Description

Summary:

• Excellent, well-managed company, track record of strong proven organic growth, accretively consolidating a fragmented industry, high free cash flow w/ ~100% conversion, 35-40%+ ROCE, AAA ESG rating, clean balance sheet with 1.1x leverage and material capital returns (2% dividend yield, $2.5B buyback authorization, company has repurchased >11% of the company since the beginning of fiscal ‘20)

• One of the largest distributors in the country with >$29B revenues, dominant in its categories, market share winner, exposure to solid long term end markets diversified across residential (54%) / non-res (46%) and RMI (60%) / New construction (40%)

• Despite the company’s history, size and business quality, believe the stock remains under the radar domestically as it only recently changed its listing from the LSE to the NYSE; it has been historically primarily covered by European analysts who don’t know the US endmarkets and is not yet included in any major U.S. industry coverage groups or indices

• Each of these factors are dynamically changing and is an opportunity to buy an exceptional compounding asset in a technical transitional period at, in my view, a highly discounted absolute and relative valuation to its inferior peers; FERG trades at a 2-5x+ EBITDA multiple discount to most of its peers and believe this disparity will collapse over a short horizon with several fundamental and technical ways to win as described herein

History/Business:

• Diversified, value-added distribution business that dominates in its core end markets; 75% of revenue from markets where hold #1 or #2 position; majority of business is driven by more stable and less discretionary repair/remodel/RMI (Repair, Maintenance, Improvement) markets; natural inflation beneficiary

• Market share:  #1 in core plumbing/PVF, waterworks, commercial/mechanical, fire/fabrication; #2 in industrial and resi trade, #3 in facilities supply and HVAC, #4 in resi e-commerce (see page 6 of annual report for chart on market size, share and TAM)

• Competitively advantaged share gainer due to scale, density, supply chain / procurement / inventory advantages, omnichannel go to market offering, inventory positioning, ability to be multi-trade specified supplier; classic distribution model sitting in the middle of fragmented 37k supply base on one side and 1M customers on the other; current Market Distribution Center (MDC) rollout plan places highly automated/robotics driven facilities in each major US market, further distancing FERG from its competition, driving share and widening its inventory, cost, scale and time to market moats

• US organic growth rates from 2011-2022:  8.0%, 8.8%, 8.6%, 8.0%, 9.6%, 4.7%, 7.4%, 9.9%, 6.2%, 0.4% (COVID), 12.8%, 24.2%; over this time frame, M&A added a further ~2% annually on average to the top line

• Excellent and aggressive management team; highly variable cost structure (60-70%), proven ability during COVID and prior slower periods to manage the business and protect profitability

• Hosted an inaugural investor day in January 2022 (great deck and presentation on IR site) targeted at large long-only institutions and new domestic sell side coverage, providing a comprehensive overview of the strategy and establishing compelling medium-term growth and earnings targets:  (i) mgmt projects 7-12% annual rev growth (3-5% mkt growth + 3-4% share gains + 1-3% M&A), (ii) operating leverage, material 100% FCF conversion, (iii) teens earnings growth before material buybacks

• History:  operations are 100% in the U.S. and Canada, but the stock was historically listed in the UK as Ferguson was formerly the crown jewel division of the multinational conglomerate Wolseley plc; over time, Wolseley divested all of its other assets, switched reporting to GAAP in USD, culminating with the decision to move the listing from the UK to the US, a two-year process that was completed in May 2022;  CEO, CFO, senior FERG management all US based and most been with company long time

Thesis/Opportunity:

• Timing of abovementioned listing change unluckily occurred during volatile stock market backdrop creating an air pocket of demand for the stock; on the front end, the stock was de-listed in the UK and as a former FTSE100 member caused systemic technical passive selling as FERG was removed from that index (estimate >10-15% of float); have since been in a time frame where the natural fundamental and long-only buyers both don’t know that company yet and are reluctant to add exposure in current macro backdrop

• Furthermore, until very recently, FERG was not eligible for US major index inclusion; (i) all tests for Russell inclusion were just passed and FERG will be added to the Russell 1000 index effective June 23rd, estimate that this will drive ~$1.5B of index related buying volume (~5% of the company), (ii) earlier this year, all tests were also passed for S&P500 inclusion, unlike the Russell which is systematic, S&P500 inclusion is at the discretion of the committee and can occur either on quarterly rebalances (early September is the next chance) or if a company is taken out between quarters due to merger (ATVI) or other issues (FRC, SIVB); believe is a top inclusion candidate based on its size / large market cap / revenue base vs. other eligible companies and also should benefit from an industry weighting perspective; believe is a matter of when not if FERG will be added and estimate that this with drive further index related buying representing ~15-17% of the company

• Believe the (i) the re-listing will ultimately attract material natural domestic fundamental buy-side investors who had previously not known/covered the company and/or been unable to invest due to lack of domestic listing and resultant liquidity (stock is now highly liquid having traded domestically for last year or so), (ii) sell-side research coverage will continue to transfer to the more appropriate relevant domestic analysts (e.g., JPM, UBS and Jefferies recently switched following Barclays last year) and (iii) most importantly, the likely inclusion in the S&P 500 and Russell indices will provide a material technical tailwind as well as cause fundamental and long-only index/sub-index benchmarked investors to focus as believe FERG will become a “must know/own” stock

• Fundamentally, I believe the market is concerned about the company’s construction exposure/related volumes and that inflation is now a headwind as many distributors have been somewhat overearning; I believe FERG has much less new construction exposure than its comps and that the combination of finished goods (85%) vs. commodity (15%) mix, share gains, operating leverage, and M&A sets a much higher earnings base vs. market expectations; unlike many of its distribution peers, FERG’s gross margin did not materially expand during the last several years of excess inflation and the company’s gross margins have already largely normalized and been incorporated in company guidance

• Strategic optionality:  given its dominance in the segments it operates and especially since it largely sells to the “Trade Pro”, believe FERG would be an excellent target for HD or LOW; each is strategically focused on the faster growing attractive “Pro” customer and if one was successful in buying FERG, it would own this market forever and box out the other; view as a lower probability event and also downside protection on FERG stock; note that Trian is the #6 holder and owns 7.4M shares or 3.6% of the company

• Comps EBITDA multiples:  FAST (18.3x), SITE (18.2x), WSO (16.3x), POOL (16.0x), HD (13.8x), GWW (13.2x), LOW (11.4x), CNM (9.9x); based on public disclosures, the average annual organic growth of these comps over the last 5-10 years has been 300-500bps less than FERG

Conclusion:  opportunity to buy an exceptional compounding asset in a transitional period at a discounted absolute and relative valuation with immediate catalysts to collapse this EBITDA multiple disparity; with a >$30B market cap, FERG currently trades at 11.3x EBITDA, 15.5x earnings and a 6.5% FCF yield; see a compelling risk/reward with modest downside risk based on quality / stability / FCF / growth of the business (plus a put to HD or LOW); in a base case see a $190 stock (up ~30%) as earnings deliver and multiple expands 2-3x, and in a bull case see a $225 stock (up >50%) as the company is added to the S&P500 and Russell 1000, the stock is fully distributed and trades in line with the best comps, as it should give its size and superior growth and ROCE

Important Disclaimer

The information contained herein (the “Information”) represents the views of the author as of the date submitted based on public information published or disseminated by the companies referenced below, including, but not limited to, through SEC filings, investor relations materials and public conference calls, or other third parties as of such date.  Securities of the companies discussed herein have been and are currently portfolio holdings of the author or clients of the author’s firm.  The Information does not constitute investment advice or a recommendation, and it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or other asset or to participate in any trading or investment strategy.  Furthermore, not all relevant facts and information may have been considered in developing the Information and such Information is subject to change.  The author has no obligation (express or implied) to update any or all of the Information or to advise you of any changes to the Information; nor does the author make any express or implied warranties or representations as to the completeness or accuracy of the Information or accept responsibility for errors.  You should not rely on the Information, in whole or in part, without conducting your independent verification as to its accuracy.  The Information contains forward-looking statements, including observations about markets and industry and other trends as of the date hereof. Forward-looking statements may be identified by, among other things, the use of words such as "expects," "believes," “targets,” or "estimates," or the negatives of these terms, and similar expressions. Forward-looking statements reflect the views of the author as of such date with respect to possible future events. Actual results could differ materially from those in the forward-looking statements as a result of factors beyond the control of the author and you are cautioned not to place undue reliance on such statements.  The Information may not be reproduced or disseminated in any manner without the express written consent of the author.

Catalyst

Continued execution and index inclusion