EUR 850.00 For Business Accounts Only

Morningstar | LR Updated Forecasts and Estimates from 13 Nov 2018

Our key takeaways from Legrand's third-quarter results are (1) there is an increasing probability of a European residential construction market slowdown (but not a crash) in 2019, and (2) margin weakness--the main focus of the earnings call--is short-term noise, with underlying factors starting to abate. The shares sold off moderately after results but are not yet cheap enough to be attractively priced relative to our EUR 54 fair value estimate, which includes a revenue growth slowdown next year. We maintain our fair value estimate and narrow moat rating.

At the group level, the results were in line on revenue growth (organic up 3.9%) but underlying EBIT margin was weaker than expected, down 160 basis points year over year. France, Legrand's second-largest market (15% of sales), saw a softening in demand that affected the group margin disproportionately. Unexpected destocking from customers in France led to a 4% decline in revenue.

Like other companies, Legrand plans to increase prices to offset raw material price increases, but it also has significant exposure to the U.S. trade tariffs with a sizable business there and significant procurement and manufacturing exposure to China. If the latest round of U.S. tariffs on China goes through as planned, with a 25% increase on some components that the company either makes or sources from China, Legrand would see a 7% increase in its cost of sales in North America starting in January 2019 and would need to increase prices there by 3% to offset the tariff impact, something it is prepared to do. However, we already seeing some abating factors that could take some of the sting out of the tariffs, including a declining Chinese currency and a cooling off of raw material price hikes. Also, Legrand has started raising prices in the U.S. due to other cost inflation. Therefore, we see the margin weakness as short term and surmountable. Our forecasts for next year include a stable EBIT margin on a full-year basis.

The France destocking raises the question of whether end customers are preparing for a continued slowdown. Remodeling or renovation drives much of Legrand's business in France, and renovation-driven demand has been weak throughout the year, but new housing starts are also looking lacklustre now. As a result, Legrand's customers may have been building up inventories throughout the year. Management indicated that there are no signs of a rapid near-term restocking. Geberit, which reported results recently, also suggested a slowdown in residential construction demand and named in particular the France, Austria, and Netherlands markets. We believe this suggests next year will probably be a period of flatter demand for European residential construction-related demand, and we have factored that into our forecasts for both companies. After two years of recovery-level growth, we view a slowdown as an expected part of the cycle.