Strength beyond the Bathroom
By Michael Jaffe
American Standard (ASD ) is familiar to most people for its bathroom and kitchen fixtures. But it actually derives most of its revenues from air-conditioning products. We at Standard & Poor's have been impressed by its ability to record relatively solid earnings over the past couple of years (with operating earnings up 2.4% in 2002) despite very soft markets for its primary commercial a/c products.
Also a maker of commercial vehicle-control systems, American Standard has accomplished this solid performance as a result of a diverse geographic (43% of 2002 sales outside of the U.S.) and business base, and what we see as a strong management effort. The shares carry S&P's highest investment recommendation of 5 STARS (buy).
American Standard derived over 60% of its revenues in 2002 from its a/c segment. Approximately three-quarters of that division's business comes from commercial markets, where demand for equipment has been depressed over the past couple of years by very weak global economies. However, recent operating performance has been aided by strength in residential a/c products, as well as in its servicing, parts, and maintenance business.
FIXTURES AND FITTINGS.
With U.S. home purchases at or near record levels in recent years, demand for American Standard's products has been strong, and maintenance of a/c systems is something that typically goes on under most economic circumstances. About 23% of the division's sales were made outside the U.S. in 2002.
American Standard's bath and kitchen segment generates the vast majority of its revenues from the sale of fixtures and fittings. Residential markets account for over three-quarters of sales, with commercial and industrial markets providing the remainder. Although strong U.S. housing markets have aided this segment recently, nearly two-thirds of American Standard's revenues are derived in foreign markets (mostly Europe), where residential trends haven't been as positive as in the U.S.
A third product segment, vehicle-control systems, makes braking and control systems for the worldwide commercial, luxury, and utility vehicle sectors. Over 75% of sales are typically recorded in Europe, where truck and bus production fell by 8% in each of the past two years. Commercial-vehicle markets were even weaker in North America. However, the division has lately recorded decent performance, on higher product content per vehicle and improved market penetration.
TAKING THE GE WAY.
Although we at S&P believe few factors driving demand for American Standard's products and services will change in the coming year, we look favorably on management's initiatives to improve sales, boost margins, and strengthen the balance sheet. Efforts to increase sales focus on expanded marketing efforts, building of brand awareness (some of its brands include Trane, American Standard, Porcher, and Wabco), the introduction of new products and services, and further geographic expansion.
American Standard is trying to improve margins through leveraging raw-materials purchases, reducing the number of suppliers, and improving supplier logistics. It's also implementing the Six Sigma program -- made famous by GE (GE ) -- and other productivity-enhancing actions. American Standard has also been taking steps to lower its effective tax rate and reduce its high level of debt.
We think the latter factor represents the biggest negative. In 1988, the threat of a hostile takeover prompted management to orchestrate a leveraged buyout. When American Standard reemerged as a publicly traded company in February, 1995, it was still saddled with the high level of debt from that transaction. But though its $1.9 billion of long-term debt at 2002 yearend left long-term debt at a very high 85% of total capital, that ratio is still well below the yearend peak of 175% at Dec. 31, 1998. With American Standard likely to continue generating strong levels of free cash flow in coming years, we expect its debt-to-capital ratio to continue to improve. By Michael Jaffe
S&P looks for sales to grow by about 3% in 2003. We see ongoing strength in domestic residential a/c markets and domestic bath and kitchen markets, which will likely be partly offset by continued soft demand for commercial a/c equipment -- that area will likely bottom out. We expect margins to widen, on the leveraging of materials costs, productivity initiatives, and a likely reduction in the effective tax rate to about 32% from 33.3%.
These factors should outweigh some competitive pricing pressures and costs related to product development and expanded marketing efforts. We see earnings per share increasing by 12% in 2003, to $5.65, from $5.04 in 2002.
Based on S&P's call for 2.6% real U.S. gross domestic product growth in 2003, followed by a 4.1% gain in 2004, we forecast a mid-single-digit sales increase in 2004, as we expect commercial a/c sales to finally show some signs of revival. With American Standard likely to gain some incremental benefits from its efficiency initiatives, we expect EPS to expand by 14%, to $6.45, in 2004.
On a Standard & Poor's Core Earnings basis, we expect EPS of $5.36 in 2003, which would fall 5.1% below our operating income forecast. This signals a relatively high quality of earnings, with the difference related to the costs of expensing stock options and the impact of American Standard's defined-benefit pension plan.
At a recent price-earnings ratio of 12 times our 2003 EPS estimate of $5.65, we believe the shares are undervalued for what we think is a solidly run company in the early stages of a cyclical business recovery. We feel that it should instead be trading closer to the current market multiple of 16 times expected 2003 earnings (based on the S&P 500-stock index), through which we arrive at a value of $90.
Our discounted cash-flow analysis suggests that American Standard shares have an intrinsic valuation of $97, based on what we believe are conservative assumptions. We based that valuation on 10% free cash-flow growth in the next two years and mid-single-digit gains in most of the next 13 years (with a few years of negative growth to reflect the business' cyclicality). Blending our two valuation methods, we derive a price target of $94. That represents appreciation of about 35% from the stock's recent level.
Of course, earnings forecasts and share-price targets have risks. Possible ongoing economic weakness driven by geopolitical woes could set back any recovery in commercial equipment markets -- and possibly end the current prolonged upturn in U.S. housing markets. Also, negative sentiment toward the U.S. because of the war in Iraq could prompt certain nations and individuals to avoid products of U.S. companies -- and hamper American Standard's ability to continue its geographic expansion.
Analyst Jaffe follows buildings products stocks for Standard & Poor's