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Morningstar | Dulux Keeps Delivering Earnings Growth Despite Slowing Housing Construction

Narrow-moat-rated Dulux rarely disappoints, and fiscal 2018 was no exception. Underlying net profit after tax grew 4% in fiscal 2018 to AUD 146 million, in line with our expectations. This performance was supported by a resilient maintenance and home improvement market and continued strength in new housing construction. We maintain our AUD 7.50 per share fair value estimate; at current levels, the shares appear fairly valued. The board declared a final dividend of AUD 14 cents per share. This takes the full-year dividend to AUD 28 cents per share, a 6% increase on the prior year and equivalent to 72% of net profit, which was slightly ahead of our expectations.

The outlook for fiscal 2019 is broadly positive. Around two thirds of the company’s revenue (and most of the paint revenue) hinges on the maintenance and renovation of existing housing stock. While we expect new housing starts to taper off in the coming years, we don’t envisage this having a major impact on Dulux’s earnings as new housing typically accounts for around 15% of group sales. Additionally, Dulux’s products are typically late in the construction process and, as such, should continue benefiting from strong construction for at least fiscal 2019. We forecast mid-single-digit revenue and earnings growth over the next five years.

We believe Dulux’s decorative paints business can continue growing at a faster pace than the broader market for at least the next five years. This was evident during fiscal 2018, where the core business increased sales around 5%, double the pace of the market. This reflects market share gains and strong pricing, both of which are supported by the company’s strong brand equity, healthy relationship with Bunnings, and ongoing reinvestment in marketing and product development. The company was able to maintain its 18% EBIT margin in paints despite higher input costs and new Merrifield factory commissioning costs. These additional expenses were successfully mitigated through good cost control and higher pricing. Dulux has a solid record of defending its margins, and we forecast current levels to continue for at least the next five years.

Selleys and Parchem ANZ was the only division which missed our expectations, albeit by a slim margin. Revenue growth was a modest 3%, although margins were a little soft due to weakness in the Selleys trade business and Parchem New Zealand. Whilst these struggling segments only represent a minor portion of the division, the company has committed to improving performance in the near term, and we have confidence in management team’s ability to drive a recovery. Moreover, Selleys boasts a strong brand, and with heavy exposure to the renovation market, the segment is well placed for mid-single-digit earnings growth.

B&D Garage Doors is one of the more cyclical divisions, as almost half its sales is tied to new housing construction. However, as these products are late in the construction cycle, and fiscal 2019 completions are expected to be broadly consistent with fiscal 2018, we continue to expect mid-single-digit growth in the near term. From fiscal 2020 onwards, we expect housing approvals to taper off, which will constrain revenue growth to the low single digits. The division’s EBIT margins grew around 40 basis points to 10.4% in fiscal 2018, although as the cycle starts to turn in the coming years, we don’t expect any margin expansion beyond current levels.

Despite net debt increasing by AUD 13 million to AUD 389 million, net debt/EBITDA fell slightly to 1.3 times from 1.4. This modest increase in debt reflected the investment in a new paint factory, although we are not concerned, given the reliable earnings. Now that the firm has passed the capex-heavy stage, we expect net debt to fall towards 1 times EBITDA and remain around this level. This level is extremely comfortable and in our opinion leaves scope for a long-term dividend payout ratio of 75%-80% on average, above the firm’s 70% target. Operating cash flow conversion was a little soft although not alarming, falling to 75% from 86%. This reflected additional stocking requirements for the new paint factory and higher year-end inventory due to the higher input costs. Excluding these, cash conversion was 83%, and we expect this metric to remain above 80% for the foreseeable future.