Reece Australia: AGM 2013
Recommendation
At last week's AGM, Reece Australia, the supplier of plumbing and bathroom products, reported a solid first quarter, with sales up 8% on the prior corresponding period. Executive chairman Alan Wilson said that, as a result, first-half profit before tax was likely to rise 5–7%.
There is much to admire about Reece Australia: net cash, returns on capital over 25%, smart owner managers (with about 44% of the company), and a long track record of organic growth, at least until recently.
There are a couple of problems, though. The first is that growth has tailed off in recent years. In the 10 years to 2008, earnings before interest and tax rose at a compound average of 19% a year, but in the past five years it has fallen slightly. Part of this is no doubt due to the 'soft housing market' and 'cautious consumer', which chief executive Peter Wilson referred to in his AGM address, but this should sort itself out over time and doesn't worry us unduly. More worrying is that as the company gets bigger, growth will quite simply get harder to come by and, with Woolworths' Masters joint venture joining the fray, the market is also getting more competitive.
The second problem is that the growth has always come at the cost of relatively high levels of capital expenditure and therefore somewhat restrained free cash flow: in the 15 years to 2008, free cash flow averaged just over half of net profit. That doesn't matter so much when you're making good returns: in the 10 years to 2008, Reece increased its capital base from $119m to $484m and its EBIT from $30m to $165m – an incremental return on the new capital of almost 40%. But with EBIT falling since 2008, while capital employed has risen to $619m, the return on incremental capital has been negative. The overall return on capital employed is still a healthy 25% but, as you can see from Chart 1, it's travelling in the wrong direction.
What hasn't been going in the wrong direction, from the point of view of shareholders, is the company's share price, which is up 49% in the 12 months since Reece Australia: Result 2012 on 5 Sep (Hold – $19.15).
That puts the stock on a PER of 24 times the $1.20 in earnings per share the company made in 2013, a dividend yield of about 2.2% based on the 62 cents of dividends paid in respect of the 2013 financial year, a skinny free cash flow yield of about 2%.
That pricing already reflects a significant improvement in economic conditions, and no doubt takes account of the company's former glories – which may be harder to come by in future.
We're increasing our price guides to Sell above $27 (from Take Part Profits above $25) and Buy below $18 (from Long Term Buy below $17), but that still means a downgrade to SELL.