No light at the end of Wolseley's demand tunnel

The building supplies group's recent results failed to offer any hope of a recovery in demand

Anthony Dayrit 15 June, 2009 | 5:09PM
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Building products distributor Wolseley earlier this month issued its interim statement for the first nine months of the year (July year-end), and the results didn't provide any glimpse of a recovery in demand. Revenue and operating income fell 15% and 65%, respectively, driven primarily by continued weakness in the firm's end markets. The United States commercial and industrial construction sector, which tends to lag the residential market, experienced further deterioration during the period--a trend we think is likely to persist throughout most, if not all, of the year. Demand from the company's European markets also remains weak, with the UK and Ireland both posting revenue declines of 15% and a plunge in operating income of 75%. With softness in nonresidential construction piggybacking off of the deep housing declines across all of the firm's geographic regions, we believe Wolseley will continue to face fierce near-term head winds.

On a positive note, Ferguson, Wolseley's North American plumbing and heating products operation, sustained only a mild hit to profits despite a 15% revenue decline, as margins of 5.1% decreased 130 basis points from 6.4% during the year-ago period. Despite weak demand, Ferguson's performance is relatively encouraging, and the results were due to a focus on higher margin products such as private label and counter sales. In addition, the company recently divested its North American building materials business, Stock Building Supply, entering a joint venture agreement with private equity firm The Gore Group, which will now hold a 51% stake in the business. We view this as a smart move by the company, since Stock's heavy leverage to new residential construction and lumber prices resulted in the business haemorrhaging profits--Stock posted an operating loss of $246 million in 2008 and has already lost about $170 million during the first three quarters of 2009. Partially divesting the building materials business should also allow the firm to concentrate on its core plumbing and heating distribution operations.

Although conditions will remain challenging in the near term, Wolseley has taken significant steps to reduce its cost structure and improve its liquidity position. Since August 2007, the company has reduced head count by around 17,000 and closed more than 700 store branches. In addition, the company raised £1 billion through an equity issuance and rights offering in March, using the proceeds to pay down its hefty debt load. The recapitalisation allowed Wolseley to avoid breaching a covenant on its credit agreement, which requires net debt to be less than 3.5 times EBITDA. With net debt of £1.5 billion drastically reduced from £2.9 billion in the year-ago period, net debt/EBITDA now stands at 1.7. Wolseley has added some breathing room, and we have reduced our cost of equity estimate to account for this reduced leverage, resulting in an upward revision to our fair value estimate.

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Anthony Dayrit  Anthony Dayrit is a stock analyst with Morningstar.

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