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Resideo: Another Spin-Off, Another Busted Stock

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About: Resideo Technologies, Inc. (REZI)
by: Cardon Capital
Cardon Capital
Value, special situations
Summary

In a market that’s been brutal to almost all spin-offs, REZI is no exception.

Guidance reduction is the cause of the recent sell-off.

We think REZI has a more stable business model than most give credit for, being a market leader in both segments.

Despite the hair on this one, a mid-single digit multiple is simply too low, we think the stock is set to outperform.

Resideo (REZI), Garret Motion (GTX), Covetrus (CVET), Frontdoor (FTDR), & Entercomm (ETM).

What do these 5 stocks have in common, you ask? Aside from being spin-offs and/or reverse mergers (ETM, CVET), all - in the past year - have been hammered by the market after bringing down guidance. Some have seen their share prices fall by 80%, all saw their share price at minimum get cut in half.

We've written about two of the more compelling companies on that list previously on this site (CVET, FTDR). Several others have written about GTX & ETM. Today, we'll be honing in on Resideo. But first, a word about spin-offs in general.

In the past few years we've seen many commentators on this site, various blogs, and Twitter express skepticism about the validity of investing in spin-offs. The argument usually goes that while spin-offs were once a lucrative investment arena, too many investors know about the space and, alas, the spin-off market has become efficient.

While it is true that spin-offs have grown in popularity and that a more pronounced group of individual investors and professional managers of smaller funds have flocked to this arena over the past couple decades, we're of the opinion that increased buying from this group of investors have had a negligible impact on price discovery. This is simply because the players who are forced to sell spin-offs are in possession of vastly more shares than the number of enterprising investors combing over any given spin-off.

We maintain that spin-offs are still a good spot to go bargain hunting in because it's one of the spots where institutional investors aren't likely to be buying - rather they're normally forced sellers. So while it is true that you can log on to this site or Twitter and see people discussing the latest spin-off - we're not convinced that's the relevant metric. Professional money managers two decades knew about spin-offs, just like the ones today do. But that didn't make the market efficient, because the number of buyers didn't offset the number of sellers. We believe that still holds true today.

We really couldn't put it any better than Christian Ryther of Curreen Capital did:

Indeed, let's dust off one of those 10-Ks right now...

Overview

Resideo was spun-off Honeywell in October of last year. REZI is a provider of critical residential comfort and security solutions. The company has two main segments: Home Care Products & Security, and ADI distribution. Home Care attributed 49% of revenue ($2.5 billion) while the distribution segment contributes 51% ($2.6 billion). Given the distribution segment's predictable lower margin profile, ADI contributes only 25% of operating profit, leaving 75% coming from the Home Care segment.

REZI is a global leader in offering residential comfort and security products, as over 150 million homes have their products installed - thus Resideo dominates this market. The company operates globally with close to 70% of sales coming from the US and 25% from Europe. The spun-off entity will continue to manufacture its products under Honeywell's name - having a 40 year contract with HON. The business also maintains a high-quality customer base, including the likes of ADT, The Home Depot, USAA, among others. Both segments have been around for 40+ years.

The company has a comprehensive product suite, detailed below:

(Source: Investor Day)

REZI makes products that are designed for all areas of the house inside and out - both behind and on the wall. These products include thermostats, cameras, heating controls, water filtration, motion detection, leak and freeze detection, and much more. Roughly 2/3rd of Home Care sales are Comfort and Care products, while the remaining 1/3rd belongs to the Security products. Over 35% of these products are "smart" - being connected in the Cloud and able to be accessed from your phone. Management maintains that they enjoy between 40%-60% global market share with the various products in this division. Indeed, this is a segment that has a great reputation among its customers (Net Promoter Score >50, for example) which has resulted in impressive share of its respective market.

Crucially, management indicates that 80% of product sales are driven by replacements - not new housing starts. This insulates REZI a meaningful amount from an otherwise cyclical end market.

The company sells ~10% of these products to retailers, with the remaining bulk of sales going to a combination of OEMs, distributors, or other factories. These products are installed via professional contractors, OEMs, and home builders. The contractors specialize in HVAC/ Energy Management, Electrical & Lighting, Security and Safety, among others.

(Source: Investor Day)

The company's ADI distribution segment is a market leader, being the number 1 distributor of security products globally (management estimates this segment has ~30% share). The ADI distribution segment serves 100k+ professional contractors. Management claims ADI is the market leader in the Americas and Europe, while also being a strong player in India. REZI has 19 distribution sites scattered throughout these three regions and distributes >350k products.

An unexpected shift

REZI disappointed investors with the results from Q2 with margins from the Home Product segment declining as the company announced that they had begun to invest in growth initiatives. With over 1,300 engineers and 3000 patents - REZI is certainly not a high-risk upstart investing in "growth" that will ultimately prove illusory. Rather, this is a market-leading company that has been around for almost half a century. The "growth" management is investing in is simply new product launches - something that is routine for a business like this.

What's more, investors should be applauding management for taking these growth initiatives rather than selling off the stock. That's because any growth achieved by the company is highly lucrative for shareholders. Here's why: management recently brought down guidance for FY'19 to $330-$350 in EBITDA. REZI is asset-light and generates a healthy amount of free cash, as Capex in the business has averaged ~$58 million the past three years (1% of revenue). So we can call free cash flow ~$270. REZI has invested capital of $611 (working capital = $311, PPE = 300). Thus, returns on capital employed with this business are 40%+. This means that any sustainable growth attained by the company is extremely profitable for shareholders. Looking out the next five years, management sees growth between 7%-10% in the top-line. High returns are only beneficial to investors insofar as the company can grow. As shareholders, what the company earns on incremental capital is what matters to us. With a business generating mid-40% returns, any growth in revenue and earnings is what investors should be demanding - not skeptical of.

Value

Honeywell graciously spun-off Resideo with an Indemnified Reimbursement Agreement. Resideo has to pay 90% of whatever these costs turn out to be, but are capped at $140 million in any one year. For our valuation of the business, we'll assume these payments are met in full every year.

It should be noted the EBITDA guidance cited above was post-indemnification charge. Taking the lower bound of guidance, REZI will do $330 million this year in EBITDA. Market cap is $1.2 billion, with net debt at $1.05 billion - for an EV of $2.25 billion. This brings EV/EBITDA close to 7x. For a business that's a market leader, that generates the type of returns REZI does, and has the potential growth profile that this company does - a 7x multiple is demonstrably too cheap. If we assume next year the company will be able to generate $410 in EBITDA (what was the lower bound of prior guidance), then that would be a forward multiple of ~5.5x.

If we were to take a 9x multiple of this year's earnings, we're left with a price target of $16/share (123 million shares outstanding) when we back out the ~$1 billion in net debt. If we take the unlevered free cash flow of $270 million cited above, we're left with a 12% yield when compared to the company's total enterprise value.

We think top-line growth, margin expansion, and a multiple rerating will drive shareholder returns for the next 3-5 years.

Anyway we slice it, REZI is too cheap.

Disclosure: I am/we are long REZI. 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.