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Morningstar | In Line 2018 Result for No-Moat Reliance Worldwide; Upgrade to Europe Margins Drive 6% FVE Increase

We increase our fair value estimate 6% to AUD 3.60 per share reflecting incremental synergy benefits within John Guest, but still view shares as overvalued. No-moat Reliance Worldwide's fiscal 2018 results were in line with our bottom line expectations. Net sales of AUD 769.4 million were up 28%, including a bit less than a month of contribution from the John Guest acquisition, completed in June 2018. Excluding this purchase, revenue rose 24% to about AUD 745 million, slightly ahead of our forecast for 21% gains. Nonetheless, EBITDA tracked our projection at AUD 157 million, excluding John Guest, and a small one-time charge U.S. import-duty reclassification. This was ahead of guidance but in line with our forecast for AUD 156 million.

The Americas segment remains a solid growth opportunity. Sales growth of 29% ahead of our forecast for low-double-digit gains, largely due to a full year of Holdrite sales following the acquisition, and one-time improvement from a roll-out to Lowe's stores in the fiscal second half. We expect further rollover effects from the latter, and sales growth to slow to about 12% in fiscal 2019, but nonetheless expect high-single-digit revenue gains through fiscal 2023.

Outside the U.S., Asia Pacific revenue growth of 6% trailed our forecast for 9% gains, and we expect continued softening over the near term as the Australian residential construction picture weakens. Conversely, Europe was strong with sales growing 22%, excluding impact of John Guest, and only slightly behind our forecast for 27% gains. We expect continued double-digit top-line growth here over the next five years.

Reliance forecasts fiscal 2019 EBITDA of AUD 280 million to AUD 290 million, slightly below our prior forecast for AUD 304 million. We adjust our forecast--now AUD 294 million given our slightly lower margin outlook for the Americas and APAC. But we're still above management's guidance--given an opportunity to enjoy better than expected synergies in John Guest.

We expect margin uplift in the Americas going forward, benefiting from strong sales growth and thus improved scale, cost-out initiatives, and positive impact from Holdrite. As such, despite margins remaining flat in the fiscal year at about 17%, due to increased copper prices, higher SG&A expenses, and near-term investments, we expect EBITDA margins to climb to about 23% over the long run.

While Australian housing approvals have remained solid over the past few months, benefiting the Asia Pacific segment in the second half of fiscal 2018, we're concerned the market is in oversupply versus long-run population averages, particularly given the recent softness in house prices. As such, we forecast slight declines in revenue over the next couple of fiscal years, with EBITDA margins similarly slipping from the recent historically high levels, to about 21% by fiscal 2023 from 22.6% in fiscal 2018. Nonetheless, we think the midcycle margin level for this segment is higher--nearly 24%, by our estimate--given more-tepid raw material pricing, and Reliance's internal efficiency efforts and long-term revenue rebounding to a low-single-digit growth rate.

Beyond Europe's strong top-line performance, we were also impressed by improved profitability, as EBITDA margins of 4% put the segment ahead of schedule on our assumed rebound. While we already forecast margins eventually rising to double digits, we now think the near-term performance for Reliance's European business is a bit brighter given the increased scale from John Guest and ongoing efficiency improvements. Further, management identified another AUD 10 million in annual synergies from the John Guest acquisition, 50% higher than the prior AUD 20 million estimate, starting in fiscal 2020.

Fiscal 2019 capital expenditure will likely be a bit higher than we’d originally expected, given management's guidance for AUD 65 million to AUD 75 million versus our prior AUD 47 million projection and capital spend of AUD 37 million in fiscal 2018. The majority of the increase in expenditure relates to John Guest, with Reliance earmarking AUD 25 million in capital projects for the new subsidiary in fiscal 2019.

Nonetheless, Reliance's balance sheet remains in good shape. Following an equity issuance in late fiscal 2018 to fund the John Guest acquisition, net debt/EBITDA is manageable at 1.57 times on a pro forma basis, including a full 12 months of earnings from John Guest. We continue to expect further improvement in gearing in fiscal 2019, with strong organic growth to see the ratio improve to 1.24 times.