GWA Group. Getting its house in order HOLD

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1 Vol m Construction Australia Equity research November 17, 2015 HOLD Current price: Target price: A$1.83 A$1.90 Previous target: A$ Up/downside: 3.6% Reuters: Bloomberg: Market cap: Average daily turnover: GWA.AX GWA AU US$362.5m A$510.5m US$1.94m A$2.70m Current shares o/s 278.9m Free float: 100.0% Price Close Price performance 1M 3M 12M Absolute (%) Relative (%) Alexander LU, CFA T (61) E alex.lu@morgans.com.au Relative to S&P/ASX 200 (RHS) Nov-14 Feb-15 May-15 Aug-15 Source: Bloomberg Josephine LITTLE T (61) E josephine.little@morgans.com.au GWA Group Getting its house in order The majority of GWA s business is linked to the renovations and replacements market, which remains subdued despite recent strong house price growth. We forecast flat (+1.4%) FY16F EBIT growth impacted by the weaker AUD/USD. We initiate coverage with a Hold rating and A$1.90 target price. We see limited share price upside over the next 12 months given the subdued Australian economic environment, weaker AUD and lack of new MD strategy, although the buyback should provide some support. Commentary suggests building activity should remain strong Building activity in Australia continues to track at record levels with commencements reaching an all-time high of 211,484 in FY15. Recent commentary from GWA s major customers, building materials peers and property developers implies strong activity is likely to continue in FY16 (Sep YTD +13% on the pcp), although activity may cool from current peak levels. Given GWA s products are typically installed towards the end of a project, record building activity should be a positive for earnings over the next few years. However, the trend towards multi-unit dwelling construction is likely to mitigate some of this benefit given fewer average products per dwelling and at typically lower price points. but renovations activity is still subdued Despite the strength in building activity, by far the largest portion of GWA s revenue (>50%) comes from the renovations and replacements market. In that regard, the renovations market in Australia has been fairly weak with low consumer confidence weighing on activity despite relatively strong house price growth. With the Australian economy still fragile and recent tightening in credit policies from the major banks, this is likely to keep a lid on renovations activity growth over the next few years, in our view. We forecast flat EBIT growth in FY16 impacted by currency For FY16, we forecast 1.4% EBIT growth to A$73.8m driven by 4.0% revenue growth. Current favourable building conditions should benefit GWA in FY16, although we expect weakness in the AUD/USD to result in higher COGS despite efforts from management to strip further cost out of the business. We forecast FY16 DPS of 10.0cps. Our FY16 forecast average AUD/USD rate is 73c. Keeping all else equal (assuming no price increases, no stock and no hedging), we estimate an average 1c fall in the AUD/USD (on an annualised basis) will have a A$2m (~3%) negative impact on EBIT. We initiate coverage on GWA with a Hold rating and A$1.90 TP We initiate coverage of GWA with a Hold rating and A$1.90 blended (DCF, SOTP, PE) based target price. While GWA has a well-known stable of brands, solid balance sheet and good free cash flow generation, we expect subdued macroeconomic conditions, weak AUD/USD and a potential slowdown in building activity over the next 12 months to impact earnings growth. With new Managing Director, Tim Salt, not taking over the role until 1 July 2016, we believe the stock is likely to trade sideways given the absence of a clear growth strategy for the business going forward. Financial Summary Jun-14A Jun-15A Jun-16F Jun-17F Jun-18F Revenue (A$m) Operating EBITDA (A$m) Net Profit (A$m) Normalised EPS (A$) Normalised EPS Growth 0.0% 19.6% 14.6% 7.4% (8.3%) FD Normalised P/E (x) DPS (A$) Dividend Yield 3.01% 3.28% 5.46% 6.01% 5.46% EV/EBITDA (x) P/FCFE (x) Net Gearing 34.1% 30.1% 39.4% 41.5% 35.6% P/BV (x) ROE 12.4% 15.4% 15.7% 13.8% % Change In Normalised EPS Estimates Normalised EPS/consensus EPS (x) SOURCE: MORGANS, COMPANY REPORTS IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN ) AFSL A PARTICIPANT OF ASX GROUP Powered by EFA

2 Figure 1: GWA financial summary AIFRS AIFRS AIFRS AIFRS AIFRS HOLD Income statement (A$m) FY14A FY15A FY16F FY17F FY18F Projected return Revenue Current share price A$1.83 EBITDA Price target A$1.90 Depreciation & amortisation Upside (downside) 3.6% EBIT mth dividend yield 5.5% Net interest expense TSR 9.0% Pre-tax profit Tax expense Shares on issue (m) Minorities GWA market cap (A$m) NPAT pre-abnormals EPS pre-abnormals (cps) Trading multiples (x) FY14A FY15A FY16F FY17F FY18F Abnormal items after tax EV/EBITDA Reported NPAT EV/EBIT Reported EPS (cps) PE DPS (cps) - ordinary DPS (cps) - special DPS (cps) - total Valuation summary Franking (%) 100.0% 83.6% 100.0% 100.0% 100.0% DCF A$1.96 Sum-of-the-parts A$1.86 Segmental EBIT (A$m) FY14A FY15A FY16F FY17F FY18F PE-relative A$1.86 Bathrooms & Kitchens Blended valuation A$1.90 Door & Access Systems Corporate / Other DCF inputs Total underlying EBIT RF rate 4.3% Debt premium 2.0% Cash flow statement (A$m) FY14A FY15A FY16F FY17F FY18F Cost of debt 6.3% EBITDA Beta 1.00 Net interest paid MRP 6.0% Tax paid Cost of equity 11.0% Working capital Net debt (A$m) 92.0 Dividends received EV (A$m) Other L/T growth 2.5% Operating cash flow (1) WACC 9.6% SIB capex (2) Growth capex (3) Total capex Key earnings ratios FY14A FY15A FY16F FY17F FY18F Other Revenue growth YoY -4.0% -5.2% -19.1% 3.2% -2.8% Investing cash flow EPS growth (adjusted) n.a. 19.6% 14.6% 7.4% -8.3% Cash dividends paid (4) Dividend yield - ordinary 3.0% 0.0% 5.5% 6.0% 5.5% Equity raised / (repurchased) Dividend yield - total 3.0% 3.3% 5.5% 6.0% 5.5% Net borrowings / (repaid) Payout ratio 44.7% 0.0% 60.0% 60.0% 60.0% Other Free cash flow yield 5.3% 7.2% 4.4% 6.6% 8.3% Financing cash flow Effective tax rate 29.1% 31.0% 30.0% 30.0% 30.0% FX impact Net cash flow Free cash flow (1-2) Balance sheet debt metrics FY14A FY15A FY16F FY17F FY18F per share Net debt Deployable cash flow ( ) Gearing (ND/Equity) 34.1% 30.1% 39.4% 41.5% 35.6% Gearing (ND/ND+Equity) 25.4% 23.1% 28.3% 29.3% 26.3% Balance sheet (A$m) FY14A FY15A FY16F FY17F FY18F Net debt/ebitda 1.9x 1.1x 1.5x 1.5x 1.5x Current assets EBIT interest cover 5.8x 9.9x 10.5x 9.3x 8.9x Cash Receivables Inventories Working capital metrics FY14A FY15A FY16F FY17F FY18F Other current assets Inventory/Sales 28.3% 19.6% 24.5% 25.6% 27.6% Total current assets Debtor days Non-current assets Creditor days Property, plant and equipment Intangible assets Derivative financial instruments Return metrics FY14A FY15A FY16F FY17F FY18F Other non-current assets Return on assets 9.1% 11.6% 13.1% 13.2% 12.0% Total non-current assets Return on equity 8.9% 12.4% 15.4% 15.7% 13.8% Total assets Current liabilities Payables Key assumptions FY14A FY15A FY16F FY17F FY18F Derivative financial instruments Building approvals 194, , , , ,722 Interest bearing liabilities Renovations and replacements growth 0.6% -0.4% 1.0% 1.0% 1.0% Other current liabilities AUD/USD Total current liabilities Non-current liabilities EBIT margins Interest bearing liabilities Bathrooms & Kitchens 23.8% 25.2% 24.8% 25.0% 24.0% Deferred tax liabilities Door & Access Systems 9.1% 7.5% 6.5% 6.5% 6.5% Derivative financial instruments Total 20.4% 21.2% 20.7% 20.8% 20.1% Other non-current liabilities Total non-current liabilities Total liabilities Net assets Shareholders equity Issued capital Reserves Retained profits Minority interest Total shareholder funds SOURCE: MORGANS RESEARCH, COMPANY 2

3 Where to from here? Investment case summary Initiate coverage with a Hold rating, A$1.90 target price We initiate coverage of GWA with a Hold rating and A$1.90 target price. While we are attracted to GWA s stable of brands, solid balance sheet and good free cash flow generation, we see subdued macroeconomic conditions in Australia persisting and a potential slowdown in building activity over the next 12 months impacting future earnings growth. The weaker AUD/USD will also be a headwind. With new Managing Director, Tim Salt, not taking over the role until 1 July 2016, we believe the stock is likely to trade sideways given the absence of a clear growth strategy for the business going forward. Key changes that could cause us to take a more positive view on the stock include the announcement of a credible growth strategy and evidence of a sustained improvement in renovations activity. On the other hand, continued depreciation in the AUD/USD, further market share loss and a sharper-thanexpected drop in building activity could see us move to a more negative view on the stock. Our target price is based on an equally-blended (DCF, SOTP, PER) valuation methodology. On a DCF basis, we value GWA at A$1.96. On a SOTP basis, we value GWA at A$1.86 and on a PE relative basis we also value GWA at A$1.86. Upside/downside risks to our target price being met include an improvement/deterioration in macroeconomic conditions, stronger-thanexpected/weaker-than-expected building activity and a higher/lower AUD/USD. Key investment highlights Strong brands GWA possesses some of the best known brands in the building industry. Brands like Caroma, Dorf, Clark, Fowler, and Gainsborough have been part of Australian homes for many years. Caroma, for example, was established in 1941 and continues to be the go-to brand for many in the industry for its high quality, reliability and ease of installation. Solid balance sheet and cash flow generation GWA s balance sheet remains solid with plenty of room for pursuing growth or capital management opportunities. As at FY15, gearing metrics were solid with ND/EBITDA at 1.1x and ND/(ND+E) at 23%. EBIT interest cover is very healthy at 9.9x. GWA also generates good cash flow with FCF of A$30m in FY14 and A$40m in FY15. Tailwind from record building activity Building activity over the past two years has been very strong. Given there is usually at least a 6-12 month lag between building commencement and when the bulk of GWA s products are installed (ie. towards the end of a project), the full benefits of this strong activity are yet to fully flow through to sales. We therefore believe strong industry conditions should provide a tailwind for earnings in FY16 and possibly into the beginning of FY17. We note that GWA generates around 33% of revenue from the building market. Focus on core businesses going forward Following a string of unsuccessful acquisitions over the past five years, GWA has now refocused its business towards its core and most successful brands. We believe the restructure and cost out programs GWA has undertaken over the past couple of years puts it in the strongest position it has been in a long time. In our view, this will allow management to better focus on future growth opportunities without having the distraction of dealing with underperforming businesses. New MD looks to have the right credentials GWA announced recently that long-serving Managing Director, Peter Crowley, will retire on 30 June He will be replaced by former Managing Director of Diageo Australia and New Zealand, Tim Salt. Tim started at GWA on 7 September 2015 and will take over 3

4 the Managing Director role from 1 July Tim spent much of his career in beverage companies including Tetley Tea in the UK, Pepsi in Australia and the US, and Lion Nathan in Australia. While it remains to be seen how successful Tim will be driving GWA s growth over the next few years, his experience in global manufacturing should be a positive, in our view. Catalysts for share price appreciation Rising AUD/USD GWA announced in late 2014 its decision to cease production at its plastics operations in Adelaide and its vitreous china manufacturing facility in Sydney. The decision resulted in GWA becoming a full importer of products in its core Bathrooms & Kitchens and its Gainsborough businesses. Being a pure importer, a rising AUD/USD should therefore result in a reduction in GWA s cost of acquiring overseas goods. New MD strategy outlined earlier than expected With new Managing Director, Tim Salt, not taking over the role until 1 July 2016, there is a chance he may not outline his growth strategy for the company until the FY16 result in August Should Tim announce a credible strategy for the company prior to officially taking over, we think it could be a catalyst for a stock rerating. Further capital management GWA recently announced a A$30m buyback commencing December 2015 to November Given GWA generates good free cash flow, there are opportunities for further capital management in the absence of acquisitions or growth investments. Potential risks/issues to consider Weaker consumer sentiment and deterioration in economic conditions Given household renovations activity is largely a discretionary spend, a weakening economic environment could cause households to be more cautious and see projects cancelled or delayed, which is likely to have an impact on GWA s sales volumes. Decline in Australian house prices Slower growth or a reduction in Australian house prices is likely to result in households becoming more cautious about the value they can get out of starting a renovations project. Households usually feel a project is worth doing if it can add value to their dwelling. DIY investors are also less likely to embark on a profit making venture through purchasing, renovating and reselling in a falling house price environment. Their opportunities for profit are less than in a rising price environment. The direction of house prices could therefore influence demand for GWA s products. Falling AUD/USD - With GWA being a full importer of products, a depreciating AUD/USD should make it more expensive to import these products. This was highlighted in GWA s 1Q16 trading update where it noted time lags on price increases are likely to result in some FX under-recovery in FY16. Keeping all else equal (assuming no price increases, no stock and no hedging), we estimate an average 1c fall in the AUD/USD (on an annualised basis) would have a A$2m (~3%) negative impact on EBIT. Slowdown in building activity With building approvals running at all-time highs, these levels are unlikely to be sustained going forward, in our view. Industry headwinds are starting to emerge with stricter credit policies and higher lending rates on mortgages. We think these restrictions are likely to at least slow the rate of growth in building activity and if credit policies become more stringent, there is risk of a more pronounced correction. Continued trend towards multi-unit dwelling construction - There has been a noticeable trend over the last five years towards multi-unit dwelling construction given solid population growth, increased urbanisation and limited housing supply. The growth in high-rise apartments has seen demand for lower priced household fixtures and fittings increase given the usually higher level of investor participation. Investors usually care less about the quality of a product. Multi-unit dwellings also have fewer average products per dwelling compared 4

5 to a detached dwelling. If the trend towards multi-unit dwelling construction continues, it is likely to have a negative impact on GWA s sales and margins. Weather Bad weather can impact GWA s sales because builders can t get on site to continue or complete a job and can cause delays to projects. These delays can result in sales that were meant to be booked this year being pushed back to later years. New MD s strategy still unknown While the appointment of Tim Salt as Managing Director looks to be a good one, he is yet to reveal his strategy for the company going forward. Given he doesn t officially take over the role until 1 July 2016, we think investors may be reluctant to back the management team until a clear growth strategy is outlined. This could see the share price track sideways for the next 6-9 months. Strong competition GWA s products are subject to heavy competition from both domestic and international players. While GWA has strong and wellknown brands, aggressive price competition or the emergence of new players could affect GWA s position in the market and limit its ability to push price rises through and/or gain market share. Offshore supply disruptions GWA s decision to offshore all of its products has left it more susceptible to supply disruptions. This was the case with Gainsborough in FY14 where GWA experienced problems with the transition to a new supplier in China, which led to lower sales and loss of market share. Housing market current state of play Renovation market remains subdued The main market for GWA s products is the renovations and replacements market, which accounts for around 52% of revenue. In that respect, the renovations market in Australia has been in a prolonged period of weakness, with the last three years being the weakest over the past decade. We believe this is largely due to the subdued economic environment with low consumer confidence weighing on activity despite relatively strong house price growth over the last few years. Figure 2: Australia renovations spend (A$m) 33,000 32,000 31,000 30,000 29,000 28,000 27,000 26,000 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 SOURCES: MORGANS, ABS Renovations to dwellings include a range of activities, from everyday home maintenance repairs to larger, more expensive projects. General home maintenance work accounts for the largest share of expenditure on alterations and additions every year. There are over 9m homes in Australia that regularly require maintenance, with this type of work characterised by a large number of relatively low value jobs. Due to its usually urgent and necessary nature, general home maintenance is relatively stable and 5

6 predictable over time. Households generally undertake regular repairs to their homes irrespective of macroeconomic conditions. Aside from regular must-do maintenance work, discretionary renovations usually represent a major investment for households. Homes naturally age over time and are often brought up to date with contemporary designs and trends. The extent of updates is variable, ranging from relatively minor cosmetic updates to major structural works. Demand is therefore dependent on the household s financial position and ability to outlay a relatively substantial amount of capital. Economic conditions therefore play an important part in determining demand. Consumer sentiment factors such as employment outlook, income, house price expectations and borrowing costs all contribute to a decision to renovate or not. GWA estimates that households typically update or replace their bathrooms and kitchens every 15 years. Figure 3: Westpac consumer confidence index 115 Figure 4: RBA cash rate (%) 5.00 Figure 5: Australia unemployment rate (%) SOURCES: MORGANS, BLOOMBERG SOURCES: MORGANS, BLOOMBERG SOURCES: MORGANS, BLOOMBERG The previous charts indicate the Australian economy is still in a relatively subdued state. Despite the RBA cash rate being at an all-time low, we have not yet seen a sustained improvement in consumer confidence and the Australian unemployment rate over the past year. We believe a rebound in discretionary renovations spending is unlikely to occur unless we see a noticeable improvement in these two economic indicators. With recent news commentary on a potential cooling in house prices and tighter credit policies from the major banks, this could lead to further weakness in consumer confidence over the next few months, in our view. Building activity remains strong Building activity in Australia continues to track at record high levels with building commencements reaching an all-time high of 211,484 in FY15. This represents a 17% increase on the pcp. As shown in Figure 6, current commencements are noticeably higher than in previous cycle peaks. If we look at building approvals (where data is more frequently available and nevertheless tracks closely with building commencements), growth still looks solid. Total building approvals in the three months to September were 3% higher than the previous three months and 13% higher than the pcp. With the major banks announcing out of cycle interest rate increases on mortgages in October, it will be interesting to see whether this will have a dampening effect on activity levels over the coming months. The bulk of GWA s products are not installed until at least 6-12 months after commencement of a project (i.e. closer to completion), so the current upswing in building activity is likely to flow through positively for GWA in FY16 and potentially into the start of FY17, in our view. 6

7 Figure 6: Building commencements rolling 12m Figure 7: Australia building activity - rolling 12m 250, , , , , , , , ,000 50, , , ,000 Building commencements SOURCES: MORGANS, ABS Total approvals Total commencements Total completions SOURCES: MORGANS, ABS Looking at data for Australia s two largest states, NSW and VIC, building commencements have been largely driven by strong growth in NSW over the past three years. Following a relatively weak period between June 2011 and June 2014, growth in VIC has picked up strongly over the past year to now be the main driver of growth nationally. We estimate that GWA earns approximately 50% of its revenue from these two states. Figure 8: Building commencements growth (NSW, VIC and Australia) - rolling 12m 50% 40% 30% 20% 10% 0% -10% -20% Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 NSW VIC Australia SOURCES: MORGANS, ABS but trend towards multi-residential construction a negative Breaking down the composition of building commencements between detached (houses) and non-detached (multi-unit apartments including semi-detached row or terrace houses and townhouses) dwellings, we note the trend towards nondetached dwelling commencements over the past five years. Over the 15 years to FY10, houses as a percentage of total building commencements were consistently steady at around 65-70%. However, from FY11 there has been a noticeable trend towards non-detached approvals with the percentage of houses falling to 54% in FY15, as shown in Figure 9. This has been driven by the growth in high-rise apartments as structural changes in housing supply and increased urbanisation has resulted in denser living around capital cities. Figure 10 highlights the acceleration in the annual number of multi-unit housing starts compared to houses over the last five years. 7

8 Figure 9: Houses as a percentage of total building commencements 100% 90% 80% 70% 60% 50% 40% 30% 20% Figure 10: Building commencements - houses versus multiunits (rolling 12 months) 140, , ,000 80,000 60,000 40,000 20, % 0% FY95 FY97 FY99 FY01 FY03 FY05 FY07 FY09 FY11 FY13 FY15 SOURCES: MORGANS, ABS Commencements - Houses Commencements - multi-units SOURCES: MORGANS, ABS This increasing shift towards multi-unit dwellings means there is a longer lag time between building commencement and completion (houses typically take around 6-9 months to construct whereas high-rise apartments could take more than 12 months). We note that the bulk of GWA s products are installed towards the end of a project. The shift to medium/high density building has resulted in GWA noting increased sales of lower priced products over the last few years given this segment of the market has historically had a higher level of investor participation. Investors typically care less about the quality of the product installed. Multi-unit dwellings also have fewer average products per dwelling. While GWA s sales to multi-unit dwellings represents only around 10% of revenue, in our view, the trend towards higher density building is likely to have some negative impact on volume demand for GWA s products (given fewer average products per dwelling) in addition to putting pressure on margins (given increased demand for lower priced products). We think this will somewhat negate the positive impact from record high building activity levels. We note GWA s overall exposure to the building market represents around 33% of revenue (23% detached housing, 10% multi-unit). Recent trading commentary from key customers GWA s major customers include Tradelink, Bunnings and Reece. Together, we estimate these customers make up around 45% of revenue. Recent commentary from these customers suggests strong building activity experienced in FY15 is expected to continue in FY16. It was interesting to note that Tradelink expects residential activity to slow from recent peak levels in FY16, with multi-dwelling and apartments continuing to drive the market. Figure 11: GWA customer recent trading commentary Customer Tradelink Reece Bunnings Recent results commentary - Buoyant residential construction market but weak conditions in the mining, resources and infrastructure sectors. - Strong earnings growth in a number of businesses exposed to new housing construction, particularly Laminex, Fletcher Insulation and Tradelink. Outlook - Residential activity likely to slow from recent peak levels, with multi-dwelling and apartments continuing to drive the market. - Non-residential expected to remain subdued, especially mining, resources and infrastructure sectors. - Building activity was very strong in FY15 and this momentum is expected to continue into FY16. - Positive trading momentum was achieved through the year, capitalising on favourable underlying trading conditions. 8

9 Recent trading commentary from Building Materials peers We take a look at commentary provided by companies in the Building Materials sector for a guide to current and expected trading conditions. Overall commentary from these companies suggests building activity is likely to remain strong (especially on the east coast) for the remainder of FY16, although there was some caution that activity levels may cool slightly from current peak levels. Figure 12: Building Materials peers FY15 commentary Company Recent results commentary Adelaide Brighton (ABC) - Demand growth from improved residential construction activity. - Housing activity is at healthy levels on both the east and west coast of the country. CSR (CSR) Brickworks (BKW) DuluxGroup (DLX) Boral (BLD) - Given recent building approvals and financing data, as well as feedback from our major customers, we anticipate robust demand for our key products will continue over the medium term, bolstered by improving activity in the alterations and additions market. - The current order bank along the east coast is extremely strong. Home builders in the major markets of Sydney and Melbourne are reporting strong demand and work in hand extending by up to one year. However government s across Australia need to do more to overcome land title bottlenecks, delays in building approvals and trade shortages. - The new housing construction market which has experienced strong growth over the past two years, is expected to remain strong throughout financial year Although housing approvals are peaking, the lag between approvals and completions should provide a strong pipeline of work. - Continued strength in the Sydney construction market will be needed to offset a depressed Queensland construction market. - Housing activity expected to come off its peak. Recent trading commentary from Property Developers Recent trading commentary from Property Developers supports commentary from GWA s customers and Building Materials peers that property market conditions remain strong, although this looks to be confined to the east coast market with WA continuing to slow. Figure 13: Property Developers recent trading commentary Company Peet (PPC) AVJennings (AVJ) Stockland (SGP) Lend Lease (LLC) Recent results commentary - The Australian property market continues to benefit from good population growth, a low interest rate environment and relatively low unemployment rates. - However, there also remain some key challenges including changing consumer and business sentiment; the contracting resources sector, particularly in Western Australia, and other job losses in the manufacturing sector, and the ongoing issue of affordability. - Expect conditions will remain positive for the foreseeable future. - Market fundamentals remain very positive, with continued population growth, a low interest rate and more stable employment environment. - Current market activity in new residential housing markets follows a period of sustained downturn and lack of supply in many key markets. - Pent up demand resulting from historical low consumer confidence to transact, and a lack of land supply for over a decade, has seen the rebound in the New South Wales market and Auckland. - Residential markets around the country are at different stages. - We expect markets in Sydney and inner Melbourne will moderate with a more normalised level of growth. Brisbane is showing improvement, Melbourne growth corridors remain sound and Perth has continued to slow as anticipated. - Strong population growth and high overseas migration continues to fuel housing demand. - Dwelling completions have not kept pace with housing demand. - Australian residential cycle remains strong with record land-lot settlements in communities and apartment pre sales thresholds achieved rapidly. - Expect some impact from credit restrictions including application of recent macro prudential tools (APRA minimum mortgage risk weights/cap on lending growth in certain sectors). 9

10 Morgans valuation and peer analysis We value GWA at A$1.90 per share Our 12-month valuation on GWA is A$1.90 per share. Our target price is also based on our valuation, which we arrive at using an equally-weighted blended (DCF, SOTP, PE) methodology. Figure 14: Blended valuation Valuation (A$ per share) DCF 1.96 SOTP 1.86 PE 1.86 Average 1.90 SOURCES: MORGANS ESTIMATES DCF valuation On a DCF basis, we value GWA at A$1.96 per share. Key inputs into our DCF valuation include a WACC of 9.6%, geared beta of 1.1 (an ungeared beta of 1.0), and terminal year growth rate of 2.5% pa. Figure 15: DCF valuation (A$m) Valuation Comment PV of forecast cash flows WACC of 9.6% PV of perpetuity cash flows Terminal year growth rate of 2.5% Enterprise value Net debt 92.0 Equity value Shares (m) Equity value per share (A$) 1.96 SOURCES: MORGANS ESTIMATES Sum of the parts valuation We set out our sum-of-the-parts (SOTP) valuation below. On a SOTP basis, we value GWA at A$1.86 per share. The valuation multiple we use represents a 20% discount to the average Building Materials listed peers FY16F EV/EBITDA multiple. We apply a 20% discount due to GWA not being as vertically integrated as its peers, hence it has less control of the supply chain and is more susceptible to supply disruptions. Our discount also reflects Tim Salt s lack of track record running a listed company and unclear growth strategy given he doesn t take over the Managing Director role until 1 July Figure 16: SOTP valuation FY16F EBITDA (A$m) Adj avg peer EV/EBITDA (x) Implied EV (A$m) Comment Bathrooms & Kitchens % discount to peers Door & Access Systems % discount to peers Enterprise value Net debt 92.0 Equity value Equity value per share (A$) 1.86 SOURCES: MORGANS ESTIMATES 10

11 Figure 17: Building Materials comps Last price Mkt cap (m) EV/EBITDA EV/EBIT ND/EBITDA EBIT interest (x) (x) PE (x) EPSg (%) ROE (%) (x) ND/(ND+E) Div yield cover (x) P/FCF P/B Company name (A$m) yr EPS CAGR Adelaide Brighton Ltd , % 5.1% % -1.3% CSR Ltd , % 7.7% N/A % 6.4% DuluxGroup Ltd , % 3.9% % 7.8% Boral Ltd , % 3.9% % 10.2% Fletcher Building Ltd , % 5.8% N/A N/A % 5.4% Average % 5.3% % 5.7% 2-yr EBIT CAGR SOURCES: MORGANS, BLOOMBERG *Priced at 16/11/2015 PE relative valuation On a PE relative basis, we value GWA at A$1.86 per share. We derive our valuation by applying a 20% discount to the average Building Materials listed peers FY16F PE multiple. Our methodology is consistent with our SOTP valuation. To put this into perspective, our target PE multiple also broadly represents a 20% discount to the Small Industrials index FY16 multiple (14.3x), reflecting our concerns that the current building cycle may be nearing its peak. Figure 18: PE valuation FY16F Comment Morgans EPS (cps) 16.9 Target PE multiple (x) % discount to peers PE valuation (A$) 1.86 SOURCES: MORGANS ESTIMATES GWA s historical one-year forward PE multiple is set out below. While GWA may look cheap relative to its historical PE multiple, we note data was only available from November This was around the start of the current upswing in the cycle, which may not be indicative of GWA s trading multiple through the cycle. Figure 19: GWA 1-year forward PE (x) Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14 Feb-15 May-15 Aug-15 GWA PE Average SOURCES: MORGANS, BLOOMBERG 11

12 Company overview Business divisions GWA s current portfolio comprises two business divisions Bathrooms & Kitchens and Door & Access Systems - having divested its Heating and Cooling division in FY15 following a strategic review of the company s businesses. The Bathrooms & Kitchens division is the main driver of group earnings, accounting for around 77% of revenue and 92% of EBIT. Figure 20: FY15A divisional revenue split Door & Access Systems, 23% Figure 21: FY15A divisional EBIT split Door & Access Systems, 8% Bathrooms & Kitchens, 77% Bathrooms & Kitchens, 92% Figure 22: SWOT analysis Strengths Weaknesses - Well established and recognised brands including - Exposed to falling AUD given almost all products are Caroma, Dorf, Clark, Fowler, Gainsborough. imported. - Continual focus on product innovation that improves - Relatively cyclical business affected by design and installation capabilities. macroeconomic conditions. - Solid balance sheet. - High customer concentration with top three customers making up around 45% of revenue. - Highly competitive industry with multiple players. Opportunities Threats - Current strength in building activity should support - Correction in Australian house prices could impact earnings growth in FY16 and possibly beyond. renovations and building activity. - Further cost out potential. - Trend towards multi-residential construction likely to impact sales and margins given preference for lower priced products. - New CEO taking over mid-2016 could see fresh growth strategy. - Bad weather prevents builders from completing jobs on schedule and can push out sales of GWA's products. - Increased competition from cheaper substitute products. - Lower AUD could make imported goods more expensive. SOURCES: MORGANS Bathrooms & Kitchens products GWA s Bathroom and Kitchens products comprise some of the best known brands in the industry. Its main products and services include vitreous china toilet suites, urinals, basins, plastic cisterns, bathroom accessories and fittings, acrylic and pressed steel baths and shower trays, tapware, showers and accessories, stainless steel sinks and laundry tubs. Within this division, the Caroma brand is the main driver of earnings. 12

13 Figure 23: GWA s Bathrooms & Kitchens brands SOURCES: GWA Door & Access Systems products GWA s Door & Access Systems division designs, imports and distributes a wide range of access and security systems for use in residential and commercial premises. The division comprises two business units: Gainsborough Hardware - Australian designer, importer and distributor of a comprehensive range of residential and commercial door hardware and fittings, including security products. API Locksmiths - National supplier of security and access control systems and locksmithing services to major commercial enterprises. 13

14 Figure 24: GWA s Door & Access Systems brands SOURCES: GWA Key drivers In our view, the key driver of GWA s business is renovations and replacement activity given this represents approximately 52% of revenue. While general repair and maintenance work is fairly consistent, spend on discretionary renovations is likely to track in line with GDP growth in Australia. Over the last five years, underlying volumes have been difficult to track given multiple acquisitions, business restructures and supply disruptions. We estimate that overall volumes in the current Bathroom and Kitchens and Door & Access Systems businesses have been largely flat. Between FY16-18F, we forecast renovations and replacements activity to grow by 1% pa. Longer term, we forecast growth of 2% pa. While this is slightly lower than our long term GDP expectations, we remain comfortable with our conservative approach given the weakness in renovations and replacements activity over the past few years. We therefore see upside to our forecasts should activity levels turn out to be higher than expected. Building activity is also a major driver of GWA s earnings. We use building approvals as the key indicator of building activity in Australia. While we acknowledge that not all building approvals progress to the commencement stage (and therefore completion stage which is where the bulk of GWA s products are installed), we believe they are correlated enough to warrant tracking. The higher frequency of building approvals data (monthly versus building commencements which is quarterly) also allows us to quickly gauge any emerging trends in the market. GWA s exposure to the new construction market represents around 33% of revenue. Building activity has been very strong over the past two years with 221,447 approvals in FY15 the highest on record. This followed 194,874 approvals in FY14. Approvals for both years were well above the long term average of around 165,000 pa. 14

15 Figure 25: Australia building approvals - rolling 12m 240, , , , , , , ,000 Building approvals - Rolling 12m SOURCES: MORGANS, ABS Given the unprecedented number of building approvals in FY15, we forecast a slowdown in growth in FY16 followed by a reduction in FY17 and FY18. For FY16, we forecast 8% growth in building approvals to 239,163. Given YTD building approvals are currently running 13% above the pcp, our forecast may prove to be conservative. We forecast building approvals to fall 10% to 215,246 in FY17 and 10% to 193,722 in FY18. Despite the fall in activity levels in FY18, we note this is still well above long term averages. Further tightening in bank lending policies and a larger-than-expected slowdown in house price growth over the next few years could see downside risks to our forecasts. Customers GWA sells all its products to merchants and does not sell directly to the consumer. GWA s three largest customers include Reece, Tradelink and Bunnings. Combined, these merchants make up around 45% of group revenue with the remaining sold to smaller operators. Sales to merchants are usually conducted on a needs basis and orders are taken out weekly or sometimes daily. On larger building projects that require higher quantities (and therefore longer lead times), GWA usually enters into a contract with the customer for a specified quantity and price per unit. Figure 26: Percentage of revenue from largest customers (FY15A) Reece, 16% Tradelink, 15% Other, 55% Bunnings, 14% Competitive environment The markets that GWA operates in are highly competitive, with a number of domestic and international players. We estimate that GWA s market share in its chosen markets is over 20%, with its share of the sanitaryware market (where the Caroma brand competes) substantially higher. Ironically, GWA s main 15

16 customers are also its main competitors, with Reece, Tradelink and Bunnings all competing in the sector through their own-branded products and exclusive supply agreements. Competing brands to GWA s Bathrooms & Kitchens division include Roca, Porcher, Laufen, Modella and Estillo. Competing brands to Gainsborough include Lemaar and Ikonic. Strategy and growth Following a number of restructures over the past few years, GWA is now focused on its core businesses where it has strong brands and market positions. GWA s strategy is to ensure its core businesses - Bathrooms & Kitchens and Door & Access Systems - are in a good position to capitalise on strong building activity levels and build their competitive position to improve financial returns. GWA has also undertaken a number of cost improvement initiatives over the past few years which the company expects will increase operations and supply chain efficiencies and fund growth opportunities. GWA will also look to grow through continuous innovation, improving speed to market and introduction of new products. Acquisition and divestments track record GWA has made a number of acquisitions and divestments since As can be seen in the table below, acquisitions such as Brivis Climate Systems and Gliderol did not perform to GWA s expectations and have subsequently been divested. In addition, a number of other businesses including Rover Mowers, Sebel Commercial Furniture and Dux Hot Water were identified as non-core and have also been divested over the past few years. Figure 27: Business acquisitions and divestments (since 2008) Date Acquisition Divestment Price (A$m) EV/EBITDA Rationale multiple (x) Dec-08 Austral Lock To complement Gainsborough products. Feb-10 Rover Mowers 11.0 The lawn mower industry has changed substantially in recent years and Rover does not have the scale to be competitive in its own right. Mar-10 Brivis Climate Systems To complement Dux water heating business and leverage off existing builder relationships. May-10 Wisa Beheer 17.0 No longer core with limited growth prospects and uncertain outlook in Europe. Dec-10 Gliderol To complement Door and Access Systems division. Aug-11 Sebel Commercial Furniture 24.0 Identified as non-core. Sep-12 API Locksmiths 13.1 Provides access to new markets and extends product offering of the Door and Access Systems division. Nov-14 Dux Hot Water 46.0 Identified as non-core. GWA to focus on Bathrooms and Kitchens and Door and Access Systems businesses. Dec-14 Brivis Climate Systems 49.0 Identified as non-core. GWA to focus on Bathrooms and Kitchens and Door and Access Systems businesses. Jun-15 Gliderol 7.0 Intention to exit the garage door market. In our view, GWA s decision to exit underperforming businesses and focus on its current core businesses of Bathrooms & Kitchens and Door & Access Systems is a step in the right direction. While acquisitions such as Brivis Climate Systems and Gliderol over the past five years have not gone to plan, we feel the current stable of brands gives GWA a solid foundation from which to make a fresh start in its growth strategy. However, given its mixed success in the past, we would prefer GWA in the near term to focus on developing sustainable organic growth strategies rather than via acquisitions. 16

17 Financials 1Q16 sales up but FX likely to weigh on FY16 earnings GWA provided a first quarter trading update at its AGM in October. For 1Q16, group sales were up 3% with sales for both operating divisions (on a continuing basis) higher than the pcp. Bathrooms & Kitchens sales were up 3% and Door & Access Systems rose 2%, which was predominantly driven by price increases implying some market share loss. Given GWA sources all of its products from overseas, the ~9% fall in the AUD/USD since 1 July 2015 is expected to have an impact on FY16 earnings. Lags on price increases to recover the impact of the lower AUD is likely to see FY16 earnings weighted to the 2H. No formal earnings guidance was provided which was a change from previous years. We forecast 1.4% EBIT growth in FY16 For FY16, we forecast 1.4 % EBIT growth to A$73.8m driven by 4.0% revenue growth. Current favourable building conditions should benefit GWA in FY16, although we expect weakness in the AUD/USD to result in higher COGS despite efforts from management to strip further cost out of the business. We forecast 1H16 EBIT growth of -3.0% to A$34.0m and 5.4% growth in the 2H to A$39.9m as price increases begin to take effect. Our forecasts imply a 46/54 1H/2H EBIT split, which is in line with management expectations for earnings weighted to the 2H. Our FY16 forecast average AUD/USD rate is 73c. Between FY17-19F, we forecast -4.0% average EBIT growth pa due to our expectations of a slowdown in building activity from current record levels and a continued subdued economic environment. Over the longer term, we forecast average EBIT growth of 4.7% pa. Upside surprise could come from better-than-expected economic conditions fuelling faster growth in the renovations market, stronger-than-expected building activity levels and a higher-than-expected AUD/USD assisting product purchases (we forecast 74c long term). With management expecting the resumption of dividend payments from 1H16, we forecast FY16 DPS of 10.0cps (1H16 DPS 5.0cps), broadly representing a 60% payout ratio. We expect GWA to maintain this level of dividend payout ratio going forward. Upside/downside risks to our forecasts include a pick-up/deterioration in macroeconomic conditions, stronger/weaker building activity and a rise/fall in the AUD/USD. 17

18 Figure 28: GWA income statement summary (cont ops.) (A$m) FY14A FY15A FY16F FY17F FY18F Total revenue Bathrooms & Kitchens Door & Access Systems Operating costs EBITDA D&A Total EBIT (inc Assocs) Bathrooms & Kitchens Door & Access Systems Corporate/Other Net interest PBT Tax Minorities Normalised NPAT Abnormals (after-tax) Reported NPAT EPS - normalised (cps) EPS - reported (cps) DPS (cps) Dividend payout ratio 45% 41% 59% 61% 60% Franking 100% 84% 100% 100% 100% EBITDA margin 19.2% 19.2% 18.2% 18.4% 17.4% EBIT margin 16.1% 17.1% 16.7% 16.9% 15.9% NPAT margin 9.5% 10.6% 10.5% 10.5% 9.9% EBITDA growth 6.5% -1.4% 4.3% -7.9% EBIT growth 12.9% 1.4% 4.4% -8.4% NPAT growth 19.6% 3.4% 3.0% -8.8% EPS growth 19.6% 14.6% 7.4% -8.3% We expect GWA s balance sheet to remain healthy over the next few years despite an increase in gearing on the back of the share buyback and restructuring activities. For FY16, we expect gearing (ND/(ND+E)) to rise to 28.3% (from 23.1% in FY15). FY16 interest coverage however is expected to remain strong at 10.5x (from 9.9x), although this is expected to reduce in FY17 and FY18. Figure 29: GWA balance sheet summary (A$m) FY14A FY15A FY16F FY17F FY18F Current assets Total assets Total liabilities Shareholder's equity Net debt ND/(ND+E) 25.4% 23.1% 28.3% 29.3% 26.3% Interest coverage (EBIT) ROA 9.1% 11.6% 13.1% 13.2% 12.0% ROE 8.9% 12.4% 15.4% 15.7% 13.8% We forecast free cash flow (pre-dividends) to reduce from A$40.2m to A$22.4m in FY16. The reduction in free cash flow is largely due to restructuring activities GWA announced in FY15 being implemented in FY16 and FY17. Given the relatively low maintenance capex requirements of the business (management has guided to A$3-6m pa going forward), we expect FCF to track largely in line with earnings growth longer term. 18