Ferguson: Weaker Demand And Elevated Valuation Make HVAC Distributor A Hold (NYSE:FERG)

Introduction

Ferguson plc (NYSE:FERG) is a value-added distributor that does everything from HVAC, plumbing, and appliances to help customers replace and maintain equipment. In this article, I’ll discuss the company’s Q2 2024 results, my outlook for the company, and analyze the current valuation and risks to see if the current share price offers investors an attractive entry point.

Company Overview

Ferguson is a distributor of HVAC and plumbing products in the United States and Canada. With just under $30 billion of annual revenue today, the company has grown to 35,000 employees. About half of its business is residential and the other half being non-residential (commercial and industrial). The customer base of over 1 million customers is very diversified with no single customer accounting for over 1% of the company’s sales.

Background

When comparing Ferguson’s price performance to the rest of the market, the company has been a clear outperformer. Since the financial crisis of 2009, shares of Ferguson have returned 841% compared to the S&P500’s return of just 501%. With an annualized return of 17.4% on average per year, investors who’ve held onto the stock for the long-term have done quite well.

This outperformance can also be displayed through the company’s financials. Over the last 20 years, Ferguson has delivered impressive CAGRs in both sales and profitability, with revenues growing at a 5.4% CAGR and EBITDA growing at a 7.6% CAGR. In the last decade, revenues and EBITDA have grown at CAGRs of 5.9% and 11.5%, respectively, demonstrating that the company is still growing at above average rates of return (source: S&P Capital IQ).

Recent Results

In its most recent results for Q2 2024, Ferguson reported a miss on both revenues and EPS. Revenue for the quarter clocked in at $6.67 billion, down 2.2% year over year and missed consensus estimates by $90 million and EPS came in at $1.74 compared to the consensus estimate of $1.84.

Overall, this was a pretty weak quarter for Ferguson as shares slide over $10 following the news release. When analyzing what drove the sales decline, markedly lower demand from customers as well as price deflation of around 2%. When removing the additional revenue gained from acquisitions, which contributed 1.5%, organic revenue fell 3.7% with more weakness in residential sales compared to non-residential sales. Residential sales were down 3.5% and non-residential were down 0.6%

Ferguson has traditionally been an acquisitive company purchasing small tuck-in acquisitions where it can add value either through margin expansion or a presence in new geographies. In the last 5 years, the company has done over 50 acquisitions.

During the quarter, there were three new acquisitions announced which should add about $220 million in annual revenues to the company’s top line. While the purchase price for each one of these acquisitions is unknown, Ferguson has already deployed more than $500 million in acquisitions for F2024 and management expects about $600 million of revenue contribution for the full year related to acquisitions.

On the margin front, Ferguson was still able to maintain decent profit margins. Gross margin was 30.4% for the quarter compared to 30.2% last year but the company’s operating profit margin for the company declined from 8.0% from the same quarter last year to 7.1% this quarter. The reason for the increase in gross margin was as a result of the company’s pricing strategy but higher SG&A costs pulled down the company’s operating profit. This also meant that earnings per share fell year over year as well, down 9.7% to $4.40.

Despite the drop in EPS, this didn’t stop Ferguson from distributing excess cash to shareholders. Historically, Ferguson has returned cash through a combination of both dividends and share buybacks. So far for F2024, the company has already done $250 million in share repurchases and paid out another $0.79 per share as a quarterly dividend (a 5% increase compared to last year). Overall, this return of surplus cash via share buybacks and dividends highlights the stability of Ferguson’s business as well as management’s confidence in the long-term future of the company.

Finally, with respect to the balance sheet, Ferguson had $704 million of cash with $3.60 billion of long-term debt on its balance sheet at quarter end. With Net Debt of $2.90 billion, this brought the company’s Net Debt to EBITDA ratio to 1.1x, indicating that the company has ample cash flow to service its debt. The bulk of its debt, 85%, is fixed rate debt which is comprised of long-dated maturities and at low interest rates, thus leaving the company with relatively low refinancing risk. Historically, Ferguson has operated with fairly minimal leverage and has done a good job of maintaining a healthy balance sheet.

Outlook

As for my outlook for Ferguson, I would not expect significant growth for the balance of the year, with results missing estimates and falling short of expectations, management hasn’t revised guidance lower and it’s unclear if that’s because they expect a meaningful pickup in the second half of the year or if they are being too conservative.

So far, what we’ve seen is softer demand across the board for Ferguson’s products. Looking at the end markets it serves and the industry drivers, we can see that single-family housing starts are likely to decrease about 5% year over year, which is a net-negative for Ferguson. In addition, the repair and remodel activity market, which encompasses demand for things like HVAC, has been under pressure.

The Leading Indicator of Remodeling Activity, a metric which is published by the Joint Center for Housing Studies at Harvard University, predicts that the downturn the U.S. economy has experienced in early 2024 should bottom out sometime later this year. That doesn’t leave me too exciting for the company’s rest of 2024.

That said, the company has a great balance sheet and there is likely some opportunities to be more aggressive in M&A if valuations are attractive and Ferguson can find the right targets. Taking a longer view, when the market returns to a more normalized cycle, revenue should pick up closer to the 5-7% range, funded partially by organic growth and partially by acquisitions, consistent with the company’s long-term revenue CAGR. By 2028, the market size in the U.S. is expected to grow at a CAGR of 6.3% to $280.1 billion so industry tailwinds certainly favor Ferguson.

Valuation

Based on the 14 sellside analysts who cover Ferguson’s stock, there are 10 ‘buy’ ratings, 3 ‘hold’ ratings, and 1 ‘sell’ rating, with an average price target is $233.76, with a high estimate of $261.89 and a low estimate of $183.07 (source: TD Securities). From the current price to the average price target one year out, this implies potential upside of 16.3%, not including the 1.6% dividend yield. With total return potential of 17.9% over the next year, analysts seem pretty bullish on the company’s near term outlook.

Analyzing the historical valuation range, Ferguson seems to be trading at the upper bound of its historical P/E range. At 23.4x P/E, the company’s multiple is above its ten year average of 20.4x, suggesting potential overvaluation.

When looking comparable companies that exhibit similar growth profiles, leverage ratios, and operate in similar or adjacent industries, Ferguson trades slightly above the peer group at 14.1x forward EBITDA and 19.5x forward earnings. While one may be able to make the argument that Ferguson is a higher quality business model with a higher return on equity (30%+ over the last decade) and a track record of delivering steady returns, the company’s shares aren’t exactly cheap for an HVAC distributor that is likely to grow in the mid-single digits.

Thus, I would say that shares are rather expensive today and don’t represent good value. Closer to the midpoint of the historical valuation range of 20.4x P/E or the median P/E of the peer group at 19.4x P/E, shares of Ferguson might represent better value. This would imply a share price between $165 to $175, which would look to me like a more attractive entry point and provide a better margin of safety.

As for the risks to my investment thesis, the main one would be softer market demand persisting into 2025. Looking at consensus estimates, the market is predicting a modest rebound in both sales and EBITDA for the company (5% and 8% growth respectively) and so market weakness lasting longer than expected would be a drag on the company’s share price. The second is the company’s acquisition strategy. While Ferguson has proven itself as a disciplined capital allocator maintaining a conservative balance sheet, there’s a risk that as the company becomes larger that small tuck-in deals will no longer be able to meaningfully move the needle. There’s also the risk to consider that if valuations were to rise again, then Ferguson would likely not be able to find ways to deploy capital at high rates of return, resulting in multiple compression in the company’s share price.

Conclusion

Ferguson has been a great performer over the long-term and is about as high quality as you can get in the HVAC space. There are clear advantages to being a trusted brand, having economies of scale, and deploying capital efficiently through accretive acquisitions. However, with the recent quarterly results, the company is experiencing challenges such as softer demand and lower operating profit margins. While I expect a recovery in 2025 and the current weakness is likely temporary, the company’s valuation appears to be stretched compared to historical averages, raising concerns about potential overvaluation. While analyst sentiment suggests bullishness, I don’t think the stock offers an attractive entry point at its current price levels with a large delta between its forward multiples and the peer group forward multiples. As such, with a target for $165 to $175 per share, I’d be waiting for a pullback before initiating a position in the company’s shares today. For these reasons, I rate shares as a ‘hold’.