Allegion - Good Business In An Attractive Industry

Summary

• Allegion estimates that the size of the global markets they serve were approximately $30bn in revenue in 2016.
• The main competitors are Assa Abloy and dorma+kaba Group.
• It is expected that the security products industry will benefit from favorable long-term trends.
• Based on Bloomberg estimates top line should grow in 2018 and 2019 at the rates of 11.3% and 5.3%.

Investment Thesis

Allegion (NYSE:ALLE) operates in the industry which is the beneficiary of the global trends. Competitive advantage (moat) stems from strong and innovative brands and high switching costs.

Company Description

Allegion is a leading global provider of security products and solutions. The company offers an extensive portfolio of mechanical and electronic security products across a range of market-leading brands. They operate in three geographic regions: Americas; Europe, Middle East, India and Africa ("EMEIA"); and Asia Pacific.

Industry Overview

Allegion estimates that the size of the global markets they serve were approximately $30bn in revenue in 2016 with compound annual growth of about 2 to 4% per year over the past four years.

An important driver of the business is the technology shift toward electromechanics with more and more digital and mobile solutions. The sales potential is attractive since less than 10% of the world's doors are estimated to have digital technology (digitization leads to shorter life cycles with more frequent additions, replacements, and upgrades). For instance, electromechanical locks have a lifespan of 7-15 years, while mechanical locks have a lifespan of 15-40 years. If we know that electromechanical locks are more expensive and have a shorter lifecycle than it is logical to conclude that they provide producers with potentially higher revenues.

The security products markets are highly competitive and fragmented throughout the world, with a number of large multi-national companies and thousands of smaller regional and local companies. This high fragmentation primarily reflects local regulatory requirements and highly variable end-user needs. The main competitors are Assa Abloy and dorma+kaba Group.

Secular trends

It is expected that the security products industry will benefit from favorable long-term demographic trends such as continued urbanization of the global population, increased concerns about safety and security and technology-driven innovation.

1. Urbanization should provide long-term growth, especially in emerging markets. According to WHO the urban population in 2015 accounted for 54% of the total global population, up from 30% in 1950 - it is expected to increase to 60% of world population by 2030. By 2050, 70% of the world's population will be urban. As a consequence of that people will continue to seek prosperity with increased security at home and at work in the urban environment.
2. As a result of increasing wealth in emerging markets and changing demography leisure traveling increases worldwide, and people want to be secured and protected.
3. The safety and security of people and property are top priorities and on the other side, they provide producers with numerous opportunities.
4. Digitization/Connectivity (Internet of Things and Cloud) is rapidly shifting demand toward more electronic and mobile security solutions. This trend is accelerating in both new construction and the aftermarket.

What Could Go Wrong?

Some of the factors that could cause Allegion business strategy to fail: (a) weak macroeconomic environment in the US and international markets; (b) failure to anticipate changes in the market environment (new customer requirements and competition); (c) failure with M&A policy; (d) currency exchange rate fluctuations may adversely affect results (cca. 30% of revenues were derived outside the US); (e) dilution of brands quality; (f) legal judgments, fines, penalties or settlements; (g) cybersecurity attacks and etc.

In addition, I would like to mention that Allegion has total debt of USD 1.5bn, which is sustainable at this moment, but we should be careful. The other two risk comes from a failure to anticipate and proper response to competition and failure to adequately allocate capital.

Quarterly results & Outlook

Q1 2018 results:

• Revenues were up by 11.7% (3.3% on an organic basis = price +1.3% and volume +2.0%) comparing the same period last year;
• The Americas segment revenue increased 7.7% (+2.7% on an organic basis);
• The EMEIA segment revenues were up 26.9% (+5.9% on an organic basis);
• The Asia-Pacific segment revenues increased 3.9% (+0.2% on an organic basis);
• Operating income was USD 98.7m, a decrease of 0.8% over the same period 2017. Adjusted operating income was USD 104.2m, representing an increase of 2.8% compared to Q1 2017;
• Q1 2018 available cash flow was negative USD 18.8mi, a USD 29.9m improvement versus the prior year. The year-over-year improvement in available cash flow is primarily due to the USD 50m discretionary pension funding payment in the prior year along with higher earnings. Those increases were partially offset by increases in cash taxes and working capital;
• The company ended third-quarter 2017 with cash of USD 152m and total debt of USD 1,509m.

Regarding the outlook for 2018, the company expects to deliver revenue growth in a range of 10.5% to 11.5% compared to 2017. Organic revenue growth is updated to a range of 4% to 5%. On the bottom line, the company expects to achieve EPS in the range of USD 4.20 to USD 4.35, or USD 4.35 to USD 4.50 on an adjusted basis (representing growth of approximately 10% to 14%). The company is targeting full-year available cash flow of USD 380 to 400m.

To Sum Up

Today, it is a business worth something around USD 7.4bn (EV = USD 8.7bn), with FCF around USD 330m (Bloomberg estimate for 201 is USD 353m). Based on Bloomberg estimates top line should grow in 2018 and 2019 at the rates of 11.3% and 5.3%. At the end of 2019 FCF should reach the level of USD 463m. Is it realistic or not we will see, but organic growth of the underlying business should be somewhere around a low to mid-single digit rate.

In a nutshell, Allegion has a good position and portfolio of well-recognized brands. Furthermore, Allegion has built a valuable network of channel partners within North America, which supports the continued growth of the company's installed base. Valuation-wise, paying something like EV/FCF of around 25x (2018E) for the business which grows single to mid-single digit rate seems a bit high for me. Therefore, in my view, it would be wise to wait for a better entry point because I don't see at this valuation level a margin of safety.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.