Shares in building materials supplier Grafton Group (LON:GFTU) fell 12% in early trading today as it warned that softer third quarter trends would lead to a 4-8% drop in profits versus expectations:
The Grafton share price has had quite an adventurous year, starting the year at around 700p, it had advanced to over 900p in the summer. This recent price fall takes it back to the start of the year, although it does look like there is support kicking in at 750p.
Grafton own quite a few brands that are well known in the UK such as Selco and Builders Warehouse and until recently, Plumbase. They are relatively thinly spread, operating in the UK, Ireland and Netherlands but have forged very strong market positions in each.
Perhaps this warning comes as little surprise, as the manufacturing sector has been weak recently, with many firms holding off on projects. This had led to a spate of profit warnings in the sector as contracts have been delayed.
What’s gone wrong at Grafton?
We get this news in an update which has been brought forward to inform the market. Volumes were up on the quarter, but deteriorated through to the end. In more detail:
Volumes in the UK merchanting business were affected by weak underlying demand fundamentals as households deferred discretionary spending on home improvement projects against the backdrop of increased economic uncertainty. While the Irish economy continued to benefit from positive momentum, there was some slowing in demand in the merchanting and DIY markets as consumer sentiment eased in response to a more cautious international outlook. Despite generally favourable conditions in the Netherlands merchanting market, demand has been affected by a Court ruling on nitrogen emissions which has delayed the grant of permits for new construction projects.
This is then translated into figures:
Against the backdrop of softer third quarter trends which have continued into October, the Group currently expects to report full year operating profit for continuing operations in the range of 4-8 per cent lower than current consensus1.
The expectations are quantified, either £193.5m or £206.4m depending on whether the new accounting standard IFRS 16 is applied.
Grafton: A Solid Business
In many cases, companies issuing profit warnings are in bad shape, but this isn’t the case for Grafton. At £1.8bn market cap at the time of writing, it is also one of the larger ones. Despite selling commodities (products are available elsewhere) their results are good (taken from Stockopedia) and there is a good trend of increasing turnover and profits. Growth is not totally organic and is aided by acquisitions.
Margins are also relatively good at 6.3%, which is way above the supermarkets for instance. The divestment of the plumbing division (which had much lower margins) should also give margins a further boost.
As we can expect, the stores generate real cash which is also converted into profit:
Free cash flow is also very strong every year, and the dividend policy clearly shows that they are living within their means: dividends have been increasing slowly but are still well covered (3.7 times at the last annual report).
This has meant that debt has been paid down without the need to issue further equity, excluding the impact of the new IFRS (which treats future lease payments as debt) the company are in a good position financially with no net debt after their divestments (and assuming no further acquisitions). This is not to say they have no borrowings, but they have very large cash balances, balanced out by debt which is financed at very low interest rates (at rates of 0.84% and 1.41%), reflecting the market’s confidence in the ability to pay.
In short, currently I view this as in a great position current and clearly not in any danger.
Capital Expenditures, Intangible Assets
Perhaps being picky, but one thing going against Grafton is that it is a relatively capital intensive business. Capital expenditures have remained at 40% of operating cashflow, and a cursory look at the breakdown shows that most of this is required. £34.1m was needed for opening new branches and upgrading others – some stores can be particularly large and therefore expensive to upgrade.
Another £32m was required for other assets such as vehicles to transport goods, and to also purchase tools that customers can hire. If the company is to keep on growing its network of branches these expenditures are necessary. Arguably in a bigger slowdown these expenses can be cut, but to the detriment of the business.
The business also capitalises its IT development costs which sits on the balance sheet at £36.7m. On the same subject of intangible assets, some £646m is on the balance sheet and there has been no impairments to date. Potentially this may be a source of a profit warning in the future if there is a structural change in any of the units markets.
Are Grafton shares fairly priced?
The price drop has been rather modest today compared to other profit warnings. The headline figures of a 4-8% drop in profits reflected a quarter that started out strongly but deteriorated sharply towards the end, and subsequent quarters may be poor in their entirety if the trends persist.
But it could be the case that this is a case of deferred spending rather than withdrawn spending. A further loosening in credit to support the housing market (which seems likely) would no doubt benefit the variety of brands that Grafton has, and the board have indicated a willingness to expand to new geographic markets which would also provide a new source of profits. More importantly the resources are there to finance acquisitions and with the scale of the company, it is easy to imagine some synergies.
So on the valuation, it seems fairly undemanding. Stockopedia gave a forward P/E of 13, which may still hold today given both price and earnings have deteriorated. This does not strike me as particularly expensive given the results the company have given so far and their disciplined approach, although I can accept that the sentiment for this sector faces some quite strong headwinds in the short-term.
I do feel the company will be strong enough to ride these out and while I don’t think the price is an absolute bargain at the moment, there may be a chance it could develop into one, so i will be an interested watcher. 4/5.