Reliance – a mid-cap worth considering
The downturn in Australia’s housing-construction cycle has huge ramifications for the economy, sharemarket and building-material stocks, such as plumbing suppliers.
The bears argue housing is ripe for a massive correction. They say excessive supply, particularly in apartments in the main capital cities, will coincide with a spike in mortgage stress and a sharp tightening of bank lending standards for investment properties.
New apartments in some developments will have to be discounted heavily in a market where there are fewer buyers as banks restrict finance to those with small deposits. This cycle will feed on itself, causing property prices to tumble and bad debts to spike.
The bulls counter that the property downturn will be gradual and manageable. Interest rates will remain low for longer and unemployment levels are stable. Moreover, developers will adjust to conditions by reducing new property supply.
As usual, the answer is somewhere in between. Building approvals fell a seasonally adjusted 13.9% in the year to July 2017, latest Australian Bureau of Statistics data shows. That was a few points better than the market expected, after approvals bounced in June.
National Australia Bank (NAB) in May predicted new housing commencements would drop 13% in 2017, 7% in 2018 and 9% in 2019. That would lead to a 4% fall in actual construction as the industry “self-regulated” the amount of new supply.
On balance, NAB predicts the housing market will be modestly oversupplied by late 2018, with variations across states. It described commentary about a construction correction as “overly alarmist”, although cynics might expect a bank to have a more sanguine view on the topic.
Make no mistake: a housing-cycle downturn is inevitable. It’s a question of magnitude and whether sharemarket valuations have sufficiently responded to “peak construction”.
I don’t see a property correction rather than crash in FY18, principally because lower-for-longer interest rates and an okay economy will give developers more time to reduce new-dwelling supply. That said, new inner-city apartment supply in Brisbane, for example, looks problematic. And supply/demand fundamentals are finely balanced; much could go wrong if interest rates rise faster than expected.
As such, beware holding Australia-focused building-material stocks late in the housing cycle, particularly those that have rallied hard during the construction upswing.
Don’t fall for the argument that some building-material suppliers will benefit as high property prices encourage people to stay put and renovate. The refit and renovation market is significant, but not enough for most building suppliers to offset a prolonged downturn in new dwellings.
With plumbing stocks, do not subscribe to simplistic thinking that such companies are defensive. Yes, households need plumbing supplies in good and bad times. Reece, for example, has a terrific long-term record. But these stocks rely on new housing construction cycles.
This thinking informs my view on three plumbing-related stocks: Reliance Worldwide Corporation, Reece and GWA Group.
1. Reliance Worldwide Corporation (RWC)
Reliance is the pick of ASX-listed plumbing stocks at current prices for two reasons. First, about 62% of revenue is earned in the Americas, meaning Reliance is far less exposed to the Australian housing cycle. The complication is currency risks from a rising Australian dollar.
The second reason is innovation. Reliance designs, makes and supplies water-flow and control products used in plumbing and is known for its SharkBite push-to-connect (PTC) product, an innovation used in behind-the-wall plumbing systems that is faster and easier to install than traditional copper joining.
SharkBite sales are rising in the US as Reliance expands its presence in Home Depot and accesses Lowes’ network, and as the plumbing industry responds favourably to the product. Reliance can grow earnings by taking market share from other plumbing providers rather than relying on an improving United States housing cycle to boost sales.
Reliance has done well since listing. The family-owned company raised $919 million in an April 2016 Initial Public Offering at $2.50 a share. The stock has rallied to $3.60 after its FY17 result, released in late August, topped market expectation.
After-tax net profit of $65.5 million for FY17 compared to the prospectus estimate of $62.6 million. It was a better result than it appeared given Reliance expensed acquisition and restructuring costs, as well as product roll-out expenses to Lowes stores in the US.
A tight EBITDA guidance range of $145-$150 million suggests Reliance is confident in its outlook. The company has barely put a foot wrong as it expands in the giant US market.
An average price target of $3.64, from a consensus of seven broking firms, suggests Reliance is fully valued. I believe it can do better than the market expects over 12 months, although gains will be slower from here.
I wrote favourably about Reliance for the Super Switzer Report in March 2017 at $2.80 a share. I suggested a 20% total return in the company (including dividends) was likely over 12 months. That return has already been surpassed, but I’ll stick with Reliance as one of the more impressive mid-cap Australian companies.
An expanding US presence is the key to the next re-rating in Reliance shares.
2. Reece (REH)
The market-leading plumbing group can be hard to get a handle on. Relatively fewer broking firms cover Reece because stock liquidity is relatively low, and the company is not known for excessive market communication. Its FY17 results presentation has five slides!
As other companies provide verbose promotional presentations, Reece’s is suitably brief and impressive. The slides show a company that has been a model of consistency in sales, profits and dividends growth. The five-year annualised total return is 18%.
That consistency, rare for a building-material company, suggests Reece is well placed to weather a housing-construction downturn. The company reported record sales in FY17, supported by record customer satisfaction and an excellent organisation culture and leadership.
But is this as good as it gets, for now? Reece’s slightly negative total return over one year suggests the market is concerned about the company’s high exposure to the Australian and New Zealand building cycles.
The other issue is valuation. Reece is on a trailing Price Earnings (PE) multiple of about 21 times, Morningstar data shows. The company deserves a valuation premium to the market given its long-term performance and dominant industry position. Even so, Reece looks like a hold at the current price as Trans-Tasman building cycles weaken.
3. GWA Group (GWA)
GWA earns about four-fifths of its revenue from bathroom and kitchen products, the rest from doors and access systems. The company is best known for Caroma and Fowler bathroom products, Dorf taps and Clark kitchen products.
Like Reece, GWA earns most of its revenue in Australia. Unlike plumbing-parts suppliers, GWA operates further up the value chain and is more exposed to the refit market. About half of its end-market exposure is in the renovation and replacement segment.
GWA’s return on equity has averaged 16% in the past three financial years. It hovered around 10% in FY13 and FY14. The company says it is growing faster than its industry, but revenue growth of 2%in FY17 is a concern in a buoyant housing market.
The recent full-year result suggests GWA is doing a solid job on cost cutting, but its shares have fallen about 10% to $2.84 since the August news.
A slowdown in housing and apartment construction in FY18 will weigh on GWA’s earnings and the renovations market looks stable at best as households struggle with high debt and record-low wages growth. Tailwinds for GWA and other building-product suppliers are easing.
Most broking firms have hold or reduce recommendations and an average price target of $2.88, based on the consensus of seven firms, suggests GWA is fully valued. Macquarie’s 12-month target of $2.60 suggests GWA is a touch overvalued, even after recent falls.
I’ll stick with the bears on this one. GWA is a steady performer and its forecast PE of about 15 times is not overly demanding. But it’s hard to find a catalyst to re-rate the stock as the housing cycle turns. The odds favour a flat or modestly weaker share price over 12 months given GWA’s late-cycle housing exposure.