Ferguson PLC (FERG LN)
Ferguson is the leading North American specialist distributor of plumbing and heating products and waterworks and fire fabrication products. Specialist distributors such as Watsco, Fastenal, and Pool Corp have compounded shareholder value at more than twenty five percent per annum over three decades due to industry fragmentation, long runways for accretive tuck in acquisitions, and competitive advantages that come with densification and scale benefits. Ferguson has all of these strengths, but what makes Ferguson unique is that despite now having all of its business in North America, the stock is listed in the United Kingdom and is owned primarily by non-US investors. This dynamic has created a valuation discount to peer Repair, Maintenance and Improvement (RMI) businesses in excess of fifty percent. We believe this technically driven valuation discount is set to change in 2020. With any business we invest in, we look for multiple ways to win. With Ferguson, there are three.
First, Ferguson is nearing completion of a decade long simplification of the business. This simplification entailed exiting twenty-five countries and thirty business units that lacked industry leading market share and the subsequent competitive advantages. What remains is a stronger, more focused market leader in North America specialty distribution. However, due to the legacy business footprint, Ferguson is still listed in the United Kingdom and generally not known or held by US investors. We believe that the board of director’s ongoing review of the company’s listing will result in a relisting in the United States and create upwards of fifty percent near term pricing appreciation as investors learn about the quality and growth outlook of the business. This is not a requirement for our investment, as we are happy to own the business for the long term whether or not it relists on US stock markets, but the asymmetric risk reward profile offers an attractive free option on near term price appreciation.
Second, as Ferguson management shifts its focus from simplifying the business to improving the core business, we believe they will build on the fifteen tuck in acquisitions completed last year as they continue to consolidate a highly fragmented industry. Ferguson’s proven, repeatable process for identifying, executing, and integrating tuck in acquisitions spins the flywheel which supports market share growth, scale advantages from purchasing power, product availability, route density, technological superiority, and vendor rebates, which grow the margin advantage over peers. Higher margins are then partially reinvested into superior services favored by Ferguson’s trade-oriented customer base. Superior products and superior services then help Ferguson grow its market share from an industry leading high teens to upwards of forty percent, in line with other best in class distributors.
Third, as Ferguson’s market share scales, there is a greater opportunity to move up the value chain and expand their private label product offering. As the private label product offering is expanded, customers are afforded a greater choice at better prices, and Ferguson receives a higher gross margin.
Ferguson’s three paths to value creation are supported by a high return on invested capital business with sixty percent of sales to non-discretionary end markets, and a commercial customer base that favors convenience over price due to a purchase process determined by labor efficiency. We are happy to be long term shareholders of Ferguson, even if only two of the three value drivers come to fruition.