The last year and a half has been a little more challenging for Regal Rexnord (RRX) than I’d expected. While the integration of Altra seems to be going well, and I’m still bullish on the company’s long-term leverage to automation, end-market expansion, and margin leverage, weakness in factory automation has hit even harder than I’d expected.
With that, the shares have produced a mid-single-digit return since that last update, lagging the broader industrial space and diversified automation rivals like ABB (OTCPK:ABBNY) and Siemens (OTCPK:SIEGY), but outperforming Rockwell (ROK) (a company heavily leveraged to North American discrete automation).
Nothing has changed with regard to my core thesis, and I continue to be bullish on the long-term potential of the business. I can’t say that the valuation is a slam dunk, particularly on the cash flow side, but I do expect healthy mid-single-digit revenue growth over the long-term and meaningful margin expansion, and as markets recover, I believe Regal Rexnord can get a little more love from the Street.
Looking Back At Q2 Earnings – Ongoing Core Industrial And Automation Weakness Remains An Issue
Regal Rexnord’s second quarter was definitely mixed, and I think the reality that orders remain negative on a year-over-year basis and management once again lowered guidance for the year are the important takeaways in regard to still-weak industrial end-markets that may not really rebound until 2025 given higher interest rates and evidence that many companies are delaying capital spending plans until after the upcoming U.S. elections.
Revenue declined 7% on a pro forma organic basis, and while the revenue number was a little higher than the sell-side average (about 3%), it’s possible there was some modeling noise there regarding the sale of the Industrial Systems division to WEG (OTCPK:WEGZY). In other words, it’s better than a miss, but I’m not reading as much into this beat as I might otherwise.
Gross margin improved about five points on a GAAP basis, while pro forma adjusted EBITDA fell 9%, with margin down 50bp to 22.2%. GAAP operating income rose 17%, with margin up nearly three points to 11.4%, while adjusted operating income fell 11%, with margin up 30bp to 13%.
By segment, Automation & Motion Control saw 10% organic revenue erosion, a 21% decline in adjusted EBITDA (margin down almost two points to 22.5%), and a 31% decline in adjusted operating income (margin down 30bp to 11.1%). Industrial Powertrain Solutions saw a 3% organic revenue decline, 6% growth in adjusted EBITDA (margin up more than two points to 25.8%), and 23% growth in adjusted operating income (margin up more than three points to 14.7%). Power Efficiency Solutions revenue declined 10% in organic terms, while adjusted EBITDA fell 23% (margin down 250bp to 16.1%) and adjusted operating income fell 25% (margin down more than two points to 12.9%).
The Major Drivers Here Aren’t Too Surprising
Looking at the results posted by other companies in the automation, motion control, and HVAC components sectors, not much about Regal Rexnord’s results were that surprising. Many industrial end-markets have seen prolonged inventory destocking and reorder activity has been weak in the face of uncertain end-market demand. At the same time, factory automation has been especially weak (despite generally healthy trends in new factory construction) as companies have paused their capex spending plans.
Regal Rexnord management reported a 1.5% year-over-year decline in organic orders, though they did note that orders trended up for July. Looking broadly at how many industrials revised expectations for the full year lower, including Fortive (FTV), Illinois Tool Works (ITW), Johnson Controls (JCI), and Rockwell, I don’t see much in Regal Rexnord’s outlook that stands out as particularly troublesome.
Management noted that aerospace, data center, and medical end-markets remain strong, and that’s broadly consistent with what the large majority of other industrials have said – though the strength in medical may be a little above average, and could perhaps reflect Regal Rexnord benefiting from demand in areas like injector pens (the company sells a lot of the mechanical “guts”, including motor encoders, gears, and drive screws). Likewise, ongoing strength in metals/mining could reflect some healthier demand on the motion/discrete side, given that Rockwell also noted some strength here, while ABB saw softer results.
As far as weak areas go, weak discrete factory automation should surprise nobody. Likewise, with weaker overall “general industrial” demand and ongoing weakness in agricultural and construction equipment. Weak residential HVAC remains a challenge, and this has been going on for more than a year now, though I’d note that companies like Carrier (CARR) and Lennox (LII) talked about improving volumes for North American residential (which should be much more relevant to Regal Rexnord).
The Outlook
At this point, I do still see some risk to second half results, given weakness in multiple industrial end-markets and automation overall. I’m cautiously optimistic that destocking is largely over, but I’m not willing to extrapolate that to a meaningful (let alone strong) restocking cycle until, perhaps, late in the fourth quarter. I do have some concerns that weak off-road machinery could roll over into 2025, but I’m more bullish on a return to growth for automation and residential HVAC.
I’m still pretty bullish on RRX’s long-term prospects, as I’m looking for long-term revenue growth in the 4% to 6% range. I could see the company, perhaps, looking to add some more exposure in electrification – the company already sells automatic transfer switches and parallel switchgear (the former automates switchovers to back up power, while the latter facilitates using multiple power sources, including onsite microgrid generation) and could look to add complementary products.
On the margin side, I’m a little less bullish than management on FY’24 adjusted EBITDA margin (I’m looking for around 22.5% at this point), but I think 25%-plus within three years is definitely attainable. Long term, I think mid-teens FCF margins are achievable and I’m expecting high single-digit to low double-digit annualized free cash flow growth.
Discounted cash flow doesn’t suggest that Regal Rexnord is particularly undervalued right now, and that concerns me some. A mid-to-high single-digit prospective return isn’t great, though perhaps the upcoming Investor Day will point toward higher revenue growth, margins, and/or FCF conversion than I currently model. A margin and return-based EV/EBITDA is more encouraging, though, with a 12.5x forward multiple supporting a fair value close to $190.
While not really part of the outlook, I do want to note that management here does something pretty cool every quarter – devoting a slide in each earnings presentation to a segment of the business and going into a little more detail. Recent profiles have included power systems, conveying, and micro-motion, and I really wish more companies would do this. On the other hand, I also wish management would bring back their end-market review slide, as it’s particularly useful for people like me who follow multiple industrial end-markets.
The Bottom Line
I’m honestly torn on the valuation, but I was the last time I wrote about the stock, so that’s not really a new development. My value orientation leads me more toward the less promising DCF-based fair value and a “hold” outlook, but I do like the business mix here, and I think the outlook for 2025/26 will be good. With a surprising (to me, at least) lack of clear bargains in the industrial space, I’m staying positive here on those good long-term prospects, but I do want to note the risk of weaker results/guidance and derating in the second half of the year.
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