GWA: flush with opportunity?
It is known by many names: loo, dunny, latrine, throne, john, potty and can are just a few of them. My favourite, made infamous by former Merrill Lynch boss John Thain who spent $35,000 on his masterpiece, is commode. Yes, we have many names for the humble toilet. Few, however, would think of toilets as a great business.
Yet GWA, the owner of the Caroma brand, boasts wonderful returns from making and selling toilets over a long time. For most of that time, however, these results have been obscured by less illustrious businesses in the GWA portfolio.
Even two years ago, GWA sold garage doors, air conditioners and hot water systems – all at lousy margins and awful returns. It manufactured some of its products in Australia which meant cash inflows were partly directed towards maintaining factories and machinery, while working capital was tied up in inventory.
Key Points
Restructure improves the business
We expect higher free cash flow and returns
Transformation includes new risks
While the core Caroma business still generated excellent results, aggregated profits, polluted by other businesses, didn't reflect that quality.
That has now changed. GWA has made sweeping changes to its business, overturning almost 15 years of diversification. It has sold businesses, moved manufacturing offshore and dramatically cut costs and capital expenditures. For the first time, the quality of its core business will be displayed.
Is this an opportunity for investors to buy into a decent business that's still disguised as a poor one?
Well, no. At least not yet. In preview, GWA is a better business now than it ever has been, but it isn't quite cheap enough.
Selling its air conditioning, hot water and garage door businesses – all of them at a loss – leaves GWA with two remaining businesses, a kitchens/bathroom business and a doors business. Let's look at each in turn.
Kitchens and bathrooms
This segment designs and sells toilets, taps, baths and basins under brands that include Caroma, Dorf, Fowler and Stylus. It also distributes international brands including Hansa and Virtu.
GWA is a significant supplier of toilets in Australia and toilets alone account for about two-thirds of revenue. Taps – including kitchen, bathroom, shower and laundry taps – account for 20–30% and sinks and tubs for less than 10%.
Renovators, a bafflingly common breed in Australia, account for 50% of sales while new construction accounts for about 35% and commercial sites the remainder. With the strongest construction market on record and a booming residential property market, you might expect sales to be booming. They aren't.
As Table 1 illustrates, segment revenues have been flat. The property boom has yet to be seen in the results, mainly because it is led by high rise construction and the installation of GWA's bathroom and kitchen fittings occurs late in the cycle.
2010 | 2011 | 2012 | 2013 | 2014 | 2015 | |
---|---|---|---|---|---|---|
Revenue ($m) | 337 | 332 | 404 | 367 | 306 | 330 |
EBIT ($m) | 74 | 79 | 67 | 64 | 73 | 83 |
EBIT margin (%) | 22 | 24 | 17 | 17 | 24 | 25 |
Assets ($m) | 473 | 457 | 499 | 478 | 435 | 408 |
ROA (%) | 16 | 17 | 13 | 13 | 17 | 20 |
Capex ($m) | 9 | 5 | 17 | 7 | 1 | 1 |
Building materials businesses are now starting to report significant benefits from the boom. Over time, we expect revenues from this business to do the same. The renovation market, usually correlated to house prices, has been flat for years and may be permanently impaired because of the prominence of high-rise dwellings which attract fewer renovation dollars.
There are several figures in Table 1 that capture attention: the extraordinarily high and stable EBIT margin, for one. Last year, the segment reported EBIT margins of 25% – for this kind of business that's remarkable.
The bottom two lines of the table are also revealing. GWA has closed and sold its manufacturing plants and is now a pure brand business. It designs and distributes its own products, but lets someone else make them in cheaper locations overseas. Unfortunately, the company chose the exact wrong moment to do this – with the cost of overseas manufacturing rising as the Aussie dollar has fallen. Even so, the move should have long-term benefits, with capital expenditures falling dramatically and returns on capital rising.
The bathroom business has consistently generated above average margins and return on assets, suggesting it retains pricing power. Indeed, it has largely passed on the cost of the lower currency without being punished by consumers.
Poor doors
As Table 2 illustrates, the doors business isn't as good. Margins are low and variable and depend heavily on competitors. Clearly, GWA has little pricing power here, and this is reflected in the low return on assets. At just 11%, returns are about half those generated from the bathroom business although, with doors accounting for less than 10% of EBIT, this is only of marginal importance.
2010 | 2011 | 2012 | 2013 | 2014 | 2015 | |
---|---|---|---|---|---|---|
Revenue ($m) | 83 | 114 | 139 | 141 | 93 | 97 |
EBIT ($m) | 14 | 17 | 14 | 11 | 8 | 7 |
EBIT margin (%) | 17 | 15 | 10 | 8 | 9 | 7 |
Assets ($m) | 52 | 109 | 106 | 121 | 67 | 63 |
ROA (%) | 27 | 16 | 13 | 9 | 12 | 11 |
Capex ($m) | 1 | 1 | 4 | 5 | 0.4 | 0.5 |
We're surprised GWA hasn't sold this division and would support the eventual disposal of the business unit to allow GWA to focus on the more lucrative bathroom business.
Messy accounts
A raft of changes has created an accounting mess; one-offs, impairments and writedowns have been a feature of GWA's financial results for the past few years. The improvement to its business hasn't been reflected in its accounts so far but that should change from next year as restructuring charges end.
We've estimated earnings over the next two years for the new business in Table 3 (which also includes historical numbers for the old business for comparison).
By 2017, we estimate that GWA could be earning about $50m a year in net profit, or about 18 cents per share, generating return on equity of about 15% and free cash flow of about $60m. This compares favourably with its performance in recent years. The company could generate enough free cash flow to provide a yield of about 4% (which should be fully franked) while also, for the first time, ploughing cash back into product development.
Year to 30 June | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016E | 2017E |
---|---|---|---|---|---|---|---|---|
Revenue ($m) | 657 | 642 | 602 | 565 | 399 | 426 | 448 | 470 |
EBITDA ($m) | 112 | 121 | 88 | 82 | 81 | 84 | 90 | 94 |
EBIT ($m) | 97 | 102 | 74 | 68 | 67 | 75 | 72 | 75 |
NPAT ($m) | 49 | 63 | 40 | 32 | 19 | -16 | 47 | 49 |
EPS (c) | 18 | 23 | 14 | 12 | 6 | -5 | 17 | 18 |
U'lying EPS (c) | 19 | 21 | 15 | 13 | 12 | 15 | 17 | 18 |
DPS (c) | 20 | 20 | 20 | 13 | 6 | 0 | 10 | 11 |
Op cash flow ($m) | 67 | 89 | 60 | 63 | 34 | 44 | 63 | 66 |
Capex ($m) | -11 | -25 | -26 | -15 | -6 | -5 | -5 | -5 |
FCF ($m) | 57 | 64 | 34 | 48 | 28 | 39 | 58 | 61 |
ROE (%) | 13 | 14 | 11 | 8 | 7 | 3 | 14 | 15 |
Caroma has a long history of product innovation – it invented the dual flush toilet and was the first manufacturer to earn a five star water rating – yet that has stalled in recent years. More product investment could lift revenues further.
Why no buy?
There is a lot to like about the new GWA which should, for the first time, start to show the strength of its core brands. Using our estimates for next year's earnings, the business trades at a free cash flow yield of 8% and a PER of 15 times, which appears fairly priced.
Another way to assess value is a sum of the parts calculation. Doing so suggests an enterprise value for GWA of about $870m. Adjusting for debt and corporate costs leaves an equity value of about $750m or about $2.70 a share. This confirms our early hunch: at current prices, GWA is fairly priced rather than outright cheap.
To justify a buy at the current price, we'd have to be very confident of higher than average revenue growth. With the construction boom under way, that's possible – even likely. Yet morphing from a manufacturer to a pure brand owner heightens risk as new suppliers must maintain standards at lower cost. We're also concerned about heightened competition, especially as the currency falls.
We expect higher revenue growth but we're not prepared to pay for it and demand a larger discount to our assessed value. At around $2.20 we'd likely take another look at GWA but, for now, we'll sit and wait.