Many hedge fund managers, including Barry Rosenstein of Jana Partners, Nelson Peltz of Trian Partners, David E. Shaw of D E Shaw, Eric Mindich of Eton Park Capital and Steven Cohen of SAC Capital Advisors, reported new stakes in Allegion PLC (NYSE:ALLE) during fourth quarter of 2013.
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Most, if not all, of the hedge funds that own Allegion PLC (NYSE:ALLE) received their stakes due to their ownership of diversified industrial company Ingersoll-Rand PLC (NYSE: IR). Following pressure from activist investor Nelson Peltz, IR spun-off its residential and commercial security business to shareholders in a tax-free transaction in late November 2013, resulting in a Dublin-based publicly traded company called Allegion.
With annual revenue of $2 billion, annual EBITDA of $400 million and a market capitalization of $5.2 billion, ALLE is a leading provider of global provider of security solutions for homes and businesses. Operating in a $25 billion global market that is growing 5-7% but is highly fragmented, the company plans to expand both organically as well as through acquisitions. Allegion PLC (NYSE:ALLE) boasts above-average margin and return on invested capital metrics as well as strong free cash flow generation, which it will use for reinvestment in the business, opportunistic acquisitions and capital return through dividends (10-20% payout ratio) and share repurchases (to offset dilution). During its 4Q13 earnings release, ALLE provided EPS guidance of $2.25-2.40 for 2014, which compared favorably versus the consensus estimate of $2.27.
Spin-off situations tend to be good investment opportunities, as smaller divisions of larger companies tend to be misunderstood and incorrectly valued initially. In addition, the divested company can better focus on its specific business, increasing returns for shareholders in the process. Initially, however, the spun-off stock could underperform, as investors who received the shares might not want to hold it; once this initial selling pressure is gone, the stock tends to outperform. This seems to have been the case with Allegion PLC (NYSE:ALLE), whose stock declined 16.1% over 18 days since its spin-off on November 18, 2013 versus a 1.9% return for the S&P 500. Since then, however, the stock has appreciated 34.2% versus a 7.0% return for the overall market. Currently, the stock trades at a modest premium valuation to peers on a forward P/E basis (22.8X versus 21.9X for peers). We believe this premium is justified (and perhaps too small), as the denominator (earnings) should benefit from Allegion PLC (NYSE:ALLE)’s exposure to a recovering U.S. economy, as well as opportunities to grow in international markets (which comprise approximately a third of revenue) and expand margins in Europe and Asia-Pacific. With low requirements for working capital investments and capital expenditures, the company should be able to convert more of its EBITDA to free cash flow and, potentially, increase its payout to shareholders over time. Given these fundamental drivers, and as the market gains a better understanding of ALLE as a stand-alone business, we expect the stock to continue its outperformance.
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