Wolseley last week provided an interim update for the first quarter of fiscal 2010, and the results confirmed our thesis that while residential end market demand is showing signs of stabilisation, deterioration in the commercial and industrial sectors will continue in the near term. Reported revenue fell 13% (20% decline on a constant currency basis), which wasn't surprising since weak demand levels continue to pressure sales volumes. North American revenue fell 17% while European sales sank 10% from the prior-year period.
Ferguson, the firm's US plumbing and heating segment, experienced acute softness during the period because of declines in the commercial and industrial end markets. The company attributes this weak performance to a continued lack of adequate financing for construction projects.
We expect the challenging demand environment to persist through the next few quarters, which will probably result in sustained pressure on operating margins. We have reduced our fair value estimate to account for continued volume declines across the firm's operations, as well as a revised share count to reflect the full effects of the firm's equity issuance and rights offering.
Thesis
(Last updated 20-11-2009)
Wolseley is a leading distributor of building materials for the global market. Although deterioration of the housing market has pressured profitability, we believe the company is positioned to generate solid returns over the long term.
Wolseley's business has suffered recently because of the weak housing market, and the short term doesn't appear to offer any relief. About two thirds of the company's sales depend on the US and European housing markets. Although the end of the housing slump is not yet in sight, Wolseley has an advantage over its competitors through its global footprint. Its revenue is split about evenly between its North American and European operations, so the firm may still achieve solid results even if one market is down. Still, construction activity will probably remain slow over the near term throughout the firm's markets.
We think Wolseley's position as a leader in the building material market should provide an edge over the long term, however. As the number-one distributor of plumbing and heating supplies to professional contractors, the company earns a narrow economic moat through its purchasing power. In addition, the industry is highly fragmented, and Wolseley has ample room for growth because it captures only a 3% share of the construction material distribution market. The company has addressed the current weak economic conditions by cutting costs through employee layoffs and branch closures, which should leave it with an improved cost structure when demand recovers.
Wolseley has made a number of recent improvements during the downturn, but we don't see a recovery on the near-term horizon. The company partially sold Stock Building Supply, its North American building material business, entering a joint-venture agreement with a private-equity firm that will now hold a 51% stake in the business. With significant exposure to new residential construction, Stock had been hit hard by the housing slump. In addition, the company paid down a sizable portion of its debt by raising £1 billion through an equity issuance and rights offering. The plan entailed an initial equity issuance to institutional investors, followed by a 1-for-10 reverse stock split, and finally a rights offering to existing shareholders. The move helped Wolseley avoid breaching its covenants on its credit agreement, but the firm will probably continue to deal with a soft demand environment in the short term.
Valuation
We do not at present have a fair value estimate for the PLC shares but
we are lowering our fair value estimate for the ADRs to $2 per share
from $5. The largest driver of the change is our revised share count,
which now accounts for the full effects of the firm's equity issuance
and rights offering. In addition, we have lowered our revenue
projections for 2010, since the company continues to suffer from soft
demand. Although the new residential and repair and remodeling markets
appear to be stabilising, the commercial and industrial sectors continue
to deteriorate, pressuring sales volume. We now forecast a top-line
decline of a mid-single-digit percentage for 2010, down from our
previous estimate of a slight recovery. Our operating margins
assumptions for 2010 are unchanged; we model margins of around 3% during
the year. The company has substantially reduced both head count and
branch stores throughout the downturn, and we think these actions could
provide a tail wind to margins when demand eventually returns. Over the
long term, we project mid-single-digit percentage growth. Long-term
profit margins should average around the mid-single digits, which are in
line with mid-cycle figures.
Risk
A prolonged downturn in construction activity is certain to hurt
Wolseley's top line, as the company depends heavily on new residential
and commercial construction. Another risk is that the company's
acquisition-driven strategy may not always result in smooth integration
or the desired returns on investment.
Management & Stewardship
Chip Hornsby resigned as CEO in June and was replaced by Ian Meakins.
Hornsby had served as CEO since 2006. During his tenure, the company
struggled not only because of the construction downturn but also because
of high debt brought on by previous acquisitions. Meakins previously
served as CEO of international foreign exchange Travelex and CEO of
health-care product distributor Alliance UniChem. Although Meakins lacks
experience in the building product industry, we think he has ample
knowledge of branding and distribution operations, which is integral to
Wolseley's long-term success. We believe the board has sufficient
independent representation, as John Whybrow has served as chairman since
2002. The board also has adequate compensation levels, and performance
evaluation criteria are appropriate. We like that 80% of each board
member's bonus is based on a mix of financial targets that are important
to shareholders--past-year performance is measured by trading margin,
cash flow, and growth in earnings per share. We would like the
compensation policy even more if it included a return on capital
component as well.
Overview
Growth: Although Wolseley enjoyed robust sales during the housing
boom, it posted a revenue decline in 2009 as a result of the downturn in
the construction sector. We think near-term growth will come primarily
from a recovery in volume because the company has no plans to pursue
acquisitions in the immediate future.
Profitability: Wolseley benefited during the housing peak, as operating margins averaged 5.5% from 2003 through 2007. However, margins contracted in 2008, and the company posted an operating loss in 2009 as cost-cutting was unable to completely offset the dramatic falloff in sales volume. Over the long term, we forecast normalised margins to hover around the midsingle digits.
Financial Health: The recent equity issuance and rights offering prevented the company from breaching the covenant on its credit agreement, which stipulates that net debt must be less than 3.5 times earnings before interest, taxes, depreciation, and amortisation. With current net debt of around £1 billion, the firm's net debt/EBITDA ratio now stands at 1.4.
Profile: Wolseley is a leading distributor of building materials, with headquarters in the United Kingdom. It has a network that spans 28 countries throughout Europe and North America. The firm operates in the United States under the brand Ferguson, its plumbing and heating segment. The company recently partially sold Stock Building Supply, its US building material business.
Strategy: Although Wolseley has historically pursued an acquisition-heavy strategy, the weak market will force the firm to cut back on purchases in the short term. Wolseley's near-term plan is to protect profits and reduce debt. The company plans to achieve this by lowering its cost base, as it has reduced head count by more than 17,000 and closed more than 700 branches across its operations since August 2007.
Bulls Say
1. The firm possesses strong brand power, as a number of its product
lines such as Ferguson, Brooks, and Wolseley are well recognised by
professional contractors.
2. With only 3% market share in a highly fragmented market and operations concentrated in North America and Europe, Wolseley possesses substantial room for growth, especially in emerging markets.
Bears Say
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1. Integration problems with past acquisitions could eat up Wolseley's
cash and credit lines, endangering future acquisitions.
2. Pricing for raw materials is unpredictable, and Wolseley's gross margins may suffer during price spikes for commodities such as steel and lumber.
