Near-Term Uncertainty Clouds Reece’s Outlook

This story features REECE LIMITED. For more info SHARE ANALYSIS: REH

Premium-priced Reece released merely in-line FY24 results with an uncertain near-term outlook.

-Reece’s in-line FY24 result carried by US outperformance
-Second half earnings for the A&NZ region decline
-Management sees near-term challenges for both regions
-Brokers agree shares are currently overvalued

By Mark Woodruff

Even a “well-managed, high-quality business,” as stockbroking analysts describe plumbing products supplier Reece ((REH)), will struggle to hold back the tide of upcoming cyclical forces. 

Potentially adding further downward pressure on the share price, in-line unaudited FY24 results for the company did little to dissuade previously held views of “overvaluation”. Reece shares tend to trade on a notable valuation premium and thus the stock is virtually never Buy-rated.

For the near-term, management expects macroeconomic headwinds will weigh for both the A&NZ region and the USA, despite a standout FY24 performance in the latter.

The company had benefited from record levels of pull-forward spending during covid, notes UBS, but this backlog has been worked through.

Now, activity remains depressed in the Australian residential market as affordability issues persist, explains Goldman Sachs. Unfortunately, the A&NZ region accounts for around 65% of group earnings with the balance derived from the US.

As longer-term fundamentals in the sector remain positive, with demand for housing and infrastructure supported by long-term structural factors, management intends to keep investing in both businesses via bolt-on opportunities, especially in the US.

Reece reported a 3% increase in FY24 profit to $416m, while FY24 adjusted earnings of $1,007m slightly missed the consensus forecast. The US performed broadly in line, whilst A&NZ margins of 14.6% were weaker-than-anticipated due to a softening housing market.

Key positives, according to Morgans, include a 30bps rise in the group earnings margin to 11.1%, due to good cost control, despite the weaker second half A&NZ housing market, as well as a 20bps increase in the return on capital employed (ROCE) metric to 15.5%.

While people-related expenses remain a headwind, it appears to Macquarie management is confident around relying upon price adjustments to recoup costs. Reece has around 8,000 employees and more than 650 branches in Australia and over 240 branches in the US.

In A&NZ, Reece is a distributor of products for plumbing, bathrooms & kitchens, waterworks, irrigation & pools, along with heating, ventilation, air conditioning and refrigeration (HVAC-R) products. 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 entered the US market in 2018 with the acquisition of Morsco, a top-five supplier (at the time) of Plumbing and Waterworks and then made further acquisitions as recently explained: https://fnarena.com/index.php/2024/07/01/reece-stellar-business-priced-for-perfection/

A&NZ region

In a tale of two halves for the A&NZ region, first half earnings rose by 7%, supported by moderate price inflation and a healthy backlog of activity, explains Morgans.

However, second half earnings declined by -7% as the backlog of activity was largely worked through, and volumes declined by -3% due to softer housing conditions.

While RBA interest rate cuts continue to get pushed out, Citi notes housing permits are beginning to flatten, implying a potentially shallower dip.

The standout US performance

In the US, demand conditions are “mixed,” according to management, with “green shoots” in new single-family housing construction.

Second half revenue rose by 6% versus 1% growth in the first half with the business experiencing some moderate price deflation. Earnings from US operations also rose by 15% in the second half.

In light of those “mixed” demand conditions, a 7% increase in second half volumes marks a “solid” performance, in Morgans view.

While there are some signs of life in R&R plumbing, with Home Depot recently noting positive momentum, Citi points out Reece has a larger New Housing (relative to A&NZ) exposure in the US.

The US footprint continues to strengthen, notes Macquarie, with the opening of an additional three branches in the second half, totalling 15 for FY24.

The less cyclical repair & renovation (R&R) market currently represents only around 20% of Reece’s US revenue, so earnings are likely to be more volatile in the short-term than for the A&NZ business, which has a much higher exposure to R&R, explains Morgans.

Margins in A&NZ and the US

Falling -20bps short of forecasts by Goldman Sachs and consensus, Reece’s adjusted earnings margin for FY24 came in at 11.1% for the A&NZ region.

As the second half base now reflects wage increases and early-stage labour cost reduction, UBS believes the margin should find some support.

In the US, this broker forecasts a broadly flat margin profile over the next two years given the store rollout remains a mix of M&A and organic additions, which presents a margin headwind in the preliminary stages.

Reece maintains a strong balance sheet, highlights Ord Minnett, with net debt down to $518m from $725m in FY23.

The board declared a final fully franked dividend of 17.75 cents bringing the total FY24 dividend to 25.75 cents.

Valuation concerns and the outlook

Trading on a 42.3x FY25 price earnings multiple and a 1.0% yield Morgans (Reduce) believes Reece’s stock price is overvalued in the short-term.

Citing the same valuation multiple, Morgan Stanley (Underweight) agrees the current share price is unsustainable, while Sell-rated Goldman Sachs refers to a demanding valuation, with shares trading in excess of their historical average premium to the ASX200.

While Morgans (Reduce) admires management’s progress on re-branding and expanding the network, investing in digital capabilities, and increasing exposure to the more stable R&R market, this broker’s modest near-term earnings growth forecast also suggests an overvalued stock price.

Citi (Neutral) suggests a slowing A&NZ market will be troublesome given Reece’s market share here locally.

This broker cites limited visibility around the timing of RBA interest rate cuts, how deep the cycle will be, as well as management’s plan for cost-out.

Citi has a Neutral rating for Reece, but five other brokers covered daily in the FNArena database are on Sell or equivalent.

Following FY24 results, the average target increased to $22.28 from $21.45, still well beloe where the shares are trading.

Outside of daily coverage, Goldman Sachs is also Sell rated, with a target of 23.25.

FY24 results including audited financials will be unveiled tomorrow, August 22.

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