Thesis
Ferguson (NYSE:FERG) is a North American market leader with a great track record of capital allocation, and the stock is still under the radar because it recently changed its listing from the LSE to the NYSE. The company will soon be added to the Russell, and perhaps even the S&P. Ferguson can still experience more growth in its markets. I will explain each of my thesis’s key parts in the following sections.
Company Description
Ferguson distributes plumbing and HVAC products primarily to the repair, maintenance, and improvement, new construction, and civil infrastructure markets. It serves over 1 million customers. The company has approximately 1,700 branches and only operates in North America. Ferguson has a dominant market position, being #1 in four of the nine markets it operates in, #2 in two, #3 in two, and #4 in one.
Business Segments
United States (95% of revenue, 11% Adjusted Operating Profit)
The United States segment operates primarily under the Ferguson brand and provides expertise, solutions, and products, from infrastructure, plumbing, and appliances to HVAC, fire, fabrication, and more, to residential and non-residential contractors. As of July 31, 2022, the United States business operated 1,509 branches and 10 national distribution centers, serving all 50 states with approximately 33,000 associates.
Canada (5% of revenue, 7% Adjusted Operating Profit)
The Canada segment operates primarily under the Wolseley brand and supplies plumbing, HVAC, and refrigeration products to residential and commercial contractors. The Canada segment also supplies specialist water and wastewater treatment products to residential, commercial, and infrastructure contractors and supplies pipe, valves, and fittings (“PVF”) solutions to industrial customers.
Opportunities
Ferguson recently passed Russell inclusions and will be added to the Russell 1000 index on June 23rd. The company might also be added to the S&P 500. The date is not clear as of yet, but companies usually join the S&P on a quarterly basis. If the company is successful in joining both Russell and S&P, then a lot of capital will be inducted into the company, which might lead to a jump in the stock price. Plus, as companies join major indexes, demand and interest will increase, and as demand increases, so does the value of the company. I believe that the relisting from the LSE to the NYSE will expose the company to more investors. Additionally, the likely inclusion of Russell and S&P will support the buy/long side. The company had revenue of $29 billion in 2022, and the markets it operates in had revenue of $340 billion. There is definitely more room for expansion, and if the company keeps progressing the way it has, it can grab more market share through strategic acquisitions.
Capital Allocation
Ferguson’s management has done a good job at allocating capital, in my opinion. The balance sheet seems healthy with a 1.1x debt-to-EBITDA ratio. The company has used capital in four ways. Acquisitions, dividends, share repurchases, and organic growth. The U.S. industrial distribution market is mostly made up of smaller distributors, and management has capitalized on that by going on a series of acquisitions. Since August 2022, the company has completed five acquisitions. Repurchased 6 million shares year to date and recently extended its share repurchase program by $500 million. Dividends increased by 9% year over year. The company has spent 2% of its revenue on acquisitions in the last three years. Overall, management has done well at strengthening its market position and returning cash to its shareholders.
Valuation
In terms of valuation, both the company’s P/E and EV/EBITDA ratios are trading below the sector median. P/E ratio of 15.7x (sector median 16.89x) and an EV/EBITDA ratio of 10.7x (sector median 11.64x). I used discounted cash flow to evaluate the company. I project revenue to grow at a compounded annual rate of 5.8% over the next five years to $37.5 billion. From 2020 to 2022, Ferguson spent 2% of its revenue on acquisitions. These acquisitions have fueled much of their growth. I expect the company to use 2% of its revenue for acquisitions as they continue to focus on growth and creating value. Using a discount rate of 7.83%. I discounted the future free cash flow and terminal value into the present. I got an equity value of $36 billion, or $189 per share, which represents a 30% upside from the current price of $146.
Risks
1) Looking at Ferguson’s business model, I believe the company is exposed to economic conditions since 48% of its revenue is from residential buildings as of Q3-23. As the demand for housing decreases due to high-interest rates and remodeling spending due to high prices, Ferguson’s revenue might take a hit. In Q3 23, residential revenue declined by 3% YoY and total revenue by 2% YoY. It seems like the company is starting to feel the pain of high-interest rates. This decline in revenue was expected by the company. The firm is currently doing better than its competitors. Home Depot’s revenue is down 4% YoY, and Lowe’s is down 6% YoY. I believe that the current economic conditions are short-term headwinds for the company.
2) Despite Ferguson being a market leader, they do face competition from Home Depot in its residential business and Amazon in its e-business. So far, Ferguson has done well navigating competition by focusing on one region (North America) rather than expanding geographically. Small acquisitions have also strengthened their market position.
Conclusion
The bottom line is that Ferguson has a dominant market position underpinned by a good management team. A free cash flow yield of 6% and 23.6% ROIC in 2022. I believe the relisting from the LSE to the NYSE will expose the company to more investors, and if the company is successfully added to the Russell and S&P, then it will boost investor confidence. There are risks to consider, just like with any other business. Management has done a good job looking after shareholder value by increasing the dividend yield and repurchasing $2.5 billion in shares since FY 2020. As always, I will leave you with a quote.
“The secret of getting ahead is getting started.” – Mark Twain
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