Reece (ASX:REH) shares are trading near all time highs as we approach their full year results. Time to buy, or time to sell?
Reece is a supplier and marketer of plumbing products to customers in the trade, retail and commercial markets. It is an importer, wholesaler, distributor and retailer of domestic and international brands of plumbing products. REH provides a broad range of bathroom fixtures, pipes & fittings, tools & hardware to plumbers, building contractors, civil engineers and design consultants. The Company’s network has expanded to over 600 branches across Australia and NZ, with an average of 11 greenfield sites per year since 2013.
Acquisition of MORSCO is a Key Growth Driver
Traditionally operating in the Australian and NZ market, the Company recently expanded into the US. This was via the 100% acquisition of MORSCO, a leading US distributor of plumbing, waterworks and HVAC (Heating, Ventilation, Air-conditioning and Cooling) products. The acquisition, completed in early July 2018, was the Company’s first in a market outside of its core operations (i.e. Australia and NZ). MORSCO distributes over 125,000 products from 5,000 vendors through its 171-branch network in 16 US states. REH has existing products and services in the HVAC segment. The main factors underpinning the growth profile for MORSCO include:
- MORSCO provides REG with exposure to the fast-growing US Sun Belt region. These are states located in the southern tier of the US and a region that is growing faster than the US as a whole. Around 43% of MORSCO’s group sales in calendar year 2017 were generated from Texas, with five of the 16 states in which MORSCO operate (Texas, North Carolina, California, Arizona and Georgia) accounting for over 75% of sales.
- MORSCO has a top three market position in 85% of its locations. More significantly, Texas’ growth rates for both nominal GDP and populations look even more favourable than the Sunbelt region generally. In particular, Texas’ nominal GDP growth rate at 5.3% outpaces both the Sunbelt at 4.7% and the US as a whole at 4.1%. These factors underpin the potential for both organic growth and future acquisitions.
- Further, the acquisition will increase the Company’s exposure to the expansionary US residential housing cycle at a time when housing starts in Australia are moderating after peaking in 2016. In particular, Sales growth for the Company’s core Australian & NZ businesses are forecast to decline to low-to-mid single digit in FY19 and FY20. This is compared to 10% growth expected in FY18 and reported sales growth of 9.2% and 6.7% in FY16 and FY17, respectively.
MORSCO Acquisition Comes with an Increased Risk Profile
MORSCO is the largest acquisition undertaken by REH and the first acquisition in a market outside of its core operations (i.e. Australia and NZ). While the key benefits from the acquisition are the significant uplift in sales and exposure to high-growth regions within a large US plumbing market, there are limited operational synergies from the MORSCO acquisition and MORSCO is a lower-margin business.
A More Stretched Balance Sheet
The majority of the purchase price for MORSCO was funded by a credit facility. As a result, gearing has increased significantly. It is now at a level where the balance sheet is unlikely to support potential further acquisitions for some time. As such, this raises the prospect of a further equity raising. This will be to fund future sizeable acquisitions and/or to reduce debt levels. In terms of potential acquisitions, the Company is likely to pursue future acquisitions in the US. The US is considered a large, fragmented market with “numerous potential consolidation opportunities across plumbing, HVAC and waterworks” segments.
Foreign Exchange Risk
With ~25% of the combined entity’s EBITDA now denominated in US$ as a result of the MORSCO acquisition, there is now a currency exposure that the Company previously did not have. The Company reports in A$ and the portion of revenue from the US currently appears to be unhedged (hence exposed to a stronger A$), as REH has yet to outline its foreign exchange strategy for the US.
Fundamental View of Reece
With the shares trading on a 1-year forward P/E multiple of ~25x, we take a cautious view in light of the increased risk profile at a time when the core Australian & NZ businesses are facing declining sales growth.
Technical View of Reece
Since peaking in May, the shares have gone on to make a few lower highs. Despite that, it also is making higher lows. The resulting triangular pattern is telling us that Reece will soon make a break, to the upside or downside. It is, however, too early to know which direction it will take. Having said that, whatever direction it does go in, the move is likely to be fairly large. With results coming up , that will be the ideal catalyst to jump on board. That is, if we get a break to the upside. Or it may be a sign to exit the investment (if we get a break to the downside)
At time of writing, the Company informs us that they are aiming to release their results to market on 30 August.
Michael Gable is managing director of Fairmont Equities.
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