I’ve said it before, including in reference to Sika (OTCPK:SXYAY, SIK.S), but it bears repeating – low valuation doesn’t make stocks go up and high valuation doesn’t make them go down. While Sika hardly looked cheap when I last updated my thoughts on the company, solid execution through the pandemic, increasing expectations of green building retrofits, growing optimism on margin targets, and increased Street coverage have all contributed to another 40% or so move up in the share price.
I can’t tell you that Sika is cheap by any fundamentals-based approach. I can say, though, that this is an uncommonly well-run company with significant growth opportunities in all of its core markets, as well as meaningful margin leverage potential. With “green building” now a hot secular trend, I don’t think valuation multiples are all that important to the stock for the time being. I do believe “the time being” is a key caveat though; while I do believe that Sika is an excellent company with a great future, I do also believe that valuation matters over the long term, and it’s hard to see how this stock re-rates substantially higher.
Not A Lot New In The CMD… And That’s Fine
Sika presented its annual Capital Markets Day at the end of September, and while there wasn’t anything really thesis-changing there, that’s fine – company management does a very good job of communicating its plans, goals, and operating details to investors, so I wasn’t expecting any major new developments.
A key focus of the meeting was Sika’s consistent messaging on the 15-18% EBIT margin target (from recent levels around 13%). Gross margin improvement is going to be a key part of that, and the company already has excellent mid-50%’s gross margins. Looking ahead, though, there are ongoing opportunities from adding automation to manufacturing (most recently in the adhesives/sealants facilities), as well as opportunities in sourcing and logistics.
An even bigger opportunity is in reconfiguring the go-to-market path. Sika has traditionally done most of its business directly, but the acquisition of Parex helped push distributor-based sales closer to 40%. Over time, I see the opportunity for this to head closer to 50%/50%, and this could offer a point or more of EBIT upside, as well as grow the business with smaller customers that are harder to serve directly. Building distribution channels is a time-consuming and expensive process, though, and I believe management is going to increasingly focus on distribution as an important element in its M&A target selection (Cummins (CMI) did this to good effect years ago).
As far as growth goes, management remains focused on increased cross-selling. Sika has a wide range of building/construction products, but per-project content is still far less than what management believes it could be; management believes they can drive a doubling of construction project content (from 0.5% to 1%) over the next three years.
In the short term, management called out “quite excellent” demand in the third quarter. Indeed, non-residential construction activity has been surprisingly resilient through the pandemic (management said China is already back to pre-COVID-19 levels). Likewise, residential construction activity has been robust and getting stronger in the U.S. Autos, which make up about 10% or so of Sika’s revenue mix, have clearly been weaker, but the company has outgrown underlying build rates by more than 10pts and the auto market is also showing a healthy early recovery.
Leveraging Green Opportunities
Green building retrofit opportunities in the U.S. and Western Europe have become a hot topic over the summer, with both proposals in the EU and in candidate Biden’s platform bringing more attention to the topic. Whether there are large top-down government spending/stimulus programs or not, commercial building clients are increasingly demanding more rigorous environmental compliance from building owners/operators, and the rents are starting to reflect this. So, it’s an increasingly clear proposition for building owners – retrofit to get green(er), or see your rents suffer.
Sika addresses this trend on multiple levels. From enhanced waterproofing to insulation to roofing materials and improved sealants, Sika offers a range of products that reduce a building’s environmental impact/profile, and the products themselves are produced in increasingly environmentally sustainable ways (it’s among the major priorities of management).
To offer an example, I’ll highlight the company’s concrete additives and admixtures business. Readers who have read my prior articles on FLSmidth & Co. (OTCPK:FLIDY) may remember that I’ve pointed out that cement production is a major CO2-generating industry, but while FLSmidth offers a portfolio of retrofit products that can reduce the emissions footprint of cement plants, demand has been weak, as cement companies really can’t afford the upgrades (and governments have been reluctant to crack down).
Enter Sika and its SikaGrind additive. SikaGrind replaces up to 25% of the clinker content, and clinker production is responsible for most of the CO2 emissions of a cement plant. The company also offers an additive/admixture called ViscoCrete, which reduces the water needed for cement by about 40%, reducing the water needs for building projects.
Those aren’t the only examples. Sika’s roofing and flooring products can reduce energy consumption through improved insulating capabilities, and I expect meaningful future growth in areas like functional building facades.
I do have some near-term worries about the pace of newbuild non-residential construction in both North America and Western Europe, but less than half of Sika’s commercial business is newbuild, and I believe retrofit opportunities can offset this. I’d also note that the company’s addressed market opportunities are still meaningfully underpenetrated, and market share growth can more than offset near-term headwinds from new building starts. I’d also note that in the auto business, Sika remains positively leveraged to future growth in hybrids and EVs, as more of these vehicles will include structural bonding (adhesives) in lieu of welding.
I also expect M&A to remain a key part of the growth story, likely contributing about 100-200bp/year to growth over the long term. I’m a little concerned about “multiple creep”; Sika used to routinely execute deals at 1x sales, but recent deals have exceeded that multiple. I don’t mind the company paying for quality, but it’s still worth monitoring. With larger conglomerates like BASF (OTCQX:BASFY) increasingly willing to sell off parts and pieces, I believe Sika won’t be suffering for a lack of potential deals. Again, I would also note that future deals may be driven as much by distribution as adding new products/capabilities, as expanding the company’s distribution channels could have a meaningful positive impact on operating margins.
I still expect Sika to generate long-term revenue growth around 6-7%, with M&A included in that number. As for margin leverage, this is where you see the most deviation between analyst expectations, with a few expecting Sika to achieve 18% operating margin in 2022. I think that’s exceptionally ambitious; I think 16-17% is a more likely target for ’22. Longer term, though, I believe Sika will build on its market-leading margins (adhesives specialist Henkel (OTCPK:HENKY) is one of the only comps with better margins) and achieve mid-teens FCF margins – a level few specialty chemical companies reach.
As you might have guessed from my opening paragraphs, discounted free cash flow, margins, returns, EBITDA and so on aren’t all that much help now with valuation. Bullish sell-side analysts are driving their price targets with low discount rates and/or arguments that in this low-rate environment, Sika deserves an even stronger multiple to forward earnings.
That’s fine, and I don’t disagree that near-zero rates complicate the valuation exercise, but I think Sika’s stock price performance is at least partially unmoored from the financials now – it’s a very well-run company that plays on a popular secular growth theme. I don’t know how long that will last, and I’ve been wrong in underestimating the re-rating potential before, but I can’t bring myself to chase the shares at this level, even though I think it’s an exceptional company.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.