FERG - Ferguson: A Good Company But Slightly Overvalued

2023-03-09 13:07:22 ET

Summary

• Ferguson’s revenue and margin growth should be impacted in FY23 and FY24 due to volume declines and tough comparisons.
• The company has good long term tailwinds in both residential and nonresidential markets.
• Based on my DCF analysis, the stock is currently overvalued.

Investment Thesis

Ferguson plc ( FERG ) should continue to experience volume declines due to the weak residential market, especially new construction. This should impact the company’s revenue and margin in 2H FY23 and FY24. The company is reducing headcounts and improving productivity at its facilities through automation, which should offset some of the headwinds on profitability. In the medium- to long term, the company’s revenue and margins should benefit from aging houses and infrastructure, different legislative acts such as the Infrastructure Investments and Jobs Act (IIJA), the CHIPS and Science Act, and the Inflation Reduction Act, and onshoring activities. Based on my DCF calculations, I believe that the stock is currently overvalued, and hence I have a hold rating.

Recent quarter performance

FERG recently reported mixed financial results for the second quarter of FY23. The company reported a 5% Y/Y increase in revenue to $6.8 billion, beating the consensus estimate of $6.67 billion. The revenue growth was driven by 2.7% organic growth and a 2.6% contribution from acquisitions, partially offset by a 0.4% headwind from negative foreign currency translation. However, the gross margins for the quarter decreased by 40 basis points Y/Y to 30.2%, due to inflationary pressures on certain commodity products and the business mix. The non-residential business outperformed residential, resulting in a lower gross margin, as non-residential has lower margins compared to residential.

The adjusted operating margin for the quarter also declined by 50 basis points Y/Y to 8.5%, due to the lower gross margin and negative FX translation. The adjusted EPS for the quarter declined by 1% YoY to $1.91, which missed the consensus estimate of $1.95. The decline was due to a lower adjusted operating margin and higher interest expense, resulting from a slight increase in debt levels, partially offset by the company’s share buyback program.

Near-term Analysis and Outlook

In Q2 FY23, FERG experienced moderate overall growth in the U.S. market due to challenging comparisons. The company's United States segment, which accounts for 95% of total revenue, grew by 5.4% Y/Y, with 2.6% attributed to organic growth and 2.8% to acquisitions. The residential business, which contributes 54% to total U.S. revenue, only grew by 1% Y/Y due to a slowdown in new residential construction. However, the healthy repair and remodel (R&R) market more than compensated for this weakness, driven by healthy backlogs near contractors. FERG has a significant 60% exposure to the R&R business and 40% in the new construction business.

On the other hand, the non-residential business, which contributes 46% to the total U.S. revenue, grew by a robust 11% Y/Y in the quarter, fueled by broad-based growth across all end markets. The commercial market increased by 9% Y/Y, the infrastructure end market grew by 7% Y/Y, and the industrial end market grew by an impressive 24% Y/Y. In summary, the company's strong non-residential business and healthy R&R end market contributed to FERG's growth in the quarter.

FERG has been successful in managing both its operating and non-operating expenses in the first half of FY23 through several measures. These include reducing overtime, bringing in temporary labor, and allowing natural attrition without backfills to decrease the number of Full-Time Equivalents (FTE). Additionally, the company targeted headcount reductions, resulting in a reduction of approximately 1,500 FTEs in the first half of FY23 and 500 FTEs in February 2023, to respond to the current market conditions. These actions have been beneficial to FERG by reducing its cost base and improving its adjusted operating profits in the first half of FY23. The adjusted operating profit increased by 6.7% to $1.45 bn in 1H FY23.

In the second half of FY23, I believe the company’s revenue growth should be negative due to tougher comps and slowing end-market volumes. The repair and remodel market in the residential market and the complete nonresidential market remain healthy, which should partially offset the negative growth in 2H FY23. Apart from organic growth, the company is also focusing on M&As. It acquired five companies in the first half of FY23, bringing in $300 mn in annualized revenues and spanning across the HVAC, Waterworks, and Industrial customer groups. The company's net leverage ratio of 1.1x at the end of Q2 FY23 is within its target range of 1x to 2x, giving it liquidity for future M&A activity. Management has projected low single-digit revenue growth for FY23, which seems reasonable given the strong growth experienced in the first half of the year.

I believe the adjusted operating profit in 2H FY23 should decrease due to the volume declines. However, this decrease should be partially offset by the lower FTE headcount and the company’s focus on improving productivity and efficiency through warehouse automation and automated back-office systems. Overall, I believe the company's margins in FY23 should decline year over year due to the impact of volume deleverage.

Medium to Long term Opportunities

Despite the current challenges faced by the residential market, particularly in new construction, the underlying fundamentals of this market remain strong. The median age of homes in the U.S. is around 40 years old, which provides a solid foundation for the repair, maintenance, and improvement markets in which the company has a strong foothold. Furthermore, there is a considerable shortage of housing, with an estimated undersupply of around 4 million homes, which presents a promising opportunity for FERG's residential business in the medium to long term. These tailwinds should drive the company’s residential business in the medium to long term.

On the non-residential side, there are several fundamental trends, such as onshoring activity, different legislative acts, and aging infrastructure, that should create a multiyear tailwind for the company. Firstly, there is a significant pipeline of construction activity for projects over $400 million, which should generate around $650 billion of construction activity over the next five years. These projects span several industries, including semiconductor chips, electric vehicles and battery plants, biotech, and pharma. Secondly, the U.S. government has passed several legislative acts that provide federal and state tax incentives across various industries. For instance, the Infrastructure Investment and Jobs Act (IIJA) focuses on segments such as roads, power, transit hubs, and water and sewer projects, while the CHIPS and Science Act includes $39 billion in manufacturing incentives. The Inflation Reduction Act (IRA) of ~$500 billion focuses on investments in energy, climate, and health care. These legislative acts should stimulate construction activities in non-residential markets in the medium to long term, thereby benefiting the company. Lastly, the average age of commercial buildings is over 50 years, and there should be increased activity over time for repairs, maintenance, and replacements. The drinking water and wastewater piping systems in the U.S. are aging, and FERG’s diversified waterworks business positions it well to work on this opportunity.

Overall, FERG has strong medium- to long-term opportunities in both the residential and nonresidential markets. These opportunities should fuel growth in both the top and bottom lines of the company

Balance Sheet and Cash Flow Analysis

FERG has a healthy balance sheet with a net leverage ratio of 1.1x. The company's capital allocation strategy prioritizes investing in organic growth through capital expenditures, dividends, consolidating fragmented markets via bolt-on acquisitions, and share repurchases. In the first half of FY23, the company acquired $564 million worth of shares and recently declared a $0.75 per share quarterly dividend .

Furthermore, the company's working capital had a positive impact on its cash flow during Q2 FY23 as inventory levels decreased due to the easing of supply chain constraints. Inventory, excluding acquisitions, decreased by $235 million in the first half of FY23, generating $1.2 billion in operating cash flow. This represents a significant increase of $946 million compared to the same period last year. Overall, FERG's sound financial position and strategic capital allocation priorities should benefit the company in the long term.

Risks to my thesis

I am anticipating a moderate demand in the R&R and nonresidential markets in 2H FY23. However, if the economic conditions worsen, the volume declines should be significant, leading to flat to negative year over year revenue growth and depressing margins in FY23.

Valuation

I arrived at the conclusion that Ferguson is slightly overvalued by conducting a DCF analysis. In my analysis, I projected a modest 2% revenue growth rate for 2023 and expected revenue to remain flat in 2024, mainly due to anticipated volume declines in the second half of the fiscal year 2023 and fiscal year 2024. However, beyond the fiscal year 2024, I anticipate mid-to-high single-digit revenue growth, primarily driven by favorable trends in both the residential and non-residential markets. The capital expenditure should increase in the coming years as the company plans to continue investing in market distribution centers, branch networks, and technology programs. I used a discount rate of 9% and arrived at a fair value of $134.53, which is ~4% below the current price.

Conclusion

The company’s revenue growth in the near term should be impacted due to the weak residential market and tough comparisons. However, the long term trends in both residential and nonresidential markets remain healthy, which should lead to mid- to high-single digit growth beyond FY24. Based on these near term headwinds and my DCF calculations, I am maintaining a hold rating on the stock.

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