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American Standard: Clearing the Air

Peel back the onion and you'll see this diversified company is misunderstood and undervalued.

This column was originally published on RealMoney on Oct. 19 at 12:57 p.m. EDT. It's being republished as a bonus for readers.

Say the name

American Standard


and the first thing that comes to mind is a toilet or a sink fixture. American Standard makes bath and kitchen fixtures, of course, and that means the company is precariously tied to residential home construction.

We all know how that movie is ending; the only problem is that movie isn't over yet and it could get worse.

Indeed, American Standard shares slid 1.6% Tuesday after it posted in-line third-quarter earnings but cut its full-year profit forecast, in part due to weakness in its bath and kitchen division.

Conventional wisdom is that American Standard will suffer the same fate as the U.S. residential real estate market. But this line of thinking only scratches the surface of the company. Though the company certainly needs to improve performance in its bath and kitchen unit, its ties to the U.S. new-home construction market are smaller than its brand name suggests. But misconceptions about its association with the U.S. homebuilding industry has afforded an opportunity to buy a company with great franchises at an inexpensive valuation.

Just the Facts

Before we address the problem, let's get the facts.

American Standard will generate $11.3 billion in revenue this year, 10% higher than 2005, through its three divisions -- Air Conditioning Systems, Vehicle Control Systems, and Bath and Kitchen. These will represent roughly 61%, 17%, and 22% of total company revenue in 2006, respectively.

At the divisional level, 70% of Air Conditioning Systems' (AC) sales last year were to commercial customers, according to the company's 10-K, and only 11% of AC Systems' sales were tied to new residential construction worldwide. While the division is American Standard's most heavily reliant on the U.S., 26% of the customers are internationally based.

This year, the division is experiencing strong growth, up 15% so far. American Standard is taking share in both the commercial and residential markets from competitors such as

United Technologies'

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Carrier Division and

Johnson Controls'

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Coleman Division.

Worldwide commercial construction has contributed substantially to the division's growth, with orders up 25% and backlog up 50% year over year in the September 2006 quarter. Higher energy costs have been one of the drivers of the commercial upgrade cycle as well, as new systems can be operated much more efficiently than those installed 10 to 20 years ago.

The residential air conditioning division has shipped fewer units this year than last due to a regulation to increase minimum energy efficiency that went into effect on Jan. 1. Anticipation of the regulation pulled many new unit sales into the 2005 supply channel. The slowdown in new housing hasn't helped either. Nevertheless, American Standard's residential AC revenue was up 17% year over year in the most recent quarter, driven by higher pricing for these higher-efficiency units and increased market share.

The Vehicle Control Systems division is primarily an international-based business with only 12% of sales in 2005 coming from the U.S. The division supplies a variety of systems and electronics to the heavy trucking industry. Sales are up 7.5% year to date and operating margins on the business are the strongest of ASD's three divisions, around 13% so far this year. Though I expect the division's revenue growth to be flat to down slightly in 2007, as a change in North American truck standards will slow demand, its margins should remain at current robust levels.

Lastly, only one-third of Bath and Kitchen (BK) sales are tied to the U.S. -- roughly $800 million in annual sales. And while 85% of U.S. sales are to residential customers, only $170 million of those sales are tied to U.S. new-home construction, the company estimated on Tuesday's conference call. So far this year, sales are about flat with last year, though operating margins are down significantly.

Fixer Upper

So what's ailing the BK division? Higher commodity and energy costs are impacting manufacturing margins, and poor execution with right-sizing the operations are the answers. But rest assured its poor performance is not tied to residential homebuilding, with a paltry $170 million of exposure out of $11.3 billion in total sales, or 1.5%.

On the conference call, American Standard CEO Frederic Poses says he still believes BK can achieve 8% operating margins over time. This year's margins will come in near 1%, which will work out to about 3% of total company operating earnings. The difference for shareholders between the 8% goal and the 1% reality is 55 cents of earnings per share.

That's a substantial difference, considering American Standard expects to post earnings of $2.65 to $2.70 per share for the full year, down from the $2.70 to $2.80 it expected as of three months ago, due to continued underperformance of the unit.

I can't be fully confident in an 8% operating margin outlook, but at 13.6 times my 2007 earnings per share and free cash flow per share estimates, the stock isn't pricing in that expectation either. In a worst-case scenario for 2007, I expect the company will earn at least $3 per share, and that assumes no improvement in the BK division.

If the company divests or fixes its ailing Bath and Kitchen division, the stock should move substantially higher on its own with earnings power near $3.75 per share. With returns on invested capital exceeding 20%, the company would fetch a 20 times price-to-earnings multiple, putting my eventual target near $75 per share.

In the meantime, the company is currently returning all free cash flow to shareholders in the form of dividends and buybacks. Sentiment also couldn't get much worse: 13 of 16 analysts who rate the company have it as hold or sell.

American Standard would fit nicely within another industrial conglomerate. Its AC Systems and Vehicle Controls business fit perfectly with


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businesses, and BK could be sold off to help finance the transaction. With relatively little debt burden now considering the cash flow dynamics of the business, I believe there is a variety of ways for investors to make money over time. As always, solid execution will get them there fastest.

At the time of publication, Ferayorni was long American Standard, although positions may change at any time.

Justin Ferayorni, CFA, is the founder and principal of Tamarack Capital Management and was an analyst and portfolio manager at Bricoleur Capital. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ferayorni appreciates your feedback;

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