Reliance Worldwide Corporation (ASX:RWC) shares have been recently supported by two themes: i) Expectations that US sales continue to show resilience into 1H21 and ii) A shift in investor preference towards cyclical stocks. A market update issued early last month revealed that the impact of COVID-19 on RWC’s operations is varied by region. Accordingly, we recently undertook a review of the fundamentals to assess whether there is value at current levels.
About Reliance Worldwide
The Company is a global designer, manufacturer and supplier of premium-branded water flow and control products. These are typically used by end-users such as plumbers/contractors. These end customers purchase RWC’s products (either as individual products or in combination with other products as plumbing solutions) through a number of distributors, including wholesalers and retailers, through their physical and online stores.
RWC holds the leading market position in a number of product categories. It was also the first to introduce a full range of Push-To-Connect (PTC) fittings to the US plumbing industry, through its premium SharkBite brand in 2004. PTC fittings allow lengths of pipe to be connected through a rapid push-on connection mechanism, without the need for soldering, clamps/rings, glue or tools.
The Company has three operating segments: Americas, Europe Middle East & Africa (EMEA) and Asia Pacific (APAC). The Americas and EMEA segments each contribute ~40% of group earnings.
How has COVID-19 impacted the business?
The EMEA segment has been the most affected, with demand at only 35-40% of levels prior to COVID-19. In the Americas segment, sales in the US are tracking ‘broadly in line with expectations’. Although Canada (a much smaller contributor to the Americas segment) has been affected by restrictions on activity in some provinces.
The key factor underpinning recent sales performance in the US is that plumbing in that country is an essential service. Unlike the UK, channel partners have not limited services. RWC notes DIY sales have increased as people stay at home (i.e. the decision to repair a pipe or fix a hot water system is unlikely to be deferred based on social distancing). This makes RWC’s US business relatively defensive, as RWC’s products in the US are principally for the repair market and minor remodel segment.
Operations in Australia, which comprise the majority of the Asia Pacific (APAC) segment, have not seen a significant deterioration to date. However, management expect new housing construction (which accounts for ~50% of demand) to decline over the next year. The reason why RWC’s Australian business does not have the same level of defensiveness as the US business is due to its heavy use in new construction. As such, volumes in Australia are forecast to fall 15-20% in FY21.
In response to COVID-19, the Company has implemented cost savings that include: i) Placing 40% of UK workforce on furlough (i.e. a leave of absence) and ii) Cuts to executive and Board remuneration. These actions are in addition to cost savings and improved efficiencies generated across the business from other measures. Further, the cost base is benefitting from lower copper and resin prices.
The Business Had Some Challenges Prior to COVID-19
Margin Decline in US Business
The most notable challenge for the Americas segment was that the EBITDA margin had been steadily declining since 1H18. The decline in EBITDA margin in 1H20 was due to RWC being unable to cover increased expenses (product development and selling & marketing) with a commensurate revenue improvement. In particular, revenue growth is reliant on channel partners boosting inventory ahead of each winter period to the same extent as the previous corresponding period (which did not occur in 1H20).
Another factor likely contributing to recent EBITDA margin weakness is that sales of higher-margin products, such as Holdrite and RWC’s EvoPEX PTC product, which are aimed at the new construction market, have not gained traction. Further, the Company still has a relatively lower exposure to the new construction market.
As evidenced in the 1H20 results, lower-than-planned group volumes have a significant impact on overall earnings. In addition to volume impacts related to COVID-19, RWC has recently faced volume pressure in other areas of the business. In particular, sales from newer products are not meeting management’s expectations. This has led to the Company re-evaluating its product developments. In our view, this indicates a lack of traction in new product commercialisation.
We consider that there are a number of headwinds for the share price:
1. While the trading update confirmed the relative resilience of US sales, it also confirmed the more cyclical nature of earnings in continental Europe and Australia.
2. Given the extent of volume declines expected in key segments, the internal cost savings initiatives (both independent of, and as a result of, COVID-19) – as well as commodity input prices remaining supportive – are not expected to mitigate group earnings pressure.
Notably, cost measures implemented in the EMEA segment, a significant impact on the segment EBITDA margin (for FY20 but most notably for FY21) is still expected, given that the extent of the volume decline cannot be offset by the cost savings measures put in place. Overall, the performance of EMEA remains a key concern, with any potential turnaround likely to depend on how long government-imposed restrictions remain in place.
3. We consider that there is a possibility that the Company undertakes an equity raising over the short term, in order to fund potential acquisitions and/or reduce the level of debt on the balance sheet.
During April – May, RWC had been trading sideways to consolidated the bounce off the March lows. It then broke free of that range (circled) and we now expect it to rally from here. The first obvious target will be a retest of $3.50.
Michael Gable is managing director of Fairmont Equities.
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