Australia | May 19 2015
-Significant leverage to home building
-Concerns about non-paints business
-Acquisitions a potential catalyst
By Eva Brocklehurst
DuluxGroup's ((DLX)) paints & coatings business starred in the first half, with earnings up 9.0%, while non-paint earnings, particularly garage doors & openers, were weak, down 27%.
Guidance for FY15 is unchanged albeit vague, expected to be "higher" than FY14. The company expects existing home demand will remain strong but the commercial outlook is less positive. Of note, margins in paints are expected to be flat which implies a sharp reversal through the second half, UBS maintains. Operating margins have expanded by 160 basis points over the last five years but if margins have indeed peaked, then the broker believes there is a risk to the company's premium valuation.
Of comfort is management's record of under-promising. One other concern for UBS is the amount of investment in the non-paints business needed to drive growth, with shareholders seemingly having to take higher costs up front for a future benefit.
Countering these concerns, Morgan Stanley envisages limited downside given lower tax and interest rates and expects the stock to retain its slight premium to the industrials index, ex financial stocks. The broker highlights the lack of clarity in guidance, with management simply indicating a target of making up the losses from the first half in garage doors & openers, and assumes this implies a flat outcome for FY15 versus FY14. The results underscored the importance of the housing market and turnover for the company.
The results underwhelmed Credit Suisse. The balance sheet may be in great shape but there are operational concerns around the businesses acquired from Alesco, such as garage doors, which leave the broker questioning the long-term prospects. Credit Suisse remains attracted to the core paints business but, near term, suspects the premium afforded to the share price could be challenged until there is more evidence of a turnaround in underperforming assets.
Given the first half results were supported by the timing of Easter, guidance for a flat margin outcome in FY15 is difficult for Macquarie to ignore. Estimates are lowered slightly on this basis. Nevertheless, the broker expects the investment in marketing and brand will yield medium-term benefits rather than be a structural negative. Garage doors & openers as a business is undergoing a significant disruption to revenue as a consequence of new products and channels but Macquarie suspects the impact will be temporary. With weaker competitors the business should be in a better position going forward.
Macquarie believes the stock is a relatively defensive exposure among building materials peers and the negative reaction to what is primarily transitory impacts is not justified. An Outperform rating is maintained. Deutsche Bank is more cautious, believing the results raise questions about the company's leverage to increased building and construction activity. This broker retains a Sell rating, noting the first half result was boosted by lower interest and tax expenses and the benefit of the timing of Easter.
Strong growth in the first half from home exposure, boosted by the earlier Easter, may reverse in the second half, Deutsche Bank suspects. New housing construction is expected to be strong in Australia over the rest of 2015 but the company indicated market share growth is likely to be limited in this lower margin segment because of pricing discipline.
The outlook for commercial and infrastructure business, at around 16% of revenue, is less positive, in Deutsche Bank's opinion. The company noted at its FY14 result that major engineering and infrastructure project opportunities were weak, with mining capex winding down and new infrastructure projects still some time away. Also, the company's markets in China and PNG are subdued and expected to stay that way for the remainder of FY15.
Citi believes the weakness in the garage doors & openers business was uncharacteristic, negatively affected by the introduction of a new dealer distribution strategy and the transition to a new product line. The broker acknowledges Parchem sales also fell in the half because of softer civil infrastructure and non-residential markets.
An acquisition is still a possible catalyst and Citi estimates Dulux can easily fund, via debt, a $170m acquisition. The other trend to watch is the smaller lot sizes, as medium density housing requires smaller garage doors and the average number of these per house has fallen more than 20% with the contraction in lot sizes. Furthermore, as a percentage of building approvals, detached housing has fallen to 51% in 2015 from around 69% 15 years ago. That said, while the rate of growth is slowing, all new homes add to the existing housing stock which currently drives 62% of the company's revenue, Citi contends.
FNArena's database contains one Buy rating (Macquarie), six Hold and one Sell (Deutsche Bank). The consensus target is $5.85, which suggests 1.7% downside to the last share price.
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