|Shares Out. (in M):||26||P/E||16.4||13.6|
|Market Cap (in $M):||1,129||P/FCF||14.3||11.8|
|Net Debt (in $M):||260||EBIT||97||117|
I think AZZ is a “B” business at a B+ cyclically-adjusted valuation with fundamentals that are about to "stop getting worse." While not a "pound-the table" endorsement, I thought it might be of value to some in the VIC community (it has never been written up on this forum).
Brief Business Description: AZZ is country's largest non-captive galvanizer, a niche business that represents roughly 2/3rds of AZZ’s profits. The other 1/3rd of AZZ consists of a several small “electrical and industrial” businesses that primarily manufacture engineered products that help distribute electrical power between generators, transformers, and switching devices. The company has been profitable for ~30 consecutive years. 82% of revenue is derived from the United States (OUS is mostly Canada) and is headquartered in Fort Worth, TX.
The galvanizing market has been sluggish (partially due to temporary hurricane impacts in TX) and zinc costs (which are passed through on a 30-90 day lag) have risen consistently & considerably over the past 12 months, depressing AZZ’s profitability. Over the next 24 months, I expect margins to revert back towards historical levels as (1) end markets improve (products that are galvanized are things like bridges, guardrails, cell towers, ladders, and boat trailers), (2) zinc costs subside (or are passed through), and (3) recent acquisitions are integrated.
The thesis can be boiled down into three pillars:
Consolidation = will industry-wide pricing stable, and perhaps improve competitive dynamics over time
Recent margin compression (due to rising zinc costs) is temporary
Favorable valuation & strong FCF
The two major risks are:
Capacity growth could return to the galvanizing industry. Over the past several years, the # of galvanizing facilities in the US has remained constant ~140.
Exposure to energy. While drilling related business only accounts for ~5% of AZZ’s revenue, AZZ’s galvanizing facilities index somewhat highly to states where the health of the energy business is key to industrial production. I believe the worst is behind us, as the "petrochemical" market declined from 14% of sales to 7% from FY16 to FY17.
I believe the 1YR risk/reward is favorable (~3:1). I expect AZZ to move higher with higher with >10% EPS growth ex deals (driven by end-market recovery + margin expansion via zinc cost pass through + self-help) coupled with upside from more tuck-in galvanizing deals. I believe the stock’s multiple is likely to expand from current levels as revenue and EPS growth re-accelerates after some acquisition indigestion and commodity issues.
*Note, FY17 galvanizing margins include $7.3mn of realignment charges (~194bp headwind). Bear case essentially assumes no margin recovery from pro-forma FY17 levels. Additionally, electrical EBIT margins were 13% in FY17, excluding purchase accounting and the company has targeted 15% margins for this segment
(+) The galvanizing segment provides a stable stream of income/FCF. This has helped the overall company generate $400mn in FCF over the past 5 years, equal to ~35% of the current market cap.
Industry consolidation should lead to structurally stable/rising margins. As seen below, AZZ (~30% share) and VMI (~11% share) have both been buyers of galvanizing businesses over the past several years…The industry remains highly fragmented with ~50 single facility mom and pop players (140 facilities nationally).
Low value/weight = local pricing power. Similar to the aggregates industry (VMC), the amount of freight costs is relatively high vs. the value of the product being shipped. Therefore, galvanizing plants have significant pricing power for projects/customers in their immediate radius (it is hard for competitors 500+ miles away to undercut them on price).
(+) Management has been dramatically upgraded over the past few years and has improved incentives across the organization. AZZ’s CEO Tom Ferguson spent 25 years with Flowserve where he oversaw $3bn in sales and 11,000 employees across 56 countries. He recruited several of his former colleagues to join him at AZZ. While Mr. Ferguson was President of Flow solutions (~36% of FLS’s EPS & the fastest growing segment during this tenure), Flowserve was a great stock, outperforming the S&P by >400%. FLS is regarded as a very well-run company. In a recent AZZ conference call, “We have converted our profit-sharing program to a performance-based bonus program. This program is designed predominantly around operating income cash flow, return on assets and productivity. To help drive results, every employee is now a participant in the incentive program. We have also extended equity-based compensation deeper into our management ranks.”
(+) Strong FCF profile and solid valuation. Over the past 6 years, FCF has been ~19% higher than net income. While AZZ trades at 25x consensus FY18 EPS, it only trades at 11.7x the average FCF generated in ‘15 & ‘16.
(-) Galvanizing is a competitive industry. If margins/returns get pushed too high, new supply is likely to come online. As seen in this Youtube video, there isn’t a ton of IP or value-add in this process. AZZ also faces competition from captive galvanizing facilities and alternative forms of corrosion protection (like paint).
(-) There has been some modest capacity growth, which has impacted pricing in the gulf. While opening a new galvanizing plant from scratch is a difficult venture (low initial utilization vs. high initial cost of plant/chemicals), two new plants have recently opened in the United States in areas overlapping with AZZ plants. Metalplate announced a $10mn investment for a plant in Jennings Louisiana, and V&S recently opened a plant in Memphis.
(-) Vulnerable to rising zinc costs (at least within 30-90 windows). Per KC Capital, “zinc is a key cost (30-40%) in the galvanizing process. Zinc prices have been relatively benign during the past two years, averaging about $1.00 per pound. However, zinc prices did rise sharply from about $0.60 per pound to over $2.00 per pound during 2006-2007.” During 2017, zinc costs have gone on a historic rise, as illustrated below.
(-) There is some cyclicality to the business. AZZ’s end markets generally follow the health of industrial production, which has slowed slightly of late. However, I feel as though we aren’t even in the sweet spot of the cycle. New power generation projects (a significant end market for AZZ), could remain depressed (though increased nuclear & coal/gas switching is a positive).
What is galvanizing? Hot dip galvanizing is a metallurgical process in which molten zinc is applied to steel. The zinc alloying renders corrosion protection to fabricated steel for extended periods of up to 50 years. Galvanizing is used in a wide variety of industrial applications where corrosion protection of steel is desired, including electrical and telecommunications, bridges and highway, petrochemical, and general industrial markets. Thus, demand for galvanizing services generally follows the industrial U.S. economy.
As described in an initiation from Kansas City Capital, “Galvanizing companies are very much indistinguishable from each other except for kettle sizes. (A large kettle may allow some firms to galvanize very large fabricated products that others simply cannot.) Pricing discipline within this industry has been relatively good and operating margins across the cycle have generally reflected that discipline. The absence of any new galvanizing facilities and the consolidation efforts of AZZ and VMI have likely had a role in keeping margins relatively stable.”
Price increases (to pass through rising zinc costs)
|Entry||04/05/2018 11:53 AM|
Thanks for the write-up. We've done some work on this name and couldn't get there. Please let us know if you have thoughts on any of our questions below:
|Entry||04/05/2018 12:21 PM|
ActII, in the 8-K with restated numbers, unbilled DSO was actually not up y/y in Feb. 2017 ($50mm vs. $63mm in Feb. ’16). But given the large sequential increases in the restated unbilled rec. for the Qs ending in May and Aug. ’17 ($60mm and $69mm respectively), we suspect AZZ’s unbilled receivables/unbilled DSO were up y/y in those periods – although we won’t know for sure until we see the amended filings. Regardless, the old accounting method obscured what looks like some significant cost overrun projects. Are you concerned about a further rise in the unbilled receivable balance in the Nov. ’17 and Feb. ’18 filings? And do you have thoughts on what the “problem contracts” might be