Ferguson: Quarterly Dividend Payer Is Attractively Valued

Ferguson (FERG) is one of my favorite companies. I worked over a dozen years in the HVAC industry and saw how wholesalers are money-making machines if they are led the right way. Unfortunately, I don’t own many shares in Ferguson. Since the company moved its main listing to NYSE, I have been pondering how much they will be hurt from the housing slowdown.

The investment thesis on Ferguson is widely known. The company has an attractive market position, selling millions of different products from thousands of suppliers to over a million customers. Asking the customers to pay quicker than having to pay to its suppliers, is an excellent way to finance the business.

The cash generated can be used for business development. Ferguson rolls-up smaller competitors, integrates them, and adds up efficiency and revenues, making the acquisitions highly accretive. The stock has transferred its main listing from London to New York this year, which should increase demand for the stock. Additionally, the stock trades at lower multiples than most of its wholesale peers.

Company overview

Formerly Ferguson was part of a British company called Wolseley but in an unusual arrangement where Ferguson disposed of Wolseley’s business in the UK. Today Ferguson is a North America focused distributor of products used in HVAC, industry and waterworks among others. According to ACHR News, Ferguson is the second-largest HVAC distributor after Watsco (NYSE:WSO). Ferguson has a 5% market share of a $70 billion market. It operates from 11 distribution centers and serves customers in over 1700 outlets.

Ferguson has an impressive track record. The company has been able to grow revenue and profit at a fast pace. In the fragmented industry, the growth strategy relies on acquisitions. Ferguson has made 44 acquisitions in the past five years and by acquisitions Ferguson aims to generate 1-3% sales growth, targeting 7-12% growth in total. Still, the company carries only a little debt, 1x EBITDA. I believe warehouse automation, digitalisation and private label sales will boost profitability in the coming years.

Recession is not necessarily a huge worry

During the last major downturn in 2008 Ferguson was a very different company, so it is difficult to make a direct comparison only by looking at previous financials. Most likely, the next recession won’t be the same either. Let’s assume here that we won’t see as severe housing recession as we did in 2008.

In November the new single-family home construction fell to its lowest level in more than two years according to Bloomberg. Applications to build decreased 11% and permits of one-family homes fell 7% month over month. Homebuilder sentiment is at its lowest level in a decade. Fortunately, for Ferguson, there are still a record number of units under construction which will help with the business and explains Ferguson’s excellent performance for the past quarters.

How exposed Ferguson is to residential construction? Much less exposed than in 2008. Today, 56% of its revenues are generated in the residential sector and 40% of that business is new construction. I would believe that residential business is more profitable than large commercial projects.

It is very difficult to assess the impact of the housing slowdown on Ferguson’s earnings. In 2008-2009, EPS of Watsco decreased from $2.28 to $1.52, approximately one-third. Watsco is today more exposed to housing than Ferguson.

If we take a very simplistic approach and assume that Ferguson’s earnings are derived from different segments in proportion to their earnings, we come to a conclusion that 22% of earnings are generated from residential new construction. Of course, if the economy enters into a recession, most likely it’s not only residential construction that slows down.

Fortunately, there are a few forces and trends holding up the business. Ferguson is one of the beneficiaries from investments to energy efficiency and renewables. For example, heat pump sales are still growing and hitting new records while water heater sales are declining. The fact that U.S. housing stock is aging will help to support remodeling and replacement sales. It is difficult to live without plumbing and heating.

If we estimate that the EPS decline would be 20% for a year, earnings would rebound to the starting point and continue to grow slightly slower than historical average, the stock would still be a buy. The calculation assumes a 10% discount rate and a terminal multiple of 15. Together with dividend growth, these assumptions would make Ferguson a buy below $130 dollars.

Catalysts supporting the stock

The calculation above expects that Ferguson would trade at a higher multiple than it is today. A P/E multiple of 15 would be closer to the average of its peers but higher multiple would be also justified by its fundamentals. There seems to be a general understanding that Ferguson is trading on a lower multiple for technical reasons.

Part of the low valuation could be explained by the selling pressure created by the outflow of Europe-focused investors and funds. There’s been a long wait for this tide to turn. At the end of November, Baird named Ferguson “maker of plumbing and heating products” as a stock pick due to the potential to be included in the S&P 500 Index.

There’s definitely limited awareness and understanding of the company. Due to the disposal of the European operations and their inclusion in the historical data, the company doesn’t screen well. The company in the databases is a different one. The company is domiciled in the UK, which might repel some investors.

The potential demand for the stock is evident when comparing the ownership structure to Watsco. BlackRock and Vanguard are the two largest owners of Watsco holding nearly 20% of the shares. The largest owner of Ferguson is still hedge fund Trian with a 5.4% ownerhship and Vanguard is the second largest with 3.4% ownership. BlackRock has 0.7% ownership.

The valuation of Ferguson is undemanding, considering the quality of its business and the valuation of its peers. Established distributors such as Watsco, Fastenal (FAST), and W.W. Grainger (GWW) all trade at higher multiples. Core & Main (CNM) that got listed in July 2021 is also an interesting opportunity in the water infrastructure distribution. Full comparison is available here.

Superb capital allocation

The company clearly communicates its capital allocation strategy. First comes organic growth, focusing on technology and expansion of the footprint. Second, the company prefers dividends, then acquisitions and lastly share buybacks. In the last four years, the ROCE has varied between 28-40%.

The company has paid a dividend since 2000 except in 2008 and 2009, in the aftermath of the financial crisis. Formerly, Ferguson paid a semi-annual dividend. However, the company recently declared a quarterly dividend of $0.75 per share, translating to a dividend yield of 2.4% and a payout ratio of 32%. The recent dividend declaration represented a 9% dividend increase. Ferguson has $0.6 billion left in its share buyback program, representing 2.3% of the current market cap.

Conclusion

Ferguson has a simple business mode, a great historical track record, and good growth prospects. The investment thesis is simple. The stock is attractively priced when taking into account the business quality, peer valuations, and realized and targeted growth. Despite the looming recession risk, the current price can be a place to start accumulating a position and enjoy the well-covered and increasing dividend.