management gave guidance on long-term growth as below.
This to me appears too conservative. I estimate that Allegion could achieve 6-9% revenue growth until eLock reaches maturity at 60% in 10 years or more. Combined with positive operating leverage and capital allocation, Allegion could be a mid-double digit earnings-per-share grower for a decade to come.
As with other businesses, Allegtion’s revenue growth comes from three drivers: pricing, volume and mix.
- Two percent pricing, the same as inflation.
Allegion has strong pricing power. It has achieved inflation-like pricing. It is likely continue to do so. Management frequently says that Allegion has high pricing power.
2. One percent volume.
Volume should grow with real GDP. Allegion has been growing at an above-market rate. We can assume just 1% to be on the safe side.
3. Three to six percent mix change.
Change in product mix will be the main driver of Allegion’s growth. This is because eLocks are much more expensive than mechanical locks, as illustrated below. The Schlage eLock set is almost double the price of a similar mechanical set sold at Home Depot.
Therefore, demand shifting to eLocks means higher revenue. I estimate that, depending on the number of years for eLocks to reach 60% marturity, mix change could bring 3-6% revenue growth, everything else being equal. By these figures, Allegtion’s revenue growth rate could be 6-9%.
- Allegion is a high-quality business with a strong competitive position and strong management.
Allegion has industry-leading (and improving) margins, and high return on invested capital.
The access (i.e., locks) industry is quite fragmented. Allegion’s CEO has said that the market is valued at $30 billion to $40 billion, with the top five players accounting for about 40%. As one of the top five, Allegion looks to have about 8% market share.
Given this backdrop, I am a little surprised to see the strong margins of Allegion driven by its Americas segment. Allegion’s Americas business is no doubt a high-quality business with strong brand equity, strong competitive positioning and strong management. Allegion’s EMEIA and Asia Pacific businesses have low margins because of a small scale. But that can be a source of growth when the business becomes larger either organically or through acquisitions.
Allegion’s margins in Americas are superior to those of its competitors.
Margins are also improving. Management guided for 50 to 100 basis points of margin improvement on an annual basis.
ROIC is well over 20% for a hardware business in a fragmented market.
Risks
- The access industry is cyclical and tied to the building cycle. The cycle may be peaking.
Allegion gains about 50% of revenue from new construction and 50% from after-market. Building and remodel activity heavily influences the business. The CEO said that in the 2008-2009 down cycle, Allegion’s revenue declined 35%. But the company was still profitable, and operating margin was down only 200 basis points.
Recently, the U.S. residential construction market has begun softening. A slowdown is well anticipated. But when we look at the history, it seems that the current building activity is still way off the peak and even slightly below the historical average since 1960. There is no sign pointing to a severely weak cycle coming.
Valuation
Allegion is reasonably priced at a premium over its peers. Its enterprise value-sales deserves a premium because of higher margins. EV-Ebitda deserves a premium because Allegion has a high free cash flow conversion. Capital expenditures are only two-thirds of the depreciation and amortization.
EV-Ebitda is still at the low end of a short history.
This valuation is attractive for a multi-year grower. At $94 a share, it is a long-term buy. At below $90, investors can get more aggressive in accumulating an position.
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