Acuity Brands, Inc. (AYI) designs, produces, and distributes a variety of lighting solutions for the commercial, industrial, and residential applications. On January 8, 2013, the company released its earnings results for Q1 FY13. Acuity reported net sales of $481.1 million and adjusted earnings of $0.69. The street was expecting $498.8 million and $0.81.
Given the recent earnings report, the company's near-term outlook, and its elevated valuation, it's time to sell AYI. The shares also present a short opportunity with an excellent risk/reward.
The Next Two Quarters Look Tough For Acuity
Following the earnings miss by Acuity, consensus estimates were lowered for each of the next two quarters. Earnings estimates for Q2 FY13 dropped from $0.70 to $0.63, and Q3 FY13 estimates dropped from $0.94 to $0.89. Revenues are now expected to be $469.6 million and $513.0 million for Q2 and Q3, respectively.
To determine whether Acuity can meet these lowered expectations in the near term, I have modeled the company's income statement for the next two quarters. With the continued downward trend in Acuity's end markets and falling margins, it appears that the company will have trouble meeting these lowered revenue and earnings estimates.
Starting first with the forecast of Acuity's sales, my model correlates Acuity's historical results with monthly Manufacturer's Shipments, Inventories, & Orders data for electric light equipment provided by the Census Bureau (category U35AVS), as well as non-residential spending provided in the monthly Construction Spending report. The model is updated with the latest information available and that information is used to project the shipments and spending based on current trends. To account for seasonal changes in these figures, the model focuses on year/year growth rates for comparison.
The chart below shows the correlation between Acuity's sales and the shipments of electric light equipment for the past several years. Note that the chart also includes data for the upcoming quarters (Q2 and Q3 of FY13). The model assumes a decline in year/year growth in light equipment shipments of 4.0% and 3.6% for those two quarters.
The next chart shows the correlation between Acuity's sales and non-residential construction spending. For Q2 and Q3 of FY13, the model assumes year/year growth in non-residential spending of 0% and -0.25%, respectively.
Based on these correlations and the growth assumptions for future quarters, Acuity's year/year sales growth for Q2 should be approximately 0.9%, which equals sales of approximately $461.9 million. Sales for Q3 should increase at the same rate and total $491.0 million. These sales projections are currently below the $469.5 million and $513.0 million consensus estimates for Q2 and Q3, respectively.
In its earnings release, Acuity blamed the decline in sales on a lull in demand for the non-residential construction market and a general "wait-and-see" approach by its customers. It expects a more stable demand in the second half of FY13, but noted that Q2 is the softest quarter of the year from a sales perspective, and demand will be inconsistent. These statements are all consistent with the sales projections generated by the model.
Acuity identifies two primary operating expenses in its income statement: Cost of Goods and Selling, Distribution & Administrative expense. In the most recent quarter, the Cost of Goods increased slightly over the previous year and caused gross margins to drop just over 40 bps. In its earnings release, the company identified temporary inefficiencies associated with the closure of a production facility as an explanation for reduced margins. However, Acuity classified these as special charges and provided adjusted earnings to exclude them (the adjustments are reflected in the model).
For Q2 gross margins, the model assumes a drop of 130 bps from Q1 (compared to an average drop of 160 bps in the past four years). For Q3, the model assumes an improvement of 160 bps from Q2 (compared to an average improvement of 156 bps). The chart below shows how the gross margins of 39.1% and 40.7% projected for FY13 Q2 and Q3 compare to the company's historical gross margins. Note that the historical gross margins in the chart are grouped by quarter because they vary significantly from quarter to quarter due to seasonal effects.
To complete the earnings estimate, the model projects that Selling, Distribution, and Administrative expenses will be 29.45% and 29.00% of sales for Q2 and Q3, respectively. This assumes an increase of 23 bps from Q1 to Q2 and then decrease 45 bps from Q2 to Q3. This compares to an increase of 20 bps and then a decrease of 49 bps for these same two quarters in FY12. The other significant items in the income statement are the tax rate, which was set at 35% for both quarters, and the outstanding shares, which are projected to increase slightly to 42.5 million.
Under these sales and expense assumptions, Acuity will earn $0.57 and $0.76 per share in the next two quarters. Both of these estimates are below the street's current projections of $0.63 and $0.89.
With any forward-looking model, it is always a useful exercise to understand the sensitivity on the projections with any change in the underlying assumptions. For FY13 Q2, there is a 6-cent difference between the model and the street's estimate. Of the 6 cents, approximately 1 cent corresponds to a difference in projected revenues and 5 cents relates to the difference in projected expenses. In the model, every 20 bps change in the gross margin or SD&A expense will move the earnings estimate a little more than a cent. The same is true for every 1% change in the tax rate. For the Q3 projection, approximately 4 cents of the difference is due to revenue projections and 9 cents relates to the difference in projected expenses.
Acuity's Sales and Earnings Growth Are On the Decline
To determine whether the recent downturn is just a bump in the road for Acuity, I also looked closely at the trends in overall sales and earnings growth. To account for seasonal effects, my analysis focuses on year/year growth rates using a four-quarter rolling average.
As the chart illustrates, the rolling year/year growth rates for sales has dropped from a peak of over 11% a year ago to low-single digits. The earnings growth has seen a more significant decline. It peaked six months ago and will actually move into negative territory later in the year if my model is accurate. Even under the street's estimates, the earnings growth rate will drop below 5%. The lone bright spot here is that Acuity has been able to maintain a consistent 6% profit rate over this time period. Thus, the numbers show that relatively small changes in sales growth can have a big impact on Acuity's earnings growth rate.
Acuity Is Overvalued
Acuity currently trades at a 20 P/E multiple based on the street's estimated earnings of $3.27 for FY13. The sales and earnings growth rates do not support this multiple, and the current trends suggest that resumed growth is several quarters off in the future.
So why then does Acuity trade at a 20 multiple? Before reporting FY13 Q1 earnings, Acuity was expected to earn $3.52 per share this fiscal year (representing 17% growth year/year) and $4.22 in FY14 (almost 20% growth year/year). In this market, this level of projected growth can support a 20 multiple.
With the current downward revisions, however, the expectations are now $3.27 (or 9% year/year growth) and $4.00 (23% growth) for FY13 and FY14. It is apparent from these projections that many of the analysts that cover the stock have not properly adjusted estimates for FY14. Indeed, the estimates range from a low of $3.33 to a high of $4.50. If Acuity's earnings are consistent with my projections, investors will eventually turn on this stock and the P/E multiple will likely drop.
According to Yahoo Finance, the average multiple for other companies in Acuity's sector is just above 14. At that same multiple, AYI would trade at around $46, which is $20 below the current price. With the average P/E multiple for the S&P 500 around 12, there are far cheaper stocks that you can pick up with a better potential for growth and far less risk.
The Short Trade
Over the past six months, AYI has traded between four horizontal levels (indicated by the blue lines in the chart below). Just before Acuity reported earnings for Q3 FY12, the stock traded between $50 and $57. Over the following three months, the stock peaked just under $70, but fell back to the $57 support level after disappointing Q3 FY12 earnings. Investors shrugged off the disappointment and the shares climbed up to $70 again earlier this month. After disappointing Q1 FY13 earnings, the shares found support at the $62 support level again and currently sits at $66.
With the recent earnings miss and sales/earnings in a downtrend, it is unlikely that the shares will breakout above the $70 mark in the near future. Thus, the downside risk for a short trade here is around $4. The reward is potentially far greater. A move down to the $57 or $50 levels is a possibility. For example, if the stock were valued at a 15 multiple (just above the sector average), that would put the shares at around $49. The potential downside in the shares provides an excellent risk-reward for a short trade.