Back in January, three under-the-radar stocks looked to be good values, and they've all had a pretty good 2019 so far. Sustainable water stock Xylem is up 21%, security lock company Allegion is up 31%, and heating, ventilation, and air conditioning (HVAC) company Ingersoll-Rand is up 34% on a year-to-date basis at the time of writing. Given such strong rises, it's a good idea to reassess whether they are still good values now.
Looking at the trends in full-year EPS guidance usually tells an investor a lot about a company's prospects. As you can see below, it's a mixed bag. Xylem has already cut its full-year guidance, and it now stands below what analysts were predicting in January. Meanwhile, Allegion has maintained guidance, and Ingersoll-Rand has raised it to the high end of its previous range.
Full Year EPS Guidance
At Q1 2019
At Q4 2018
Analyst Consensus in January
Xylem (NYSE: XYL)
Ingersoll-Rand (NYSE: IR)
Allegion (NYSE: ALLE)
Data source: Company presentations.
Xylem lowers guidance
The investment thesis behind the stock focuses on its ability to translate mid-single-digit revenue growth into mid-teens EPS growth through ongoing margin expansion. Xylem isn't an obviously cheap stock -- after all, it trades at 25 times the midpoint of its full-year EPS guidance -- but its exposure to the expanding need for water infrastructure in emerging markets and the need for maintenance spending in developed markets puts it on a solid, and defensive, growth trajectory.
Image source: Getty Images
In addition, the company's investments in smart technology solutions such as advanced infrastructure analytics (AIA) to enable smart metering and monitoring look set to add a growth kicker to an already attractive story.
It's a compelling story, but unfortunately there's a snag in 2019: Management reported a disappointing first quarter from a margin perspective, and also pushed out its expectation for an adjusted operating margin of 17%-18% by 2020 to "extending beyond 2020."
The reason -- or rather, the two reasons?
First, CEO Patrick Decker said the first quarter saw "[l]ower margin performance" which was "driven by the mix of products that we sold and operational factors that we should have identified and planned for, most notably in our sales and operations planning process." As a consequence, restructuring and realignment costs will now be $60 million to $70 million, instead of the previously planned-for $30 million.
Second, management took the decision to delay the implementation of a series of business initiatives partly designed to cut costs. The reason? Management claimed it was in order to optimize their implementation and minimize the disruption the might cause to revenue growth. As such the cost savings from the initiatives are now expected to hit in late 2020 and 2021 according to Decker on the earnings call.
The news is obviously disappointing, but the stock is arguably still a good value. For example, Zylem still expects to convert 105% of net income to free cash flow (FCF). If that is the case, then the company should generate around $600 million in full-year FCF. Moreover, the company is investing heavily right now. Its capital expenditures exceed depreciation, which should lead to faster earnings growth relatively soon. Adjusting for this spending surge to fuel growth, it has the potential to add another $100 million to that FCF total.
Based on the assumed $700 million in underlying FCF, Xylem trades on a forward price-to-FCF multiple of 21 times -- that's a reasonable valuation to pay for mid-teens earnings growth, but the company needs to stay on track in 2019. In short, Xylem is still a good value, but keep a close eye out for the next set of results. They need to be blemish free.
Allegion continues to roll
There wasn't a lot wrong with Allegion's first-quarter earnings report, and the company remains on track for 2019 and beyond. If you believe in the convergence of mechanical and electronic security systems, and the benefits of web-enabled and internet of things (IoT)-enabled locks and doors used to monitor and control locks remotely, then you believe Allegion has a bright future.
That said, you will have to pay up if you want to buy Allegion stock, particularly after its recent strong rise. The company's available cash flow outlook (basically FCF but with pension contributions included) of $430 million to $450 million puts it on a forward price-to-cash-flow multiple of more than 22. That strikes me as a bit pricey for high-single-digit EPS growth, particularly as a slowdown in the residential housing market could negatively impact its outlook.
Ingersoll-Rand grows from strength to strength
Last but not least, Ingersoll-Rand continues to look like a good value. Management raised full-year guidance to the high-end of its previous range, and underlying HVAC orders remain supportive of a combination of mid-single-digit revenue growth and double-digit PS growth -- not least because the raw material cost headwinds in 2018 and 2019 will hopefully abate in the future.
Moreover, Wall Street warmly welcomed the news that Ingersoll-Rand will spin off its industrial business and then merge it with Gardner Denver (NYSE: GDI). The deal will lead to an increased focus on Ingersoll-Rand's core HVAC operations. Management continues to believe in FCF of around $1.6 billion in 2019, putting Ingersoll-Rand on a forward price-to-FCF multiple of 18.5. All told, despite the strong rise in 2019, the stock continues to look like a good value.
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