ASSESSMENT 2: STEPS 3-6

Step 3: REECE GROUP Ratios and Accounting Drivers

Blog Post: Is Reece Group Going Down the Drain?

Reece Group have been around

for 100 years, so I expected their ratios to

reflect their history of strong sales growth

and market dominance, and they did for

2016 to 2018. However, in 2019

everything suddenly looked ‘bad’.

Economic profit and free cash flow went

from positive to negative, PM and ATO

were down, and they were highly

leveraged. However, OI, sales and NOA

still increased, which made things

confusing. In 2019, Reece Group made a large business acquisition which influenced their

ratios greatly. It was hard to see past the acquisition to what their ratios might have been if

they hadn’t made the purchase.

Did that one large business acquisition cause Reece Group’s ratios to tumble? How do

I know for sure? The ratios for 2019 also reminded me that you can’t view one year in

isolation and you can’t rely on past figures to continue into the future. If I just looked at the

past, I would expect Reece Group to bounce back and continue creating value for their equity

owners, but now it is the worst of times for the global economy so will Reece Group bounce

back and maintain their market power?

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Profitability Ratios

Reece Group’s net profit margin was relatively stable from 2016 to 2018, generating

approximately 8 cents of profit per dollar of sales, but in 2019 it decreased by 55.73%. The

substantial decrease in their net profit margin can be attributed to a $78,269 increase in

interest expense in 2019, because their net profit still increased by 10%. In 2019, Reece

Group took on significant debt to fund a major business acquisition which increased their

interest expense significantly. However, when I compare the net profit margin to the profit

margin (PM) I can see that after removing the interest expense and financial income, Reece

Group’s operations still did not generate as much profit from sales compared to previous

years, despite a 103% increase in sales, as shown below.

2016 2017 2018 2019

Net Profit Margin (%) 8.44 8.72 8.35 3.70

PM 8.74 8.85 8.64 4.86

Reece Group’s net profit margin and PM, even at 8%, seems rather low. I wonder if it is due

to Reece Group having the largest market share in their industry and therefore, they generate

a lot of sales and are able to keep prices low?

Reece Group’s return on assets (ROA) shows that they have been using their assets

less efficiently to generate a profit since 2017, with the most significant decrease of 53.26%

occurring in 2019. However, since the total assets have been increasing steadily since 2016,

the return on average assets (ROAA) should give a more accurate measure of their ability to

efficiently use their assets. The ROAA shows that Reece Group are slightly better at

generating a profit from assets, than the ROA suggests, as shown below.

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2016 2017 2018 2019

ROA (%) 12.08 12.55 9.66 4.52

Difference (%) -22.98 -53.26

ROAA (%) 12.92 11.20 5.95

Difference (%) -13.32 -46.90

Even though Reece Group’s ROAA has decreased significantly in 2019 it is still

almost double the industry average of 3 cents. However, the ROA still includes financial

assets and the effect of debt (interest expense) so comparing the ROA with the return on net

operating assets (RNOA) should give a clearer picture of Reece Group’s ability to

efficiently use their operating assets to generate a profit, as shown below.

2016 2017 2018 2019

ROA (%) 12.08 12.55 9.66 4.52

RNOA (%) 18.02 18.21 17.04 7.55

ROOA (%) 14.53 14.69 14.08 7.05

The return on operating assets (ROOA) and the RNOA are almost identical for 2019 and

when I break ROE down (see page 4) I can see that operating liabilities make up the

difference of 0.50%. It is exciting to see how all the numbers work together!

I can also compare the ROA with the return on equity (ROE) because the main

difference between them is financial leverage. If a company had no debt then assets = equity,

and the ROE and ROA should be the same. However, the more leveraged a company is, the

more ROE will rise above ROA because as debt increases, equity shrinks. I know that in

2019, Reece Group followed an aggressive leveraging strategy to possess MORSCO, so it is

interesting to see the significant difference between ROE and ROA in 2019, compared to

previous years, as shown below.

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2016 2017 2018 2019

ROE (%) 18.59 18.21 12.16 11.24

ROA (%) 12.08 12.55 9.66 4.52

Does this suggest that 2019’s high ROE gives a false impression because Reece Group are

carrying a lot of debt, with an increase in financial leverage (FLEV) from 0% in 2018, to

76% in 2019? Increased leverage results in higher interest payments, which are tax deductible

and therefore increases ROE.

To determine the impact of leverage further on ROE for 2019, I can ‘break ROE into

pieces’ by using the equation and figures below:

ROE = ROOA + (RNOA – ROOA) + (ROE – RNOA)

2016 2017 2018 2019

ROOA (%) 14.53 14.69 14.08 7.05

RNOA (%) 18.02 18.21 17.04 7.55

ROE (%) 18.59 18.21 12.16 11.24

ROE = 7.05 + (7.55 – 7.05) + (11.24 – 7.55)

= 7.05 + 0.50 + 3.69

= 7.05 + 4.19 = 11.24%

This tells me that in 2019, only 3.69% of Reece Group’s ROE came from financial leverage

and 0.50% from operating liabilities, compared to 7.05% from operating assets, so perhaps

they are not overleveraged after all? However, Reece Group’s ROE at 11.24% for 2019 is

high compared to the industry average of 4.5%. Also, their RNOA (PM x ATO) decreased

significantly in 2019 which would reduce their ROE, so it appears that leverage has had a

huge impact in keeping their ROE high. However, ROA at 4.52% exceeds their net

borrowing cost (NBC) of 2.73% so perhaps the expected income from their purchase of

MORSCO will offset the added risk from leverage?

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Efficiency Ratios

Reece Group’s total asset turnover ratio increased slightly in 2019 so they were

generating $1.22 in sales for every dollar of assets, after a decrease in 2018. The decrease in

2018 can be attributed to a 430% increase in cash from the previous year, whereas the slight

increase in 2019 can be attributed to the 685% increase in intangible assets, from 2018. The

increase in intangible assets in 2019 included goodwill and branding from the purchase of

MORSCO, whereas the increase in cash in 2018 can be attributed to having no financial

obligations. When the non-current assets are removed, the current asset turnover ratio

shows a much greater efficiency at generating sales per dollar of assets, and I can see clearly

how the intangible assets contributed to a decrease in the total asset turnover ratio in 2019.

When I compare the total asset turnover ratio and the current asset turnover ratio with the

asset turnover ratio (ATO) I can finally see a downward trend in efficiency, as shown

below.

2016 2017 2018 2019

Total Asset Turnover 1.43 1.44 1.16 1.22

Current Asset Turnover 2.65 2.64 1.80 2.79

ATO 2.06 2.06 1.97 1.55

Liquidity Ratios

Reece Group’s current ratio shows that they are in a good position to pay their short-

term debt with their current assets, and that the ratio has been steadily increasing since 2016,

from 2.04 in 2016, to 2.47 in 2019. However, in 2018 there was a large jump to 3.41 because

Reece Group had a significant amount of cash (compared to previous years) while retaining a

similar amount of current liabilities. In 2019, Reece Group had a 113% increase in trade and

receivables and a 77% increase in inventory as a result of the acquisition of MORSCO, as

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well as an 89% increase in trade and other payables, which is likely also due to the

acquisition rather than being unable to pay suppliers as quickly.

As inventory and receivables can be difficult to liquidate, or recover, comparing the

current ratio with the quick ratio 1 and quick ratio 2 should help me to see if Reece Group

can repay their debt quickly, as shown below.

2016 2017 2018 2019

Current 2.04 2.17 3.41 2.47

Quick 1 1.08 1.09 2.17 1.25

Quick 2 0.25 0.24 1.25 0.16

When inventories and prepayments are removed (quick ratio 1), Reece Group can still pay

their short-term liabilities with their current assets. However, when receivables are removed

along with inventories and prepayments (quick ratio 2), current assets do not cover short-term

liabilities for all years, except 2018 when Reece Group were in a strong cash position. This is

a surprising contrast to the current ratio and shows the benefit of having a large amount of

cash, because when cash was approximately 400% higher in 2018, compared to all other

years, Reece Group would have no problem paying their debts quickly.

Financial Structure Ratios

Prior to 2019, Reece Group’s debt/equity ratio and equity ratio reveal a strong

equity position with operations being financed through less debt and more equity over time.

However, in 2019 the debt/equity ratio increased to 1.25 so Reece Group had more debt than

equity. Conversely, in 2019 the equity ratio decreased and showed that Reece Group financed

45% of their assets with equity (and 55% with debt). However, despite the high debt/equity

ratio and lower equity ratio in 2019, Reece Group’s times interest earned shows that

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earnings before interest and tax (EBIT) sufficiently covers the increased cost of interest on

their debt at 4.57 times, as shown below.

2016 2017 2018 2019

Debt/Equity (%) 52.86 45.73 23.58 124.65

Debt/Equity 0.53 0.46 0.24 1.25

Equity (%) 65.42 68.62 80.92 44.51

Equity 0.65 0.69 0.81 0.45

Times interest earned 37.13 52.36 64.44 4.57

However, is a times interest earned of 4.57 sufficient because one website I consulted

suggested that times interest earned should be at least 5 times, whereas another said 3 times?

Also, in 2019 Reece Group had a 685% increase in intangible assets so did this skew their

equity ratio since the amount of equity has remained similar across all years?

Reece Group’s financial structure has changed significantly in 2019, compared to

previous years, because they have been aggressive in financing their growth with debt and

equity with the purchase of MORSCO in the United States for AUD $1.9 billion. Reece

Group’s equity did not change significantly from 2018 to 2019 so as long as Reece Group’s

cost of debt financing remains less than its future earnings, they should continue to create

value for their shareholders.

Market Ratios

Looking at Reece Group’s market ratios has left me with more questions than

answers. Reece Group’s earnings per share (EPS) has decreased significantly in 2018 and

2019, to 40 cents and 36 cents respectively, showing that they are allocating less profit to one

share. In contrast, the market has been showing increasing confidence in Reece Group’s

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ability to grow earnings with the price earnings ratio increasing from 3.32 to 27.25, over

four years, as shown below.

2016 2017 2018 2019

EPS 1.93 2.13 0.40 0.36

Price earnings 3.32 4.15 23.87 27.25

Why does the market view Reece Group so favourably when their EPS has decreased so

significantly? and share prices are trending downward? (as shown below). Were the share

prices and the EPS driven down by the dilution of shares due to the equity raising in 2019?

What drove the share price down in 2018? Reece Group’s price earnings ratio is higher than

the industry average of 18.6 so does that suggest that Reece Group’s stock is undervalued in

2016 and 2017, and overvalued in 2018 and 2019?

Reece Group’s dividend per share (DPS) is trending similar to their EPS with less

income being distributed as dividends over time. Similarly, the dividend yield has shown a

significant decline in the rate of return a shareholder receives through dividends in 2017 and

2018. However, the dividend payout ratio reflects how much of Reece Group’s earnings are

paid out as dividends and they have been consistent at paying out 40% to 50% of their net

earnings as dividends across the years, as shown below.

2016 2017 2018 2019

DPS ($) 0.79 0.94 0.18 0.20

Dividend Yield (%) 12.35 10.66 1.88 2.06

Dividend Payout (%) 40.66 44.39 43.98 50.74

I think Reece Group’s dividend payout is ‘good’, but the market ratios are all a bit confusing

and it is easier for me to understand the financial statements then the market ratios.

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Economic Profit

Reece Group’s economic profit has been increasing since 2016, but in 2019 they

made an economic loss of -$15,821.59. Similarly, Reece Group’s accounting profit (CI) was

increasing until 2019, as shown below.

2016 2017 2018 2019

Economic Profit 110,627.58 120,566.57 123,200.20 -15,821.59

CI 193,498.00 210,899.00 228,744.00 223,808.00

Reece Group’s economic profit reveals more information than the CI because it considers the

opportunity cost of taking one action over another. As the largest company in their industry in

Australia, Reece Group would normally make an economic profit because they lack

competition from smaller competitors. However, in 2019, Reece Group’s large business

acquisition contributed to a significant decrease in economic profit.

Accounting Drivers: Economic Profit

The key accounting drivers of economic profit are RNOA (driven by PM and ATO),

cost of capital (WACC) and NOA, (i.e.), economic profit/loss = (RNOA – WACC) x NOA.

Reece Group made an economic profit from 2016 to 2018 because their RNOA was greater

than their presumed WACC of 8%, and NOA increased each year. However, in 2019 the

RNOA fell below the cost of capital, despite a substantial increase in NOA, and Reece Group

incurred an economic loss, as shown below.

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2016 2017 2018 2019

PM (%) 8.74 8.85 8.64 4.86

ATO (x) 2.06 2.06 1.97 1.55

RNOA (%) 18.02 18.21 17.04 7.55

WACC (%) 8.00 8.00 8.00 8.00

NOA ($) 1,103,666.53 1,180,789.07 1,363,353.76 3,517,734.87

Economic Profit ($) 110,627.58 120,566.57 123,200.20 -15,821.59

2016 to 2017: Growth∈sales → ↑PM → ↑NOA →↑ RNOA

In 2016 and 2017, the ATO was identical (at 2 decimal places) so the small increase in

RNOA was brought about by a small increase in the PM, driven by a 7% increase in sales.

The increase in sales resulted in an increase in inventory, property, plant and equipment and

trade and other receivables, which increased the NOA. As the ATO remained unchanged it is

easy to see that the change in NOA was driven by an increase in sales, which was equal to the

increase in operating assets (6.72%) which helped to keep their ATO stable, as shown below.

2016 2017 2018 2019

Growth in inventory, PPE, receivables (%) n/a 7.48 12.44 64.06

Growth in OA (%) n/a 6.72 12.19 141.68

Growth in NOA (%) n/a 6.99 15.46 157.80

Growth in sales (%) n/a 6.72 10.67 103.22

2017 to 2018: Growth∈sales → ↓ PM ↓ ATO→ ↑ NOA → ↓ RNOA

In 2018, growth in OA exceeded growth in sales so Reece Group’s ATO decreased slightly,

and the growth in NOA was more significant at 15%. It is interesting to see how even a slight

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decrease in ATO can result in a decrease in RNOA. As growth in OI was almost identical to

2017, it is easy to see the impact of sales on PM, and that the difference between OI and sales

needs to remain small for PM to increase, as seen below.

2016 2017 2018 2019

Growth in OI (%) n/a 8.10 8.02 14.25

Growth in sales (%) n/a 6.72 10.67 103.22

Growth in PM (%) n/a 1.29 -2.40 -43.78

Growth in NOA (%) n/a 6.99 15.46 157.80

It is interesting that even small percentage changes can have an impact on RNOA, which

ultimately impacts economic profit, for example, if ATO remained at 2.06x, economic profit

would have increased from $123,200 to $136,335, and created more value for equity

investors.

This shows me how important it is for Reece Group to efficiently use assets to generate a

profit because, as the largest company in their industry in Australia, they will be making a lot

of sales rather than high profit margins.

2018 to 2019: Growth∈sales → ↓ PM ↓ ATO→ ↑ NOA → ↓ RNOA

In 2019, growth in sales resulted in the same movements in PM, ATO, NOA and RNOA as in

2018. However, in 2019 Reece Group made an economic loss, compared to an economic

profit in 2018. Their 44% decrease in PM and 21% decrease in ATO shows that they are

generating significantly less profit from sales and they are much less efficient at using NOA

to generate sales, respectively. This significant change in PM and ATO drove RNOA down

below the WACC of 8% so they made an economic loss. However, as Reece Group made a

large business acquisition in 2019, they had an increase of 685% in intangible assets, and

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growth in sales of 103%, which contributed to a large increase in OA, and NOA, as shown

below.

2016 2017 2018 2019

Growth in inventory, PPE, receivables (%) n/a 7.48 12.44 64.06

Growth in intangible assets (%) n/a 1.88 10.03 685.04

Growth in OA (%) n/a 6.72 12.19 141.68

Growth in NOA (%) n/a 6.99 15.46 157.80

Growth in sales (%) n/a 6.72 10.67 103.22

Growth in OI (%) n/a 8.10 8.02 14.25

Reece Group’s 685% increase in intangible assets, which included goodwill, was

driven by the acquisition of MORSCO and the acquisition contributed significantly to a

158% increase in NOA, and a 103% increase in sales. However, increased operating expenses

as a result of the acquisition caused OI to only increase by 14%, which resulted in a

significant difference between sales and OI and drove PM down to 4.86 %, from 8.64 % in

2018. Similarly, the difference between sales and NOA also increased and drove ATO down

to 1.55x, from 1.97x in 2018. If Reece Group had not purchased MORSCO, their OA would

have increased at a similar rate to previous years ($2,010,994, instead of $4,361,111) and all

other things remaining unchanged, Reece Group would have made an economic profit,

instead of a loss.

Accounting Drivers: Free Cash Flow

The key accounting drivers of free cash flow are OI and NOA, (FCF = OI - ∆NOA).

Reece Group’s acquisition of MORSCO also resulted in their free cash flow being negative in

2019, driven by a substantial increase in NOA and a comparatively small increase in OI, as

shown below.

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2016 2017 2018 2019

Operating Income ($) 198,921 215,030 232,269 265,357

Growth in OI (%) n/a 8.10 8.02 14.25

Growth in NOA (%) n/a 6.99 15.46 157.80

Free cash flow ($) 137,907.16 49,703.81 -1,886,023.91

Growth in sales (%) n/a 6.72 10.67 103.22

The acquisition increased sales by 103% in 2019, but it also increased operating expenses,

including $28.5 million for business acquisition costs, by 116%, so OI only increased by

14.25%, which results in a large difference between NOA and OI. It is interesting to see that

free cash flow is largest when the difference between NOA and OI is the smallest, like it was

in 2017.

As growth in OI was similar for 2017 and 2018, a 15% increase in NOA was

responsible for a substantial decline in free cash flow, from $137,907 in 2017, to $49,703.81

in 2018. The 15% increase in NOA was driven by several small business acquisitions in

Australia which resulted in a 12% increase in inventory, property, plant and equipment and

receivables, as well as a 10% increase in intangible assets and a 10% increase in sales. These

figures show me how important it is for sales to grow at approximately the same rate as

NOA, and preferably faster to maintain a positive free cash flow (and economic profit).

Free cash flow is used to repay creditors and to pay interest and dividends so should

investors be concerned? Will Reece Group’s free cash flow (and economic profit) return to

positive next year when the effects of the business acquisition start to subside? Based on their

strong performance growth over 100 years I would suspect so, but in 2020 we are facing a

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global recession and I can see clearly for the first time how it is the economic and business

realities that ‘actually’ drive the numbers.

Step 4: REECE GROUP’s Key Economic and Business Drivers

Blog Post: Step 4: Determining Reece Group’s Key Economic and Business Drivers

When I was completing this step it

finally dawned on me just how

critical the key economic and

business drivers are to a firm’s

performance. This realisation was

exciting, and nerve-wrecking and I

knew I had better make the right

choices here ….

Before I could identify the key economic and business drivers of Reece Group, I had

to remind myself of the scope of their goods and services, which include:

Plumbing and bathroom products to residential customers, volume home builders and

commercial developers

Civil construction products and services including water mains, sewerage, drainage,

fire services, gas mains and telecommunications

Wholesale and retail supplier to the residential and commercial heating, ventilation,

air conditioning and refrigeration (HVAC-R) industries

Irrigation and pools for irrigation contractors, landscape designers and homeowners

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The housing construction market is one of the key drivers of Reece Group’s accounting

drivers because dwelling constructions potentially use products and services from all of

Reece Group’s business divisions: plumbing and bathroom supplies, civil construction,

HVAC-R and irrigation and pools.

The Housing Construction Market

Economic and business driver of PM, RNOA and NOA - Strong sales growth arises from a

demand for products and services, driven by the number of dwellings being constructed in

Australia, New Zealand and the United States.

In 2019, the residential and commercial housing construction market in Australia

began to downturn. Single storey house building had started to slow down in 2016, but high-

rise apartment construction was still going strong into 2018, as seen below.

abs.gov.au (2019)

Overall, total housing construction fell by 2.7% in the last quarter of 2019, and has fallen for

four quarters, as seen below. Residential building work fell by the greatest margin at 3%.

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abs.gov.au (2019)

However, as Reece Group’s products are not usually required until housing is almost

complete, the downturn did not affect sales revenue in 2019, and they recorded record sales

growth in Australia and New Zealand of 6.6%, with sales revenue up by $2.866 million. The

2019 tax year completed the first year of trading in the United States, by MORSCO and

accounted for

$2,598 million of sales revenue (total sales revenue: $5,464 million), as well as contributing

to an increase in NOA of 158%. The housing construction industry in the United States is

expected to follow the ANZ downturn in 2020.

Capacity to Acquire New Businesses

Economic and business driver of NOA - Strong sales growth arises from the capacity to

increase their market share through business acquisitions.

Reece Group have a strategy of reinvesting earnings back into the business in order to

accomplish their growth strategy. The expansion into the United States, in 2019, was fuelled

by the inability to expand anymore in Australia. In 2018, Reece Group has expanded to over

600 branches in Australia (and New Zealand), with approximately 11 greenfield sites per year

since 2013, and their products hold 38% of the market share. The acquisition of MORSCO in

the United States now makes Reece Group the 5th largest plumbing supplies business

globally. MORSCO has a top three market position in 85% of the sunbelt region, which is an

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area of the United States that is growing faster than the rest of the United States, as seen

below.

Reece Group (2019)

Some of the other business acquisitions Reece Group has made over the last four years

include:

The expansion of Actrol, who are wholesalers to the HVAC-R industries, into New

Zealand in 2018, after the acquisition of Actrol in Australia in 2014

The acquisition of the leading wholesaler Heatcraft in New Zealand in May 2018

The acquisition of 13 Edward Gibbon and Zip Plumbing Plus stores in New Zealand

in July 2018

The acquisition of Tubs, Taps and Tiles in Alice Springs, in 2018

The acquisition of Viadux in 2017 which enabled Reece Group to supply large scale

water distribution systems to water utilities, councils and civil contractors, and

complemented their existing small civil business

Innovative Products and Exclusive Brands

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Economic and business driver of PM, RNOA and NOA – Sales growth from products that are

high quality, exclusive to Reece Group and save time, driven a desire to maintain a

competitive advantage in the market.

Part of Reece Group’s business strategy is to provide innovative products to their

customers, and they are constantly seeking out products from international suppliers that can

make life easier for their customers. They also have their own brand of tools (Big Dog brand)

to help keep prices competitive. In 2019, Reece Group was recognised as third on the AFR

Most Innovative Companies Property and Construction list for their innovative processes and

culture, as well as the development of a networking app for tradesmen. They also established

a product innovation award in 2019, worth $10,000, that encourages customers to create

innovative new plumbing products.

At the 2018 WorkSafe Awards, Reece Group won the ‘Best Solution to a Manual

Handling Issue’ award, with their custom-built Prime Cyl-Lift controller which replaces the

need for employees to manually lift or roll heavy metal cylinders, which can cause back

injuries. Reece Group also identified a growing need for large capacity hot water systems for

high-density apartment living and developed the Thermann 50L Commercial Water Heater,

which is easy to install, uses less materials and space and delivers 96.4% heating efficiency.

Additionally, some of the world’s best brands can only be purchased at Reece Limited and

include:

Roca Laufen Hideaway Geberit Mizu

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Reputation and Lack of Competitors

Economic and business driver of PM, RNOA and NOA – Sales growth from products that are

high quality, exclusive to Reece Group and save time, driven by a trustworthy reputation and

the largest market share.

Having been around for 100 years Reece Group has a brand name that is known by

most Australians and it is not uncommon to see workers at work sites wearing Reece t-shirts.

As the largest plumbing supplier in Australia, Reece Group have more staff and stores so can

stock a large range of products compared to any other plumbing supplier in Australia.

Additionally, for tradesmen ‘time is money’ so they will choose Reece over other competitors

because they know the product will be in stock.

International Trade Relations and Foreign Currency Exposure

Economic and business driver of NOA, PM and RNOA – Sales growth driven by access to

inventory through good trade relationships with international suppliers and profits driven by

foreign currency exposure.

Reece Group source parts and products from 30 countries globally so good trade

relations with international suppliers is paramount to ensure product orders are fulfilled and

delivered on time. With the purchase of MORSCO in 2019, Reece Group now face a

substantial currency exposure risk that they did not previously have because the United States

revenue appears to be unhedged. It is surprising that Reece Group have not hedged their

currency exposure so as to avoid any financial loss and this may affect profit margins in the

future.

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Identifying Reece Group’s key economic and business drivers was easier than I

thought, and it made me realise just how important they are to a firm’s performance. I feel

lucky to have been given Reece Group as my company because they have performed well for

decades and their key economic and business drivers will be on my mind if, and when, I

analyse any other companies in the future. The hardest part of this step was connecting the

key economic and business drivers to the accounting drivers because I feel like they all

interrelate, and can’t really be separated, e.g., having the capacity to acquire new businesses

will clearly increase Reece Group’s NOA but increased NOA will also increase sales and

PM, ATO and RNOA.

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Step 5: REECE LTD (REH) Forecast and Valuation

Blog Post: Assessing Reece Group’s Potential

I’m not a wine drinker, but this image still made

me laugh and made me think of the record online

sales that Reece Group have been making when

people around the globe were told to stay home, as

a result of the coronavirus. However, looking to

the future Reece Group are unlikely to replicate

record online sales as the effects of the global

recession become more evident.

To determine Reece Group’s forecast of their key accounting drivers for the next five

years, I analysed Reece Groups half year figures for 2020 (HY20) as a starting point for

forecasting for the next five years. As Reece Group import many of their products, I was also

interested in how the last global recession of 2009 affected their PM and sales growth, so I

analysed net PM and sales growth over the past 10 years. I also considered any changes to

Reece Group’s key economic and business drivers that may impact their future value. Finally,

I considered if there were any new economic and business drivers that would impact Reece

Group, e.g. the current global coronavirus recession.

Background

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Reece Group have been operating in Australia for the past 100 years and are currently

the largest plumbing supplier in Australia. Their Australian business accounts for 75% of

their earnings, and they have been trading as a limited liability company since 1992. They

currently have 825 stores in Australia, New Zealand and the United States. With their

acquisition of MORSCO in the United States in 2019 they are now the 5th largest plumbing

supplier globally. There is vast potential for growth in the US but current economic and

business conditions, coupled with high debt on the balance sheet will pose a significant

challenge for Reece Group over the next few years, especially since they want to continue

their store roll-out and acquisition strategy in the US.

Financial Highlights

Reece Group have undertaken two capital raisings in the last two years, which is

unusual as previously they have gone decades without raising capital. Most recently in April

2020 they raised $600 million to take advantage of any new opportunities that may arise in

the future, as well as to support the business in the current economic climate, increase

liquidity and reduce debt. The latest capital raising has diluted shares, with the Wilson family

shareholding reducing from 73.3% to 67.7%.

Other significant financial highlights, as at HY2020, include:

Sales revenue of $2,962 million, up 9% to $5,707,245

MORSCO sales revenue up 19% (9% on a like for like and constant currency basis)

Zero sales growth for Australia and New Zealand

Net profit after tax up 3.6% to $209,294

Dividend of 6 cents per share (March 2020)

Dividends now temporarily suspended

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Volatile share price over past 3 months

High level of debt

The last global recession of 2009 contributed to a decline in sales growth of 0.3%, and

in 2012 the decline in sales growth of 2.9% was a result of a downturn in the housing

construction industry, as seen below.

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 *2020

NPM 6.4 7.6 7.6 7.5 7.8 6.9 7.9 8.4 8.7 8.4 3.7 3.6

Sales 4.9 -0.3 4.0 -2.9 1.1 15.7 17.4 9.2 6.7 10.7 103.2 9.0

*HY 2020: US Sales 19% (US/AUD 9%); No sales growth in ANZ.

In 2014, Reece Group acquired Actrol, which boosted sales growth from 1.1% in 2013, to

15.7% in 2014. From 2014, they continued to acquire businesses and roll-out stores in

Australia and New Zealand (ANZ) which has maintained sales growth. With a down turning

housing construction market in ANZ, they made their most significant acquisition in 2019,

with MORSCO in the United States.

Key Aspects of Forecasts

The Housing Construction Market

In the final quarter of the financial year in 2019, the housing construction market had

fallen by 2.7% in Australia, and in the first quarter of 2020 it fell by 1.4%, as seen below.

abs.gov.au (2019)

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Additionally, residential housing construction declined by a further 0.6% from the June

quarter, to 3.6%. The Australian Financial Review (AFR) suggests that the current

coronavirus health crisis will reduce total housing commencements by 33,000 in the 2020

financial year but will bounce back slightly in 2021, as shown below.

However, the AFR after predicting an upturn in 2021 recently adjusted their forecast of new

dwellings from 173,100 to 140, 000, and suggest that new dwellings could possibly fall

below 140,000. The Australian Bureau of Statistics (ABS) reported that residential building

construction rates fell by 4.6% in the last quarter, and overall construction work is down by

7.4%, compared to December 2018. Reece Group has managed to maintain sales revenue,

with no sales growth, in Australia and New Zealand for HY20 because most of their products

are used at the end-stage of housing construction. However, the new global economic crisis

driven by the coronavirus will likely impact in the second half of 2020, and significantly

affect sales growth over the next few years.

The Global Coronavirus Recession

The coronavirus recession is a new economic and business driver and is predicted to

be the most severe economic downturn since the Great Depression, and worse than the global

recession of 2009. The housing construction market was already on a downturn before the

coronavirus recession so its effects will be magnified by the closing of businesses, high

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unemployment levels, ‘stay at home’ policies and hindrances to supply chains brought on by

the recession. New Zealand was in a nationwide lockdown since 25 March and only recently

Reece NZ opened showrooms and trade counters on the 14 May.

However, with people staying at home Reece Group’s online sales reached record

levels in early 2020, as more people undertook DIY improvements, and purchased hot water

units and heating equipment. The state governments in Australia have also fast-tracked

construction of social housing and government infrastructure as part of their coronavirus

construction stimulus package, which could also boost sales for Reece Group. Additionally,

construction is still being approved for homes destroyed in the bushfires at the start of 2020

in Australia. The purchase of MORSCO which is eight times the size of the Australian

plumbing market could also offset the economic and business effects felt in Australia and

New Zealand.

Capacity to Acquire New Businesses

With the purchase of MORSCO Reece Group’s capacity to purchase new businesses

has decreased because they are now highly leveraged. However, they are committed to their

growth strategy and have recently raised $600 million to help lower debt and assist with new

store roll-outs and acquisitions.

International Relationships

Reece Group exclusively stocks international brands and imports parts and products

from China and 29 other countries. Disruptions to travel, as well as international shut-down

policies in other countries as a result of the coronavirus are likely to impact Reece Group’s

ability to import and export products. Additionally, tenuous trade relations with China

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currently, as a result of the coronavirus, may impact Reece Group significantly because

China is a main supplier of parts and products to Reece Group.

Future Estimations

Sales Growth

As discovered previously when examining Reece Group’s past sales growth over the

last 10 years, the global recession of 2009 and the housing construction downturn in 2012

both adversely affected their sales growth. Therefore, I estimate the current global recession

and downturn in the housing construction industry will also decrease sales growth. However,

the acquisition of MORSCO will provide a buffer since it has already contributed to an

increase of 9% in the first HY20. Sales growth was zero in ANZ for the first HY20 so I am

estimating it will drop below zero in the second HY20 and sales growth will only reach

12.1%. As Reece Group are at the end stage of housing construction and the downturn is only

just beginning in the United States, I am estimating the current economic climate will affect

their sales into 2022, after which time they will likely roll-out some more stores and possibly

make some small acquisitions in the United States, which will boost sales.

Profit Margin (PM)

I have estimated that the new unhedged currency exposure from the United States will

adversely affect their profit margin, as will any additional acquisitions and store roll-outs.

Asset Turnover (ATO)

I estimated that the ATO will slowly increase to pre 2019 levels of around 2.

Growth Rate

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I have used the terminal value growth rate that Reece Group use in their 2019 annual

report of 2.5%.

Return on Incremental Net Operating Assets (RINOA)

I had the most difficulty deciding on a figure for RINOA but chose 5% because I

believe that Reece Group will continue to expand slowly in the United States but will not take

on any other major acquisitions, like they have done with MORSCO in 2019.

Valuation

When researching Reece Limited’s (REH) share price, I became aware of how many

websites got it ‘wrong’ when I was trying to figure out why there was a huge decline in price

in 2018. Perhaps, they were using some different metric that I am yet to learn about, or

perhaps it was just a good reminder to choose trustworthy sources. I consulted Reece Group’s

annual reports and the ASX website to examine their past share prices, which shows an

increase in 2018 at the peak of the housing construction industry and with the announcement

of the MORSCO acquisition (as seen below).

2014 2015 2016 2017 2018 2019

5.98 6.86 7.32 8.31 12.65 9.76

Share Price at 30 J une ($AUD)

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Own graph (2020)

My Valuation

Market Capitalisation $5,620,026.00

Enterprise Value $7,933,764.57

Number of Ordinary Shares 645.98 million

Valuation Share Price $12.28

Market Share Price (as at 27 May 2020) $8.78

Reece Group’s enterprise value is higher than its market capitalisation which is to be

expected because they have more debt than cash on their balance sheet. I am fairly confident

in my valuation because I would expect the share price to be higher than it historically was,

with the expansion into the United States in 2019.

Recommendation

Reece Group is an owner managed family business with an excellent long-term

performance record and despite two equity raisings in the last two years, that have diluted the

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owner’s shares, I don’t expect the Wilson family will ever relinquish their control. Reece

Group have gained long term potential for continual growth from their expansion into the

United States, and as long as they can manage their currency exposure, they should continue

to experience sales growth and increased profit margins. The housing construction market

downturn is expected to hit the United States in the second HY20 and unemployment has

substantially increased due to the current coronavirus global recession. Therefore, with a

market value of $8.70 per share, as of the 28 May 2020 (which is 25% lower than in May

2018), and an enterprise value of $12.28 per share my recommendation would be to BUY.

Learning in this Unit

At the start of the unit I was not enthralled about having to discuss assignment

material with others, write on my blog and give feedback again. Equally, I was not excited

about the prospect of KCQ’s and peer wise. However, once I got started, I was reminded of

how valuable KCQ’s are because they help me to deeply understand the unit content. I would

recommend that future students reread the study guides two to three times when doing KCQ’s

because each time I reread them I picked up something I had missed. Giving feedback, and

receiving feedback, from other students was also invaluable because it helped me to see

things I missed, and I was able to help others likewise. I rediscovered my passion for

blogging this unit and it is a fun way to discuss your company. I recommend that future

students be creative with their blogs by adding pictures and using humour. Blogging about

your company gives you a chance to just ‘be yourself’ and have a bit of fun in an otherwise

‘serious’ unit.

I did not find face book and peer wise as valuable this unit compared to previous

units. There was not a lot of discussion on face book and I found that students gave low

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scores on peer wise which dampened my enthusiasm to participate. There is a lot of work

involved in this unit and I was never able to complete the assignment task in the time frame

that Martin allocated. Martin’s 4 to 6 hours would be at least 4 to 6 days for me because there

are a lot of new concepts that are confusing so I would reread and do additional research on

google. I recommend that future students set aside at least a couple of hours a day for this

unit, rather than 1 or 2 days a week because it gives you time to ‘digest’ the information and

come back to it with ‘fresh eyes’ the next day. Overall, I have learnt a lot in this unit, possibly

more than any other unit in my degree, but I still feel like I could learn more so as to

understand valuations better.

I think I have a good grasp on restating financial statements, most of the ratios and

economic and business drivers and would be happy to assist new students with these. The

most important revelation in this unit I had was that all businesses will succeed or fail

depending on how well they know their economic and business drivers, because they explain

the financial statements and reveal whether management has a good understanding of their

business in the local or global marketplace. I would still like to learn more about the share

market so I can avoid the pitfalls of believing what others think, because in this unit I have

learnt that my opinion and analysis of my firm is the most important one. The realisation that

my analysis is the only one that matters (if I do it well) has carried over into my personal life

and given me added confidence in voicing my own opinions. I can finally see why Martin

likes to include personal stories and scenarios in the study guides because at the end of the

day accounting is about understanding a business run by ordinary people, attempting to be

successful in a constantly changing world, just like life.

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