AZZ Stock: Improved Risk-Reward (NYSE:AZZ)

Earlier this year I looked at AZZ Inc. (NYSE:AZZ) when I concluded that the company made a big deal. In the long haul, I have been quite impressed with the company despite the challenged and cyclical end markets.

The company has seen sales rise from a quarter of a billion in 2006 to a billion a decade later. At the time, the company moved away from its nuclear logistics activities, as the company moved away from lower and cyclical energy markets, to move into more stable operations like galvanizing. The transition triggered a huge rally from $5 in 2016 to $60 in 2016, but ever since the company has been struggling quite a bit.

Former Take

Forwarding to the pandemic, or just before the outbreak of Covid-19, shares traded in their mid-forties. This valuation was applied to a business which posted a billion in sales on which adjusted earnings were reported at $2.75 per share, while leverage was very reasonable at 2 times. With the company originally guiding for a billion in sales in 2020, the results fell short for obvious reasons, and while 2021 was set to become a bit better, results still lagged compared to the original 2020 guidance.

Revenues for the year 2020 fell to $839 million, with adjusted earnings down to $2.11 per share. The company has seen improving momentum throughout 2021, and in January of this year, the company upped the full year earnings guidance to $3.10 per share alongside the release of the third quarter results. The 25 million shares traded at $49, for a $1.2 billion equity valuation, that is excluding about $160 million in net debt.

While 2021 was gradually looking to become a better year, the company announced a huge deal in March, right as Ukraine took the world news headlines for well-known reasons. At this point in time, AZZ reached a deal with Carlyle to acquire Precoat Metals in a $1.28 billion deal, effectively equal to the own enterprise valuation of AZZ.

After factoring in tax synergies, the purchase price fell to $1.13 billion, equal to 8.2 times EBITDA for a business providing metal coatings. With $700 million in sales, the deal is a bit smaller than the $900 million revenue number of AZZ as profitability of $137 million (in terms of EBITDA) looks reasonable, with margins coming in a few basis points short of 20%. Despite the huge deal, little has been communicated in terms of margins, accretion and financing, quite surprising given the size of the deal.

While I liked the standalone business at 15 times earnings, with leverage around 1 times EBITDA, as the core metals business was doing fine and the infrastructure segment provided room for improvement, I was cautious following the Precoat deal, mostly on the back of poor information provisioning.

More News, Greater Insights

In April, the company posted its fourth quarter results with full year revenues up 8% to $903 million. Metal coating sales rose 13% to $513 million as already fat margins in the low twenties inched up another point. Infrastructure Solutions revenues were flat at $384 million as adjusted margins essentially doubled to 9% of sales as earnings came in at $3.35 per share.

This was quite encouraging, as the company guided for a strong first quarter as well. More information on the Precoat deal revealed a targeted net leverage ratio of 4.2 times upon closing, with the deal closing in May. The pro forma number reveals a $1.6 billion revenue number and $293 million in EBITDA, bolstering the margins of the business a great deal. Net debt will increase to more than $1.2 billion, more than the enterprise value as 25 million shares outstanding value equity at $42 at just $1.05 billion here and now.

With the Precoat deal turning the business into a metal coatings business, the company has moved quickly to sell a 60% stake in its infrastructure group in a deal valued at $300 million, with cash proceeds pegged at $228 million. This deal will cut net debt likely to around a billion, with leverage coming down to less than 4 times already just after closing of the deal. This is encouraging as the business is 100% tied to the North American market, isolating the business largely from major geopolitical events, but not from economical events of course.

And Now?

The truth is that the company guides for 20% earnings per share growth following the Precoat deal, which reveals a run rate close to $4 per share. While leverage is still quite high, earnings power is solid as I see a real roadmap for leverage to rapidly fall towards 3 times not too far from now. If earnings power indeed comes in at $4 per share, valuations have been reset at just 10-11 times.

If the company can execute and the economy remains solid, we could see a real re-rating of the valuation multiple to the mid-to-higher teens which based on $4 in earnings power reveals a roadmap to $60-$70 per share, but it requires a few quarters of deleveraging and for the part of the earnings power the economy to hold up nicely as well, two big assumptions.

While I was quite skeptical on the Precoat deal in March, I like the dilution a lot better now with shares down $7 ever since. In the meantime, the company posted solid fourth quarter results, issued a comforting near-term guidance, offered better insights on the Precoat deal, and it is addressing leverage as well with a solid sale, all of which is compelling enough for a modest position given the risk-reward situation here, albeit that leverage is still a bit high to my taste.