Friday, January 18, 2013

Acuity Brands Can Bounce Back, Research and Analysis

Another disappointing set of results from Acuity Brands (NYSE: AYI) saw the stock down sharply in trading and question marksare being asked about the company’s growth prospects. I happen to hold the stock and, while it is never a good feeling to see a second earnings ‘miss’ in a row, I think investors should take a longer term view here and put things into perspective.

What Happened With Acuity’s Results?

A brief summary of the Q1 Results:

  • Q1 revenues of $481.1 million vs. analyst estimates of $498.8 million
  • Q1 EPS of 69c vs. analyst estimates of 81c

So it is a pretty big miss by any standards. Disappointing? Yes but I don’t think it is particularly challenging to the longer term investment thesis here. For a good primer on the company I recommend reading an earlier article linked here.

Acuity reported that it experienced a ‘lull’ in demand for non-residential construction and described that particular end market as ‘tepid.’  Commercial and Industrial (C & I) customers were cited as adopting a ‘wait and see’ approach to spending with issues like the fiscal cliff hanging over them. Furthermore, Q1 demand was referred to as ‘inconsistent’ and volatile with Q2 predicted to be the same but the usual hopes for a second half rebound were put forward.

The good news is that residential demand has ‘rebounded’ and the long term story of growth driven by LED based products remains in place. They now represent over 13% of sales and although Acuity, as ever, pointed out that they weren’t necessarily higher margin products, but they are expected to help drive increased sales of associated products like controls. More color on the state of the LED lighting market will be given when Cree (NASDAQ: CREE) gives its forthcoming results. Cree is not only instrumental in bringing down the costs of high quality LEDs but it also has a fast growing LED lighting division.

The bad news is direct residential sales only account for around 10% of Acuity’s total sales, and its position is strongest in the commercial and industrial side of things.

Is it time to walk away from the stock?

I think not and here is why.

A Quarter Too Early for Acuity Brands

Investors in Acuity (including me) had built up hopes for an early recovery in its end markets on the back of an improving residential market. In addition, other economic indicators have suggested strength. For example the Architectural Billings Index has perked up a bit in recent months.

However, it isn’t an even recovery. There are clear differences in the various components of this index with residential being noticeably stronger than C & I.

I think this data needs to be understood in the context of the overall economy.

Essentially, the US recovery has been a lot weaker and more gradual than previous recoveries but, at least in my book, most recovery phases follow a set pattern. The consumer starts spending, businesses start expanding, capital spending follows, hiring turns up and then the virtuous cycle of more consumer spending kicks in as employed people feel more inclined to spend.

This cycle is no different, and while listening to Discover Financial Services (NYSE: DFS) recent results it was clear that it felt that consumer deleveraging was coming to an end and the demand for credit had picked up. This is occurring at a time when its charge-off rates are at historic lows and DFS seems encouraged to expand lending. I would expect a similar story from Wells Fargo on Friday. Moreover, key bellwethers like Home Depot have been getting progressively more positive on housing since the summer.  HD is reporting increasing willingness amongst its customers to buy discretionary housing related items. This isn’t just about maintenance spending anymore.

Putting these arguments together suggests that the follow through of stronger residential spending leading to C & I spending will eventually happen, but issues like the fiscal cliff and the election have held back this event. Indeed, Federal Reserve surveys are indicating that demand for C & I loans is coming back as well as banks being more willing to loosen standards.

This looks like a quarter too early for Acuity but the long term trend remains in place.

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