Is Current Premium Justified For Dulux?

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

-Mixed reactions to H1 results
-Is premium justified with softer housing?
-Or is it defensive stock, longer term positive?
 

By Eva Brocklehurst

Duluxgroup ((DLX)) dominates the paints and coatings market in Australia with its well-known brands, yet the company managed further market share gains in the first half from the re-launch of its Wash & Wear paint range. Margins also expanded by 50 basis points in the half year.

This positive aspect largely offset the retail channel de-stocking emanating from Woolworths' ((WOW)) Masters and Home Timber & Hardware as well as contract losses with Mitre 10 in New Zealand, resulting in a 4.0% lift to overall earnings in the half.

UBS incorporates a paint margin of 17.5% from FY16. While this is historically high, the broker believes it is sustainable, given the changes to the product mix as well as market changes relating to the exit of Masters from the retail channel, which should ultimately benefit Dulux. The broker envisages limited free cash flow being generated in the near term, given investment in new paint capacity, and considers the stock is trading close to fair value.

Citi is upbeat, noting leading indicators remain positive in key markets, with new housing strong and existing housing resilient, although the commercial and infrastructure sectors are subdued. This broker believes the results were good quality, with the company taking share in a challenging market while exercising cost control.

Paints in Australasia remain the driver of the company's earnings, generating 73%, while Citi notes Garage Doors & Openers has consolidated operational improvements. The broker expects new product developments will enable the company to generate above-system growth, with a potential supplement from acquisitions. Citi believes the stock justifies the premium at which it trades, given the quality of the business.

Other brokers are more subdued. Deutsche Bank substantially so, viewing the results as low quality, boosted by lower expenses, as net operating cash flow declined 27%. Guidance may be maintained for underlying earnings growth in FY16 but Deutsche Bank expects investors to focus on the lack of operating leverage at this point in the housing cycle, retaining a Sell rating.

The deterioration in cash flow disturbed Ord Minnett as well. The broker concedes management has flagged a short-term correction in retail channels and, in the second half, alleviating some of the one-off impacts should mean continued modest growth.

Outside of paint, the performance was more patchy, CLSA agrees, but highlights the fact these businesses are only 8.0% of earnings and 5.0% of valuation. Short-term concerns may exist regarding top line growth in paints but the broker, not one of the eight monitored daily on the FNArena database, believes the stock is one of the most consistent in the market and retains a Buy rating with a $7.30 target.

Credit Suisse is underwhelmed, particularly given the decline in the construction and consumer products division, driven by a soft Parchem result and the Selleys brand de-stocking. The broker believes execution around costs is the key to the second half, with the current earnings profile warranting a below-market multiple at this point in the cycle.

Renovation activity is strong and housing turnover high. Interest rates are low and consumer confidence outside of mining is good. Despite all these positives, the broker points to underlying growth across the core business being estimated at just 1-2%. Hence, Credit Suisse considers the stock's premium generous, given the indicators suggest a slowing in key end markets.

House price growth and housing turnover are precursors to renovation activity and both these indicators have slowed. Moreover, the new home construction market is approaching its peak with just 12 months of activity suggested in the pipeline.

Furthermore, the broker contends input costs are now a headwind with raw material prices expected to grow. On this note, management's commentary marks a significant transition, in Credit Suisse's opinion, to inflation-style growth from a falling raw material cost environment.

Competition is also expected to heat up in FY17 with the entry of Sherwin Williams to Australia and using price to offset cost inflation may be difficult if Dulux wants to grow market share, Credit Suisse maintains.

Caution prevails at Morgan Stanley too. The broker envisages few risks to near-term expectations but further afield expects a weakening housing market will flow through to Australian paint volumes.

Management is exploring offshore opportunities outside of Asia and part of this plan is looking to leverage the relationship with Wesfarmers ((WES)), as that company launches its Bunnings business in the UK. This makes sense to Morgan Stanley, given the recent large investment Dulux has made in expanding Australian paint capacity. Still, the broker perceives limited earnings growth in FY17 and FY18 and retains an Underweight rating.

While management is confident, Macquarie is cautious about competition, suspecting the merger of Sherwin Williams with Valspar could have medium-term impacts for Dulux. Meanwhile, Parchem is battling soft conditions in the engineering and infrastructure segment. Dulux does not expect increased infrastructure spending to translate into higher demand until 2017.

Macquarie observes the outlook is driven by margins, with Paint & Coatings margin improvement expected to carry through FY16 as disruptions in the New Zealand channel are normalised. The broker contends the market share growth in renovations in Australia stands out in the context of an increasingly crowded market, demonstrating the company's success with new product launches.

Despite taking a neutral stance on the stock for the short term, Morgans remains positive about the longer term, given strong brands and relatively defensive earnings, and would look to reconsider its view on any share price weakness.

There is one Buy rating (Citi), three Hold and four Sell on the database. The consensus target is $6.10, suggesting 4.3% downside to the last share price. Targets range from $5.20 (Deutsche Bank) to $$6.99 (Citi).
 

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