Description

Summary

Ferguson sells plumbing, HVAC, and building supplies to contractors and homeowners. Ferguson is a classic hourglass distributor with over 34,000 suppliers and over a million customers. Stock is about 40% off the highs and is ~11x this years earnings and ~13.5x normal / earnings power.

I believe Ferguson is cheap due to fears about residential end markets and because the company in its current form is new to US based investors. After years of divestitures, Ferguson (fka Wolsely) is 95% US based. They transitioned from IFRS to US GAAP for periods after August 1, 2021. A US primary listing came in March 2022 after which Ferguson went from a premium to a standard listing in London and left the FTSE 100. Ferguson’s advisors tell them that index ownership for their shares is roughly 10% vs. US peers that could be double that. It will take some time to get into some indices like the S&P 500 which comes after certain criteria have been met. First is the filing of a 10-K, which will happen this fall at the end of the fiscal year. Second is an annual liquidity test, which requires liquidity to move to the US and which is measured on an annual basis.

Business Overview

Ferguson has scale advantages (and in businesses like HVAC, exclusive regions) in businesses with very little technology change. In coming decades, plumbing, HVAC, etc. will look largely the same. By the nature of the products sold and the way they are distributed, they’re protected from both foreign and e-commerce competition. Ferguson has 1,679 branches and customers visit branches several times a week, with the majority of business bought or delivered by branch. Pro customers turn to Ferguson because of convenience, product availability (or ability to order quickly) and service.

In the US they have 6.5 million square feet across 10 distribution centers and 35 million square feet across the branch network. This gives same day or next day capabilities for 95% of the US population. Branch distribution is done through 5,300 fleet vehicles.

Orders are fulfilled as follows:

51% delivered from branches

21% collected from branches

16% delivered from suppliers

12% delivered from DCs

Business Lines:

Residential Building and Remodel (fka Residential Showroom) – 14% of US revenue

Operates a network of 247 showrooms serving both consumers and trade customers. Showrooms display bathroom, kitchen, and lighting products.

Residential Trade – 20% of US revenue

Serves residential RMI and New Construction in plumbing, sanitary supplies, tools, repair parts, and bathroom fixtures. Plumbing contractors have access to 1,679 branches.

Residential Digital Commerce – 10% of US revenue

Sells through build.com / Build with Ferguson. Uses the same distribution network as the trade business.

HVAC – 11% of US revenue

Residential and commercial markets.

Commercial/Mechanical (fka Commercial) – 14% of US revenue

Plumbing and mechanical contractor products and services including bidding and tendering support

Facilities Supply – 4% of US revenue

Products and services for the maintenance of commercial facilities.

Fire and Fabrication – 3% of US revenue

Fabricates and supplies fire protection products and systems for commercial contractors.

Industrial – 6% of US revenue

PVF and Industrial MRO. Specializing in automation, instrumentation, engineered products and turn-key solutions.

Waterworks – 18% of US revenue

Distributes pipe, valves and fittings (PVF), hydrants, meters and related water management products alongside services including water line tapping and pipe fusion often to civil or municipal organizations.

Business Quality and Valuation

If you pull up summary financials on your Bloomberg, Ferguson looks like an unspectacular business where the top line hasn’t grown for a decade, but within that you’ve had a nicely growing US business and the divestiture of everything else. 

The US business (shown below in USD) revenue CAGR from FY05 to FY22E was 8%, and operating profit CAGR was 11%. The past 10 years have seen average revenue growth of 11% and operating profit growth of 17%. 

Management expects to grow revenue 7-12% through end market growth of 3-5%, over-market growth of 3-4% and acquisitions of 1-3%. They expect flow-through to trading profit of 11-13% and low/mid-teens EPS growth. Despite a very hot residential market after covid and a slowdown more recently, I think medium term demand is supported by a prior period of underbuilding and by an aging housing stock even as I know we're due for correction in the short term. Given the medium term tailwinds, fragmented end markets, and historical evidence of an ability to grow nicely, I find the management case to be credible and realistic.

A key part of my Ferguson analysis is normalizing the effects of covid on the business. Ferguson says their business is 40% tied to new construction and 60% tied to RMI (renovation, maintenance, improvement). Commercial new construction is 14% of the total, and commercial in total is 44%. Residential is 56% of the total with 36% Residential RMI and 20% Residential new. 

Some portion of RMI is truly non-discretionary, but the rest is influenced by factors like home values and existing single-family home sales (chart below):

Below you can see the growth in Ferguson end markets as well as Ferguson’s organic growth in those markets:

The Residential market saw strong growth in FY 2021 (ended 7/31) and decent growth over the last four years. Ferguson’s growth outstripped the market, and acquisitions boosted growth beyond that.

What I’ve attempted in the “normal” case above is to revert sales to historical trend but take into account recent price inflation. Starting with 2019, I advance sales by 3.8% per year (lower than the market growth due to the covid homebuilding boom but consistent with historical averages you can see in the graphic below and giving no credit to share gains) and I boost that figure by 20%, which is roughly the price inflation over the past 18 months. Note that 1QFY22 was at low teens price inflation and 3Q22 is over 20% for FERG products! Perhaps some of that inflation is covid/temporary, but I think prices in these products are at a new normal and probably flatten, rather than deflate, in the near future.Finally, and most importantly, I adjust margins down to 8.5%, which is a reversion almost to 2020 levels. The reversion in margin is an educated guess but I think it would be aggressive to extrapolate recent margins into perpetuity. 

My normal case is consistent with past industry growth and doesn’t give credit to recent share gains or inorganic growth:

I expect some level of reversion in recent growth rates, especially residential, but we’re not talking about a crash in the level of business either. In FY 2008, ’09 and ’10 organic growth was -2.3%, -23.8% and -11.5%. Operating margins were 7.2% in FY 2007 and fell to 7.1%, 5.3% and 4.6% in FY ’08, ’09, and ’10 respectively. I don’t expect nearly that magnitude of decline now.

Ferguson is well off its highs and is about 11.3x earnings for FY ’22 ending 7/31/22. If you adjust margins downward from recent levels above 10% to 8.5%, you would be paying 13.5x earnings (at last reported share count) for a company with an attractive long term growth profile at high returns on capital. This is a better price than the more cyclical HVAC OEMs and compares favorably to WSO, which has enjoyed similar growth at similar returns (although overall I would vote it a better business). It also compares favorably to companies like POOL and SITE, where I'd argue the covid bump has been larger and the multiples are way higher. Ferguson should also enjoy some tailwind from its recent listing in the US which will bring increased coverage and index inclusion. I see total returns as low teens from growth plus FCF (after growth expenditures and buybacks) and as high teens / low 20s including multiple expansion to something market or better but below companies like POOL or SITE. Thats a decent return for a distributor with stable and somewhat countercyclical cash flows, a lot of whitespace for growth, and a conservative balance sheet. 

Risks

The home centers have made varying degrees of effort to better serve pro customers, which is a threat to Ferguson, but in every product line there is plenty of share to take from others before these companies compete more directly. Plus, the easy way to serve more pro customers for LOW is to just buy FERG. 

The other risk is that I've misjudged how much Ferguson has benefited from covid times. I use the GFC has an extreme lower bound on the downside, especially since Ferguson is less tied to new construction, but maybe that's wrong. It is scary to look at charts of affordability, which suggest a decent correction is in order and that the rent is too damn high. To the extent remodeling is driven by price appreciation, that isn't helpful. 

Catalyst

Increased investor awareness, index inclusion, some stabilization of residential housing.