REH moat, page-154

In case Wesfarmers didn't have enough on its plate, they could be eyeing a stake in Fletcher Building, owner of plumbing supplies business Tradelink.

@neoteric,

The more I think about this proposition, the more it appears to me to be a move that Wesfarmers management could be able somehow justify without raising too much of the market's ire (not that I think that means it has a high degree of probability of happening).

And, as a Reece shareholder, I hope it does happen, because it will introduce a rational competitor (i.e., Wesfarmers) to the Australian plumbing supplies industry, and remove an operator (i.e. Fletcher Building) that was happy to occupy a share of the market despite generating negative economic returns from doing so.


Here is some context:

In FY2010 (which is the last full-year that Tradelink's financial results were broken out before Tradelink's then-owner, Crane Group, was acquired by Fletcher Building), Tradelink generated $41m of EBIT from its 227 stores (equivalent to EBIT of $181,000 per store).

By comparison, last year Tradelink made EBIT of just $5m, according to Fletcher Building's 2017 Annual Report.

As a long-term Reece shareholder, I have always monitored the performance of Tradelink, and I can recall attending a presentation in with Fletcher Building management soon after Fletcher had bought Crane Group.

The commentary from Fletcher management at the time, was something along the lines of:

"Out of Tradelink's 220-odd stores, about one store in five is generating returns in excess of the company's cost of capital, but around one store in three is loss-making at the EBIT level; the balance of the store portfolio are not actually losing money, as such, but are generating unsatisfactory returns."

Based on FBU's deteriorating financial position in just about every year since then, coupled to the fact that the entire Tradlink business today generates just $5m in EBIT (compared to $41m when Fletcher took control of it), it stands to reason that more than just one Tradelink store in three will be loss-making today... I reckon almost half of them would be reporting losses, and very few of them would be generating returns above their cost of capital.

And Wesfarmers, being the shareholder-value aware, financial pragmatists that they are, would know that one of the quickest and easiest ways to lift earnings is to discontinue loss-making businesses.

So, I am quite confident that, should WES acquired FBU, one of the first orders of business will be to shut down those parts of the FBU empire that are making losses and are deemed challenging to be turned around.

With little doubt, a large part of Tradelink's store portfolio would fall squarely into that category.

My guess is that the better part of 100 Tradelink stores will never be able to generate acceptable financial returns, and to spend money on them trying to get them to where they need to be will be tantamount to throwing good money after bad.

So, I think that under WES's ownership, we'd see a good 70 or 80 Tradelink stores shut down within 12 months.

(The reason the FBU hasn't to date acted to rationalise Tradelink's store portfolio is because it would cost a significant amount of money to do so, and FBU's parlous financial position means that it would not be able to service the contingent liabilities that would crystalise if it sought to shut down 100 under-performing Tradelink stores; for example, operating and property leases, restructuring and redundancy charges, working capital write-downs. [*]. By contrast, WES - being a much larger company and with its balance sheet in pristine condition - has no such financial constraints and could fund any major restructuring and store rationalisation exercise at Tradelink with ease.)


Taking this a step further:

At around $4.0m pa turnover per store, collectively, those 70 or 80 stores Tradelink that are likely to be shuttered-in, if under WES control, would represent something like $300m in industry sales, or around 5% to 6% of the current plumbing supplies market in Ausrtralia.

And even if Reece was able to win its proportional share (say, 40%, to be conservative) of those shuttered Tradelink sales, it would mean an extra $120m in Revenue to Reece, and - applying Reece's GP Margin of ~33% - that in turn would translate into around $40m in additional Gross Profit.

And a $40m Gross Profit windfall is effectively a 5%, 10% and 12% uplift in Reece's expected Gross Profit, EBIT and Pre-Tax Profit for FY2018.

(Of course, such an exercise is not mean to be prescriptive, but rather indicative of some of the financial benefits that are likely to accrue to Reece if WES did end up owning and controlling Tradelink, the Number 2 player in the plumbing supplies market.)


So, while I have no firm views on the likelihood of WES acquiring FBU, wearing my REH shareholder hat, I certainly hope it does happen.

Because, as I've tried to demonstrate above, a rational player such as WES, with both the will and the financial ability to remove loss-making capacity from the industry, will result in improved financial returns for all the industry operators, including Reece.

Here's hoping.




[*] FBU's NIBD-EBITDA is ~3.0x and EBIT-Net Interest Cover is a mere ~4.1x. And besides its >$2bn of net borrowings, @30 June 2017 FBU had near-term, off-balance sheet liabilities of amounting to some $650m.