DLX Result and Valuation

GrayLynchEtt,

Following on from the TPI thread:

I thought the result was another typical high-quality Dulux result, with good operating leverage evident in the P&L

In the legacy Dulux paint business, the top line grew organically by 6%, and EBIT grew by 12%. Again, a great performance from the jewel in the Dulux crown.

The Consumer and Construction business, where EBIT grew by 3% on flat sales, was merely a so-so result, I thought.

But again, the acquired ALS garage door business - in terms of its organic growth - disappointed. The garage doors business is not showing the margin expansion I had anticipated/hope for at the time that the acquisition was announced.

It is still a firmly fixed cost business and for EBIT to have grown by just 4% when the revenue line was up by 6% is not a good omen for the way this business might perform during the inevitable residential construction cycle downturn.

The Cabinet and Architectural Hardware business, Lincoln Sentry (also acquired with Alesco) produced a stellar result, with EBIT up 25% on Revenue growth of 8.5%, but it’s really just a small division in the scheme of things.

The standout feature of the result to me, however, was how quickly the balance sheet is able to repair itself after being geared up. This is testimony to the strong free cash generational ability of the company.

NIBD-to-EBITDA is now 1.5x, down from 2.0x 12 months ago, and 2.3x at the time of the acquisition of Alesco.

This is a company whose business resilience and surplus capital generation is such that it can bear NIBD-to-EBITDA of closer to 3x. So I think they can sign an acquisition cheque amounting to $200m with relative ease.

Which gets to your point about the DLX board seeking another acquisition in the new year.

My take on this is like it always is:

I apply a 5:4:1 rule to acquisitions: out of every 10 acquisitions 5 are almost sure to destroy shareholder value, 4 will basically just wash their face in terms of meeting their cost of capital, and 1 will be clearly value-accretive.

As case in point, I don’t believe the Alesco acquisition was value accretive: the Garage Doors part of Alesco – which is by far the largest - is still acting as an anchor to the growth rate of the broader DLX group, almost two years down the track.

Since the acquisition of Alesco, Dulux’s heritage Paints and Coatings business has grown Revenue by an average annual rate of 9.4 %pa compared to Alesco’s businesses, Garage Doors (3.9% pa) and Lincoln Sentry (2.8%pa).

And EBIT growth for Paints and Coatings have averaged 12.9%pa over that period, compared to Garage Doors @ 1%pa and Lincoln Sentry (at 10%pa, but that includes overhead synergies, which are non-recurrent).

The point I am trying to make is that the acquisition of Alesco has taken DLX into structurally lower-growth (and more capital-intensive and more cyclical) businesses.

Besides:

1. The one-off uplift in the EPS accretion in the P&L from buying an earnings stream (Alesco) which is more additive to DLX per share earnings than the incrementally higher interest expense (the good old re-leveraging arbitrage), and
2. The synergy benefits from removing duplicated fixed overheads (also largely one-off in nature)

the net result of the Alesco acquisition, after these integration sugar hits, is that DLX’s organic growth profile becomes diluted, and the quality of the heritage franchise has been diminished.

And that is the sort of case study that highlights the pitfalls of acquisition-led growth: it often devalues the starting franchise.

And that is why I wish DLX would rather accelerate capital returns to shareholders, than acquire stuff.

In terms of consideration of DLX as an investment proposition today, one observation I like to make is that DLX is analysed by either building materials analysts, or chemicals analysts, neither does justice to the highly respected brand that Dulux’s paints business represents.

Meaning that, valuation-wise, analysts compare (wrongly) DLX to either cyclical construction companies or even more cyclical commodity chemical companies: it is far superior to those sorts of businesses: It largely is an R&D-led, intellectual property company.

[Remember, this is a company that told Woolworths (via Masters) to get stuffed. Not too many businesses are of such a strength that they can have the gumption to do so.]

The way I view DLX as an investment proposition is a business that can:

• grow its top line through the cycle by 1% to 2%pa (absent market share gains) and raise its price by 3%pa, for organic Revenue growth of 5%pa
• operating leverage means that EBIT will grow by 7% to 9%
• financial leverage means that NPAT grow by 10% to 12%

For that sort of reliable, predictable growth from an industry leader, I think valuation multiples at a 10% or 15% premium compared to the broader market is justified.

But it’s still not cheap enough to buy, I don’t think.
And nothing in the latest result makes me think any different.

Mad