Why Reliance deserves a spot on your watchlist
There are three useful clues when deciding to sell a stock. The first is when company “insiders” unexpectedly sell part or all their shares and are first to head for the exit.
From James Packer getting out of free-to-air TV, to the Lowy family selling its shopping-centre empire, it usually pays to follow founders who decide to exit an industry.
Insider-selling signals, of course, can be fallible. Some directors sell shares because they have a big tax bill or a divorce to settle. Some founders sell because they or their family want to enjoy the fruits of their labour and work less. An exit was always part of their plan.
Some companies benefit when the founding family exits, institutions join the share register and stock liquidity and governance improve. Every company is different, but caution is needed when founders who live and breathe the industry decide it’s time to get out.
The second clue is when small and mid-cap companies make large overseas acquisitions. I search for small-caps with a genuine global footprint because the best ones quickly outgrow this market. But too many small-caps have destroyed wealth with overseas acquisitions.
Slater & Gordon headlines a long list of small-caps that bet the farm on an offshore acquisition and tanked when it soured. The pattern is familiar: a small-cap becomes a market darling, raises too much equity capital, spends it on an overpriced acquisition and underestimates the risk. Management and board hubris abounds.
When the offshore acquisition goes haywire, the small-cap spends its time trying to fix the acquisition and the core business suffers. Earnings are downgraded, the balance sheet becomes stretched and most of the acquisition is written off.
The third clue is hype. When one fund manager after another gushes about a small-cap – and it is hard to find a sell recommendation – it’s usually time to get out. A chorus of commentators becomes fixated on the company’s growth and extrapolates it too far into the future.
Plumbing-goods manufacturer Reliance Worldwide Corporation (RWC) ticked these boxes, to varying degrees, in the past 12 months. BRW Rich Lister Jonathan Muntz sold the family’s remaining 10% of Reliance in February this year, ending its three-decade connection with the company it founded and grew into a global operation.
The family sold 30% of Reliance when it floated in early 2016 and has progressively sold down at prices mostly much higher than today. In fairness, the Muntz family’s exit from Reliance was well flagged by the market; but why sell out of a company rapidly growing in value?
Reliance bought John Guest Holdings, a global leader in plastic push-fit fittings and pipes in the United Kingdom, for $1.22 billion in June 2018 as part of a big push into the UK and Europe. That was a huge deal for Reliance, now capitalised at around $3 billion.
John Guest looked a clever acquisition and may yet prove to be one. But corporate Australia is littered with examples of small-caps that struggled to integrate large overseas acquisitions, or underestimated regulatory or competitive risks in unfamiliar markets.
Reliance also had the third clue – hype – when its shares peaked above $6 in August 2018. The market could not get enough of Reliance, even though its share price had more than doubled the company’s Initial Public Offering price within two years of listing.
Rise and fall
To recap, I wrote favourably about Reliance for the Switzer Report several times after its float at $2.50 a share and in early 2018 nominated it as a top stock idea on Money Talks with Peter Switzer on Sky News Australia. The idea worked well for readers.
Reliance was one of my favoured mid-cap stocks at the time and among the best IPOs I had seen in years. It was and still is a cyclical business that is genuinely innovative, has a global footprint and unique product (the Sharkbite push-to-connect plumbing fittings) that is well regarded in the plumbing industry.
I lost interest in Reliance in June 2018 after its share price soared and included it in a feature about “three stocks to sell” for the Switzer Report in an end-of-financial-year special. It was $5.34 at the time and traded below $4 at the time of writing. Reliance wasn’t easy to include in a bearish article.
I wrote in June 2018 in the Switzer Report: “Reliance’s … valuation, after soaring gains over 12 months … leaves little room for error. Early investors in Reliance should take some profits and maintain a smaller holding to benefit from any further upside.”
Reliance tumbled 16% on Monday, 13 May after downgrading earnings guidance for FY19 from to $260-270 million, from $280-290 million. The stock fell 4% the next day.
The absence of a modest freeze event in the United States, an average level of winter storms that causes cracked or broken pipes, affected sales. Reliance said the lack of a freeze event hurt sales by up to $15 million in FY2019 and underlying earnings (EBITDA) by up to 3%.
Also, several key US channel partners reduced (plumbing) inventory in the second half of FY19, further weighing on its sales.
Reliance said the John Guest acquisition was meeting sales expectation but sales in the core UK and Spanish markets were behind expectations. This was partly because Reliance decided to exit some production lines after the John Guest acquisition. Also, the Spanish market for the company’s products had not grown as quickly as expected.
In Australia, the housing-construction downturn has weighed on plumbing-product sales. Although the Asia Pacific region is Reliance’s smallest geographic segment, the housing downturn will take $10-$15 million from net sales for FY19.
In the background are market concerns about the US-China trade war and its negative effect on the cost of materials and manufactured components imported from China to the US – a threat that could hurt earnings in Reliance’s Americas division if it came to pass.
Economic uncertainty in the UK after the postponement of the Brexit deadline is another factor for Reliance, which took a huge bet on the UK and Europe with the John Guest acquisition.
Is there value?
Taken together, Reliance is facing a “perfect storm” of domestic and global factors. From the weather, to politics, trade wars and the housing downturn, not much is going its way. But with the share price down by more than third from its peak, how much bad news is already factored in and is value starting to emerge in Reliance?
It’s too soon to know. Most broking firms have price targets well in excess of Reliance’s current price, suggesting the stock is materially undervalued. Some brokers still have price targets near $6 for Reliance. Those valuations will come down in the next few days as analysts cut earnings forecasts and target prices for Reliance (some brokers still have targets above $5 after this weeks’ downgrade). Morningstar’s fair-value estimate – $3.60 before the downgrade and now under review – looked reasonable.
The first profit downgrade is rarely the last in small- or mid-cap companies and none of the headwinds facing Reliance will change direction anytime soon.
Nevertheless, most factors hurting the company are temporary rather than structural. There will be another US freeze event that will support higher plumbing sales; geopolitical uncertainty around trade and Brexit will eventually subside; and Australian housing will recover.
A deal-breaker would be the John Guest acquisition performing below expectation. That is the key to Reliance and its next leg of growth. If the acquisition does better than expected, Reliance will be worth a lot more in 3-5 years than it is today. If it disappoints, Reliance will struggle.
Reliance said it remains “very pleased with the progress of integrating the John Guest and core RWC businesses. Cost synergies are being realised as expected and we are starting to see revenue synergies coming through”. Reliance’s communication since the acquisition has consistently stated the acquisition is performing to expectation on sales and synergies.
Long-term growth drivers for Reliance are still firmly in place: its products have low penetration in the US, giving room for significant market-share growth. And it’s innovative Sharkbite products provide a point of differentiation and advantage in the global plumbing market.
At $3.62, Reliance is on a forecast PE of 15.1 times FY20 earnings, on Morningstar numbers (the PE could change as earnings forecasts are reduced). Still, that’s broadly in line with the S&P/ASX 200 average, even though Reliance has a stronger medium-term growth trajectory than the average Australian industrial company.
My sense is the market over-reacted to Reliance’s news, as is its way these days when companies report even the slightest profit disappointment.
Patient investors might stand aside and wait for the market to digest the bad news and for Reliance to offer better value in the next few weeks or months, in the market’s traditionally weak period after May.
Reliance shares may get worse before they get better, but this is a high-quality company that deserves a spot on portfolio watchlists for long-term investors who understand the risks of globally focused mid-cap companies in cyclical industries.
Chart 1: Reliance Worldwide Corporation