Exciting future for REH, page-18

Dont get me wrong, I'm not looking askance at the Actrol transaction in and of itself. In the scheme of things, it's actually quite small (a few hundred million dollar deal in the context of a $3.5bn company).

For me the issue is more what it portends in terms of management thinking.

They have never bought anything material in their lives, so I'm wondering if this - besides the fact that they might truly believe Actrol is a great business that they can drive up the value curve - doesn't inadvertently serve as a dress rehearsal for some bigger (as in, "Hey, that Actrol deal didn't pan out too badly, maybe we are good at this acquisition thing").

I'm a fan of the creation of goodwill value from first principles; I become far less enthusiastic when it comes to paying someone else for goodwill that they have created.


As for the earnings trajectory over the past 7 or 8 years, I have little doubt that there were cyclical forces at work (the depressed residential construction market until just the past 12 to 18 months) which has capped revenue and profit growth, despite ongoing capital deployment.

And I have no doubt that REH management over that entire period continued to do what they always do, i.e., invest in the growth capability of the business ... irrespective of where they think, or don't think, the construction cycle is.

The reason I say that with such certainty is that I heard that strategic sentiment articulated by the Reece executive chairman on several occasions during that period, along the lines of:

"We have no idea who are going to build houses and how many they are going to build in any given time period. We can add no value to shareholders in forecasting that externality, so we don't try. Instead, we continue to identify opportunities for investment in areas of our business, where we are able to generate superior returns on capital irrespective of what the construction cycle is doing, and which enhances our competitive positioning in the market place. The market cycle is what it is. We don't try to time it."


Of course, it stands to reason that when outlets are rolled out, the economic theory suggests that the best sites are the ones that are the ones that are developed first, and vice versa.

So it might be that we might be seeing - quite literally - the law of diminishing returns in action.


But my intuitive sense is that the return fade between the peak in 2007 to the trough in 2014 is, maybe 80%, due to a case of the former (cyclical headwinds), and 20% attributable to the latter (structurally less attractive - but still above cost of capital - capacity investment).


Which means that, when the cycle improves - as it is doing now - we will see returns recover to somewhere closer to 2007's peaks (but not quite at the same levels).