Today we had a three-month trading update from the world’s largest distributor of plumbing and heating products for professionals in the trade, the FTSE 100’s Ferguson (LSE: FERG).
When I open statements from the firm, I’m usually peeking through the fingers of the hand that’s over my eyes. Why? Because I remember the stock’s tremendous 80%-plus plunge in the wake of last decade’s credit crunch.
Consolidating a fragmented market
Indeed, the sector is highly cyclical. But it has to be said that since 2009, Ferguson’s shareholders have done very well indeed both from rising dividends and from an impressive increase in the share price. And cyclicality is not the whole story, of course.
Ferguson operates as something of a consolidator in what is a fragmented market. Every year there’s been a long list of acquisitions, with the firm buying up generally localised competition.
One of the most relevant points to note is that more than 90% of the company’s earnings come from the US. In September, the directors announced plans to de-merge the UK business, which trades as Wolseley. In today’s announcement, the firm said the UK de-merger is “progressing as planned.”
So the general state of the economy across the pond is important to Ferguson. And chief executive Kevin Murphy said in today’s update that the US market has been flat in the period, although the company has been winning a bigger share of it.
Both the top and bottom lines grew in the quarter. Overall, revenue increased by 5.3% compared to the equivalent period a year earlier and underlying trading profit went up by 4.8%. Within the figures, organic revenue improved by 2.5%.
A positive outlook
Looking ahead, Murphy expects further progress for the full trading year. Even though growth in the general market in North America is flat, he’s “confident” Ferguson will outperform its end markets. City analysts following the firm expect modest single-digit percentage increases in earnings for the current trading year and for the following year to July 2021.
But I’m nervous about the stock and can’t help imagining another downside scenario playing out if we get a half-decent global economic slump. Yet Ferguson ploughs on and spent $62m in acquisitions in the first quarter. There’s also a “healthy” deal pipeline.
I wouldn’t feel so twitchy about this one if the valuation reflected a cyclical firm in the mature stages of an economic upswing, as the valuations of the major London-listed banks do. But with the share price near 6,450p, the forward-looking earnings multiple for the trading year to July 2021 is just over 15 and the anticipated dividend yield is about 2.8%.
That valuation looks full, to me. Why isn’t Ferguson sporting a dividend yield of about 5%? I reckon it ‘should’ be. So, in my eyes, there’s huge potential to the downside for shareholders if business slows down.
Perhaps falling earnings and a valuation down-rating could then end up decimating the share price. As usual, I’m avoiding the shares. However, I could be wrong to do that. Over to you.