Over-Reliance?

This story features RELIANCE WORLDWIDE CORP. LIMITED. For more info SHARE ANALYSIS: RWC

Reliance Worldwide shares took a hit yesterday on a disappointing trading update featuring severe margin compression. Brokers feel the worst may now be over.

-Reliance Worldwide disappoints and shares drop -13%
-Margin pressure from higher costs and lower volumes impacted
-Global economic outlook remains uncertain
-Brokers are cautiously confident going forward

By Greg Peel

Reliance Worldwide ((RWC)) designs, manufactures and supplies plumbing fittings and other water control and heating products. The name is not misleading – Reliance operates in Australia, New Zealand, Korea, China, the US, Canada, the UK, Spain, Italy, Germany, France, the Czech Republic and Poland.

We’d like to take credit, but the company was actually founded in and remains headquartered in the US, and while seemingly a new kid is actually 73 years old.

Reliance has proven quite the success story in recent years but investors have tended to get ahead of themselves. The stock ran hard up to mid-2018 and then lost over half its value, bottoming out in the March 2020 covid crash. It then regained all of that loss to end-2021 and has since lost half of it again in this year’s bear market.

Yesterday the company provided a September quarter trading update and the stock fell -13.4%.

The issue was one of higher raw material costs meeting lower sales volumes, thus compressing earnings margins by a far greater amount than brokers had forecast. Price rises in the quarter of 8% were not enough to offset.

The value of the company’s acquisition last year of US plumbing parts manufacturer EZ-Flo was evident. As a group, revenues rose 23% in the quarter, but only 6% ex-EZ-Flo. Margins fell by -209 basis points, or -520 points ex-EZ-Flo. Group earnings thus fell -4% when brokers had forecast single-digit growth.

Sales volumes declined in the US, UK and Europe, but grew in Asia-Pacific.

The Good News

One problem was that September was the best quarter of FY22, hence comparables were always going to be tough, and management expects the September quarter FY23 will be the worst.

Given there is lag between the purchase of raw materials, such as copper, and the sale of finished products, products sold in the September quarter were at peak raw material costs. The copper price has since fallen -22% from the peak, and other commodity prices have also retreated, which will take pressure off Reliance margins going forward.

Further supporting margins will be management’s decision to run down inventory in the December quarter, when typically it would build for the northern winter.

Aside from raw materials cost increases, the company also saw higher Selling, General & Administrative (SG&A) expenses, and will now rev up its cost-out program.

The Bad News

The trajectory of volumes remains unclear. Management noted “the growth outlook for all key markets has become less certain in recent months”, reflecting global economic uncertainty, and has not provided any guidance beyond D&A and interest expense.

Brokers agree the company’s exposure to the retail restoration & renovation (R&R) market provides some buffer against a downturn (households decide to renovate their existing house rather than buy a new house) but that trend showed deterioration in the quarter, while wholesale demand will be weaker as housing markets contract.

Reliance is also cycling strong US retail sales via the Lowe’s hardware store chain in the same quarter last year.

To add to uncertainty, the EZ-Flo factory in China is currently under lockdown, and who knows for how long? Reliance is covering by shipping goods from the US.

The Response

All seven FNArena database brokers cover Reliance Worldwide. All were disappointed, and clearly caught out, by the update, and the average consensus target between them has been cut to $4.04 from $4.79.

Four brokers had Buy or equivalent ratings heading into the update, and none have wavered (noting the stock fell -13%), nor is there any change to two Holds and a Sell.

Macquarie (Outperform) believes the market over-reacted yesterday. Reliance’s end-market exposures should prove resilient, and the broker continues to see valuation support while acknowledging the risks inherent in the market and cost context.

UBS (Buy) suggests despite the unfavourable conditions, the current share price factors in margin concerns and presents significant upside in all but a severe downturn, which is something the broker does not envisage given the greater weighting to R&R and repair.

Credit Suisse (Outperform) believes the potential for margins to recover, particularly on lower commodity prices, more than offsets volume risk. Morgan Stanley (Overweight) believes the key will be the extent to which management can convince the market the September quarter should be the low point for margins given cost relief expected through the year.

Even Citi (Sell), while foreseeing ongoing underperformance, admits “normalized earnings could be closer than the market is expecting”.

Morgans and Ord Minnett both remain on Hold citing uncertainty.

It should be noted the de-rated target of $4.04 still suggests 29% share price upside.

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