Hexagon Q2'24: Temporary weakness creates opportunity

Q2 performance suffered from cyclical headwinds, but Hexagon also demonstrated strong underlying development such as good growth in recurring software revenue and improved efficiency. A cyclical recovery is not yet in sight in the near term, but we expect the underlying positive development to be increasingly reflected in earnings in Q4 and 2025. In view of the recent share price decline, we find the expected return attractive and change our recommendation to Accumulate (prev. Reduce) with a target price of SEK 115 (prev. 110).

Hardware sales suffered more than expected

Q2 organic revenue growth was 0% as cyclical headwinds in automotive and construction hurt hardware sales. Sales were 3/4% below our/consensus estimates. Weaker-than-expected revenue was also reflected in adjusted EBIT, which was 2/5% below our/consensus estimates. However, revenue quality improved as recurring revenue growth was around 8% y/y, driven by SaaS. The improved revenue mix drove gross margin to an all-time high and supported adjusted EBIT, together with continued efficiency gains from the rationalization program.

Cyclical rebound not yet in sight, but internal development bodes well for future earnings growth

Hexagon's management pointed out that it does not yet expect an improvement in demand from the construction and automotive industries in the third quarter. However, the good growth in software sales, innovation and improved operational efficiency bode well for further earnings growth once cyclical demand picks up. Management expects the good momentum in recurring revenues to continue in the near term. Q3 will be a particularly active quarter for new product launches, which Hexagon hopes will help the company strengthen its market share once macroeconomic conditions improve.

Our estimate reductions mainly limited to short term

We have slightly lowered our estimates as we expect no organic growth in Q3. We estimate organic growth to recover to 4% by Q4, mainly driven by easier comparison figures. For 2025, we estimate a clear up-tick in organic growth supported by a moderate cyclical recovery. We lower sales and adjusted EBIT by 2% in 2024e and by 1% in 2025-26e. The current year's estimated adjusted EBIT growth of 38 MEUR is well below the targeted or achieved savings from Hexagon's ongoing rationalization program, which has so far achieved run-rate annual savings of around 160 MEUR. We therefore expect the major benefits to be realized in 2025-26.

Expected return has improved given the lower share price and good underlying development

Hexagon is a diversified, high-quality technology company that creates value over the long term. We have been cautious recently as the pace of organic growth has slowed due to cyclical headwinds. We believe that the major cyclical disappointments are now behind us and do not expect any further incremental declines in organic growth in the coming quarters, even if the recovery is not yet in sight. We see Hexagon's fair adjusted EV/EBIT valuation multiple at 18x, compared to current levels of 17x for 2024e and 15x for 2025e. The reported EV/EBIT multiple of 19x is also below the 10-year historical median, even though the company's earnings quality has improved due to a higher share of software sales and other recurring revenues. We calculate the expected return over the next 3 years to be 10-11% p.a., assuming a fair adj. EV/EBIT of 18x and average earnings growth of 7% p.a. in 2025-26.