Has REH peaked?

@madamswer, @travelightor and other Reece-ophiles

We have had a good amount of discussion in recent times about REH's moat, with much fawning and adulation. So I thought I would look at some hard facts and see how well our adulation stands up to them (Travelightor, thanks for explaining that JPEG's do now allow images to be displayed in the HC space. I have now finally learnt how to save an Excel chart as an image file, such as a PDF or PNG). We learn something new every day! (when we don't know much to start with ).

Ok, I will start by stating the obvious, and that is that REH's sales are strongly correlated to the building cycle. I'm sure we all know that. However, I am not convinced we all accept the degree to which it is tied to it. Below is a chart of REH's sales revenues, plotted against all building activity, as well as all residential building activity.


For completeness, I thought I would throw in a similar plot, this time showing hardware, building & garden supplies retail sales (HBG), as well as residential renovation building activity.


Now I'm note sure which of these cycles is most significant (which all seem to be strongly correlated anyhow), but I'm sure they all have a role to play in REH's sales. I think it is further instructive to plot the annual growth in each of these, to see how they compare.

Chart footnote: REH's sales growth in FY14 excludes impact of Actrol acquisition. REH's growth thereafter includes annualised impact of Actrol.

It is clear looking at the above chart that from about FY2004 to FY2009, REH's sales comfortably grew at a greater rate than for any of the indicated industry cycles. This is also the period, as we have discussed in the past, when REH was opening new outlets at quite a rate. The way I see it, there are only two possible explanations here, either REH was increasing its market share, or plumbing & bathroom expenses were becoming a larger proportion of overall building activity. If it was the latter, I suspect there would have been a larger relative growth rate of reno work and HBG retail sales, versus overall building activity - which is not the case. So I conclude REH won a lot of market share over the period (hence the effectiveness of its store rollout program).

Post FY2009, and up until FY2011 a different story emerges. Here it appears that REH's revenues failed to keep up with building activity. Now it could be argued that the share of plumbing & bathroom activity in overall building activity may have been a factor. However, revenues failed to keep up with every category, including renovations and HBG retail sales. So I cannot help but conclude that REH lost market share over the period. That said, I don't want to over state the significance of this, after all it's only a two year period.

So let's move on to the period FY2011 to FY2017. Keep in mind that the revenue growth shown in FY14 here excludes the contribution of Actrol, whilst that shown after FY15 includes the annualised contribution of Actrol. Over this period, or at least to FY16, revenues seem to be moving in lock-step with overall building activity. That sounds ok, I guess. However, it seems to be falling far short of residential building activity, which I would have though would have been REH's key segment. Some might take comfort from the fact that growth has been running substantially ahead of the residential reno segment. Perhaps, however when we consider that this segment has a total value of maybe 12% of the entire residential building segment, I'm not sure how much comfort we should take from it.

The good news is that in FY17 revenues grew more strongly (though not by a huge amount) then all of the other industry segments. On this, Travelightor, in a recent post you said something about the FY17 results being "so-so" (I think) - I actually think they are the best results we have seen in a long time.

Of course, recent progress here is muddied by the Actrol acquisition in FY14, and the fact that REH in their usual fashion are rather sparse in their disclosures, and there is no segment breakdown. So I have no idea if what we are seeing in FY17 is progress wrt HVAC and refrigeration, or something else.

So the point of all this is that if REH's revenue fortunes are purely tied to the building cycle (at best), then the question is how much control does REH have over its destiny? If it is tied to the cycle (or one of the cycles, or a combination of) then I posit that no amount of capital expenditure will provide top line growth, but can only attempt to guarantee (if possible) no loss of market share. Don't get me wrong, the building cycle alone will probably guarantee growth over the every long term of circa 7%, or more. It's well worth investing to defend this - if high ROE's can be sustained. However, REH is spending about 50% of its operating cash flows on capex. If it's market share is already peaked, then this may be futile in terms of gaining top-line growth - and thus a lower ROE future may be in order. We may already be seeing this.

Of course, the other possibility is that the extra capex leads to improved margins (as we have discussed before). This brings us to my next chart:

As we have discussed before (and you Madamswer have made quite a point about), no improvement on the fixed-cost side of things is particularly evident. The GM continues to improve (more or less) - which is great. However, with the GM already at about 33%, further improvement here may be hard to come by. Ultimately, no one is going to supply Reece product for next to nothing, and with market share perhaps peaked, further ability to negotiate attractive purchasing terms may also have peaked. So are there any prospects for further improvements with fixed costs? Here is the next and final chart:


The largest contributor to CODB are employee costs. These, together with the other itemised items depreciation & op leases, show no substantial sign of delivering improvements. However, and importantly (I believe), the costs itemised as "other" are showing an improving trend. These costs probably include crucial items to REH's moat (marketing, systems etc) - so whether or not they should be a source of margin improvement is another question. These are under a third of all CODB, so even if the indicated trend continues, it will take a long time before it delivers any meaningful overall margin improvement.

This may well be why REH has moved into the heating, a/c and refrig space, and made its first major acquisition in FY2014. So I guess much depends on how this pans out. But this, as far as I'm concerned, is a huge unknown.

Anyhow, it's the weekend now. So have a good weekend, and hopefully as of Monday we can have some useful discussion.