It's said that trends tend to last longer than anyone thinks they will. AZZ (NYSE: AZZ) should hope that's the case. For the last three years, the electrical products and steel-galvanizing company has ridden the wave of increased infrastructure spending in the U.S. and China, and its revenue and earnings have soared.
Revenue has grown at an average rate of around 30% over the past three years, while earnings have grown even faster, as margins have improved. AZZ continued that impressive growth in the most recent quarter; its revenue was up 30% over the year-ago quarter, while diluted earnings per share rose 46%.
It's important to analyze AZZ's two main lines of business separately, because they have quite different economics.
Producing galvanized steel is a cyclical commodity business, and demand has been very strong in the past two years. Steel is galvanized when it's coated with zinc, making it resistant to corrosion. Galvanized steel is used for some automobile components, metal roofs for industrial buildings, and many other outdoor steel structures. The product accounted for 45% of the company's revenue and 54% of its operating income last quarter. However, zinc prices have risen this year, and operating margin fell to 25% this quarter from 31% a year ago.
With little product differentiation in galvanizing, as demand rises and falls with economic activity, margins will tend to fluctuate around their long-term average. If margins were to stay unusually high for too long, expansion at AZZ and its competitors would quickly drive up supply, sending prices and margins down.
Operating margins eventually should fall toward 20%, where they were in 2005 and 2006. Revenue should also fall eventually, when prices moderate. Investors should remember that most of the growth in the galvanizing segment in the past year has come from price increases, and only 12% is due to organic growth in the volume of production.
AZZ's other manufacturing line, electrical and industrial products, are less commodity-like than galvanized steel, and this segment should be less cyclical as well. Automobile production and much construction spending depend on the state of the economy, but electrical infrastructure needs to be upgraded and replaced no matter how the economy is doing. This segment's margins continued to improve, to 17.6% from 14.1% a year ago, and from 9% two years ago.
Like most industrial companies, AZZ would face falling margins if the economy were to tank. Yet if it can continue to increase its presence in emerging markets, it would be a lot less vulnerable to downturns in the U.S. In this respect, AZZ is hoping to follow the lead of larger competitors Eaton (NYSE: ETN) and GE (NYSE: GE).
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