|Shares Out. (in M):||199||P/E||9.1||8.9|
|Market Cap (in $M):||298||P/FCF||9.7||9.5|
|Net Debt (in $M):||76||EBIT||42||43|
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Volution Group plc is a leading supplier of ventilation products to the residential and commercial construction markets in the UK, the Nordics, Central Europe and Australasia. The company enjoys sustainable competitive advantages in an asset-light niche with operating margins close to 20% and a high return on capital. The company has grown sales with 14% per annum since 2014 both organically and through acquisitions. Helped by energy efficiency regulation, organic growth is expected to be 3-5% going forward. On top of that, the company has a good track record of creating shareholder value through acquisitions. The market remains large & fragmented, offering plenty of M&A opportunity in the future. We believe that the 11% p.a. sales growth from acquisitions is sustainable over the medium term.
The share price has declined 33% from its peak, due to lower operating margins in FY2018 (which we believe to be temporary) combined with concerns about economic growth and Brexit. At 9x our estimate of current year after-tax earnings, we think the valuation is very attractive for a company with the characteristics described above.
Volution is the dominant leading manufacturer & supplier of fans, air systems, and ducting to the domestic ventilation market in the UK, Sweden, and more recently New Zealand. Volution also has a growing presence in Germany and Belgium. The group operates under two divisions: The ventilation segment represents 89% of sales and consists of 14 key brands*. The much smaller OEM segment, “Torin-Sifan”, represents 11% of sales and mainly consists of designing and manufacturing electric motors for HVAC manufacturers.
Volution’s ventilation division is an asset-light design and assembly business with low capex requirements. It operates highly automated plastic injection molding facilities but sources electrical motors and printed circuit boards (PCBs) from third parties.
*Vent-Axia, Manrose, Diffusion, National Ventilation, Airtech, Breathing Buildings, Fresh, PAX, VoltAir, Welair, inVENTer, Brüggemann, Ventilair and Simx
BARRIERS TO ENTRY
Ventilation is an attractive niche in the building products industry and benefits from significant barriers to entry. The ‘Friendly Middleman’ concept applies to this business. The end-customer is typically not choosing the brand of ventilation products. This decision is made for the customer, either by the installer or the architect. As these ‘friendly middlemen’ generally pass the cost through to the end customer, they prioritize easy-to-install, reliable and familiar products that can be delivered quickly, over decisions on the pricing. Additionally, the cost of most items is low compared to the cost of labour and the overall project cost. The prices for the individual products range from a few pounds to about a 1,000 pounds for the most expensive heat recovery ventilation system for commercial properties.
Volution has a portfolio of long-established brands and guarantees fast delivery of thousands of different products through its distribution network. The company benefits from scale advantages to organize this at a low cost. It generates just under half of its revenue in the UK with a 50% market share in residential RMI (Renovation, Maintenance & Improvement), 40% in residential new-build and 20-25% in commercial buildings. In Sweden, their market share in residential RMI is over 70% and in most of their other markets Volution is Top 3 with a market share of 20-25%. Volution generates more than 50% of their revenue in markets where they are much larger than the number two competitor.
Would-be competitors are also deterred by the depth of the product range that is required to be competitive. For example, Volution offers more than 10,000 SKU’s in the UK RMI market alone. There’s no point in sourcing a few cheaper products from another supplier if the distributor can easily access 10,000 products from his main supplier.
The ventilation market in Europe typically consists of a large number of companies (of varying size and scope) producing ventilation products. Volutions’ geographical markets are generally characterized by the predominance of established domestic participants with local brand portfolios and niche applications. The concentration of local participants is partially a consequence of loyalty to familiar products, brand awareness and reputation. Another factor is the significant time and effort required to comply with local regulatory requirements and establish strong distribution channels and sales teams.
Once a brand has strong local presence, it becomes difficult for competitors to displace it. In a market with dominant local brands, growing by acquiring competitors makes more sense, which is why Volution decided to expand outside the UK through acquisitions and continue to operate under the acquired brand names in the respective local markets.
Regulation and consumer trends have been a tailwind for the demand of Volution’s products. Stricter building regulations have resulted in a shift towards air-tight buildings, resulting in increased use of Volution’s higher margin value-added systems and other more environmentally friendly solutions. This is a clear step-up from the standard unitary fans because of the need for improved indoor air quality. There is also a continuing shift in customer preference for quieter and more aesthetically pleasing fans which offer better energy efficiency and have a higher selling price and profitability.
In RMI, key drivers of demand for unitary extraction products include an ongoing need to replace or upgrade older ventilation equipment. Additional demand is created by the desire and financial ability of new and existing occupiers to refurbish their kitchen, bathroom and utility facilities. Factors such as the availability and cost of mortgage financing directly impact the ability of homeowners to undertake RMI projects and therefore indirectly the purchase of Volution’s products. The company’s revenue from the residential RMI products during the last period of declining construction activity in the UK (from 2008 to 2012) was resilient due to an increase in sales of higher value solutions driven by new regulation as well as above-inflation price increases.
The demand for their products in residential new-build is directly impacted by the level of activity in new house completions. However, even in the last period of declining construction activity in the UK, the adoption of higher value centralized ventilation systems was sufficient to offset the negative impact of lower completions.
Whereas the residential RMI market is heavily weighted towards unitary fans, new-builds can be designed to facilitate the extensive ducting and central systems which are required for higher-priced systems. A key to success in both the residential and commercial markets is having Volution’s products included early on in the specifications for public housing, residential and commercial projects. Whilst Volution does not sell directly to the relevant end users, their products will be specified on projects and this will drive sales through existing wholesalers and distributors.
Since the IPO in 2014, Group revenues have grown by 14% CAGR, with 3.1% pa organic growth boosted by 11% pa contribution from 11 acquisitions.
1. Organic Growth
Increased regulation and upselling will support sales growth over the medium term. Volution’s markets continue to benefit from the favourable regulatory framework that focuses on reducing carbon emissions from buildings (in particular new builds) and there is a notable increase in local market trends with greater focus on improving air quality, as well as the need to improve energy efficiency. Demand for value-added systems, increased functionality, energy efficiency, and silent, esthetically pleasing products support sales of Volution’s higher value and higher margin products.
Achieved organic growth of 3.1% pa has been depressed by around 1-2% pa due to the persistent headwind from UK residential RMI, but growth outside the UK was more robust over the period. UK residential new-build also grew consistently, as systems became more widely adopted. The UK public social housing RMI market has been weak, mainly because of the rent freeze imposed on public housing landlords by the last Chancellor in 2015. Residential RMI has also been soft and erratic but has been less of a drag on the Group.
Management believes it can achieve 3-5% organic growth. The UK public social housing RMI business is bottoming out and they are starting to see the results of some market share initiatives they implemented a few years ago. The company also increased prices in UK residential RMI. Price rises averaging 9% have been introduced to the UK residential RMI trade channel (c.£10m revenues pa), with the primary objective of recouping historic cost inflation. These price rises should boost organic growth and restore margins as management confirmed that early results indicate sales are not very price elastic.
Strong free cash flow has been reinvested into acquisitions, with Volution acquiring 11 companies since the 2014 IPO at an average multiple of 8x EBITDA. The acquisitions helped to drive compound EPS growth of 11% pa. Management believes that the company can keep making acquisitions at a similar, if not a greater rate than they have done historically. Volution has a strong balance sheet and the opportunity-set is large in a fragmented market with a multitude of smaller, privately-owned businesses. In terms of valuation, management wants to see a strong positive NPV for a DCF at a WACC of 10.5%-13%, depending on the region, using conservative assumptions for synergies, price increases and cost-cutting. The company uses cashflow and debt markets to fund the acquisitions. The bank covenants are set at 3x since going public. Currently the level is 1.7x but taking into account the full benefit of the recent Simx acquisition, it will drop back to 1.2x by year end. Simx is the market leader for residential refurbishment ventilation in New Zealand and had been selling Volutions’ Manrose brand for over 30 years. The familiarity with the company goes a long way in explaining the reason Volution made an acquisition in an entirely different part of the world. At 10.5x, EBITDA the acquisition looks expensive but the multiple is inflated due to an overstated historical cost structure with 3 MD’s on big salaries. Additionally enlarging the product range, especially with more expensive and higher margin products combined with cost savings, can lower the multiple substantially. The company has installed a new manager to oversee the introduction of Volutions products ranges in New Zealand. Simx already had a long-term relationship with Volution and there has been somewhat of a parallel development in the ventilation markets in New Zealand and the UK with many similarities in the product solutions. As a result, Volution was able to utilize many of the existing product and development programs as a platform for range extensions in Simx.
FY2018 operating margins were 18%, lower than the previous year at 19.2%, and which had peaked in 2015 at 22.6%. Management believes normalized margins will be higher because last year’s margin had been negatively impacted by temporary factors:
1/ Acquisitions of businesses with lower margins than Volution. Management remains convinced that it can improve the returns of acquired businesses, through more efficient sourcing, redesigning product, cross-selling, up-selling, reducing overhead and more disciplined pricing.
2/ FX-driven inflation in the UK. Volution buys $15-16m of electrical components each year. During FY 2018 the impact was felt due to a devaluation of Sterling whereas the previous year was protected by an fx-hedge that was agreed prior to the Brexit vote. Bar further depreciating of the pound, this negative impact will not reoccur in the current FY as the inflated cost of components has been offset by price increases.
3/ Decline of the UK public RMI business. Volution earns above-average margins in the UK public RMI business. A decline of this business affected group margins in previous years but has now become a smaller percentage of the overall business mix and is bottoming out.
4/ Cost overruns in establishing a new assembly facility in Reading impacted revenue, margins and cash flow in 2018. Management expects this to be completed by the end of the first half of the FY, which should eliminate a major drag from the 2018 performance. Management is also convinced this problem did not damage their relationship with its distributors.
The stock has declined 33% from its peak, driven by general negative market sentiment and concerns over Brexit in particular. At 9x our estimate of current year after-tax earnings, the valuation is attractive for a well-managed company with a strong market position in an attractive niche; a consistently strong cash flow generator with good prospects for both organic and inorganic growth.
Management targets 3-5% organic growth. Historic organic growth was 3% despite being depressed by the decline of the UK public RMI business, a headwind that is likely to disappear. Management is focused on continuing its strategy of growth through acquisitions and it has the financial means to take advantage of the large opportunity-set in a fragmented market.
Operating margins have the potential to improve as the company keeps growing, higher margin products become a larger part of the business mix and the temporary factors depressing last year’s margins disappear.
Ronnie George, CEO and Ian Dew, CFO, were appointed in 2014 and were in charge during the period of growth we described above. Their 2018 compensation was GBP 946,000 and GBP 656,000 respectively, of which approx. 50% was fixed and the balance performance based linked to general profitability, EPS and working capital. As of July 2018, Ronnie owned 2.8% of the company with another 0.5% unvested and not yet exercised. We see current management as good operators and good capital allocators based on high operating margins and EPS growth achieved with a conservative balance sheet.
- The UK public residential RMI business bottoming out
- Completion of the new assembly facility in Reading eliminating drag on 2018 performance
- UK price increases
- Sales growth and improved operating margins for the acquired businesses
- Use of the strong balance sheet for value-enhancing acquisitions
- Smaller impact of FX: FY2018 results suffered from a delayed impact of the pound’s devaluation after the Brexit vote as a result of the expiry of the hedge.
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