Description

We recommend going long Allegion (ALLE). Allegion is the 2^nd-largest global provider of security products and access solutions (after Assa Abloy). Allegion manufactures mechanical and electronic locks, hinges, key systems, closers, and door pulls, among other products. Some well-known brands include Schlage Kryptonite, and CISA, among others. 75-80% of sales come from North America, which is also the highest-margin region. Allegion was spun out of Ingersoll-Rand in 2013; the stock has been previously pitched on VIC, as a long in 2014 by bdad and as a short in 2016 by jriz1021.

Allegion is currently cheap versus its own history (16-17x P/E vs historically 18-19x) as its largest end-market (non-residential construction, around 70% of sales) is currently out of favor. However, Allegion’s business is more resilient than the market is pricing in, with 55% of sales coming from aftermarket/MRO activity. In addition, 2/3rds of ALLE’s non-residential exposure is “institutional”, i.e. healthcare, educational, and government facilities that are currently holding up much better than the office, warehouse or retail end-markets.

Allegion is particularly cheap vs the market (20% discount versus historically a 10% premium). The last leg of underperformance in recent weeks has been due to concerns about aggressive M&A in pursuit of CARR’s security business, where ALLE acknowledged a strong interest in pursuing that asset that had been put up for sale. However, last Friday’s news that HON would buy this asset for $5bn removes that overhang for ALLE and should see it return to its tested strategy of pursuing lower-risk bolt-ons.

Allegion should return to converting FCF at 100% of net income in 2024 and beyond. We believe a 6-6.5% FCF yield is a great entry point into a well-managed company with 24% margins, rational industry structure, 25% ROIC, and a GDP+ organic growth profile that, when combined with bolt-on M&A, should result in at least mid-single-digit top line growth into the future.

To assess an investment in ALLE, it’s important to spend some time understanding the Non-residential construction end-market that accounts for 70% of sales. Many regard non-res as a less volatile, later-cycle cousin of residential construction (which is 20-25% of sales for ALLE). The bear thesis on ALLE and non-res-exposed companies right now revolves around a lagging effect of higher rates being reflected in macro indicators like the ABI Architectural Billings Index or the Dodge Momentum Index. We believe it’s important to dig deeper than the headline ABI, which has printed sub-50 readings for several months earlier this year, and focus on its components: here, the best performing component of the ABI has been Institutional, which has held up much better than Residential and Commercial/Industrial. Institutional however has read above 50 most months, which we believe is more reflective of ALLE’s business.

As for residential (30% of sales), it is obviously a more volatile cycle, though ALLE also is exposed to a lot of repair activity. Needless to say, the picture here appears to be rapidly changing with the outlook for interest rates looking much more favorable in 2024. Resi has been already weak for ALLE in 2023, but in 3Q the company already talked about the de-stocking process in the channel being over, which suggests resi might well be an end-market to get excited about and that could drive some re-rating in the shares.

We think ALLE can compound EPS high-single digit to low-double-digit, earning around $8 in 2025. If the company can recoup its 100-115% of SPX P/E multiple (vs 0.84x currently), shares would trade near $150 in a year’s time. We think that’s a compelling risk-reward, and thematically gives us exposure to a laggard with construction exposure, which should be one of the obvious themes for 2024.

There is a chance the market wakes up to this quickly, as speculation around a deal for CARR’s security business had recently weighed heavily on the stock.. This was rumored to be a $3-5bn deal where ALLE would’ve had to issue equity or overlever. Since ALLE was said to be involved in this process (late Sept/early October), the stock has lagged ASSA.SS by 15%, and AWI (non-resi peer focused on ceilings) by 26%. As HON walks away as the buyer of this asset, we believe the potential for a snapback in ALLE is material.

Catalyst

• CARR deal overhang is lifted
• Enthusiasm around buildings end-market as Fed cuts rates
• Bolt-on M&A