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Why Reece Ltd is flush with opportunity

Reece Ltd (ASX: REH) is probably one of the largest least-well-known businesses on the ASX.

It was founded in 1919 by Harold Joseph Reece, who himself had associations with the Wilson family as early as 1935. Reece became a listed company in 1954 before the Wilsons eventually gained more than 50% control of the company in 1969.

The growth that Reece has achieved since the Wilson family gained control has been phenomenal.

Around 1972 — the earliest share market record I could find — its market capitalisation was $1 million. Today it’s around $6 billion and is the largest supplier of plumbing and bathroom products in the country with more than 450 stores.

But it appears that size is now counting against it.

In Australia, it’s run out of acquisition opportunities with the Australian Competition & Consumer Commission likely to frown upon any proposals for further domestic acquisitions.

MORSCO

It’s not surprising, therefore, to see that Reece has decided to venture to the US in an effort to keep the growth story alive, acquiring MORSCO, Inc. for A$1,910m.  MORSCO has sites across 16 states in the USA and is very similar to Reece in that it’s a leading distributor of plumbing, waterworks and heating & cooling equipment.

What is surprising though is the size of the acquisition and the source of some of its funding.

MORSCO’s most recent sales figures were $2,276 million (in Australian dollars). Compare this to Reece’s sales of $2,551m.

However, the merged company will see almost 74% of its pro-forma operating earnings derived from the US, assuming the acquisition goes ahead as planned.

According to 49 year old CEO Peter Wilson, Reece management have ‘done their homework’ and appear to intimately know what they’re buying, a company that they’ve been in constant discussions with for about two years. No recklessness here, we hope.

It’s a truly grand transaction, effectively doubling the size of the company with the bulk of earnings now coming out of the US.

Money, please

Oh, yes. The other remarkable feature of this transaction is the fact that Reece is raising $560m.

The raising of capital may not sound strange in any other business context, but in the 64 years that Reece has been a public company, it has not asked its shareholders once for a single dollar.

Reece has, until now, been a story of self-funded growth.

This capital raising, therefore, is a unique event in Reece’s history and we’re hoping that management know what they’re doing by tapping shareholders — as well as the debt markets — and buying up big.

The opportunity

Morsco’s sales, operating earnings and margins are all travelling along nicely with high single-digit growth.

However, what really makes this transaction appealing is its reasonable price — 14.4 times pro-forma adjusted operating earnings for the 12 months to December 2017 — and exposure to new markets in familiar industry segments. There are also the possibilities for higher organic and acquisition-led growth in the US which, Wilson says, makes the MORSCO acquisition ‘… almost like the opportunity of a lifetime’, a ‘transformational opportunity’ that will drive returns for the next generation of shareholders.

There’s a lot to like.

US new housing stats are still trending below the long-term average, and renovation spend by US homeowners continues to increase, placing Reece in a very good position over the next decade plus.

Reece operates in cyclical industries, so the best way to play this opportunity, therefore, would be to mimic the Wilson family and own these shares for the very long run. The Wilsons are kicking in $300m and will still own around 74% of the shares on issue after the transaction.

The biggest risk that things go pear-shaped is that many of the assumptions underpinning the rationale for the MORSCO acquisition don’t come to fruition. There’s also the costs of integration being higher than expected, and perhaps specific risks to MORSCO itself that Reece management haven’t discovered as a part of its due diligence.

The closing of the transaction is expected by July 2018 and it’ll be interesting to watch how this acquisition plays out in the years ahead.

Foolish takeaway

It’s hoped this expansion of the business means it doesn’t end up like other Australian businesses. Wesfarmers Ltd  (ASX: WES) and its Homebase acquisition, and Australia and New Zealand Banking Group (ASX: ANZ) with its failed Asian strategy are just two examples.

But given the steady, long-term nature of the Wilson shareholdings in the Reece business, demonstrated patience in understanding their acquisition target, and a commitment to growing shareholder wealth over the long term, I’m willing to continue holding my shares indefinitely and look forward to participating in the rights issue.

If you’re a long-term investor, then you should definitely consider Reece as one option in a diversified portfolio. And if you haven’t heard of Reece, then it’s about time you should.

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Motley Fool contributor Edward Vesely owns shares of Reece Australia Limited. The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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