Downgrading to Neutral; lacking both near term catalysts and compelling valuation argument
Prior to Q3, Wolseley had outperformed by 10% year to date. Despite the fact the stock was approaching what we viewed as fair value, it was our expectation that outperformance could continue, driven by an inflection in LFLs at Q3 and positive US news flow. However, slower current growth reported last week actually results in us cutting FY17E EPS by 2%. While the stock is off 8% in the last three days, we still only have 9% upside to our lowered price target. Given that we do not view the valuation as particularly compelling and we struggle to think of near-term positive catalysts, we are downgrading to Neutral from Overweight.
* What happened at Q3: Wolseley reported Q3 numbers in line with our expectations. US LFL sales were a touch lighter than our est. at +5% vs. our +6%, but the trading margin was comfortably ahead at 8.5% vs. JPM 8.2%. However, the group guided that US LFL growth slowed to +3% in April and Q4 to date to 2-3%, driving a group LFL of 1%. This was impacted by weather in HVAC and Waterworks, which together are 25% of revenue and pricing deflation of 3% vs. 2.3% in Q3 (JPMe: 2%).
* Changes to our estimates: We are cautious on extrapolating what is a very short period; however, we have cut our estimates to reflect 1% slower LFL growth in the US for the coming year, on the basis that pricing may be down more than the 1.5% we had assumed for H1 and based on current trends, Industrial looks likely to remain negative. Lower growth drives a cut in our DCF-based Dec-16 PT to 4,100p (from 4,300p).
* Cutting to Neutral: Wolseley currently trades on 13.7x our new 2017E EPS, inline with historical average. While we continue to view this as a multi-year share gain and margin expansion story, it is difficult for us to argue for meaningful near-term multiple expansion while earnings momentum is negative. The group is scheduled to report FY results on 27 Sept. Baring a sharp improvement in commodity pricing or industrial data, we struggle to think of positive catalysts between now and then.