Reece: Stellar Business, Priced For Perfection

Australia | Jul 01 2024

This story features REECE LIMITED, and other companies. For more info SHARE ANALYSIS: REH

Analysts praise the Reece  business but harbour valuation concerns and sound caution around housing markets in both the US and the A&NZ region.

-Valuation concerns for Reece
-Expansion into the US in the past six years
-Maturity of the A&NZ business
-But, significant long-term demand recovery, says Ord Minnett

By Mark Woodruff

Analysts universally agree bathroom and plumbing products supplier Reece ((REH)) is an outstanding business, but current sticking points are valuation and the near-term outlook for housing markets both in the A&NZ region and in the United States.

Some readers may be surprised the company sits just outside the top-thirty list of ASX companies ranked by size with a market capitalisation of around $16bn.

After becoming well established in A&NZ, Reece entered the US market in 2018 with the acquisition of Morsco, a top-five supplier (at the time) of Plumbing and Waterworks, and then snapped up Southern Californian plumbing supply wholesaler Todd Pipe in late 2019.

Last year, the company acquired Barsco – a distributor of refrigeration and HVAC-R (heating, ventilation, air conditioning and refrigeration) products, parts and supplies throughout 12 locations in Texas.

After allowing for these acquisitions and the company’s organic store roll-out, the US business now has 240 branches within its network.

In A&NZ, Reece is a distributor of products for plumbing, bathrooms & kitchens, waterworks, irrigation & pools, and HVAC-R. Apart from irrigation & pools, the company distributes the same products in the US.

Customers include SME trade plumbers, large home builders, end consumers, commercial trade, commercial developers, civil projects, and government bodies.

Reece has a network of 655 stores in the A&NZ region, which contributes 59% to group earnings. Goldman Sachs views this part of the business as mature with little room for outsized earnings growth, given an already market-leading position and over 50% market share.

Branch density in the region is relatively high with 21 stores per million people, notes the broker, which is greater than the density of either Tradelink [backed by Fletcher Building ((FBU))] or Wesfarmers’ ((WES)) Bunnings stores.

While Goldman anticipates gradual improvement in margins, there is no obvious turnaround opportunity to drive outsized earnings growth, the broker argues.

Ord Minnett agrees. As Reece derives a meaningful proportion of revenue from Australia, this broker is cautious on the near-term outlook in the absence of a material change in the state of the domestic housing market.

On the other hand, the US (which contributed 41% of FY23 group earnings) provides Reece with growth optionality, though this is more of a longer-term story, in Goldman’s view.

The US operations offer a significant platform for growth via industry consolidation and organic expansion, but this will take some time, agrees Ord Minnett.

First half results last February

Back at the company’s first half results in late-February (which exceeded market expectations), management commentary remained cautious for both geographic segments.

In the US, multi-family activity was considered a key headwind (though Macquarie noted this represented less than 10% of US exposure) and the group was cautious on the timing for recovery of both single-family construction and repair and remodel (R&R) activity.

Reece also anticipated a slowdown in the A&NZ region would impact second half trading.

At the time of these “impressive” results, showing positive US volumes and margin expansion, Citi upgraded its rating for Reece to Neutral from Sell.

Expressing optimism on the store rollout and further margin expansion, this broker, however, also remained cautious on valuation.

A significant pull forward of expenditure during the pandemic still needed time to unwind, according to UBS.

While Morgan Stanley noted backlogs over the 12 months prior to first half results helped support the residential construction market, these trends are expected to reverse in FY25 as the residential pipeline is exhausted.

Maturity of the A&NZ business and economic headwinds

In line with the consensus forecast, Goldman Sachs is forecasting a three-year compound annual growth rate (CAGR) of only 3% for A&NZ operations compared to the 11% achieved over the last 20 years.

This growth slowdown is also evident from a fall in revenue growth to 7% over the last five years from 10% per year over the past ten years, and the broker sees little room for further branch roll outs.

The short-term risks of higher, and higher-for-longer interest rates, makes the Australian housing market unattractive, according to the Head of Asset Allocation and Macro Strategist at Ord Minnett, Malcolm Wood.

Further hikes by the Reserve Bank could place additional pressure on the housing market given housing activity is cyclically depressed, reflecting higher interest rates, affordability constraints and elevated construction costs, notes Ord Minnett.

Beyond short-term weakness, the prospects for a significant long-term demand recovery are strong, with the broker anticipating long-term trend approvals almost 30% above current levels due to population growth, stabilisation in household size and a trend pace of knockdowns.

Reece’s A&NZ operations are well place to benefit, states Ord Minnett, given strong cash flows and high returns on capital.

Valuation of the US business

The US operations offer a significant platform for growth, notes Ord Minnett, via industry consolidation and organic expansion, but this may take time. After a period of exceptional growth, it’s felt volumes will decline in both regions over the next twelve months.

According to Barrenjoey, the Reece share price already factors in a more than 10% CAGR for earnings in the US business over the next 20 years, leaving little room for disappointment.

Even though the analysts believe consensus forecasts for the US division are conservative, based on the broker’s analysis of two US distributors (which are in a similar early stage of their store rollout and investing heavily in growth), Barrenjoey has difficulty justifying the current share price on a reasonable risk-reward basis.

In a further analysis looking at the overall company valuation, Morgans compared ASX-listed building/construction/engineering businesses to a range of offshore peers, and Reece stood out for its elevated multiple.

Nonetheless, this broker is encouraged by progress the company is making on rebranding and expanding the network, investing in digital capabilities, and increasing the exposure to the more stable R&R market.

Outlook

Lighten-rated Ord Minnett draws attention to Reece’s lofty valuation multiples, with the current share price more than 17% above its 12-month price target of $20.80.

Indeed, the average target price of six covering brokers monitored daily in the FNArena Database is $21.37 suggesting around -15% downside to the current share price. Citi is the only broker monitored daily with a price target above the current share price of $28.90.

Because of this potential downside, five brokers have a Sell (or equivalent) rating, while Citi is Neutral rated.

Outside of daily monitoring, Goldman Sachs and Barrenjoey also have Sell and Underweight ratings, respectively, with an average target of $22.18.

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