Hexagon Stock: Moving Into 2024 With 25% RoR, But Too Expensive (OTCMKTS:HXGBY)

Dear readers/followers,

In this article, I’ll update my case and thesis on the Swedish company Hexagon AB (OTCPK:HXGBY). You can find my last article on this particular company here, and you’ll find that I was at a “BUY” recommendation with what I consider to be both high clarity and conviction, where I added shares myself.

The return here has been an impressive 25%+, because I beat the market quite handily with this investment based on the approach of valuation investing, where I identify undervalued businesses and put money to work, waiting for the market to realize its mistake.

The company has seen a decline in its premium due to increasing costs, but its solid earnings growth history suggests potential upside. Hexagon’s growth in key segments and contract wins indicate a positive long-term thesis, despite short-term challenges in certain markets – at least this was the case before.

This is an interesting update because Hexagon was also the target of a short-selling attack, which caused a marked decline in the company’s share price. That was when I “pounced”, and you can see the result of that pounce both above and what I am about to show you.

Let’s see what we can see in 4Q24, and why I expect to outperform more when it comes to Hexagon, even if the share price level today cannot be argued to be in any way as attractive as we saw only a few months back.

Hexagon – Share price recovery after the short attack

So, obviously, we’ve seen some non-trivial 25%+ share price recovery for Hexagon since my last article. That’s similar to another company I recently covered on SA, Assa Abloy (OTCPK:ASAZF) which I also invested in. I’m far more likely to invest in these durables and cyclicals than I am to invest in tech and things that other investors seem so fond of. Maybe it’s the right choice long-term, maybe it isn’t. I’m on a triple-digit 5-year ROR for my portfolio, so I view this as the right avenue to go, but I’m happy to be proven wrong as well.

One thing that’s clear is that two months, well that’s not a whole lot of time. As things stand currently, Hexagon has proven, in my view, that the company is far from in a bad spot.

How so?

The company managed 5-7% organic growth in 4Q/FY23, with an adjusted gross sales margin of 66% for the year, and an operating margin of 31% for the quarter, with a 103% cash conversion rate for the final quarter of the year.

This led to an increased dividend of €0.13 for the company, which currently comes to a yield of 0.11% – not much to crow home about, but then again, Hexagon’s yield has never been anything that should be relied upon to by itself makes you rich, even if investing in the company has been able to do exactly that.

But growth, top line, and EBIT is the name of the game here. The company has a target of 5-7% annual organic growth in earnings, and the company has done exactly that even in a year when things were arguably at their worst. We’re seeing an operating margin above 30%, which is part of the company’s long-term goals as well, as well as the annual cash conversion well above the annual 80% low-range target.

Hexagon has also proposed, as of 4Q, tighter alignment for management with group targets, which is something I view as necessary for this particular environment.

Here are the results of the ongoing rationalization program.

Overall, looking at company trends we see an overall EU decline (except in Defense, public safety, and power/energy/mining as you’d expect), while China continues to grow generally, Asia is up mostly (ex-China), and NA is mostly up as well – with the exception of the automotive sector. it’s a mixed but positive view.

The company is also moving away from its 2-sector solution with Industrial enterprise and Geospatial solutions. I’ve long thought that this is an oversimplified way of viewing the company, and likely on a sector basis has resulted in some negatives and trends being harder to identify than with a more segmented structure.

Here is what the company has come up with.

And this goes to show you just how much these two segments have been “bursting at the seams” prior to such a reorganization. I view this as a positive, and I look forward to increased 1Q24 clarity in terms of sales growth mix, margin, and other KPIs which now will receive their deserved attention.

We already have pro-forma numbers for these segments, and it’s thus easy to identify the Safety & infrastructure & Geospatial segment as the one underperforming segment this year, with a negative 7% revenue decline for the year, and the by far lowest margin for the entire company at 22%, dragging down segments like say, Autonomous solutions or Asset lifecycle intelligence, which are in the high 33-35% ranges.

On a company-wide basis, the P&Ls do not show any high-level worrying signs. Many of these trends, including what I just mentioned, are relatively cyclical industries to begin with. Company profitability remains good, but with a company that trades at these multiples, even a slight decline from a high margin is something to keep an eye on, because their elevated premiums are a product of maintaining those high margins and that high growth. Otherwise, the company has no business trading there.

Thankfully, gross margins are looking superb, and growing.

Other than that, the company saw improvements in operational cash generation, reduced investments, and release of WC, all of which contributed to better overall results for the company. There were obviously higher interest rate costs, but this was a thing of the time.

However, on a high level, the company managed to beat most if not all long-term goals that Hexagon typically works under.

Let’s look at what we can expect from Hexagon here going forward in terms of valuation.

Valuation for Hexagon AB going into 2024 – no longer as attractive

I changed my valuation on Assa Abloy due to valuation after a 20%+ RoR in a short time. I do not believe that it is time to do the same here just yet. While we’ve seen a significant return in a short time, what differentiates Hexagon from Assa Abloy, is the fact that I believe Hexagon will actually manage EPS growth rates of at least 11-12% over the next few years on an annual basis.

Because of this, a higher multiple is justifiable here.

Based on a 5-year average of 26x or above, the company can still manage a 15%+ annualized RoR here.

The company is now well above my last PT of 103. I am bumping my PT here – I believe confirmation of the growth were seeing for 2023 and forecast for 2024, along with the expected operational improvements from the reorganization justifies a 110 SEK/share – but no higher than that.

If you want to be optimistic about this company, it’s possible to forecast it at around 26x, but I prefer forecasting at the far longer average, 20-year, which comes to around 21x. That’s where we get the forecast and the thesis that Hexagon would only be able to generate around 7% per year from here on out.

That’s not enough for me, and you should definitely consider if this is enough for you – because I do not believe it should be.

The company needs to, as such, be lowered a notch in terms of my rating because it simply no longer fulfills the requirements in terms of valuation. As I have exhaustively detailed in previous articles on Hexagon, this is a business that really tends to revert to premiums very quickly. Even the latest short attack on the company, which I do view as somewhat exaggerated, only managed to keep the company down pretty much until the next earnings report or thereabout.

S&P Global analysts continue to follow Hexagon here, going from a low of 85 SEK to a high of around 145 SEK, with an average of around 105 SEK. My own PT is now 110 SEK, which actually was the analyst average in the last article. I’m maintaining and raising because I do see improvements that I believe justify it here.

Hexagon for me was primarily an options play – but then I also did some Covered-Call buy-writes, so I am currently owning a sizeable position of shares, tied to some option contracts that expire towards the end of June this year. The return on those calls is going to be around 15-16% as long as the company doesn’t dip below 80 SEK, which I view as significantly unlikely here.

The common shares to me no longer have any appeal at 117.9, unless you believe the company deserves an out-of-time, shorter-term premium of around 25-26x.

I am not of this mindset. I like the 2023 FY results, but I don’t believe it make for any basis for raising the company’s targets above this level.

For this reason, here are my current targets and my thesis going into 2024.

Thesis

• Hexagon is perhaps the most attractive positioning industrial/software company in the world. at the right price, this company becomes a must-have, and one you do not look “back” on until it’s excessively overvalued. This company is extremely well-capitalized, attractively managed, and has expertise in future-proof global industries with a high upside.
• The trends in 2024E have now seen the company fully recover from what I view as undervaluation. I can no longer call this company a “BUY” here, but instead, change my rating to a long-term “HOLD”.
• My PT for the company is preferably double digits but at 110 SEK/share, I’m moving to “HOLD” due to the reasons mentioned above and due to the company moving well above that 110 SEK level as of the 4Q report.

Remember, I’m all about

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

The company no longer looks good enough to “BUY” here, and as such I am moving to a “HOLD” stance as of this article.

This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.