Reliance's juggling act

If there's one thing Reliance Worldwide's profit guidance has shown, it's that management likes big 'buts'. In February the company forecast earnings before interest, tax, depreciation and amortisation (EBITDA) of $280m-$290m for 2019 - but only if a 'modest freeze event' supported earnings in the southern United States during March.

By April - when we commenced coverage on the plumbing supplies manufacturer - it was apparent that American pipes had emerged from winter unscathed. It made us wonder: if this 'but' was required to meet guidance, were there others to worry about?

Yesterday we found out that Reliance had indeed been too optimistic with its 2019 forecasts. The company said it was downgrading expectations for EBITDA to $260m-$270m. As a result the share price has fallen almost 20%.

Besides the lack of freezing weather in the southern US, what else was behind the downgrade?

The first issue is that some US retail customers have been reducing their Reliance inventory. This shouldn't necessarily surprise; new hardware customer Lowe's would have taken on significant Reliance inventory during the 2018 ramp-up year, while Home Depot had earlier been de-stocking weaker product lines.

Timing related?

Reliance has explained away these inventory issues as timing effects, although it's always possible something more sinister is at work.

The second issue is Reliance's exposure to the Australasian market, where new residential construction accounts for around half of sales. This has always been quite different from the Americas, where around 85% of Sharkbite sales come from the repair and renovation market. In yesterday's announcement Reliance said that Australian sales have been weaker than expected due to its residential construction exposure.

Our concerns over inventory disturbances and weakness in Australian construction markets are partly why we said last month that the market had 'shrugged off the risks too readily'.

A couple of other problems in Spain and the United Kingdom also contributed to the downgrade. The detail is less important than the fundamental message: there's a lot going on at Reliance Worldwide. Management has its hands full and, in a geographically dispersed business, pockets of underperformance are to be expected.

Guest appearance

The news could have been worse if recent acquisition John Guest had hit turbulence, but management confirmed that sales and synergies from the business have been in line with expectations. We'd caution, however, that it's too early to celebrate John Guest as a successful acquisition - a pipe can leak for some time before bursting.

Management is now turning its attention to the 2020 financial year, as it should. Unfortunately the news there is for more uncertainty. Brexit remains a threat, although we judge the trade war between the US and China to be the bigger worry. Reliance said in the announcement that it will try to offset the effect of increased tariffs through price increases or supplier price reductions. However, we think this might be optimistic and margin pressure should be expected if the trade war lingers.

With evidence that the non-John Guest parts of Reliance's business have been going backwards, market forecasts for a 13-15% lift in EBITDA in 2020 are probably too high.

Based on management's new forecasts, Reliance is trading on a prospective 2019 PER of 20. Cash flow is likely to remain below-par this year given the inventory issue, although we'll still be looking for a significant improvement in the second half when the company reports in August.

City limits

While profit downgrades are all about the short term, it's the long term that matters. So we were concerned by the last sentence of Reliance's downgrade: 'RWC continues to invest in developing and commercialising new products, which we believe are both an attractive and necessary source of future growth, particularly as we approach the limits of new distribution and product extension opportunities'.

These 'limits' seem to speak to one of the major concerns we highlighted in Reliance Worldwide: Once bitten?. Having developed and acquired its way to leadership in the push-to-connect repair market, Reliance's future growth will come from elsewhere. Pivoting towards its new EvoPEX product, for example, introduces risks. Perhaps that's the same conclusion reached by former owners the Munz family, who have sold out of the stock since it listed in 2016.

Having already expected the business to hit some speed bumps - although not quite this soon - our price guide remains unchanged. Reliance is a good business but not necessarily a great one, and we'll need a lower price before upgrading. HOLD.

Note: The Intelligent Investor Equity Growth Fund owns shares in Reliance Worldwide.