In order to decide whether or not to take up my entitlements, I needed to have a view of what the company's financials and valuation would look like after the MORSCO acquisition.
To the extent that it may be of use to others - and bearing in mind that financial forecasting is not a precise science - below follow my modelled forecasts of:
1. some salient elements of REECE's financials,
2. relevant financial diagnostics to help inform changes in REECE's financial pedigree, and
3. valuation metrics, based on the entitlement offer price, as well as the current share price.
However, before looking at the modelled outputs, I think a brief discussion on some of the more obvious differences in the financial pedigrees of REECE and MORSCO is warranted.
Based on the limited financial information provided, there are two main points of distinction between REECE and MORSCO financials:
Operating Margins:
As another poster has already commented, MORSCO operates at significantly lower margins than REECE.
REECE's EBITDA and EBIT margins are 14% and 12%, respectively.
By comparison MORSCO's EBITDA and EBIT margins are 6.1% and 5.4%, respectively (MORSCO's EBIT has not been provided, but I have estimated it by applying a depreciation charge to the company's US$88m fixed asset base, by essentially assuming an 8-year average asset life).
Capital Intensity:
As a trade-off for its slimmer operating margins, MORSCO operates a far more fixed asset-light business model. REECE's Fixed Asset Turn (Revenue-to-Fixed Assets) runs at ~5.0x, while MORSCO's is 20x. As such, Maintenance Capex-to-Sales for MORSCO is around 0.7% (again, using reasonable assumptions to sustain the current asset base), compared to almost 2% for REECE.
However, while MORSCO does not utilise much Fixed Capital, it's business is quite Working Capital-intensive, with Working Capital-to-Sales of 23%, compared to REECE's 19%.
What I interpret from these two major differences of Operating Margins and Capital Intensity is that MORSCO is very much a "catch-and-pass" distribution business, with limited investment in supply chain infrastructure, as opposed to REECE, which has greater physical ownership in its supply chain (Distribution Centres, Warehouses, Trade Outlets, Stores, Showrooms).
Personally, I think the REECE model is far more resilient and durable, and provides far greater competitive advantages, while I'm concerned that relatively more scope exists for potential dis-intermediation of MORSCO revenues.
As such, my first pass assessment - and based on the limited information available - is that I feel REECE, by acquiring MORSCO, has moved down the business quality curve.
At any rate, with that somewhat superficial analysis out of the way, onto the modelled outputs:
1. FINANCIAL FORECASTS (All figures in A$):
Note: FY2018 figures represent Reece on a standalone basis; FY2019 to FY2021 are for the combined companies ("MergeCo"):
2. FINANCIAL DIAGNOSTICS:
As can be seen in the table below, the salient features are the lowering of Operating Margins post-MORSCO, which more than offsets higher Asset Turnover and lower ongoing Capex-to-Sales, leading to reduced ROE.
Also, Net Debt-to-EBITDA will only get back below 2.0x - a maximum level that I think is psychologically important to me - during FY2021 (!) based on my modelling.
3. VALUATION:
At the issue price of $9.30, (refer table below) the stock is trading on a prospective FY2019 multiples of P/E ~18.0x and EV/EBITDA ~12x.
Which, to me, look - at best - fair, but by no means unambiguously cheap, and it has required quite a bit of intellectual wrestling for me to decide whether or not to take up my entitlements at the offer price.
Because this acquisition is EPS accretive (to the tune of around 5% on my somewhat conservative numbers), REH's standalone P/E for FY2019 would have been a touch higher, ~19x. However, because of the significant debt component for the acquisition, there is no value accretion in terms of EV/EBITDA (had this acquisition not occurred, I estimate REH would also be valued at around 12x FY2019 EV/EBITDA.)
And, at the current market price of $12.20, the prospective valuations - while not quite in nose-bleed territory - are not far off it.
It is going to take the better part of three years of double-digit growth for the earnings to chew into the valuation prospective multiples to the extent that the stock will once again appear attractively-valued.
Again, all figures and analysis presented in this post are intended to be indicative, not prescriptive, and should therefore be interpreted with the degree of caution and prudence that are required when dealing with the ramblings of anonymous posters on online stock forums.
(20min delay)
