Description

I am long the shares of Ferguson Plc (ticker FERG LN).  It is a UK-listed company but it is a 95%-US focused business (with the remaining 5% being from revenues generated in Canada).  It is a well-run, well-managed, diversified distributor and roll-up operator with a still long runway to productively reinvest capital.  Ferguson is currently trading at a 4.5% earnings yield.   The company is led by a management and supervisory board that is genuinely thoughtful about what they do with their shareholders' money.  I think Ferguson shares are well set-up to compound in the low-to-mid teens % IRR for the long-term. 

Introduction

Ferguson is an ongoing roll-up of distributors in bathroom, kitchen, plumbing, waterworks, HVAC, facilities management and industrial MRO products across the US (with some presence in Canada).  It is a diversified company and is the #1 or #2 player in almost all of its market segments, and each of those market segments is still rather fragmented.  The chart below illustrates all of the markets where Ferguson operates, and shows Ferguson’s relative size versus its competition.

As a reasonably well-run, large distributor that does a generally good job in selecting, rolling-up and integrating the M&A targets, I think Ferguson stacks up fairly well against other well-regarded Western distributors.  One such ‘comp’ is the generally well-known, well-understood, and deservedly admired Watsco.  Watsco was written up on VIC earlier this month and also in 2014 - I recommend to refer to those write-ups as a refresher on an adjacent business model.  Note that HVAC accounts for 9% of Ferguson’s revenue and Ferguson’s HVAC business is the #2 HVAC distributor in the US after Watsco, and I believe many of the points in the Watsco write-up that describe the beauty of a well-run distributor business model strongly apply to Ferguson’s HVAC business and also partially apply to Ferguson’s other businesses. 

Business model

Ferguson is a distributor.  It distributes a wide variety of products primarily aimed at tradesmen / contractors in the plumbing, kitchen installation, industrial MRO, HVAC and waterworks professions.  Ferguson has a hub-and-spoke network of 10 distribution centres and 1,500 branches and ‘showrooms’ across the US.   The short, stylized discussion below will focus on Ferguson’s largest segment - plumbing and heating (i.e. kitchen and bathroom products).  An average contractor tends to work in a 20-mile radius of his/her home, and will visit a Ferguson outlet/showroom a few times a week to get supplies.  Here, Ferguson’s large product range, staff expertise (20,000 sales associates) and a reasonably dense store network is of great value.  Ferguson strives for its relationship with its customers to be consultative and service-oriented.  Tradesmen benefit from Ferguson’s expertise and largest selection of products.  Ferguson’s size gives it significant buying power with suppliers, and Ferguson aims to pass on these savings to its customers.   About 60% of Ferguson’s business is RMI (repair, maintenance and improvement) oriented – this results in above-average levels of business resilience in times of economic stress.  Only 15% of Ferguson’s revenue is driven by non-residential newbuild construction.  About 50% of Ferguson’s business is tendered i.e. where Ferguson closely works with customers on larger construction projects where the builder / contractor is satisfying an RFP.    Ferguson is also an omnichannel player, operating a variety of websites (including build.com and faucets.com) that promise next-day delivery; more than 20% of Ferguson's core plumbing & heating business comes from ecommerce, and this revenue is growing 30% yoy.  Ferguson has a wide variety of suppliers (including the likes of Masco and AO Smith), with no meaningful supplier concentration (no single supplier accounts for more than 5% of Ferguson’s COGS).  Ferguson sells thousands of SKUs.  A small portion (9%) of Ferguson’s total revenue comes from private label products, and Ferguson aims to gradually increase it where possible, as private label products are higher-margin for Ferguson.  Some segments of Ferguson’s business have territorial supplier-exclusivity provisions.  In HVAC (c. 9% of Ferguson’s total revenue), Ferguson has a tight relationship (akin to exclusivity) with Trane and Ferguson; this is similar to the Watsco - Carrier relationship.   The HVAC piece of Ferguson’s business is possibly the highest-quality piece of Ferguson because it is the most ‘unAmazonable’.  The rest of Ferguson’s business is not completely immune to the Amazon risk but there are some mitigating factors in the business model.  Amazon cannot replicate the consultative and service-oriented aspect of the Ferguson relationship with its customers, especially given the significant RFP-support exposure (c.50% of the business, directly and indirectly).  Amazon is also better suited towards DIY products delivered to the home, and a lot less well-suited to tradesmen-oriented products (sometimes very bulky products like toilet units) that often need to be delivered to building sites at odd hours, with no 24/7 reception desk to accept deliveries and no obvious safe space to leave an unattended delivery.  Amazon is also not best-placed to satisfy immediate needs such as when a tradesmen picks up an item on the way to a residential customer’s home after responding to a phone call. 

In more quantitative terms, Ferguson has the following business model. In the US and Canada, during the last fiscal year, Ferguson had average total assets of $11.3B, of which $2.1B were intangibles.  On the resulting $9.2B of average tangible total assets, Ferguson generated $20B of total revenue and $1.4B of GAAP EBIT, i.e. a pre-tax return on tangible assets (ROTA) of 15.2% (as a comparison, for Watsco the pretax ROTA is 20%).  The $9.2B of average tangible assets were funded by $4.4B of average equity and $3.4B of average total debt.   The business runs with positive net working capital (equivalent to c. 10.5% of total revenue).  Ferguson has c.30% gross margins.  GAAP EBIT of $1.4B translates to a GAAP EBIT margin of 7%.  GAAP EBIT converts to operating cash flow of $1.33B, i.e. a 95% conversion rate.  Ferguson then spends $200M-$250M (or 1-1.2% of revenue) on maintenance capex, and also spends $400M (2% of revenue, or 30% of operating cash flow) on acquisitions.  Pre-acquisitions, Ferguson’s equity FCF % margin is thus 5.5% and post acquisitions, it is 3.5%.   Pre-acquisitions, Ferguson converts 100%+ of net income to (levered) equity FCF.  Post-acquisitions, cash-conversion is closer to 70%.  

Acquisitions (bolt-ons) are a big part of Ferguson's business model. Overall, Ferguson grows revenue by 3-7% per annum, and about half of that comes from M&A.   Ferguson buys 10-15 companies each year, paying 0.7x-1.1x EV/sales (Ferguson trades at 1.4x EV/sales).  The companies that Ferguson acquires tend to be small and have a lower EBIT margin than Ferguson.  Ferguson tries to pay no more than 10-11x EV/EBITDA pre-synergies (this compares to Ferguson’s overall current trading multiple of 14.2x EV/EBITDA in the market).  Ferguson then rebrands the acquired unit with one of Ferguson’s brands, takes out cost and improves the margin.  This brings the effective purchase price down to below 8x EV/EBITDA.  Overall,  Ferguson has a list of 1200 companies in the US that it wants to buy and tracks closely. The targets are usually family-owned and take a long time to cultivate and negotiate, and often coincide with family succession.  Occasionally Ferguson will buy a business that has seemingly little in common with Ferguson’s current largest businesses (e.g. Ferguson recently bought an industrial tool-working business) but the targets are understood to meet Ferguson’s qualitative and quantitative payback criteria. Management's success in diversifying the business via M&A in recent years means they earnt some trust and leeway to 'experiment' or test new markets via deals like this.  

Business history, transformation, and valuation

Historically, Ferguson was a much more-Europe focused business and the overall corporate entity was known as Wolseley.  Successive management teams continuously increased the company’s US-focus to the point where today more than 90% of revenue (and 95% of profits) are from the US.  This was achieved through a heavy programme of divestments and exits, and the proceeds were redeployed to roll-up US targets (and the remainder was gradually returned to shareholders via dividends and buybacks).  Ferguson exited France in 2012, exited the Nordics in 2015, and exited Central Europe in 2017.  And earlier this month, Ferguson agreed to sell its UK business (the legacy Wolseley unit; accounting for c.5% of total Ferguson revenue and de-minimis EBIT) for $421M, to the PE group CD&R.  That deal should close by the end of the month and Ferguson’s board is expected to deploy the proceeds for a special dividend or a buyback.  Following the completion of the sale of the UK business, Ferguson will be a 95%-US business (with a 5% revenue exposure to Canada).  The UK sale has been in the works for a while, and it is accompanied by an ongoing process for Ferguson to reorient its profile towards US capital markets, as well.  In the 1H of calendar 2021, Ferguson is expected to list on a US stock exchange (likely NYSE).  Ferguson already received shareholder approval for this.   In the future, when the US-proportion of investors reaches a sufficiently high percentage, the Ferguson board will likely eventually ask for shareholder approval to make the US listing its primary one.  This should help Ferguson’s valuation multiple (14.2x LTM EV/EBITDA) shift closer towards US distribution peers.  Ferguson themselves indicated that they “would love to fetch the multiples of POOL (34x EV/EBITDA) or SITE (26x EV/EBITDA)” but in my view perhaps that is too aggressive, and something more reasonable is in the range of 15x-17x, which is closer to the blended average (17x) of HD (17.7x), LOW (14x), FAST (23x), HD Supply (9x acquisition multiple by HD in December 2020) and Watsco (24.6x).  The prospect of this kind of re-rating provides a nice near-term ‘kicker’ to the returns of holding Ferguson stock, but the impact of that would dissipate over the longer-term and it would be the economics of the business (and industry) and actions of management that would determine the % equity IRR over the long term.

Management and corporate governance

I think Ferguson’s management and board are fairly impressive.  The CEO Kevin Murphy is well-regarded in the industry and came to the Ferguson USA operations when Ferguson acquired Murphy’s family business in 1999. He was COO of the US business for 10 years until 2017, when he was promoted to the role of CEO.  The chairman of Ferguson was recently changed to Geoff Drabble; Drabble was CEO of Ashtead (AHT LN).  Ashtead has a reputation as one of the best-run industrial businesses in the FTSE100, and during Drabble’s tenure as CEO (2007-2019), Ashtead shares compounded by 25.9% (vs 5.4% FTSE100, and 11.9% S&P500 in GBP terms).  Even before Drabble’s addition to the Ferguson board, the Ferguson’s track record of stewardship of shareholder capital over the past few years is probably reasonably described as excellent.  Shifting the focus of the business and the holdco towards the US markets is smart, and over the past 5 years Ferguson returned $2.8B in dividends and $1.7B in buybacks, which is more than 70% of Ferguson’s cumulative operating cash flow during that period.  The board signalled they intend to continue the pattern of returning excess capital to shareholders.  The combination of a still big runway for FCF reinvestment (into accretive acquisitions and a business model with a 15% EBIT / tangible asset ratio) with a board that is willing to consistently return the remainder to shareholders is a sweet spot and works out well over long periods of time.  

Covid and cyclicality risks

Ferguson’s results since March 2020 have been remarkably stable.   In the 6 months to 31 July 2020 sales were down but EBIT was down just 1% vs the prior year; this is during a period where many of Ferguson’s physical branches were closed or had reduced service hours along with only curbside pickup.  As a distributor (with positive NWC), the sales contraction resulted in a release of cash, with operating cash flow up meaningfully year-on-year.  The fiscal Q1 results to October 2020 were good, with organic sales up 3.3% yoy and EBIT up by more.  However, because Ferguson caters mainly to professionals, it did not receive the massive stay-at-home, hobbyist / DIY home improvement demand boost that Home Depot and Lowe’s have enjoyed.  E.g. Home Depot’s yoy revenue growth in the past 2 reported quarters has been north of 20%.   Ferguson’s results look a lot more pedestrian vs Home Depot and Lowe’s because of a massive drop in Ferguson’s non-residential businesses (excluding HVAC, which is doing well) during covid, which was somewhat counter-balanced by better results in residential core plumbing & heating businesses. Ferguson’s results didn’t get the full DIY boost also because changing a showerhead, a toilet pipe or a kitchen-faucet is a higher difficulty level for most people compared to re-painting a room, for instance.  As a silver lining, one benefit of Ferguson not having received a massive covid / DIY WFH boost is that it will not have to 'give back' that benefit once covid is in the rear-view mirror and the US economy fully reopens (i.e. companies like HD and LOW might have some quarters with "tough comps").

Overall, 60% of Ferguson’s revenue is RMI (repair, maintenance & improvement)-linked and is expected to do reasonably well even in weaker economic conditions; management estimates only c32% revenue exposure to new construction, of which only half (c16%) is new non-residential construction.  The RMI piece of Ferguson’s revenue (c.60%) probably has some recurrence (“things break”) and good longevity to it, and this is helped by the fact that over 70% of America’s housing stock is over 30 years old. 

Other risks

Home Depot and Amazon probably pose the greatest long-term threat to Ferguson. The Amazon risk was discussed earlier in this note. Home Depot has the puzzling history of first getting rid of the biggest part of its tradesman / professional exposure when they spun-off HD Supply (HDS) 10+ years ago, only to eventually decide to grow the professional segment again by buying Interline in 2015 and then buying back HD Supply in December of last year. These moves are evidence that HD has significant long-term designs on growing its Pro segment. One mitigant for Ferguson is that all of its segments are still fragmented and it might take a while until Ferguson starts running into HD as a significant competitor for contractors' business and in the meantime Ferguson can keep growing that segment through bolt-ons. Ferguson also has the ability to reinvest FCF into many other segments where HD does not play (such as HVAC). Nevertheless, it's impossible to deny that HD is a non-zero risk for Ferguson long-term. The other key risk is that I may be misjudging the macro and the health of the US housing market (as well as the disposable incomes of US households to spend on home improvement) during the investment horizon.

Conclusion

Ferguson is a well-run, cash flow-generative distributor with a strong balance sheet and an intelligent board.  Ferguson currently trades at a 4.5% earnings yield and has a long runway to grow EBIT by MSD-HSD% for many more years through continued shrewd use of bolt-ons in still highly fragmented markets, organic growth, and some increase in private label penetration.  Ferguson can grow to become a lot bigger, in my view. Ferguson's MSD-HSD% EBIT growth will likely translate to HSD% EPS growth due to some use of buybacks.  There is also the prospect of a meaningful near-term boost to returns via a repricing of the shares closer to US peers and a gradual changing of the shareholder register.  Overall, long-term I expect a low-to-mid-teens % IRR from holding the shares.

Catalyst

Quarterly results and passage of time

US listing (1H calendar 2021)