Wolseley is the world's largest specialist trade distributor of plumbing and heating products to professional contractors and a leading supplier of building materials to the professional market. The stock has traded off on macro newsflow because it's a UK listed capital goods company serving housing and construction end markets. But there is underappreciated change going on at the company which should result in significant earnings upside relative to consensus without any recovery in end markets, making it at least a double over the next 24 months.

This is a good collection of assets that has suffered from self-inflicted pains driven by a misguided growth and capital allocation strategy. Under previous management, Wolseley was overly focused on growth, with a sales growth target of 10% p.a. that was to be achieved at essentially any cost. This resulted in massive spending on acquisitions - £3.2bn in the five years ended July 2007, representing 200% of FCF and compared to a current EV of £4.9bn. These acquisitions were in many instances unrelated, lacked clear synergies, and were never properly integrated, leading to extra layers of fat and overall increased complexity in the group.

Then enter the housing downturn. Wolseley saw cumulative organic revenue declines of 25% from July 2007 to July 2010, and EBIT margins went from 6.0% in July 2007 to 3.1% at the July 2009 trough before rebounding to 3.4% in July 2010. A levered balance sheet from acquisitions coupled with a macro downturn that crushed earnings culminated in a £1bn rights issue at the depths in March 2009. With no discernible pickup in the housing market and recent negative macro data, it's no surprise that Wolseley's market cap is still down over 50% from the peak in 2007.

Here is where the story gets interesting. A new CEO entered in July 2009 and a new CFO in April 2010. This new management team has been divesting non-core businesses, focusing on organic growth through market share gains, and working on the cost structure.

The call is that Wolseley can grow sales 5-6% organically through market share gains alone (ie, giving no credit for an end market recovery) and beat consensus margin expectations. Consensus expects about 5.5% margins in FYE7/14 for a business that consistently did 6.0%+ pre-downturn despite its focus on growth rather than profitability and recent margin enhancing portfolio changes. I expect Wolseley's margins to be higher than what they achieved previously, coming in at 8.0% in FYE7/14. If this pans out, Wolseley will earn north of £3.00 in FYE7/14 compared to consensus of £2.20 (using broker models due to low number of estimates and one erroneous entry on Bloomberg). With the stock at £15.50, this represents a P/E of 5.1x. Since you have no reason to believe my estimates yet but I want to convince you it is cheap anyway, I will highlight that Wolseley is trading at EV/Sales ttm of 0.39x compared to a 20-year average of 0.55x. These are depressed sales and the 20-year average multiple includes sales from lower margin businesses which have since been divested.

The stock is currently trading at a P/E of about 10.8x CY11 consensus of £1.44. If they meet my FYE7/14 estimates, I don't see why Wolseley cannot trade for at least 11x forward earnings, compared to a 20-year average of 11-12x, making the stock worth £33 for more than a double over the next 24 months.

There are two areas of upside over and above that. First, the stock could get a higher multiple than 11x as Wolseley continues to demonstrate an ability to grow organically through share gains in a fragmented market. US distributors or freight forwarders get healthy multiples. Additionally, any market recovery will be incremental to my earnings estimates. I estimate a full recovery to peak would add another £.85 to EPS. To be clear, I would not assume that there is a full recovery to peak, but I don't think you are paying for any recovery and I offer that number simply to quantify the magnitude of upside. I hate to freeload off of another VIC member, but cnm3d has written up an excellent US housing overview/long pitch ("US Residential Construction Equities"). I would refer you to that if you want to get pumped up about the recovery opportunity. 

Brief Company Overview

Wolseley is a specialist trade distributor and supplier of building materials. I estimate that pro forma for disposals, about 80% of sales are lightside (mostly plumbing and heating) and the remainder heavyside (ie, bricks, concrete blocks). Pro forma FYE7/11, 48% of EBIT came from the US, 7% from Canada, 16% UK, 17% Nordics, and the rest from other Europe. Sales are 36% residential RMI, 21% non-residential RMI, 20% residential new construction, 16% non-residential new construction, and 7% civil infrastructure.

This is a pretty decent business as illustrated by reasonable returns on capital, with Wolseley doing 25-30% EBIT ROIC ex goodwill pre-downturn, and stable but growing market share.

It's a local business. A plumber will only drive 10-20 miles to a branch. Strong relative local market share allows a distributor to turn its inventory faster. Wolseley's US plumbing and heating business, known as Ferguson, has over 1,200 branches and 9 distribution centers, the only plumbing competitor with any significant DC network. A study by one of their suppliers, Kohler, found that while Wolseley turns its Kohler inventory 9x per year the average distributor only turns inventory 4x and that <1% of the inventory Wolseley carries is obsolete whereas 37% of the average distributor's inventory is obsolete.

Pricing is not highly transparent. There are many specialized SKUs, the plumber is often purchasing over the counter so he does not see price tags, and there is differential pricing. Customer service, in the form of JIT, reliability of products, and fill rates, matters and is a source of differentiation.

New Management

Ian Meakins is the new CEO who entered in July 2009. He was at Diageo from 1991-2004 in various positions including President of European Major Markets and Global Supply from September 2000. As part of this role, he was a member of the Executive Committee during Diageo's business realignment to focus on premium drinks which involved the sale of Pillsubry to General Mills in 2001, the sale of Burger King to private equity in 2002, and the acquisition of parts of Seagram in 2001. He was then recruited out of Diageo to become the CEO of Alliance Unichem by the largest shareholder and then CEO, Stefano Pessina. As an aside, this came as a shock to analysts because the deputy CEO and heir apparent Geoff Cooper was surprisingly passed over. Geoff Cooper then left to become the CEO of Travis Perkins, which is the main competitor to Wolseley in the UK. Small world. Alliance merged with Boots shortly after Ian arrived so there is not much background there. He left to be CEO of Travelex, the foreign exchange and cross-border business payments company, which was owned by private equity.

The new CFO, John Martin, was CFO of Travelex while Ian was CEO. John has a clear background in turnarounds and capital allocation leading to value creation. He was part of a management buy-in group in 1996 (backed by Electra and 3i) and turned around an underperforming business in four years which led to a 5x ROI for the investors. He became CFO of Hays during their realignment where he focused the company on what he thought was the best business, divested the rest through asset sales or demergers, and returned cash to shareholders through dividends and buybacks.

When Ian joined Wolseley, the very first step was getting the right data. In the past, Wolseley executives would get monthly P&L data from the regions - there was no business unit or branch level data, limited balance sheet/cash flow data, and no non-financial KPIs. Now they have access to data down to the branch level and they can measure KPIs such as customer service metrics, share of wallet, and sales force productivity. As you can imagine, in a scrappy distribution business this type of data is immensely helpful. He also made some changes to the organizational structure. Namely, bringing John Martin in as CFO and dismantling the Europe business so that each region, UK, France, Nordics, Central & Eastern Europe, would report directly to him.

The next step was a capital allocation review of the business. Ian segmented the business into 41 different BUs on the basis that they were each in a different region providing a different product/service to a different customer. The focus on segmenting BUs was to better focus on resource allocation to drive organic growth as he felt that the company grew with no direction in the past. Capital was just allocated based on sales. He classified the BUs into three different categories, Growth Engines, Synergy Drivers, and Performance Builders, based on attractiveness of the market, strategic position, track record of performance, and synergies with the group. Growth Engines and Synergy Drivers comprised about 95% of EBIT but only 70% of capital with the Performance Builders taking 30% of capital to deliver 5% of EBIT. He put together action plans for the Performance Builders and gave them an ultimatum of up or out. With the July 2011 disposals of Electric Center in the UK, Build Center in the UK, and Brosette in France, management has taken care of all the Performance Builders. In total, they divested businesses with £1.5bn of sales, no EBIT, and £452m in book value for proceeds of £436m. The rest of the Performance Builders have delivered on their action plans and thus integrated into other businesses within the group.

Once that process was underway, management turned their attention toward operational performance. There are many initiatives in place which should add up to a very interesting market share and margin opportunity, but, to the Street's dismay, management has not laid out quantified targets. In my opinion, this is a big reason the mispricing exists. I'll talk about some of these initiatives and frame the opportunity in the next couple sections.

Topline Opportunity

Wolseley is the dominant player in largely fragmented markets. For example in the US (nearly 50% of EBIT), they are the #1 player in plumbing and heating with 12% market share, more than 2x the next biggest competitor. My estimates suggest Wolseley's sales weighted average market share by category-region is less than 7% with the UK plumbing and heating business being the only category-region with higher share than the US business. With all but one business at or below 12% market share, there is plenty of scope to significantly increase market shares over time. We know that these businesses can grow share over time based on the UK business where Wolseley has 33% share. Or we can also look at regions within the US - in the Washington DC area they have 30% share but in Chicago they have 5% share (they are currently gaining share in both regions).

Organic growth through market share gains is a key priority of this management team. They have a variety of initiatives aimed at gaining market share. A good example is the 2,000 SKU initiative which was launched in November 2009 in the US. It aimed to provide 100% fill rates within 24 hours on the top 2,000 SKUs. This program only required a $10m investment in inventory on a base of $1bn. It was so successful that they rolled it out to the top 3,000 SKUs in August 2010. These initiatives are clearly working. In the nine months ended April 2011, Wolseley's US business grew +9% organically which was 4-5% ahead of the market.

At the group level, I think they can grow 5-6% organically driven by 0% market volume growth, 3% price/mix/inflation (inline with what they have been experiencing recently), and 2-3% outperformance relative to market volumes. Wolseley grew +5.6% in the nine months ended April 2011. Any recovery in end markets will be incremental to my topline estimates.   

Margin Opportunity

While management has not laid out any formal margin targets, I have triangulated the margin opportunity based on the following: a) history combined with management commentary, b) top-down benchmarking, and c) bottom-up analysis. Combining the three, it is clear to me that Wolseley should do well north of 6.0% margins, and I think 8.0% is a reasonable estimate.

a) History and management commentary

Excluding Stock Building Supply, a US building materials business Wolseley divested in 2009, EBIT margins were consistently 6.0-6.4% from July 2002 to July 2007. If you want more history, from 1983-2007 margins have been between 5% and 8%, so the 6.0%+ was not simply due to the housing bubble. Over the next couple years, I would expect the company to get back to the pre-downturn 6% margins and to even exceed them given the business was previously undermanaged and low margin businesses have been divested.  

My view is reciprocated, albeit not quantified, by management which has indicated they should get back to historical margins "quite soon." They also share my view that historical levels are not a cap.

b) Top-down benchmarking

Let me start by saying this is an imprecise science. There are good reasons these distribution businesses can have different margins which are hard to adjust for. For example, differences in mix create a legitimate reason for margin differences - heavyside margins tend to be higher than lightside to compensate for lower asset turns. That said, I will offer some margin comps and observations. You'll notice that I am looking at pre-downturn margins here.

Company                                             2005     2006     2007    Average

Travis Perkins (TPK LN)                        10.1%   10.2%    10.0%   10.1%

BSS (BTSM LN)                                      4.8%     5.1%      5.1%     5.0%

SIG PLC (SHI LN)                                  6.3%     6.5%      6.5%     6.4%

Grafton Group (GN5 ID)                        8.2%     8.4%      8.3%     8.3%

UK/Ireland Peer Average                  7.4%     7.5%    7.5%    7.5%

Watsco (WSO)                                      7.1%     7.6%     6.3%     7.0%

WW Grainger (GWW)                            9.4%     9.8%    10.4%    9.9%

Wesco (WCC)                                       4.7%     6.9%     6.6%     6.1%

US Peer Average                                7.1%     8.1%   7.8%    7.7%

The first thing to note is that EBIT margins for the few years pre-downturn averaged about 7.5% for both the UK/Ireland and the US peer groups. That crude analysis suggests margin upside for Wolseley.

Second, the low outlier in UK/Ireland was BSS, the smaller scale price aggressor in the UK, which did 5.0% EBIT margins. Travis Perkins acquired this business in 2010 and guided to £25m in synergies by 2013 which equates to more than 150bp of sales, bringing "new BSS" to 6.5%. TPK has a reputation for being conservative on synergy guidance, so there are analysts that actually expect BSS to get to 7.5-8.0% margins in 2013. And this is despite the fact that, according to Travis Perkins management, BSS has a worse business mix than Wolseley due to a higher proportion of lower margin big contract customers!

Third, compared to the UK/Ireland peer group, Wolseley's employee expense as a percentage of sales was about 150bp higher. I believe this is due to bloat in the cost structure resulting from acquisitions that were never properly integrated. In fact, we saw administrative expense grow from 2.8% of sales in July 2001 to 4.5% in July 2007 during the acquisition binge. Closing this 150bp gap suggests 7.5% margins. Separately, please note that I looked at UK/Ireland only because those companies disclose employee expense the same way Wolseley does, but unfortunately the US peers make different disclosure.

Fourth, Travis Perkins management has confirmed that Wolseley has been undermanaged in the past and there are margin opportunities. When Wolseley was doing 6% margins, Travis Perkins was doing 10%. Travis Perkins' CFO has suggested that half of that is inherent in the business (more freehold property, geographic exposure, more small builders with better pricing) but that the other 200bp is simply due to being better run. This suggests 8.0% margins are achievable.

c) Bottom-up opportunity analysis

Now that we have a theoretical framework to suggest Wolseley should have higher margins, let's talk about how they actually get there.

First, margins were consistently 6.0%+ pre-downturn. The downturn drove margins to 3.1% at the July 2009 trough. I believe 50bp was from by pricing/mix pressure, which shows up in gross margin since COGS is simply the cost of inventory, and 250bp from operating deleverage. I expect that over the next few years they will get this 300bp of margin back, taking them back to 6.0%+ before layering on incremental improvements.

The company has indicated there is still 10-15% of spare capacity. Assuming cumulative sales growth of 10-15%, which is what they should get over the next few years if they grow 5-6% p.a. through share gains and without recovery, and a 28% gross profit margin we get at least 250bp of margin expansion from operating leverage.

On the pricing/mix front, to be honest they are still indicating that the pricing environment is tough. That said, they have been able to implement self-help such as re-pricing contracts that were out of whack and incentivizing their sales force to push higher margin products. This has led to gross margin improvement of +16bp y/y in the nine months ended April 2011 despite talk of continued pricing pressure. So I think it is quite likely that they get the 50bp back over the next few years.

Above and beyond the 6.0% they did previously, there are a few big areas of incremental opportunity I see to take them to 8.0% this time around.

The first area is portfolio changes. Wolseley's 6.0% margins included lower margin Performance Builders. Unfortunately we do not have a historical breakout of these businesses, but we can make an estimate. FYE7/07 sales and EBIT excluding Stock Building Supply were £13.9bn and £833m for a margin of 6.0%. Based on the company's disclosure during the capital allocation review, about 20% of sales were Performance Builders which earned margins 1/3 those of the group. If we extrapolate that back to FYE7/07, then Growth Engines and Synergy Drivers were doing a 7.0% margin which gives us a 100bp uplift from portfolio changes.

The second is private label penetration. Wolseley derives less than 8% of sales from private label. I believe 15% penetration is reasonable given Wolseley is 14% penetrated in the UK, competitor Travis Perkins is 15% penetrated, and the old HD Supply goal was 15%. Private label carries gross margins that are 20-25 percentage points higher, although my conversations with the company have indicated a 10-12 percentage point uplift is more likely going forward. That makes this an 80bp opportunity.

The third is administrative expense. As I suggested above, employee expense is about 150bp higher than UK/Ireland peers, which I believe is largely due to administrative expense from an acquisition binge. As management divested non-core operations and is focusing on cross-portfolio synergies, I believe they can bridge the employee expense gap relative to peers which is essentially equivalent to recovering the administrative expense bloat from the acquisition binge. But to avoid double counting from portfolio changes, I'm assuming this is just a 50bp opportunity, bringing portfolio changes + employee/administrative expense to 150bp total.

To make sure my 8.0% margin assumptions are clear, I have summarized the opportunity below:

Source                                       Margin             Comments

July 2009 EBIT margin                3.1%

Pricing recapture                        50bp                Recover full 50bp through self-help initiatives + market recovery

Operating leverage                    250bp              10-15% spare capacity, 28% GM%, get the sales through share gains

Recovery to old margins             6.1%                2000s pre-downturn average

Portfolio changes                       100bp               GE/SD were doing 7.0% when group did 6.0% = 100bp

Private label penetration            80bp                 8% penetration goes to 15%, 10-12ppt higher margins

Employee/admin exp                  50bp                 Bridge the 150bp gap, don't double count portfolio changes

New margins                              8.4%                

We are already seeing good progress on the margin front. In the nine months ended April 2011, organic sales grew +5.6%, gross margin was +16bp y/y, and EBIT margin was +130bp y/y.

Financials and Valuation

The stock is at £15.50 and there are 285m shares outstanding for a market cap of £4.4bn. The 3Q11 sales release from April 2011 indicated net debt was £824m. Since then, Wolseley has entered into agreements to sell three businesses, Electric Center in the UK, Build Center in the UK, and Brosette in France, for a total of roughly £340m. The proceeds will be used to pay down debt, bringing pro forma net debt to £484m and EV to £4.9bn.

FYE7/11 sales, to be reported October 4, are expected to be £13.6bn. The three disposals contribute about £1.1bn bringing pro forma sales to £12.5bn. EV/Sales ttm is thus 0.39x. If you look at consensus on Bloomberg, Wolseley is expected to generate operating profit about £567m, but some analysts include one-time expenses in that number. Clean EBIT is expected to be about £600m which is £590m after the disposals, giving us EV/EBIT ttm of 8.3x. EPS is expected to be £1.33 and the disposals are a penny or two accretive for a P/E ttm of 11.5x.

Now for my estimates. Pro forma FYE7/11 sales of £12.5bn will grow 5-6% organically over the next three years. This brings us to FYE7/14 sales of £14.7bn. Pro forma margins of 4.7% increase by 110bp p.a. to 8.0% for EBIT of GBP1.2bn. Wolseley will be net cash at that point so with a little interest income and a 27% tax rate, we get net income of GBP870m and EPS of £3.05. If the stock trades at 11x forward earnings compared to a 20-year average of 11-12x, it will be worth £33 for more than a double in the next 24 months.

Given sales are down 25% cumulatively through FYE7/10 with no recovery in FYE7/11 (sales growth is being driven by share gains), a complete recovery to peak would be worth over £4bn in sales and at a 8.0% margin equates to £.85 in EPS. If they get a third of that then EPS would be £3.30. Given higher ROICs and if the company demonstrates an ability to grow organically for many years through market share gains in a fragmented industry, perhaps it could trade for 13x making the stock worth £43 in 24 months.

Earnings beating expectations and the Street revising estimates up. Next earnings release is October 4th. This should be a recurring catalyst.

Some brokers have speculated (read: hope) that management will lay out long-term targets before long (FYE7/11 results October 4th?). This could result in the margin upside getting priced in sooner rather than later. 

Positive housing data. Not necessary to thesis but the stock will trade on positive housing data, it makes the margin story easier, and we can be more confident in adding in some of the £.85 in recovery EPS.