FERG - Ferguson: A Must-Own Stock For Long-Term Investors

2023-08-07 02:58:23 ET

Summary

• Ferguson is a plumbing and heating product supplier operating in the repair, maintenance, and home improvement markets.
• FERG is investing in automated distribution centers and using robots to fulfill customer orders, reducing manual handling and energy consumption.
• While the residential housing market is currently slowing, government initiatives and aging infrastructure present long-term growth opportunities for the company.

Ferguson ( FERG ) engages in the supply of plumbing and heating products to professional contractors and consumers. It operates in the repair, maintenance and home improvement markets as well as in new construction markets through its subsidiaries. The business was founded as Wolsley by Herbert Austin in 1887 as a manufacturer of sheep shearing machinery and is headquartered in the United Kingdom where it historically held a sole listing on the London Stock Exchange. In 2017, the company was re-branded as Ferguson and following a restructuring which involved the disposal of lower margin UK subsidiaries and left most of the business operating in the United States, management opted to move its primary listing to the New York Stock Exchange in May 2022.

Ferguson is a high-quality business with a strong reputation as a distributor of plumbing, industrial products and HVAC systems. The company operates in a fragmented market serving over one million customers across and is well positioned to drive share gains from smaller operators through its investments in automated distribution centers. In the majority of its end-markets Ferguson is either market leader or in second place. For instance, in plumbing and heating wholesale supplies, Ferguson holds around 33% share. In the waterworks segment Ferguson has 26% market share .

Automation Investments

Robots are being used to haul, sort and pick products to satisfy customer orders across a physical grid which resembles a 'bee hive'. The technology is controlled by a supercomputer and enables orders to be fulfilled quickly and accurately whilst reducing the manual handling of materials. In addition, its fleet of robots help deliver energy savings enabling Ferguson to reduce its carbon footprint. In coming years Ferguson will roll out more automated warehouse solutions across its warehouses, a network which puts Ferguson within 60 miles of serving 95% of the US population .

Ferguson Automated Industrial Warehouse

Cyclical vs. Structural Market Dynamics

The business delivered top-line growth of 8% from 2011-21. Clearly, its end markets are cyclical and residential housing has slowed amid a sharp rise in interest rates. Whilst trading has softened in 2023, as inflation moderates, the housing market is likely to trough over the next six to nine months. Residential new builds account for 20% of the revenue and should pick up into 2024. Moreover, U.S. government initiatives catalysed by the Infrastructure Investment & Jobs Act and Chips Act are highly supportive for US construction markets. A near $2 trillion of federal funding is set to drive a boom in large-scale infrastructure and mega projects.

Ageing infrastructure across the United States presents a structural market tailwind for a business geared to repairs, maintenance and large overhaul investment. The average age of U.S. commercial buildings is over 50 years while the average age of you US drinking water and waste water pipes is around 45 years. If utilities replace around 5% of drinking water pipelines per year, the investment cycle extends to over 20 years. Whilst the residential market faces challenges, it is worth considering that the median age of U.S. homes is 40 years . Sooner or later new homes have to be built and repair and maintenance has to be conducted. These factors are set to driving substantial investment into the industrial economy and provide a strong foundation for long term secular growth.

Financial Metrics & Valuation

The company is set to deliver sales of $30bn in FY2023 and free cash flow just shy of $2bn. Based on a market capitalisation of $31bn this puts the business on a fairly undemanding free cash flow to equity yield of 6.3%. Since 2017 operating margins have risen from 6.6% to 9.3%, a testament to increased scale efficiencies and productivity enhancements in its distribution facilities. Assuming its end markets grow at 3-4% over the long-term, Ferguson is well positioned to achieve at least 5-6% top line growth through share gains, expansion of own-label products (currently 9% of revenue versus 20% for peers) and bolt-on acquisitions.

Risks

There are near term pressures from residential end market volumes and the potential for pricing to slow. Labour cost inflation is also a concern though management has focused on managing its cost base against a tougher macro-economic environment by collectively reducing headcount by 1,500 in the first half of 2023. Labour represents approximately 60% of the cost base .

Management expects mid to high single digit inflation throughout 2023 and has guided operating margins in the 9.3-9.9% range. Commodities (steel / copper / plastic) account for 15% of costs. There has been some commodity deflation in steel whilst copper prices are off 20% from their peak in late 2021. Finished goods are not expected to see any price step ups but current pricing levels should hold.

Conclusion

Ferguson employs 6,000 value-add associates who are integral to servicing trade clients. They are well positioned as an integrated part of their client's work-flow solutions. Whilst around 50% of revenue is tied to residential housing, revenue derived from repairs and remodelling provides a natural offset to sales geared to new home construction. If homeowners are less likely to move to maintain their current fixed rate mortgage, they are more likely to invest in their current homes.

Given a strong balance sheet operating at the low end of its leverage range with only 1x net debt to adjusted EBITDA, the company is in a strong position to invest for organic growth, buy-back stock and deploy capital for further acquisitions. Ferguson's scale and strong competitive position should sustain robust growth for many years to come. Accordingly, the shares are recommended for purchase.

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