The Long and Short
Ferguson well positioned for slowdown
Meredith Contente | March 24, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Ferguson PLC’s (FERGLN – Baa2/BBB+) conservative financial policies leave it positioned well for any potential slowdown in residential and commercial construction. Management has long maintained leverage inside of 2.0x, and efficient operations have led to an EBITDA margin above pre-pandemic levels, despite the highly inflationary market. While roughly 75% of the company’s revenues come from markets where it holds first or second position, the business remains highly fragmented and presents a large growth opportunity. Strong free cash flow driven by working capital improvements supports the dividend, which was moved from semi-annual to quarterly payment.
FERGLN’s credit profile compares favorably to peers and its debt maturity profile should be viewed positively as the company has no refinancing needs until late 2025. The FERGLN 4.5% 2028 bonds provide the most value in the curve relative to peers, as the bonds trade approximately 35 bp behind both Masco Corp. (Baa2/BBB/BBB) and Stanley Black & Decker Inc. (Baa2(n)/A(n)/BBB+(n)). In other parts of the curve, FERGLN only trades between 10 to 15 bp behind peers.
Exhibit 1. FERGLN Spread Levels vs. MAS & SWK
Best in Class Credit Profile
FERGLN has historically maintained gross leverage below 2.0x and ended the most recent fiscal quarter with gross leverage (excluding leases) of 1.2x. On a net basis, leverage is closer to 1.1x and is at the low end of management’s target range of 1.0x-2.0x. Management noted that they prefer to operate towards the low end of the range through the economic cycle as it enables them to take advantage of growth opportunities. This closely aligns with management’s first capital allocation priority, which is to reinvest in the business to drive above-market organic growth. Furthermore, FERGLN’s credit profile compares very favorably to peers as MAS maintains net leverage closer to 2.0x while SWK’s net leverage metric is above 4.0x (Exhibit 2).
Exhibit 2. FERGLN Financial Comparison
Based on guidance for the full fiscal year and consensus estimates for free cash flow, FERGLN is likely to see net leverage tick up slightly, ending the fiscal year in the 1.2x-1.3x. This slight increase keeps FERGLN’s leverage below peers as we estimate that MAS could see net leverage tick up slightly as well and SWK could see a sizeable move higher as they are estimated to continue to burn cash in the first quarter of 2023.
Highly Fragmented Markets Provide Continued Growth Opportunities
FERGLN maintains leading positions in most the markets that it operates in. However, the company has the ability to further take market share, particularly in the some of the larger markets such as Facilities Supply, HVAC and Waterworks. Currently, FERGLN maintains a 1% market share (number 3 market position) in facilities supply which is estimated to be a $100 billion market. Management noted that facilities supply has been a strong organic growth driver for the company, having witnessed a 20% growth rate in the most recent quarter. Furthermore, the business allows for the maintenance of customer relationships made via commercial new construction, as it provides for additional sales growth through the life cycle of building.
Recent acquisitions made in the HVAC business helped the company to post 10% growth in the unit, with a two-year stack rate of 43%. While the majority of the HVAC business serves the residential end market, which is facing some near-term pressures, growth is coming from the repair and maintenance side of the business. Given that the median US home age is approximately 40 years old, the repair side of the business is likely to provide for growth until new housing starts return to positive year-over-year growth. Currently FERGLN maintains a 5% market share in the $70 billion HVAC market.
Lastly in Waterworks, FERGLN witnessed 6% growth in the quarter, which was on top of an impressive 61% growth rate in the year-ago period. Waterworks provides for exposure to both the residential and commercial markets. Currently the average age of US drinking water and wastewater pipes is roughly 45 years old. Additionally, wastewater treatment plants are designed to have an average life in the 40–50-year range. This aging infrastructure provides a market tailwind for FERGLN as utility companies need to replace the water and wastewater pipelines. Currently, less than 5% of water pipelines are being replaced on an annual basis, which translates to an approximate 20-year tailwind for the company.
Working Capital Improvements Foster Strong Free Cash Flow Generation
As supply chain constraints began to ease, FERGLN was able to reduce inventory levels which had a positive impact on cash flow. FERGLN, reduced inventory (excluding acquisitions) by $235 million during the first half of 2023, which helped fuel strong cash from operations growth. The inventory reduction helped improve working capital from an outflow of $841 million in the first half of 2022 to an inflow of $115 million in the first half of 2023. That said, FERGLN generated $1.2 billion in operating cash flow for the first six months of the fiscal year, an increase of $946 million from the year-ago period. While capital expenditures increased from the prior year, due to the company’s new distribution center rollout, the significant increase in operating cash flow enabled FERGLN to post free cash flow of $936 million in the first half of 2023, up from $109 million in the year-ago period. Consensus estimates put fiscal full year free cash flow at $1.88 billion, a more than 100% increase from the $859 million generated in fiscal 2022.