AZZ (AZZ) has caused quite some news since the start of October, but generally it has not been well-received by the market. The company hiked its quarterly dividend by 13%, yet the 1.2% dividend yield remains very modest.
The company furthermore announced the divestiture of its Nuclear Logistics business to Westinghouse Electric. This business is no longer considered a core activity and has been sold for an undisclosed amount. The unit was the third largest supplier of safety related equipment and employs about 180 workers, roughly 5% of the workforce of AZZ. With the unspecified proceeds, AZZ will focus on further expanding into galvanizing and energy.
While this news flow is relatively small, investors were very disappointed with the latest second quarter earnings report. Shares have lost 15% of their value over the past two weeks on the back of the soft results, warranting an investigation about the prospects going forward.
A Growth Story, Dual Focus On Galvanizing & Energy
AZZ has delivered on remarkable growth over the past decade as sales have grown from $250 million in 2006 to $900 million by now. This is a very strong achievement driven by smart deployment of capital while dilution has been very limited for shareholders and the balance sheet remains very strong.
The company has grown a $400 million galvanizing segment, a business which is very lucrative. Operating margins of this business typically come in at 20 to 25% of sales. Industrial companies, electrical utilities, OEMs and petrochemical companies are the main clients for this unit.
The energy business is larger in size with $500 million in revenues, generated from industrial and power generating clients. Margins of this segment are respectable at 10-15% of sales, but they lag compared to the galvanizing segment.
As the company is shifting away from the nuclear business, it is most likely that money will be used for organic growth and acquisitions within the galvanizing segment. AZZ has made numerous purchases in this area, especially in recent years.
Current Growth Trends Are Abysmal
AZZ started the fiscal year of 2017 on a strong note with first quarter revenues increasing by 6% towards $243 million, accompanied by a healthy book-to-bill ratio of 1.03 times.
In that respect it is almost shocking to see the second quarter results. Revenues fell by 9% on an annual basis, having fallen towards $195 million. Worse, bookings came in at $193.7 million, for a book-to-bill ratio of 0.99.
CEO Tom Ferguson notes that the second quarter is typically weaker, but that can not explain the year-over-year revenue shortfall of course. The company attributes the weak results to softness in oil & gas, but this was a headwind in the first quarter as well. One explanation does make sense. The nuclear business shipped a $14 million order in the second quarter of 2016, equivalent to 7% of quarterly sales, and this order did not recur.
These explanations still suggest that other areas of weakness and execution can be blamed for the shortfall. To address the underperformance, AZZ has decided to divest the Nuclear Logistics business and it has started a cost saving program as well, aiming to cut annual costs by $6 million. At the same time it continues to actively look for M&A opportunities while targeting operational improvements.
Despite the current softness, management remains committed that 2017 will be relative solid. Excluding the impact of divestment of the Nuclear Logistics unit, the full year results will miss the initial guidance. Management originally guided for revenues of $930 to $970 million and earnings of $3.15 to $3.45 per share.
While the profit warning looks serious, note that AZZ generated $903 million in revenues for 2016, accompanied by earnings of $2.96 per share. If these results will be repeated, which seems likely, 2017 will be flattish compared to 2016.
Valuation Gets Much More Appealing
AZZ is an excellent business in the long run, posting pretty stable margins alongside growing revenues, in part resulting from bolt-on dealmaking.
Even if earnings fall below the $3.15-$3.45 per share guidance, potentially coming in at $3 per share, the valuation multiples have come down. Given that the market anticipated earnings of $3.30 per share just two weeks ago, when shares traded at $65, AZZ was awarded a 20 times multiple at the time.
The fall in the share price towards $54, accompanied by a reduced earnings projection towards $3 per share, has resulted in valuation multiples compressing towards 18 times earnings.
The company ended the second quarter with $16 million in cash, as debt stands at $301 million, for a net debt load of $285 million. With EBITDA running at roughly $165 million per year, leverage ratios stand at 1.7 times which is very manageable.
In essence, AZZ is facing short term headwinds but it trades at market-equivalent multiples, operates with a reasonable amount of debt and continues to pursue growth through dealmaking, something which served long term shareholders well in the past decade.
I like AZZ a lot as I am perfectly willing to forgive management for the short term disappointing performance, in part driven by external environment, and in part by execution.
Management has quickly addressed the issue by cutting costs and taking measures to boost productivity. These moves, as well as projected revenue and profit growth in the second half of the year are reasons to own the shares. The 5.5% earnings yield, strong track record and solid state of the balance sheet make it an attractive investment in my eyes.
Given the great strength of the business, I would be willing to pay a premium for the shares. Shares might be awarded a 20 times multiple in this environment, as normalized earnings might surpass $3 per share going forwards, for a $60-$70 fair valuation. The 15% plunge in the share price therefore offers a great entry point in my eyes, as I am adding on my long position on further dips.
Disclosure: I am/we are long AZZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Adding on dips