DuluxGroup: Result 2018

High growth markets are overrated - just ask the management of DuluxGroup. On the 2018 results conference call last month, managing director Patrick Houlihan highlighted that volumes in the Australian decorative paints market had grown about 1.5% a year over the past two decades.

Yet over the same period, Dulux ANZ - the company's paints and coatings division - has grown revenue by around 5% a year. A little bit of market share growth, along with some judicious price increases, mean the business has produced respectable revenue growth over a long period.

The result for the year to 30 September 2018 was straight out of the playbook. Dulux ANZ produced growth of 5% in both revenue and operating profit. An 11% increase in raw material costs - for inputs such as latex and titanium dioxide - was offset by cost savings and price changes. As a result Dulux ANZ's operating margin remained steady at 17.6%, demonstrating what a wonderful business this is.

The other divisions are led by Selleys and Parchem, which comprise various products used in the construction industry. You can see the various divisional results in Table 1. Even the fairly ordinary divisions - such as the B&D garage door and Lincoln Sentry cabinet and architectural hardware businesses - produce respectable enough returns. They're still not a patch on the flagship Dulux ANZ division though.

Will the cycle return?

There's no doubt this is a well-managed business. But while Australia's 27 years without a recession suggests the cycle has been banished, all of DuluxGroup's divisions are - to greater or lesser degrees - dependent on favourable construction markets. With evidence mounting that the construction industry is weakening, how might this affect the company?

Well, Dulux ANZ has only a 15% exposure to new housing, with 65% of revenue coming from the much more stable maintenance and home improvement market segment. So a weakening housing or construction market won't have much effect, right?

We suspect that's a little optimistic. Renovation activity is likely to contract in markets where house prices are falling (currently only Sydney and Melbourne). Paint might be somewhat insulated, particularly if homeowners decide to do the job themselves rather than employ tradesmen (labour is the vast majority of the cost of painting).

But a weaker housing market is likely to threaten Dulux ANZ's historical 5% annual revenue growth. Margins could also suffer as weaker players tend to discount during downturns.

DuluxGroup's other divisions are even more exposed. B&D Group and Lincoln Sentry derive 40% and 30% of their revenues from the new housing market respectively. But they're also heavily exposed to renovation activity, which tends to be put on hold when homeowners are feeling the pinch.

Peak margins?

B&D and Lincoln Sentry also operate in much more competitive markets, as you can tell from their operating margins of 10.4% and 7.8% respectively. These could be peak margins for this cycle, and divisional earnings could get crunched in a downturn. As they account for only 14% of DuluxGroup's total earnings, however, they're not overly material.

Since the interim result, DuluxGroup's share price has fallen 13%. Most of that has occurred since the final result as the market has begun to digest a weaker outlook for construction-related companies.

Even so, management remains sanguine about the short-term outlook. Houlihan forecast that the company will this year deliver a higher net profit than the $151m reported for the year to September.

Houlihan's optimism is not overly surprising. DuluxGroup's businesses are exposed to late-cycle construction activity, and the pipeline of work remains strong in the short term. It's the 2020 financial year and beyond that's more worrying.

Our Buy price of $6.00 has been based on our expectation DuluxGroup will hit a cyclical speed bump at some stage. Earnings per share are likely to approach 40 cents in 2019, but we can imagine a 25-30% decline at some stage if the cycle turns. Such a decline does not imply this is a weak business; it's just not quite as resilient as the market thinks.

Takeover target

We'll welcome further share price weakness. Unfortunately so might others; DuluxGroup looks like a classic private equity target, while the global paint companies have been rushing to merge over the past five years. DuluxGroup might not be listed on the ASX forever.

We hope the threat of takeover doesn't encourage management to 'di-worsify'. While the 2012 takeover of Alesco, which brought the B&D and Lincoln Sentry businesses into the fold, hasn't been a disaster, further diversification away from the paints and coatings business would be a mistake.

Management has flagged it might expand further into Europe and North America. DuluxGroup already has a small presence in the UK and Asia - representing 5% of sales - but large acquisitions of mainstream paint brands are thankfully not on the agenda.

The stock now trades on a 2019 prospective PER of 17, which is lower than historically. That implies the market is finally beginning to price in the risk of lower earnings now the peak of the construction cycle has passed. We're still hopeful of a buying opportunity in DuluxGroup but we're not there yet. HOLD.