Early January, I wrote an article on the latest spin-off from Honeywell (HON), which is called Resideo (REZI) as I wondered if this was "a smart Honeywell spin-off". Something went very wrong early March as shares lost a quarter of their value upon the release of the Q4 results, requiring an update on the events and current thesis.
A Quick Look At The Company
Resideo provides critical residential and security solutions as the company is quite large with $4.5 billion in annual sales. This number is somewhat inflated as the company is in essence split equally between a products business and a lower margin distribution business. Roughly two-thirds of sales are generated at home in the US, complemented by European and other international operations.
Products made and distributed include cameras, heating controls, leak and freeze detection, thermostats and controls, as most of these devices can be linked to apps and cloud-based monitoring systems, creating a "Smart Home". This creates a secular growth trend on top of the fact that housing levels in the US are still historically on the lower side.
Story Is Not Simple
In January, I noted that the story with regards to the numbers was not easy. For starters was the fact that reported sales numbers of the distribution and production businesses did not match up with the total, possibly due to inter-company eliminations. The company itself guided for 2018 sales to rise by a solid 6% to $4.8 billion, plus or minus $30 million, yet here, the complication starts.
Honeywell has saddled Resideo with indemnification payments as a result of the costs associated with cleaning up old sites. Resideo will compensate Honeywell for 90% of these costs, capped at $140 million a year, although the agreement lasts up to 25 years at a maximum. Resideo has recognised a $640 million liability as best estimate around the time of the spin-off.
Based on 2017 adjusted EBITDA of $583 million and reducing this number by the maximum payment of $140 million a year, I ended up with adjusted-adjusted EBITDA of $443 million in 2017 and a $500 million number for 2018, or $470 million after accounting for a trademark license agreement. If that were correct, I end up with $470 million in EBITDA and $420 million in EBIT.
Holding $75 million in cash upon the spin-off and $1.15 billion in net debt (excluding the environmental liabilities) leverage stood at 2.5 times. With 123 million shares outstanding, and working with $420 million in EBIT, $50 million in interest costs and a 25% tax rate, I pegged earnings potential at $277 million, or $2.25 per share. That looked highly appealing at just 9 times earnings at $20 with organic growth solid and following insider purchases, despite the complicated finances, as payments to Honeywell will not go on indefinitely.
Something went very wrong, however. From a low around $20 at the start of the year, shares recently rose to $25 amidst the market rally before cratering to $19 again. The fourth quarter numbers were largely in line with expectations as discussed above, although fourth quarter sales growth of 5% was a bit softer than the full year 7% number. Furthermore, net debt came in at $936 million at the end of the year, below my expected numbers even after accounting for cash flow generation in the final quarter of 2018. This is sort of "compensated" for by the emergence of $88 million in pension liabilities on the right side of the balance sheet.
The problem is in the outlook, capital spending, and margins. Revenue growth for 2019 is not seen at 4%, yet at a 2-5% range, which at the midpoint is merely half a percent lower. The issue is that adjusted EBITDA is seen at $410-430 million, which compares to $476 million in 2018 (even after the indemnification payment). This margins pressure stems from a shift towards the distribution business (which has much lower margins) as well as higher investments. Note that segment margins for the distribution business were less than 6% in 2018, while margins at products and solutions were three times as much, as the shift in the mix can easily explain the EBITDA headwinds.
Net capital spending is somewhat elevated as well, with capital spending seen at $90 million in 2019, twice the depreciation expense reported in 2018, and hence creating a drag on cash flow generation.
Working with a $420 million EBITDA midpoint, and now becoming apparent that this has to be reduced by $20 million in stock-based compensation costs, I peg EBITDA at $400 million, or $350 million after accounting for depreciation charges. Interest might indeed still come in at $50 million a year as a 25% tax rate leaves earnings of $225 million, for earnings power of $1.80 per share.
This makes that low valuation multiples remain intact, and fortunately, leverage is a bit lower than anticipated, yet this is hardly any good news with sales decelerating and lower margins arriving so soon after the business has been spun off.
In January, I concluded that the spin-off looked good on paper, yet other Honeywell spin-offs, including AdvanSix (ASIX) and Garrett Motion (GTX), looked good as well, while their performance has been mixed as well.
This made me a bit cautious as I noted that optimism is naturally occurring in spin-off presentations, as I decided to wait a few quarters to see how things evolve, certainly with standalone companies incurring some other costs as well. The greater clarity provided in early March is not too good news, and although shares look dirt cheap, I find it easy to avoid the shares for now, looking for more clarity and comfort later in 2020 before buying into the weakness.
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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.