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.
Time To Go Shopping?
While COVID-19 is still creating all sorts of complications for would-be acquirers, Rexnord’s messaging from the June quarter was that they’re eager to get back to doing deals, with the company hoping to do at least two deals in the water space over the next few quarters.
Exactly what the company may acquire remains to be seen. Management has talked about wanting to increase its presence in markets like fire suppression, as well as leverage M&A opportunities to add complementary products and/or adjacent verticals. Clearly, that covers a lot of potential ground.
Given the toe-hold Rexnord has with Zurn’s plumbSMART, a software offering that assists with real-time monitoring, maintenance, and scheduling, I believe Rexnord may well try to go deeper into building controls. The company’s DiRXN digital offering provides contextual information on operating performance and smart tags focused more on the Process & Motional Control business (or PMC), but a lot of those principles should be transferable to its water business as well.
Although building controls usually focuses more on HVAC, lighting, access, and so on (and it’s conceivable that Rexnord could head in that direction over time), water is a relevant factor for many building operators as well and I haven’t heard as much about innovation in this space. I don’t honestly have a great sense for opportunities here in the office building vertical, but I believe water-centered building controls could be of significant interest in institutional (schools, et al), health care, and hospitality verticals, as well as many industrial sites, where there could be natural synergies with Rexnord’s existing business with customers in the food/beverage, power gen, mining, and oil/gas markets.
I also believe remote sensing and controls could be a target. Rexnord saw strong demand in the quarter for touchless sensing/control retrofits in verticals like restaurants, retailers, banks, and education, and I expect that to continue into calendar 2021.
Waiting For Industrial Markets To Turn
Rexnord has good leverage to some attractive control markets on the industrial side, including food & beverage and mining. Food and beverage companies are starting to automate in earnest, and I likewise expect to see more capex investment from mining companies into automated material handling systems as a way to reduce labor costs and improve 24-7 operating efficiency.
A lot of Rexnord’s end-markets remain pressured now, though, and there’s little Rexnord can do but wait it out. Power gen and consumer-facing businesses did better than expected in the June quarter (with power gen being a particular surprise), but process industries, oil/gas, and aero remain persistently weak.
Aero production rates should improve in 2021, but it will take a few years for this business to get back to normal, and that hurts a little more for Rexnord as its aero content has historically offered significantly better margins than the average for the PMC business. Oil/gas is likely going to need several years to recover, and most likely the best that Rexnord can hope for here is that companies will continue to look to invest in automation as a way to reduce costs; digitalization in particular remains an opportunity, as the oil/gas sector has automated and digitalized less than many other industries.
On the plus side, I do still see growth opportunities as the North American economy eventually pulls out of the COVID-19 recession. I’m not really sold on the reshoring thesis – that companies will relocate meaningful amounts of manufacturing back to the U.S. – but if they do, Rexnord will benefit from the higher levels of automation in those new factories and the resulting demand for gears, couplings, bearings, and conveyance systems.
I would also expect Rexnord to have leverage to the ongoing automation of logistics and distribution infrastructure through offerings like gears, couplings, and conveyance. Although management hasn’t talked much recently about doing meaningful M&A in this space, there’s a lot of fragmentation in motion & control and a lot of opportunities for Rexnord if they choose to go this route.
Rexnord’s June quarter was in many ways typical for the space. The company’s 15% organic revenue decline in PMC was basically in line with the short-cycle industrial category, and the 5% decline in water was likewise consistent with healthier than expected demand in non-resi markets (and Rexnord outperformed companies like Pentair (PNR)). The 20% beat at the EBITDA line was also consistent with a trend of better-than-expected margins across industrial companies, but I’d note that PMC margins held up well (down 160bp to 16.4%) on a 15% decline in revenue.
I’ve rejiggered my model some, mostly just to reflect a less-bad 2020 and a more moderate recovery in 2021/2022, but my long-term outlook hasn’t changed. I’m looking for long-term core revenue growth on the lower end of the mid-single digits, and FCF growth on the higher end of the mid-single digits as the company continues to pursue internal margin improvement opportunities and diversification into products (digital/software, sensors, et al) that could offer higher long-term margins.
The Bottom Line
At worst, Rexnord is valued like other high-quality industrials, and I see annualized total return potential here in the high-single digits to low-double-digits – good enough to keep this name right on that cusp of buy/hold. Given the quality of the business, management’s eagerness to get back to growth-driving M&A, and relative valuation, I’m inclined to be more positive here, and this may be a name to consider for investors who want industrial exposure at this later point in the cycle.
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.