For a company that went decades without raising capital, the fact Reece has done so twice in two years is striking.
We'd argue the second capital raising - currently underway - has been launched because Reece didn't raise enough last time. In Is this Reece's Icarus moment? on 9 May 18 (Hold - $12.30), we said that the $1.5bn of debt taken on to fund the Morsco acquisition would take the company's balance sheet from 'extremely conservative to fairly aggressive'.
The plumbing supplies company should have raised more capital two years ago. But at least Reece's management is now on the front foot with this $600m raising, so we'll forgive its earlier indiscretion.
Equity raising underway
Housing downturn looms
Reasonable price for great business
For shareholders there are two pieces of good news. The first is that Reece's share price is 25% lower than in May 2018. The second is that existing shareholders will have the opportunity to buy new shares in the current capital raising at $7.60 a pop.
Not only is the issue price 18% lower than the $9.30 of two years ago, it's just a whisker above where we recommended the stock back in 2016 (at a split-adjusted share price of $6.77). There's more on how existing shareholders can participate in this favourably-structured equity issue in the box titled 'Capital raising'.
But there's also bad news - of a sort. Reece's management is getting on the front foot because it wants to be prepared for any shutdowns arising from the corona-crisis. While Reece's plumbing supplies outlets are considered essential services, sales in New Zealand have 'materially reduced' during that country's stage four lockdown restrictions.
Reece's equity issue has been relatively favourably structured for existing retail shareholders (unlike some other companies). The institutional placement and entitlement offer has already been completed, raising $600m. Retail shareholders now get their turn and you're in fact being offered two bites of this capital raising cherry (see Table 2 below for important timetable dates).
The first bite is the 3 for 55 non-renounceable entitlement offer at $7.60 a share (the 'Retail Entitlement Offer'). But you can in fact apply for more than your entitlement should you wish (you should watch out for this potential in other companies' capital raisings too). The second bite is a Share Purchase Plan (SPP), which also allows you to apply for up to $30,000 worth of new shares at the same $7.60 offer price.
We're unable to provide personal advice and how much you apply for depends on your portfolio weighting and tolerance for risk, as you'll be exposed to the risk that Reece shares trade below $7.60 until new shares are allotted.
But $7.60 is clearly favourable given that Reece's share price is currently $9.22, so it might make sense to apply for as much as you're comfortable with in both the Retail Entitlement Offer and the SPP (remembering there might be a scale-back). You can always sell down your Reece holding now or later if you wish (depending on your portfolio weighting and risk tolerance).
Reece's capital raising shows other companies how it should be done, and we applaud them for it. Don't miss the closing date of 24 April to apply for stock in the capital raising if you were a Reece shareholder on or before 3 April.
While Reece's Australian and US outlets remain open, greater restrictions in either or both countries are possible. This capital raising ensures it has more than $900m of available resources to draw on if other shutdowns occur.
Even so, shutdowns aren't top of our worry list. Rather, we're most concerned about the housing construction downturn now underway in Australia and still to arrive in the US.
The 2020 first half result showed early evidence of the downturn. In Australia, underlying earnings before interest, tax, depreciation and amortisation (EBITDA) fell 4% on flat sales. Margins weakened, as they have in previous downturns. For context, between 2008 and 2009, Reece's operating margin fell from 11.5% to 9.9%.
In Reece's 2020 half-yearly results presentation, management pointed to forecasts that dwelling completions would fall 23% between 2019 and 2021. However, the company also outlined forecasts that Australian dwelling approvals would begin to recover in 2021 (completions lag approvals significantly, as you'd expect). But the corona-crisis is likely to delay any housing market recovery, so the probability of approvals rising next year now seems pretty slim.
We're now also expecting a housing downturn in the US, as we explained in our recent upgrade of James Hardie. With US unemployment soaring from under 4% to 12% in only two months - and likely to jump higher still - housing construction activity will certainly take a hit.
When we first upgraded Reece, however, we said that 'picking cycles is harder than it looks'. The market looks forward, of course, and is hardly unaware of the looming downturns in Australia or even the US. We've had a stab at a forecast for 2021 in the accompanying table although it's a moveable feast - as is 2022 and beyond.
What we'd highlight is that getting too hung up on cycles can cause you to miss the most important things. The first is that this is an owner-managed business with a superb long-term record. Running the Reece plumbing supplies business is in the Wilson family's DNA; and following the capital raising they will still own 68% of the stock. It's almost inconceivable that the Wilsons would sell out of Reece like the Munz family sold out of Sharkbite manufacturer Reliance Worldwide.
The second is the long-term potential from Reece's US expansion. Contrary to our initial fears, no 'time bombs' have detonated in Morsco since it was acquired in mid-2018. In fact it's performing rather well; in the first half of 2020 Morsco's like-for-like sales revenue rose 9%. Contrast that with the more mature Australia where sales were flat.
Divisional operating profit in the US rose 36% in the first half too, although perhaps a third of that was due to the acquisition of Todd Pipe & Supply in California on 1 October. There's early evidence that Morsco's margins, which remain well below the Australian division, might be benefiting from Reece's efficiency expertise.
What's important is that Morsco continues to consolidate the plumbing supplies market in the southern US. Unlike Australia, it remains a fragmented market with multiple small players - and acquisition opportunities (like Todd Pipe & Supply). Previously the balance sheet was stretched but the capital raising means Reece now has the firepower to continue its acquisition strategy.
Morsco is unlikely to ever be the market leader - a position which belongs to Ferguson plc, with US sales of US$18bn. But Morsco, with almost US$2bn of sales, should be able to carve out a profitable niche, just as third-ranked player Sonic Healthcare has in US pathology. Morsco's margin upside remains substantial.
We like the optionality within Reece - and not just in the US. Reece's main Australian competitor Tradelink - owned by Fletcher Building - has been a basket case for years, with operating margins that have rarely exceeded 2%. Downturns tend to be periods where strong market leaders such as Reece cement their positions. Distressed assets may yet become available to buy in the US.
Existing shareholders in Reece have an advantage because they may be able to acquire decent licks of stock at $7.60 in the capital raising (see box). But how should new shareholders play this opportunity?
Well, we set the current Buy price of $9.00 in late 2018 in the expectation of an eventual housing downturn. Now that one is approaching, it's fair to say the outlook has deteriorated - and the capital raising means there has been some dilution as well. Rather than wait for a cheaper entry price, however, we suggest staggering your entry into the stock. We're lifting our maximum suggested portfolio weighting from 5% to 6% - this is, after all, a high-quality business - which should allow you to acquire stock over time.
This is only the second time we've recommended Reece in four years, which shows how infrequently opportunities in wonderful businesses can appear. With the stock down 8% since our last review, we're lifting our Buy price marginally and upgrading the recommendation to BUY.
Note: Our Model Growth, Model Income and Model Ethical portfolios own shares in Reece, as do the Intelligent Investor Equity Growth Fund, Intelligent Investor Ethical Fund and the Intelligent Investor Equity Income Fund.