Why Guzman and Reece's share reversals have a lot in common

Joseph Taylor | Morningstar Australia

Guzman y Gomez (GYG) and Reece (REH) have been two of the bigger earnings season casualties so far.

As I write, Guzman shares are down around 22% since reporting. That’s despite the company revealing 23% higher global revenues than the same period last year and the domestic store rollout progressing nicely. Meanwhile, Reece reported a 3% fall in global sales and saw its shares slump by over 15%.

While a plumbing supplies company and a taco merchant may appear to have little in common, their results and subsequent sell-off shared more than a passing resemblance.

Similarity one: Lack of home advantage in US

The main source of disappointment for both companies were weak results in the US. Sales and profits in Guzman’s four stores in the US eroded, while revenues from Reece’s larger US operations fell 6% and dragged the company’s overall sales growth into the red.

As the biggest market for Mexican fast food, America was always touted as the big prize for Guzman in its ‘first Australia, then the world’ plan for taco dominance. For Reece, it was more a question of being so successful here that it needed to find somewhere else to grow.

The potential issue is that neither Reece or Guzman enjoy the advantages that they have benefited from in Australia.

Reece’s domestic business, for example, is moaty thanks to the unmatched density of its store network. This lets Reece stock more inventory and provide plumbers with the products they need faster than anyone else. Having more stores also makes it the most visible option for DIY customers, while Reece’s gravitas also enables higher margin own-brand sales.

Reece’s No Moat rating on an overall basis stems from the large investments that it is making in the US, a market where Reece is just another player. It does not enjoy the scale or density benefits that it enjoys at home, and it does not have the brand recognition to sell as many own-brand products at juicy margins.

These dynamics have underpinned our analyst Esther Holloway’s less optimistic take on Reece than other investors, and Esther says these they were visible in Reece’s result. Flat sales in the Australian business amid a weak housing backdrop hinted at this segment's strength. Meanwhile, sales in the less advantaged US biz fell 6%.

And then you have Guzman, which also has a No Moat rating from our analyst Johannes Faul, who is waiting for proof that Guzman’s excellent store economics and high returns on capital can be sustained at the far higher store count that management are targeting.

Nonetheless, it's hard to argue against the fact that Guzman has an exceptionally strong brand in Australia. This has propelled GYG to incredible growth and impressive economics domestically, but Guzman’s brand does not carry anywhere near the same weight in the US. It is also faces far tougher competition there from the likes of Chipotle.

Despite Guzman only having a handful of company-owned stores in the US, the potential for growth into this market became a big part of the stock’s story. Any bumps in this narrative were always going to be a problem, and so it proved.

Similarity two: Sky high expectations

Purely in business terms, Guzman’s experiment in the US makes sense. They are taking a relatively small punt that, if successful, could result in a huge payoff. The problem for recent investors may have been that the shares didn’t provide such an asymmetric bet on this outcome.

Even before the post-IPO surge in share price, our analysts thought that investors were taking a future domestic store count of 1000 for granted. As a result, this potentially left the shares reliant on international success for further upside. It wasn’t a free option by any means.

The same might be said for Reece, which traded (and continues to trade) at what you might call an “eye-catching” valuation for a plumbing supplies business. At my last check, it traded at over 36 times trailing and estimated annual earnings. This is higher on both measures than Microsoft and higher on a forward basis than Nvidia.

Such a high valuation suggests that investors see a lot of growth ahead for Reece, which in turn suggests that they are pricing in a US expansion resembling its success in Australia. While this may or not prove to be correct one day, it certainly sets a very high bar.

Two things to keep in mind

Over the long-run, a company’s market value and the performance of its shares will likely track the growth and performance of the underlying business. Over shorter periods, an investor’s return will also be dominated by how events map to the expectations baked into their purchase price.

While Guzman and Reece might ultimately succeed, the experience of their investors in recent days show how important it is to weigh exciting growth stories against 1) the competitive dynamics in the new market you are entering and 2) the price you are paying to participate in this potential growth.

At a recent share price of around $35, Guzman continued to sport a one-star Morningstar Rating and traded more than 100% above Johanne’s increased Fair Value estimate of $16. Meanwhile, Reece’s recent share price of $18.20 was 40% above Esther’s Fair Value estimate and commanded a two-star Morningstar Rating.

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