Rexnord Leveraging Strong Retrofit And Recovery

 

Rexnord (RXN) is still a more complicated than average story, as a big piece of the value here rests on the value of the stake Rexnord shareholders will get in Regal Beloit (RBC) upon completion of the merger of Rexnord’s Process & Motion Control (or PMC) business with RBC in a Reverse Morris transaction. Even with those uncertainties, though, Rexnord is still leveraged to a broad industrial recovery, as well as stronger-than-expected retrofit activity in non-residential that has helped offset weaker new-build activity.

These shares have done well since my bullish late March write-up, beating the broader industrial space by almost 15% and the S&P 500 by close to 10%, but a lot of that outperformance has admittedly come since second quarter earnings.

There are still quite a few moving parts to the valuation, including future multiples for Regal Beloit (particularly in light of the recent transaction between ABB (ABB) and RBC Bearings (ROLL) for ABB’s Dodge business), non-residential project development, and post-transaction corporate costs for Rexnord (which impacts margins and valuation). At this point I still lean favorably towards Rexnord, but I don’t think it’s still the clear bargain it had been in some of my prior articles.

 

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Rexnord Leveraging Strong Retrofit And Recovery

Rexnord Finds A Good Deal For Shareholders And Shifts To A Water-Driven Future

 

Win-win transactions aren’t necessarily commonplace, but I think Rexnord (RXN) and Regal Beloit (RBC) found one, with the two companies intending to combine Rexnord’s Process and Motion Control (or PMC) business into Regal Beloit in a Reverse Morris Trust transaction that will see Rexnord shareholders own something around 38% to 39% of the combined company, while also owning shares in a new water infrastructure pure play.

Having recently written on Regal Beloit, I encourage readers to check out my thoughts on that company and how it stands to benefit from the PMC deal. For Rexnord shareholders, the benefits come not only with the value of the stake in an improved Regal Beloit, a short-cycle industrial with exposure to the post-pandemic recovery, HVAC, and industrial automation, but also the higher multiples that the Street typically awards water infrastructure companies.

Rexnord shares have done well since my last update, rising more than 50% on improving post-pandemic sentiment. No longer a laggard to the industrial sector, I do still see upside potential. There are still plenty of uncertainties that complicate the modeling process, but I believe Rexnord’s near-term fair value rises to over $50 with the Regal Beloit transaction and the probable post-deal re-rating.

 

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Rexnord Finds A Good Deal For Shareholders And Shifts To A Water-Driven Future

Rexnord's Modest Relative Underperformance Looking More And More Like An Opportunity

Second quarter earnings were better than expected across the industrial space, but the reality remains that business conditions remain challenging. August industrial production was up from July and better than expected, but still down 0.4% year over year and signs of the hoped-for V-shaped recoveries are still intermittent at best. Likewise, non-residential construction isn’t looking particularly strong in 2021, as there’s a general reluctance to commit to new investments given the high economic uncertainty.

None of that is particularly good for Rexnord (RXN), and the shares have lagged the industrial sector since my last update on the company in May. I thought the shares were a borderline buy/hold call then, but relative valuation is starting to get more interesting and I like the company’s willingness to return to M&A to grow the business. I’ve thought before that Rexnord gets overlooked a bit by investors, particularly in light of good margin improvement in recent years and solid growth prospects, and this is an increasingly interesting name to me in the industrial space.

 

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Rexnord's Modest Relative Underperformance Looking More And More Like An Opportunity

Rexnord Has Attractive Long-Term Drivers And Credibility On Margin Improvement

I've liked Rexnord (RXN) as an under-the-radar play on automation and institutional/industrial water for a little while, and while I thought the valuation on the shares was equivocal back in January, the stock has continued to outperform the larger industrial sector - even though "outperform" in this case means "declined less than the others". At this point, I still see attractive automation-oriented opportunities in its process and motion control business, and I believe its water business may hold up better than non-residential construction in general. I likewise still see longer-term margin/cash flow improvement opportunities as the company moves toward mid-teens FCF margins.

With ongoing outperformance, it is perhaps not so surprising that the valuation isn't outstanding. I believe Rexnord is priced for high single-digit returns at this point. That's okay, but I typically favor higher hurdle rates and I consider this more of a hold or a buy-the-dip idea than a "buy now" idea.

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Rexnord Has Attractive Long-Term Drivers And Credibility On Margin Improvement

Better End-Market Exposures Helping Rexnord Into 2020

I liked Rexnord (RXN) a year ago, or at least I thought the company’s valuation was curiously low on a relative basis given the company’s end-market exposures and cost-reduction efforts. Since then, Rexnord has indeed leveraged that better end-market exposure, driven more costs out of the business, and adapted quite well to tariffs. The market has noticed as well, with Rexnord’s roughly 20% move up since that last article doubling the return of its industrial peer group.

Rexnord’s relative valuation isn’t quite so appealing now, but I do still see high single-digit to low double-digit return potential that is a little better than the average industrial. Although Rexnord’s leverage/exposure to industrial production and capex is a risk, I like the company’s exposure to opportunities like non-residential construction, aerospace, and food/beverage, and I think there’s relatively little destocking risk at this point. All in all, I’d say Rexnord is straddling that buy/hold line, and I think it still offers relatively better upside than many of its peers.

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Better End-Market Exposures Helping Rexnord Into 2020

As Cyclical Headwinds Rise, Rexnord Not Getting Much Love

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.

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As Cyclical Headwinds Rise, Rexnord Not Getting Much Love

Rexnord Seeing Its Process Markets Kicking In

Rexnord (RXN) was arguably a bit of a late arriver to the industrial recovery, but the company ended the year with good revenue growth numbers. Given the company's leverage to process industries and institutional construction, this next year should be relatively stronger for Rexnord than its peer group, and management continues to prune the portfolio and pursue additional cost reduction opportunities.

I thought the shares offered some reasonable relative value back in February, and the shares have done okay since then - up more than 5% and outperforming both the S&P 500 and many industrial/multi-industrial peers (though relatively in line with close peers like Timken (TKR) and Regal Beloit (RBC)). The valuation still looks okay on a relative basis, though I think there are some other industrial names out there with more upside.

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Rexnord Seeing Its Process Markets Kicking In

Rexnord Starting Its Cyclical Upswing

Improving end-markets across numerous industrial, consumer, and construction markets have largely mopped up most of the quality undervalued industrials stocks, and Rexnord (RXN) is no exception. The shares are up about 20% since my last update on the company, beating peers in its Process & Motion Control business like Regal Beloit (RBC) and Renold (OTC:RNOPF) and more or less matching its prime rival in Water (Watts (WTS)). Although the shares no longer appear fundamentally undervalued, the relative valuation is a little more appealing, and Rexnord's markets continue to improve, which could offer a little more appeal for less value-sensitive investors.

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Rexnord Starting Its Cyclical Upswing

Rexnord Should Be Seeing A Turn Now

I liked Rexnord (NYSE:RXN) back in mid-December, and I can't really complain with how the shares have performed since. Not only is the return about 10 points above that of the S&P 500, but Rexnord has done alright next to most of its process/motion control peers like ABB (NYSE:ABB), Altra (NASDAQ:AIMC), Regal Beloit (NYSE:RBC), and SKF (OTCPK:SKFRY), as well as peers in the water products sector. Better still, short-cycle industrial activity is picking up (including in the industrial MRO space) and process industries like mining seem to be past the worst, while core food/beverage continues to perform well. Add in a slowly improving institutional water market and some longer-term strategic growth opportunities and it's a relatively solid backdrop.

Valuation is no longer so compelling, but "meh" seems to be the new "bargain-priced" in the industry sector and shaving just half a point off of my 10% discount rate would give me a fair value slightly above today's price. Provided that Rexnord can show some healthy signs in its core revenue and margins later this week when it reports fiscal fourth quarter earnings, not to mention constructive guidance in line with what other industrial-leveraged companies have said, this could still be a name with some room left to advance.

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Rexnord Should Be Seeing A Turn Now

Rexnord Still A Work In Process

It has been a while since I've written on Rexnord (NYSE:RXN), largely because I thought the valuation wasn't all that interesting back in mid-2013. The shares are up about 10% since then, which is well below the return of the S&P 500, but in line with rival Regal Beloit (NYSE:RBC) and better than ABB (NYSE:ABB). Since the time of that last article, Rexnord has borne the brunt of a rough stretch in its industrial and resource-centric end-markets, and the company's margins have gotten worse, bringing the company down to mid-pack (or a little worse) in the industrial conglomerate space.

These shares have had a run since the election, but there may still be enough value here to merit a closer look. I really like the company's leverage to healthier end-markets like aerospace and food/beverage, as well as the prospects for improvement in industrial markets, eventual improvement in resource industries, and possibly a renewed focus on water infrastructure spending in North America. I believe management still has to earn the benefit of the doubt with respect to margin improvements, but mid single-digit FCF growth can support a fair value above $21 and a double-digit total expected return.

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Rexnord Still A Work In Process

Watts Water Pursuing Multiple Avenues Of Self-Improvement

Watts Water Technologies (NYSE:WTS) has had more than its share of management turnover in the past 15 or so years and the company's returns on capital have long been less than you'd expect from a company with market-leading products, but current management can't be faulted for sitting on their hands. Not only has the company undergone a fairly meaningful product portfolio restructuring, management has also set out to streamline its distribution and manufacturing footprint, while also seeking out cross-selling opportunities and international growth, and pursuing reinvestment in product development.

Margins have been picking up (on a non-GAAP basis), but organic growth hasn't been so impressive. What's more, the company's core markets aren't looking tremendously dynamic. I accept that companies in the water technology space often get a premium valuation, but paying a double-digit multiple on 12-month EBITDA for a company that is likely to generate high single-digit EBITDA growth isn't so appealing to me right now.

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Watts Water Pursuing Multiple Avenues Of Self-Improvement

Seeking Alpha: Mueller Water Still Waiting For Orders To Really Flow

Construction activity has been getting better in the U.S., but you wouldn't really know it by looking at the performance of water infrastructure supplier Mueller Water Products (NYSE:MWA), nor other related stocks like HD Supply (NASDAQ:HDS) and Rexnord (NYSE:RXN). On the other hand, it's hard to say that Mueller's shares ought to be outperforming as the company has racked up three straight quarterly revenue misses and sell-side estimates have been moving lower.

I'm still optimistic that municipal spending will pick up, but it's not all going to materialize in 2016 for Mueller. What's more, investors are still concerned about the impact of the profound weakness in the oil/gas markets and the lack of traction in Mueller's water technology businesses. Mid-single digit revenue growth and operating leverage-driven margin improvements can still support a double-digit fair value, but the shares definitely need to see some beat-and-raise quarterly performances.

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Mueller Water Still Waiting For Orders To Really Flow

Seeking Alpha: Wall Street Betting That Mueller's Profits Will Start To Flow

The markets have long loved water/fluid-management stories like Xylem (XYL), ITT (ITT), and Franklin Electric (FELE), and if you can add a residential construction rebound, you have an even better story in the making. That has certainly worked for Mueller Water (MWA), as shares have risen more than 75% over the past year, 235% over the past two years, and about 300% over the all-time low set in November of 2011.

Not surprisingly, it looks like the market has put a definite premium on the recovery potential here. I do believe that residential construction is on its way back, and I also believe that Mueller's investment in advanced products like advanced metering (AMI), leak detection, and pressure monitoring will provide a nice kicker to its growth in valves and hydrants. Mueller shares do look pricey on a cash flow basis, and could be vulnerable if the residential recovery proves shallower than expected, but I won't ignore the possibility that strong leverage could lead to significant profit growth and even higher multiples.

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Wall Street Betting That Mueller's Profits Will Start To Flow

Seeking Alpha: Despite Attractive Market Shares, Rexnord Doesn't Look Too Interesting

More often than you might think, you find situations where there's a meaningful gap between the merits of the company and the merits of that company's stock. Rexnord (RXN) is a significant player in the process/motion control and water infrastructure spaces - two markets that not only have above-average long-term growth prospects, but where Rexnord holds the #1 or #2 market share position in the segments that produce about 85% of its revenue.

Put together market-leading positions, a credible management system/philosophy, and potential rebounds in key end-markets like construction, and I can see solid prospects for the business. The stock, though, doesn't make nearly so much sense to me. Even though the shares are down almost 10% over the past year, robust expectations for margins, cash flow, and/or EBITDA aren't enough to generate a fair value that makes these shares look appealing today.

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Despite Attractive Market Shares, Rexnord Doesn't Look Too Interesting