chinaface
The following segment was excerpted from this fund letter.
Ferguson plc (NYSE:FERG)
Ferguson is a leading, primarily US-based distributor ($23B mkt cap) of plumbing and HVAC supplies that is split roughly evenly between non-residential (44%) and residential (56%) as well as repair/remodel (60%) and new construction (40%).
Like other high-quality distributors, Ferguson benefits from a prime spot in its value chain – fragmented suppliers (over 30,000), many customers (~1 million), and small competitors (75% of revenue comes from #1 or 2 market positions where the primary competitors are mom and pops). By providing great service and parts availability, Ferguson can help guide its customers to the parts they want and supply them in a timely fashion.
The contractors who buy from Ferguson certainly care about price, but price is likely not as big of a concern for most of them as getting the correct part on time and on budget. While prices going up too high too fast may lead to demand destruction, Ferguson and contractors can often pass-through increases in prices due to the company’s great service, parts availability, and that in many cases the parts are needed.
Until a few months ago, Ferguson was primarily listed in the United Kingdom (and even used the name Wolseley up until a few years ago). When I began studying the business more closely over the last 18 months as Ferguson began moving its primary listing to the US, I noticed a business performing quite admirably. Even if I exclude the recent strong results of the past 2 years, Ferguson’s returns on incremental capital have been greater than 30%.
One driver of this performance has been “improving by subtraction”. The company’s returns have improved partially as the company has sold its lower quality businesses located throughout Europe and focused more on its crown jewel US business. Furthermore, the US business has performed extremely well with high single digit topline organic growth over the prior 10 years with most of the growth coming from volume and mix rather price inflation.
A much closer analysis of the financial statements reveals that revenues in the US business have grown nearly 150% over the preceding 10 years – these fantastic results can be obfuscated by a casual look at the reported financial statements that show only a 5% growth in total company revenues before adjusting for the divestitures.
I believe Ferguson can be an excellent investment from today’s prices, possibly doubling in the next 3-5 years. Ferguson trades at seemingly attractive headline multiples of ~11x P/E and ~9x EV/EBITDA. The S&P 500 currently trades at ~16x P/E, and in a normal economic environment, Ferguson’s valuation would be a compelling setup as I’d expect Ferguson’s business fundamentals to perform better than the broader market over time.
After a few years of strong fundamentals, investors are questioning Ferguson’s near-term fundamentals partially due to increases in interest rates and the impact that may have on construction. I do not know what will happen to business fundamentals though I recognize that this business has historically done a good job of holding onto price after prices have risen. The 60% of revenues that comes from repair/remodel should provide some protection against any potential cyclical headwinds in new housing starts and commercial construction.
If the economy holds up and FERG’s earnings are flat to growing over the next several years (Ferguson usually grows earnings at a mid-teens rate), then the stock could potentially double in the next 3-5 years. If there’s a more severe pullback in business fundamentals, then Ferguson’s earnings could decline further (perhaps 25%) and our potential returns as shareholders may take longer to realize – even in this case, Ferguson’s earnings multiple would still be trading at a discount to the broader stock market despite being an above average business.
Furthermore, the balance sheet is in good shape (<1x net debt/EBITDA), acquisitions would likely become cheaper in a tougher economic environment, and Ferguson should be able to keep taking market share from weaker, under-resourced competitors.
There are a few other dynamics that are not core to the thesis but may potentially play in our favor. The first is that Ferguson trades at a significant discount to other high quality industrial distributors (for example, FAST, POOL, and WSO trade at 17x P/E or higher) despite having economics that look more similar than different.
Lastly, there has likely been some forced selling from European passive investors now that the business is no longer primarily listed in London. Management estimates that as Ferguson gets added to US indices (possibly the S&P 500) over the next year or so, there could be demand for twice as many shares. Ferguson also has some classic spinoff dynamics whereby management is now 100% focused on the North American business, and employees might be more energized by this focus and the corporate name change.
Again, these insights are only a piece of the mosaic as to why I find Ferguson to be a compelling investment today.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Be the first to comment