Painting the perfect picture – Part 2

I recently sold my investment in DuluxGroup after holding onto it for 5 years. I bought the shares a couple of months after it was spun off from Orica and the shares have really done well. In fact I only managed to buy half of what I set out to invest. My failure to buy more shares was because I tried to “time” the market to buy at a price lower than my assessment of its intrinsic value which is a story for another time.

Anyway, I recently sold my investment for the following reasons:

  1. Strong housing starts in Melbourne and Sydney have been a tailwind for DuluxGroup but the rate of growth in housing is unlikely to continue at its current pace; and
  2. DuluxGroup is being priced for perfection

Residential construction activity in NSW and Victoria

Residential construction activity over the past 3 years has been strong in NSW and Victoria especially for new apartments. One of the key drivers of this is population growth and house prices.

NSW housing starts

VIC housing starts

As shown in above charts, housing starts are at their highest since data collection began in 1984.  Although the current population growth is strong, it is still lower than the highs recorded during 2008/09 and the latest June 15 numbers may suggest that growth is coming off in both states.  Although we haven’t seen vacancy rates increase in the 2 major cities, I don’t see residential construction continuing its current trajectory. House prices are becoming relatively unaffordable in Sydney and Melbourne and this may deter new migrants to these cities.

Another important driver fuelling the housing starts is the price signal. Residential prices have been very strong over the past 3 years in both Sydney and Melbourne. From Sept 2012 to Sept 2015, Sydney and Melbourne have experienced annual compound growth of 15.2% and 8.0% respectively. There have already been reports that Q4 2016 house prices started to cool in Sydney and apartment prices in Melbourne have fallen.

Property prices

And finally, the latest RLB Crane Report show Sydney having 170 out of 220 cranes working on high rise residential projects. This puts Sydney having more cranes than New York, Los Angeles and Washington!

The Housing Industry Association is also forecasting new residential projects to slow over the next few years in both NSW and Victoria.

HIA data

Whilst it is true that the sales to new residential project form a minority segment of DuluxGroup’s revenue (biggest driver of revenue is home improvement/ renovations), I believe however that housing prices, housing starts and people propensity to renovate are interrelated. For example:

  1. Renovation may be a cheaper option for existing home owners looking to upgrade when house prices are high.
  2. High home values create the wealth affect which encourages people to renovate.
  3. High housing prices enable home owners to borrow against their home equity to renovate.
  4. High house prices stimulate new residential construction.

DuluxGroup is being priced for perfection

I believe any price above $6.50 imply that these shares are priced for perfection and any hiccup may well result in a significant downturn. I’ve put together a simple IRR calculation to illustrate my point. This analysis assumes buying shares at $6.50 now and selling them in 5 years with my required rate of return being 15%.

IRR calcThe key assumptions are of the above analysis are:

  • No change in debt levels till the exit date in FY2020; and
  • All the free cash flow paid out in dividends.

My base case (using non bearish assumptions) results in an IRR of 9.6%, short of my required return. The IRR is quite sensitive to the assumptions around EBITDA margin and the exit multiple (which drives the exit value). I’ve assumed the efficiency gains from the new factory will improve consolidated margins by 1% from current margins. The table below shows the EBITDA margin between DuluxGroup and its peers over the last 5 years.

EBITDA comps margins

Prior to 2013, DuluxGroup’s consolidated EBITDA margin was above industry average but has subsequently fallen below the average after the acquisition of Alesco (manufacturer of building products) in 2013. However, the paint & coating segment of the business has done well in FY2014 & 15 registering a healthy 19% EBITDA margin.

I believe industry margins are in the top half of the cycle given the falls in raw material prices.  Titanium dioxide, an important pigment in paint production has fallen by circa 50% over the past 5 years.

Titanium px

For my base case scenario, I have assumed an EBITDA exit multiple of 12x. This is based on the average industry EBITDA multiple over a 5 year trading history of 11.5x which I’ve rounded to 12x given DuluxGroup’s more dominant position in the Australian market compared to its overseas peers. Based on the above cash flow projection, a 12x EBITDA exit multiple is equivalent to a 21x free cash flow multiple (quite rich in my opinion for a business which has limited overseas growth and already dominant in Australia).

Hist mults

I’ve put together a table which shows the IRR under a combination of different margin improvements (from new factory starting in FY2017/18) and exit multiples. The IRRs highlighted in red represent the combination of margin and exit multiple which meets my 15% required return on an investment.

Data table

My required IRR of 15% is only met under rather the following aggressive assumptions:

  1. Revenue growth of 6% (same at the past 5 year growth with a residential boom in Sydney and Melbourne);
  2. Exit multiple of 14 and above (based on 5 year trading history, this is above the 3rd quartile of the EBITDA multiple range);
  3. EBITDA margins above 14.25% at exit (possible – if raw materials continue to fall from already low levels and new factory shows good efficiency gains).

Overall, this analysis shows that the probability of achieving my required 15% return is low whereas the probability of not falling short of my required return is higher.

Sure, things can happen in the future which could earn my required return (i.e. a takeover of DuluxGroup at a massive premium, technological breakthrough, stock market rally etc) but these events are unpredictable. We can only work with today’s facts and given investing is a game of probabilities, I would rather look at other investments with better potential to earn my required return than stay invested and hope for a long shot.

The context of my post is to articulate my reasoning for selling the stock I’ve owned due to what I believe to be the low probability of it meeting my investment hurdle. This is not an opinion for shorting this stock.

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