FERG - Building Success: Ferguson's Strategic Market Rise

2023-12-25 11:51:10 ET

Summary

• Ferguson Plc is a significant player in the supply chain for infrastructure projects in the United States.
• The company has achieved remarkable growth over the past three years, with sales increasing by 43% and adjusted operating profit growing by 60%.
• Ferguson's strategic focus on residential and non-residential sectors, along with its emphasis on repair and remodel activities, positions it well for long-term growth.

Introduction

As the United States enters a phase of intensified investment in infrastructure, the role of Ferguson Plc ( FERG ) becomes increasingly important. Specializing in distributing various plumbing and heating supplies, Ferguson is a significant entity in the supply chain for infrastructure projects.

Originating from a background in sheep shearing machinery, the company's journey to its current status is marked by strategic pivots and adaptations to evolving market dynamics and industrial trends. In the context of the U.S.'s expanding infrastructural ambitions, Ferguson’s comprehensive catalog and industry experience position it as a notable contributor.

In today's article, I'll explore Ferguson's business, along with its financial performance and recent developments. Finally, I'll provide my opinion on the stock as a long-term investment candidate.

Company Overview and Quarterly Update

As we delve into Ferguson's strategic adaptability in the evolving market, its journey from manufacturing to key plumbing and heating distribution is notable. The company balances its operations between non-residential (48%) and residential sectors (52%), with a significant focus on repair/remodeling (60%) over new construction (40%).

Ferguson's focus on repairs and remodels over new construction is an essential factor, as repairs and remodels are likely to continue even during phases in the economic cycle where new construction may slow or stop. Its diversification between residential and commercial further strengthens its business as residential provides stable revenues while commercial offers greater upside potential and volatility.

Next, we'll explore their latest earnings call's financial and operational details to understand Ferguson's competitive standing.

Earnings and Operating Profit

In Ferguson's latest earnings report, the trailing twelve months diluted EPS showed a steady plateau, contrasting to the sharp rise experienced in 2021 following the downturn induced by COVID-19. CEO Kevin Murphy, during the call, highlighted a range of significant financial metrics. Notably, the company recorded an adjusted operating profit of $773 million for the quarter, a decrease of 10.5%, alongside an adjusted operating margin of 10%.

This quarter's figures indicate a short term moderation in growth, a narrative espoused by the management.

However, Murphy also emphasized Ferguson's resilient and robust long-term performance. Supporting that claim, over the last three years, the company has achieved remarkable growth, with sales increasing by 43%, adjusted operating profit growing by 60%, and adjusted diluted earnings per share surging by 74% since fiscal 2021.

This narrative suggests that while the current quarter showed subdued growth, the overarching trend for Ferguson has been one of significant and sustained expansion.

Sales and Margins

Ferguson delivered a modest revenue decline of 2.8%. Murphy attributed the decline to challenging market conditions but maintained that the company achieved solid gross margins.

Later in the earnings call, CFO Bill Brundage delved into the financial specifics, revealing many details. The quarter saw a net sales decline of 2.8%, with organic revenue decreasing by 4.9%. This included an impact of +2.2% positive contribution from acquisitions, an essential part of Ferguson's long-term strategy; more on that later.

Brundage outlined the pricing dynamics, noting a shift from 1% inflation in Q4 to approximately 2% deflation in Q1. The gross margin was reported at 30.2%, down by 30 basis points compared to the previous year, and total costs remained stable year-over-year.

Looking at sales by geography, the U.S. business experienced a 2.7% decline in net sales, while the Canadian segment saw a 5% decline, signaling the relative strength of the U.S. market.

Brundage reaffirmed the unchanged fiscal 2024 guidance, projecting broadly flat revenue for the year. I believe that in a tough year like 2023 for so many businesses, flat revenue growth will be easily tolerated by many, at least temporarily.

Despite short-term market concerns, including over-earning during COVID-19 and impacts from delisting in the U.K., over the long term, Ferguson's revenue stability, especially from repair and remodel activities, has served as a crucial buffer against cyclical downturns, a major plus in the cyclical industrials industry.

Investor Q&A Insights

Later on in the call, various insights were gleaned during the Q&A session. An analyst from Jefferies inquired about the sequential trends in pricing, particularly regarding commodity stability. Management's response indicated stable pricing from Q4 to Q1, with a slight deflation noted in commodities. There's an expectation of modest increases in finished goods prices, which should help sales going forward.

Additionally, another analyst asked about the non-residential sector's performance. This time, management's response highlighted the sector's potential upside, especially in data centers, and projected a longer duration for mega projects. Mega projects like the data centers were reported by management to consistently contribute to the gross margin, which, in my view, makes them an important business for the company going forward. Given the ongoing demands for data center processing power driven by advancements like AI, I feel we can expect these sorts of projects to continue.

Also discussed was the potential impact of fluctuating interest rates on market recovery. Management responded that the markets are unfolding as expected, with the rate environment mainly affecting new residential construction but showing signs of stabilization. In my view, this slowdown emphasizes the merits of their repair/remodel exposure.

Ferguson's M&A Strategy

Ferguson's approach to capital allocation and M&A strategy is both strategic and disciplined, focusing primarily on small to medium-sized acquisitions. This methodology is integral to their business model, enabling them to consolidate market share effectively while cautiously navigating financial commitments.

By targeting smaller entities, Ferguson not only enhances its portfolio but also maintains a crucial balance between growth and financial stability as interest expense remains tiny (7%) in comparison to the operating income generated by the business.

This approach underscores the company’s ability to expand its market presence without overextending its resources. Smaller companies can often be acquired for a lower multiple, which has helped contribute to the company's incredibly strong returns on invested capital (20% plus).

While large-scale M&A might offer rapid expansion, Ferguson’s preference for smaller deals allows for more controlled integration and management of new assets.

This tactic is not just about increasing market share; it's also about diversifying Ferguson's operational scope and gradually entering new verticals. By carefully selecting and integrating these acquisitions, Ferguson strengthens its market position and helps extend the runway for growth.

Valuation and Risks

On the valuation front, Ferguson appears reasonably valued. At just 19.8X forward earnings and 14.2X operating cash flow per share, Ferguson trades at a similar value to the market as a whole despite delivering what I believe are exemplary returns on capital and superior future growth prospects compared to the average company.

While Ferguson's stock has experienced a significant run-up in price recently, buoyed by an improving macroeconomic backdrop, such a steep increase could pose risks, particularly for short-term traders. However, for long-term investors, the current P.E. ratio of around 20X, in my view, is by no means lofty.

The primary concern is the potential for short-term price weakness due to the recent surge, despite the promising long-term prospects of Ferguson.

Additionally, the current environment of volatile commodity prices, set against the backdrop of an ostensibly improving macroeconomic climate, poses a tangible risk to Ferguson's profit margins. Such fluctuations in commodity prices could lead to unexpected financial challenges for the company that are difficult to predict.

Another emerging risk is the growing interest of private equity firms in Ferguson's operational domain. As these firms become more active in a lower interest rate environment in seeking acquisition opportunities, Ferguson may contend with these entities for potential acquisition targets.

This increased competition could hinder Ferguson's strategic plan, mainly its focus on acquiring small to mid-sized companies, which has been a cornerstone of its growth strategy.

Conclusion

In conclusion, Ferguson Plc presents a compelling investment case. The company's strategic focus on residential and non-residential sectors, coupled with its significant emphasis on repair and remodel activities, positions it well in the industrials sector.

Despite the challenges of a volatile macroeconomic environment and the short-term risks associated with its recent stock price surge, Ferguson's long-term growth prospects remain strong. The company's disciplined approach to mergers and acquisitions, prioritizing small to medium-sized targets, has been a critical driver of its success, contributing to robust returns on invested capital.

From a valuation standpoint, Ferguson's current metrics suggest a moderate valuation, trading at 19.8X forward earnings and 14.2X operating cash flow per share. This, combined with its superior growth prospects and strong returns, makes Ferguson an attractive opportunity for long-term investors.

While the potential for short-term price volatility and competition from private equity firms in the acquisition space are notable risks, these are outweighed by the company's solid fundamentals and strategic positioning.

I rate Ferguson a "Buy."

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