As Cyclical Headwinds Rise, Rexnord Not Getting Much Love

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About: Rexnord Corp. (RXN), Includes: ETN, PH, ROK
by: Stephen Simpson, CFA
Summary

Rexnord's revenue growth has been keeping pace with the industrial sector, but the share price action seems to be punishing a lack of near-term margin leverage and/or end-market growth worries.

Markets like food/beverage, aerospace, and process industries should support mid-single-digit growth at PMC, while institutional construction offers growth opportunities in water.

Rexnord may find it harder to meet its next round of cost-cutting/efficiency targets, but the shares seem to reflect more skepticism than normal for an industrial company.

Between the rally in industrial stocks from December and what appears to be rising headwinds in many end-markets, I don’t think investors are exactly spoiled for choice for great ideas in the industrial sector, but Rexnord’s (RXN) case stands out a bit for me. I wasn’t crazy about the shares back in May of 2018, and the stock has lagged the sector by about 10% since then, but the shares seem oddly valued relative to a decent motion control business and growing water business. I am worried about a slowdown in factory capex spending as well as shrinking growth in U.S. commercial construction, but those concerns seem magnified in Rexnord’s valuation.

On Target In Fiscal Q3

Rexnord’s fiscal third quarter (calendar December quarter) was pretty much on target down the line relative to expectations, and there wasn’t much in guidance that stood out relative to its peers, competitors, and benchmarks.

Revenue rose 6% in organic terms, in line with the average for industrials this quarter. Process and Motional Control (or PMC) revenue rose 4% on ongoing growth in industrial distribution and healthy demand in food/beverage, aerospace, and process industries. The Water business grew 10% in organic terms, with strong demand in U.S. construction (commercial, industrial, and institutional).

Gross margin was up 80 bps and a little weaker than I’d expected, but that was largely neutralized by lower SG&A/corporate expenses. Adjusted EBITDA rose 11% and margin was flat, with basically flat margins in both PMC (where earnings rose 12%) and Water (where earnings rose 10%).

A Largely Stable Outlook

As far as guidance went, management did raise its overall guidance, though it did lower its outlook for growth from industrial distribution in Europe and “Rest of World” within PMC, which seems consistent with what other industrials have reported about spreading weakness in Asia and emerging weakness in Europe. Reports from companies like Rockwell (ROK), Parker Hannifin (PH), and Eaton (ETN) support a basically positive outlook for end-markets that are important to Rexnord like food/beverage, aerospace, energy, mining, and material handling, although spending on factory automation does seem to be waning and “general industrial” demand is looking softer.

On the Water side, it sounds like Rexnord continues to benefit from a significant backlog in U.S. commercial and industrial construction, as management raised its expectations here. While I’ve been expecting a slowdown in U.S. non-residential spending overall, that spending isn’t uniform. I expect institutional construction activity to be stronger (while commercial construction weakens), and that should benefit companies like Rexnord and Ingersoll-Rand (IR) with better leverage to those segments like education and health care. I’d also note that while overall non-residential commercial spending may start to weaken, here too it won’t be uniform, with better opportunities in area like climate and in areas with larger backlogs like water products.

Stepping back a bit, on an overall basis, Rexnord is vulnerable to slower spending on factory automation projects – the company’s gear drives, couplings, bearings, engineered chain products and so on are largely used in systems that move materials and goods around factory floors and warehouses (factory and logistics automation, in other words). While this is a market with attractive long-term growth opportunities, I do expect to see spending slow further in 2019. On the other hand, the company does have a strong aftermarket mix (which should hold up better), as well as a strong business in replacement/retrofit components for non-residential construction markets. In my mind, then, that reduces some of the cyclical risk here relative to names more dependent on big-ticket original equipment installations.

Self-Help Still A Driver, But The Bar Is Rising

After largely working through its SCOFR 2 cost-cutting program, management is readying the launch of SCOFR 3 – another supply chain, manufacturing, and asset optimization program that management believes will lead to another $20 million of incremental savings over the next two years or so.

Ongoing cost improvement efforts are core to the “Rexnord Business System” (similar to the business strategies in place at Danaher (DHR) and Fortive (FTV)), but I am reluctant to fully count these savings in my model. I do believe that companies with cost savings leverage are relatively more attractive at this point in the cycle, but after two largely successful cost-reduction programs, I think it’s going to be harder to find additional cost-cutting opportunities that don’t compromise the company’s ability to grow. I would note, though, that the Centa acquisition is still dragging on PMC margins and more fully integrating this business and bringing into line with the operating norms of the rest of PMC will be a net positive to margins.

While it may be a stretch to call this “self-help”, there are also still meaningful opportunities to grow the DiRXN digital initiative. Rexnord’s products are not particularly sophisticated or costly on a per-item basis, but they’re often mission-critical never-fail components that can grind an entire line to a halt. Given that, I see a large long-term opportunity for smart condition monitoring systems and components that can help customers spot problems before system failures and more efficiently schedule preventative maintenance.

The Outlook

Apart from my oft-repeated concerns about weakening trends for the industrial sector (weaker durable goods orders, etc.), I do think Rexnord is relatively well-placed by virtue of its larger exposures to markets like food/beverage, aerospace, and process industry. Lower oil prices do seem to be pinching some capex in oil/gas, but I think the outlook for food/beverage, aerospace, metals, mining, and materials handling is still basically positive for 2019 and 2020. Coupled with growth opportunities in institutional non-resi construction, I expect mid-single-digit organic growth for Rexnord over the next few years, with longer-term revenue growth closer to 3%.

Margins are a little more challenging to model. I’m expecting FCF margins to move from the high single-digits into the low double-digits and on toward the low-to-mid teens, supporting mid-to-high single-digit annualized FCF growth, but that will require ongoing success in Rexnord’s cost reduction and efficiency efforts.

The Bottom Line

Discounting those cash flows back, I wonder why Rexnord isn’t trading closer to $30, and running Rexnord’s margins, ROIC, and ROA through my EV/EBITDA modeling approach likewise leads me to wonder why the shares aren’t closer to $30, with upside into the mid-$30s.

I understand concerns about slowing factory automation capex spending and slower non-resi construction spending, but those concerns seem magnified with Rexnord relative to other industrials. I realize that the Rexnord story is still tied at least in part to improving the company’s margins and ROIC, and the debt level is still high, but today’s price seems oddly conservative to me, and I think this is a name worth further due diligence for those investors who don’t expect an oncoming recession in the U.S. economy.

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.