2023-10-12 13:52:52 ET
Summary
- Ferguson has faced challenges in the US residential market, with negative organic growth and shrinking margins as volumes have turned more definitively negative.
- Non-residential has also been weakening, led by office, retail, and warehouse, but Ferguson has emerging opportunities in "mega-projects" like new LNG and semi facilities.
- Expanded private label offerings and digital capabilities, as well as new "market distribution centers" can drive improved service quality, incremental market share, and margins.
- Ferguson isn't exceptionally cheap, but does seem undervalued relative to mid-single-digit growth expectations.
The last year hasn’t been the easiest for Ferguson ( FERG ), as the U.S. residential market has chilled significantly on weaker new-builds and softer remodeling activity and has been joined with a slowdown in non-resi activity as well. While the company has continued to execute well, there’s only so much enthusiasm the Street will work up for a company with negative organic growth and shrinking margins, even if this won’t last all that long.
Since my last update on the company , the shares have done okay. A 17% gain isn’t bad compared to the broader market nor Fastenal ( FAST ) (not a good comp for Ferguson, but often seen as a gold standard in distribution), but Watsco ( WSO ) has done noticeably better over that time. With Ferguson having generally exceeded my expectations over the last two years, I think the share price is quite a bit more interesting now. It’ll take a little while longer to return to growth, but comps get easier, housing will eventually recover, and Ferguson has some meaningful long-term opportunities not only from “mega-projects” but ongoing self-help.
Grinding Through The Downturn
I expected this to be a rough year for residential construction in the U.S., and that has been the case. With weaker permitting and housing starts, Ferguson has seen growth in the U.S. residential market trail off from barely positive late in 2022 to down to mid-single-digits in the last quarter. While remodeling has hung on a little better than I’d expected (helped by more high-end work), new construction has sapped momentum from the business and Ferguson has modestly underperformed companies like Home Depot (HD) and Lowe’s (LOW) in recent quarters, with a bigger (double-digit) hit to trade sales.
I was also relatively bearish on non-resi in the second half of this year and into 2024, and that seems to be coming through as well. While strong industrial activity has helped boost results for Ferguson, with total non-residential up 2% in the last quarter (and up 7% for the fiscal year that ended in July), the trend has been getting weaker, particularly as Industrial is no longer the offset to weakening office, retail, and warehouse that it once was, as sales growth eased from mid-teens in FQ3 to “mid-to-high single-digits” in the last quarter.
There’s really nothing wrong here beyond basic cyclicality. While there are some quarter to quarter variances in how Ferguson performs versus other comps (with names like Home Depot and Lowe’s tough to use as comps given their broader base of business), the company has continued to outgrow the market and take share, in large part through strong product assortments and availability (particularly more bespoke items). The company has likewise continued to invest in its digital capabilities, which offers convenience to customers and back-office savings and efficiencies for the company.
Given where rates are, it will take a little longer for Ferguson’s core U.S. markets to rebound. I do expect housing and non-residential to both look better late in 2024, but I do also expect a few more ugly quarters where organic volumes are concerned.
Waiting For Mega-Projects To Develop
One driver worth watching over the next couple of years is Ferguson’s leverage to so-called “mega-projects” tied to government-funded incentive packages like the Inflation Reduction Act. A lot of attention has focused on the civil engineering parts of these programs (bridges, roads, et al.), and Ferguson doesn’t have a lot of exposure there, but they do have exposure to initiatives like renovating and building schools and other public buildings.
Beyond that, though, is a host of opportunities in areas like data centers, EV/battery plants, new semi fabs, and LNG facilities. Management has talked about $30B in addressable market opportunities with a multiyear build (peaking around 2026).
Self-Help Still Matters
While investors wait for a housing rebound and for those mega-projects to come through, there are still meaningful self-help opportunities that can contribute to results.
Most industrial distributors have tried to boost their private label offerings, and Ferguson is no exception. The profitability on these lines is attractive (double the gross margin of branded products) and I think this can be an important offset to the inexorable pressure on gross margins that distributors face. While the mix of private label hasn’t improved in the last two years (still at around 8%-9%), I would note that post-pandemic supply challenges had many distributors focused more on simply sourcing what they could; I expect this to grow slowly toward a mid-teens percentage of the mix in the coming years.
Increased focus on “dualtrade” customers is another important opportunity. This basically refers to targeting customers with meaningful operations in both plumbing and HVAC, and Ferguson has sized this market opportunity at around $30B. I can see the appeal. Consider the case of a business that wants to replace a boiler system with a heat pump – you need someone with plumbing experience for the boiler side and HVAC experience for the heat pump, and it’s more convenient to use a contractor who can do both. My only real question here is how much of this market is truly greenfield for the company, as I imagine many dualtrade customers already use Ferguson for one or both sides of the business.
I also see attractive “behind the curtain” opportunities for Ferguson, including further consolidation opportunities (M&A), which I expect to be focused more on HVAC now, expansion of its digital platform (customer-facing sites like Build.com , online ordering, and digitalization of orders and logistics), and growth in market distribution centers (or MDCs).
The latter is particularly interesting to me. Ferguson has 10 large distribution centers around the country, but these MDCs put the company even closer to customers. They’re large enough to still accept full truckloads from suppliers, and management is relying heavily on automation. Given opportunities to improve product availability/fulfillment even further by placing two or three of these in large metro areas (in the past, for instance, Denver was served by a DC that was two days away), and using automation to minimize costs, I believe this can be a meaningful differentiator on service quality over the next five to 10 years.
The Outlook
I continue to believe that Ferguson can generate around 5% long-term revenue growth, some through simple underlying market growth (I’m bullish long-term on housing volumes), better exploitation of market opportunities like dualtrade and industrial, and share gains through elevated service capabilities. I’m sure M&A will remain a meaningful component as well, but I don’t expect many large deals as opposed to a long series of small deals.
On the margin side, I do expect some cost deflation in 2024 on commodity-based inputs (about 15% of the mix) and perhaps some relief on finished goods as well. I do think the EBITDA margins seen in FY’21 and FY’22 (11%+plus) aren’t sustainable or easily repeatable, but I do expect margins comfortably in the 10%’s for the next few years and I likewise expect some very gradual improvement in adjusted operating margin (around 10-20bp a year). At the bottom-most of lines, free cash flow, I expect gradual improvement toward 6% FCF margin over the next five years and some incremental progress beyond that, helping drive strong mid-single-digit FCF growth about 100bp above underlying revenue.
Discounting those cash flows back, Ferguson isn’t all that cheap on cash flow, but does still seem priced to offer a high single-digit annualized return and that’s not bad relative to the quality. Turning to my multiples-based approach, Ferguson’s margins, returns (ROIC, et al), and growth can support a multiple of 13.75x on forward EBITDA, leading to a fair value of $186. Were Ferguson to get the same sort of premium as Fastenal the target would move closer to $220, but given the differences in margin and growth I don’t think parity is a reasonable expectation.
The Bottom Line
With Ferguson near a 52-week high despite the downturn in housing, it’s hard to argue that the shares have gone overlooked. Still, I don’t find the price/valuation to be out of line. I don’t see huge near-term upside right now, but quality distributors don’t often get or stay all that cheap for long. At a minimum, I’d definitely say this is a name to look at again if there were a pullback.
For further details see:
Ferguson Facing Tougher Markets, But Still Well-Placed For Long-Term Growth