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Grafton's strong foundations hold key to weathering Brexit pressure

The building materials distributor's canny acquisition strategy could help it to ride out short-term disruption in the UK market, writes Dan White

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Grafton Group is headed up by chief executive Gavin Slark. The company's UK performance in the closing stages of 2019 was hampered by Brexit-related uncertainty. Photo: El Keegan

Grafton Group is headed up by chief executive Gavin Slark. The company's UK performance in the closing stages of 2019 was hampered by Brexit-related uncertainty. Photo: El Keegan

Grafton Group is headed up by chief executive Gavin Slark. The company's UK performance in the closing stages of 2019 was hampered by Brexit-related uncertainty. Photo: El Keegan

Brexit has clobbered building materials distributor Grafton Group, as the continuing uncertainty surrounding the UK's departure from the EU ensures that many of its British customers are keeping their hands in their pockets. Issuing its full-year trading statement on Tuesday, the company revealed that, while full-year like-for-like sales at its UK merchanting operations would be up 0.6pc, its UK merchanting sales would be down by 4pc for the last three months of 2019.

After a very good first half, when UK merchanting like-for-like sales grew by 2.8pc, sales flat-lined in August. Then, as the political uncertainty peaked, customers reined in major expenditure, in anticipation of a 'hard' Brexit.

With UK merchanting generating more than two thirds of Grafton's total sales, any downturn impacts on the entire group, with an annual 1.9pc increase in group-wide like-for-like sales being transformed into a 1.8pc decrease for the final three months. It now expects sales from continuing operations of £2.67bn (€3.1bn) and pre-interest operating profits of £202m for 2019.

Grafton first signalled that there was trouble ahead when it warned last October: "Volumes in the UK merchanting business were affected by weak underlying demand fundamentals, as households deferred discretionary spending on home improvement projects against the backdrop of increased economic uncertainty [i.e. Brexit]."

It then went on to warn that, as a result of the Brexit-induced downturn in its UK merchanting business, full-year operating profits would be 4pc-8pc lower than it had previously been expecting.

Grafton's main UK merchanting brand is the 67-strong Selco chain, which is aimed exclusively at the building trade rather than the DIY market.

By signalling the bad news well in advance, the Grafton share price was relatively unaffected by last week's announcement. After falling by more than 10pc following last October's profit warning, the share price had regained its losses by the end of November.

In fact, the Grafton share price rose last week by 7pc to £8.98. Grafton switched its listing to London in 2013 and reports its results in sterling. At the current share price, the firm has a market value of £2.13bn.

The group has not been the only UK building materials company to have been hit by Brexit. When CRH issued its most recent trading update on November 26, it warned investors: "In the United Kingdom, construction activity continued to decline amid Brexit-related uncertainty."

The UK Construction Products Association estimates that, due to the uncertainty caused by Brexit, the British construction industry grew by only 0.6pc in 2019, against the 2.3pc increase that it had been forecasting at the beginning of the year. What is it about friends in distress?

Grafton did some serious house-cleaning in 2019, announcing in April that it had agreed to pay €131m for Dutch construction products distributor Polvo.

Then, in August, it sold its Belgian merchanting business for £11m (while retaining freehold properties worth £12m) and, in October, it sold its UK plumbing and heating business, Plumbase, for a net £61m.

While the Belgian business was relatively small, with 2018 operating profits of about €1m and sales of about €100m, the purchase of Polvo and the sale of Plumbase were much larger transactions.

Polvo, which has 51 branches, generated sales of €127m and operating profits of €10.6m in 2018. The acquisition will increase the size of Grafton's existing Dutch merchanting business by over 70pc to annual sales of more than €300m.

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Plumbase had total sales of £257m and operating profits of £6m in 2018. The net effect of these three deals will be to reduce Grafton's annual sales by about £230m, but increase its operating profits by about £2m.

Grafton is disposing of relatively low-margin businesses and replacing them with much higher-margin firms.

Last year's acquisitions were merely the latest in a series of deals by Grafton, both large and bolt-on, in recent years.

In November 2015, the group purchased Dutch firm Isero, the country's leading distributor of specialist tools and fixings, with 38 branches.

Then, in March 2018, it splashed out £82m for Leyland SDM, the largest independent specialist decorators merchant in the London area, with 21 outlets.

Grafton has been extremely successful in pushing up its operating margin in recent years, from just 2.7pc during the depths of the recession in 2011 to 6.8pc in the first half of 2019.

While the fourth quarter downturn is likely to act as a drag on second-half margins, the reshuffling of its mix of businesses in 2019 will feed through into higher margins in the coming years.

The group has also been very successful at pushing up its return on capital employed, up from just 4.6pc in 2011 to 15pc in the first half of 2019.

Grafton's Irish and Dutch businesses are far more profitable than its UK businesses.

With the exception of its small manufacturing business, which had first-half sales of £41m and operating profits of £9.2m, its operations across the water are generally lower-margin, with its UK merchanting arm delivering first-half operating profits of just £60m, an operating margin of 6pc.

While Grafton may have been in the wars in the UK, it has been a very different story in this country, where the group trades under the Chadwicks and Heiton Buckley builders merchanting brands and as Woodie's, which with its 36 outlets, is the largest DIY chain in the country.

With Davy Stockbrokers having increased its forecast for Irish GDP growth in 2020 to a rip-roaring 5.5pc, all of Grafton's Irish businesses are going at full speed.

Last week's trading statement revealed that like-for-like Irish merchanting sales grew by 6.2pc in 2019 and by "only" 2.7pc in the last three months of the year, while like-for-like retail sales (basically Woodie's) zoomed ahead by 4.6pc for the full year and by 5.6pc in the final quarter of 2019.

So where does Grafton go from here? Was the final quarter downturn in the UK merely a one-off blip or the start of something more serious? Company sources point out that macroeconomic conditions are still good in Ireland and the UK, with virtual full employment in both countries. If this continues to be the case, then much of the final-quarter downturn in the UK will probably be unwound this year, as customer nervousness recedes and spending that was deferred last year takes place in 2020 instead.

We can also expect to see Grafton continue to re-jig its operations as it seeks out higher-margin, higher-return businesses and sheds the under-performers. The group is highly cash-generative and had virtually no debt on its balance sheet at the half-year stage. This gives it plenty of ammunition with which to acquire other firms.

Grafton is among the companies affected by the new IFRS 16 accounting standard that obliges firms to include amounts owed under leases on their balance sheet, something that added £540m to Grafton's borrowings at the half-year stage.

The timing of acquisitions in the building materials distribution business, particularly the smaller bolt-on deals, is largely dictated by family events: death, divorce, retirement. When the right businesses do come up for sale, Grafton will be in the market to buy.

"Our responsibility is to be a careful shopper. Any acquisitions must meet our returns requirements. They must be in good markets with good management teams," says Grafton finance director David Arnold.

Grafton has also been upgrading its Woodie's DIY chain and Chadwicks builders merchanting outlets in Ireland. In recent years, it has spent €10m refurbishing 30 of its Woodie's outlets, and has also invested in refurbishing and reformatting its Chadwicks outlets.

Despite its strong cash generation and low debt, Grafton is relatively miserly when it comes to paying dividends to its shareholders.

The full-year 2018 dividend of 18p a share worked out at just over £43m, only a little over a fifth of total cashflow of £209m, and less than a quarter of operating profits, before £4.5m property gains, of £189m.

Grafton increased its interim dividend by 8.3pc to 6.5p. If this increase is sustained for the full year then shareholders can expect to receive a total of 19.5p. This would cost the company a total of £46.2m. Still only a quarter of the £202m operating profits being forecast by the group for the full year.

If Grafton ever runs out of suitable acquisition opportunities, it can always give the money to its shareholders instead.

For Grafton, it is still very much a case of the glass being half full, rather than half empty.

"Customer confidence tends to be a slow build. We are still cautious about the first quarter in the UK. We expect to see the recovery in confidence build in the second quarter. We are up against a very strong first quarter of 2019, when the weather was very kind to us," says Arnold.

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