FERG - Ferguson: Opportunities Risks And Growth Outlook

2023-03-08 19:54:48 ET

Summary

• Ferguson is a leading distributor of plumbing, HVAC, and building supplies with over a million customers and 34,000 suppliers.
• The company has a strong competitive advantage due to its scale, exclusive regions in certain businesses, and protection from foreign and e-commerce competition.
• Management expects to grow revenue by 7-12% through a combination of end-market growth, over-market growth, and acquisitions, with flow-through to trading profit of 11-13% and low/mid-teens EPS growth.

Executive Summary

Ferguson ( FERG ) provides plumbing, HVAC, and building supplies to both contractors and homeowners. As a distributor, the company boasts an extensive network of over 34,000 suppliers and serves over a million customers. Despite experiencing a decline of around 25% from its peak, Ferguson's stock currently trades at approximately 15x this year's earnings and 13.5x its normal earnings power.

The reason behind Ferguson's undervaluation could be attributed to concerns regarding the residential end markets, as well as the company's recent shift to a US-based operation. Previously known as Wolseley, Ferguson has undergone several divestitures to become 95% US-based. They have recently transitioned to US GAAP reporting standards as of August 1, 2021, and obtained a primary listing in the US in March 2022, which resulted in Ferguson moving from a premium to a standard listing in London and exiting the FTSE 100.

Despite being advised that index ownership for their shares is around 10%, Ferguson's advisors believe that US peers could have double the index ownership. While it may take some time for Ferguson to be included in certain indices such as the S&P 500, the company is expected to meet the criteria following the filing of a 10-K at the end of the fiscal year and an annual liquidity test that requires liquidity to move to the US and is measured on an annual basis.

Business Overview

Ferguson's business operations have scale advantages and exclusive regions in businesses such as HVAC, where there is little technology change expected in the coming decades. Due to the nature of the products sold and their distribution, Ferguson is protected from foreign and e-commerce competition. With 1,679 branches across the US and 6.5 million square feet across 10 distribution centers, 95% of the US population has access to same-day or next-day delivery capabilities. The majority of business is either bought or delivered through branches, with customers visiting branches several times a week. Pro customers prefer Ferguson due to convenience, product availability, and reliable service.

Ferguson operates in various business lines, including:

• Residential Building and Remodel (formerly Residential Showroom): This business line operates 247 showrooms that serve both consumers and trade customers, displaying bathroom, kitchen, and lighting products. It contributes 14% of the US revenue.
• Residential Trade: This business line serves residential remodeling, maintenance, and new construction with plumbing, sanitary supplies, tools, repair parts, and bathroom fixtures. Plumbing contractors have access to 1,679 branches, and it contributes 20% of the US revenue.
• Residential Digital Commerce: This business line contributes 10% of the US revenue and sells through build.com / Build with Ferguson, using the same distribution network as the trade business.
• HVAC: This business line serves both residential and commercial markets and contributes 11% of the US revenue.
• Commercial/Mechanical (formerly Commercial): This business line offers plumbing and mechanical contractor products and services, including bidding and tendering support, and contributes 14% of the US revenue.
• Facilities Supply: This business line offers products and services for the maintenance of commercial facilities and contributes 4% of the US revenue.
• Fire and Fabrication: This business line fabricates and supplies fire protection products and systems for commercial contractors and contributes 3% of the US revenue.
• Industrial: This business line specializes in automation, instrumentation, engineered products, and turn-key solutions for PVF and industrial MRO and contributes 6% of the US revenue.
• Waterworks: This business line distributes pipes, valves, fittings, hydrants, meters, and related water management products, along with services such as water line tapping and pipe fusion, mainly to civil or municipal organizations. It contributes 18% of the US revenue.

Valuation

Management anticipates a revenue increase of 7-12%, which will be driven by end-market growth of 3-5%, over-market growth of 3-4%, and acquisitions of 1-3%. They also expect profits to grow by 11-13% with low/mid-teens EPS growth. Despite a slowdown in the residential market after the COVID-19 pandemic, the management team believes that the medium-term demand will be supported by a prior period of underbuilding and an aging housing stock. Although there may be a short-term correction, the medium-term tailwinds, fragmented end markets, and a history of strong growth lead me to find the management's projections to be both credible and realistic.

The price of Ferguson stock is more attractive than its peers, especially that of HVAC original equipment distributors which are more cyclical in nature. When compared to Watsco, Inc. ( WSO ), Ferguson's growth and returns are superior. In addition, Ferguson's valuation is more favorable than peers Pool ( POOL ) and SiteOne Landscape ( SITE ), which have seen larger covid-related bumps. Ferguson is expected to benefit from its recent listing in the US, which will increase coverage and result in index inclusion. I anticipate total returns in the low teens from growth and free cash flow (after accounting for growth expenditures and buybacks) and in the high teens to low 20s when factoring in potential multiple expansion to a market or better valuation, but below that of companies like POOL or SITE. These returns are reasonable for a distributor with stable and somewhat countercyclical cash flows, ample opportunities for growth, and a conservative balance sheet.

Overall, if Ferguson were to re-rate in line with its peer group, shares would appreciate by over 50%, implying significant upside skew. Given the quality of the business, and the similarities in margins, growth, and return on invested capital, it is reasonable to assume Ferguson deserves a multiple that is several turns higher, or in the same range as WSO, POOL, and SITE.

Risks

Cyclical nature of the business: Ferguson operates in a cyclical industry that is closely tied to the health of the construction and housing markets. The demand for its products and services can fluctuate significantly due to macroeconomic factors such as interest rates, economic growth, and housing starts. This can lead to revenue and earnings volatility for the company, which could impact its stock price.

Competition: While Ferguson benefits from its large-scale and extensive distribution network, it faces stiff competition from other established players in the industry such as Home Depot, Lowe's, and Grainger. New entrants could also emerge, including online marketplaces, which could disrupt the traditional distribution model.

Supply chain disruptions: Ferguson relies on a complex supply chain to deliver products to its customers. Any disruptions to this supply chain, whether due to natural disasters, political instability, or transportation issues, could impact its ability to fulfill orders and lead to lost revenue.

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