Plumbing and bathroom supplier, Reece Group, prefers the steady stream approach to earnings growth rather than a torrent. With the exception of its big US acquisition in 2018, that’s just how the 102-year old family run company likes to roll. In a cyclical industry of building and renovation, REH’s deep relationships with its customers is the secret sauce to its longevity.
REH has almost 650 branches in Australia and New Zealand. It also has over 200 branches in the USA courtesy of the MORSCO acquisition back in 2018. The plumbing and bathroom supplier relies on the building and renovation cycles with a big emphasis on partnering with trades. While plumbing hasn’t changed dramatically as a trade, the way the company does business with its customers is undergoing the digital treatment to retain its strong relationships and high quality of service.
Working capital is a key factor so that its in-stock position ensures customers can get the products they need. Working capital typically hovers around 20% of sales.
Network expansion in Australasia is a focus. The company expects to open 10-20 new branches in each of the next few years pushing capex up over $100m annually.
The US network is mostly exposed to the ‘sun belt’ southern states. Expansion of the network is focusing on the west coast. More importantly, REH is beginning to roll out the Reece brand after several years of careful management to instil the company’s ethos and processes.
Sales revenue in the USA is now greater than Australasia, but the operating earnings margin is just over half. That reflects the competitive market in the USA rather than an opportunity to increase margins. REH is generally not as concerned about margins as it is about customer service and long term business relationships. That is reflected in its obsession with its NPS (net promoter score) which is impressively high. This long term attitude is also a nod to the family business ethos which tends to be risk averse but does not make REH an easy target for competitors. How else to explain the company’s longevity and its clear customer loyalty?
Building approvals/completions, and renovations are the key economic indicators underlying REH’s business. Demand for plumbing, bathroom and water products is integral to the broader building cycle. In REH’s most recent 1H23 result, it indicated volumes in Australia had softened throughout the period although inflation had boosted prices by 11% contributing to EBIT growth of 6%. Similar trends occurred in the US business. Volumes are expected to contract further in 2H23f placing more emphasis on cost control to maintain margins.
Investment View
REH has a well-established presence in the plumbing and bathroom industry in Australia and New Zealand. The expansion into the USA brings a new set of challenges, but REH has shown ample patience and caution in everything it does. There are network expansion opportunities in both regions and REH has a solid balance sheet to achieve growth in this manner. The company places great emphasis on its customer relationships (mainly trade) which requires excellent service and depth of product. Both these factors are controllable, and this gives REH its competitive advantage.
But the building industry is cyclical making REH vulnerable to an earnings and valuation correction. In Australia, a backlog of work is supporting earnings though this will be finite as higher interest rates dig deep into consumer confidence and economic activity.
The Wilson family owns approximately 58% of the company and the free float is just over 40%. This reduces the liquidity in the stock and possibly inflates the PE premium relative to its nearest comparable stock, Reliance Worldwide Corporation (RWC). Regardless, REH’s long term PE ratio at 28x is expensive relative to the market and possibly overstates the achieved and future earnings growth potential. REH is a well-run business with few issues of concern.
Who Would Change Our View?
If REH put more store in lifting EBIT margins, particularly in the US, this would certainly boost the earnings profile.
Another acquisition could also spice things up and with leverage (net debt to EBITDA) at 1.9x, this is not beyond reason. Perhaps in conjunction with that, a sell down by the Wilson family to create greater liquidity in the shares would be appealing. In essence, REH is being run like a private business with no real appetite for risk. We acknowledge that this has served the company well in the past.
An extra point to consider might be the sub-50% dividend payout ratio which resulted in an average net dividend yield of 1.6% over the last six years. A higher payout could be accommodated without compromising the business.
Risks to Investment View
A deep downturn in the building industry would affect earnings growth and would manifest in a PE contraction. REH’s expansion into the USA may not generate the growth anticipated. Exchange rate volatility (AUD:USD) may affect translated earnings to Australia.
Recommendation
We have initiated our coverage with a Hold recommendation.
Figure 1: REH EBITDA
Figure 2: Australia dwelling approvals and completions
Figure 3: PE ratio back to long term average
Figure 4: PE relative has almost halved since peak
Figure 5: Early double digit return on equity expected for FY23f to FY25f.
