Geberit: Valuation Is Too High

Thesis

Geberit (OTCPK:GBERY) produces and distributes plumbing components for commercial and residential buildings, including water supply pipes and fittings, plumbing installation, drainage and flushing systems, and other sanitary products. On the whole, I think GBERY is a solid company. This company has a dominant market position, substantial ROIC and market share, consistently high margins (before 2022) and strong free cash flow generation capabilities. The company's long history of dividend increases is further evidence that it prioritizes the welfare of its shareholders. Given the current growth outlook (consensus expects flattish revenue until FY24) and interest rate environment, I think GBERY's current valuation is too high. For the latter, GBERY traded at 25x forward earnings in FY16/17, when rates were close to 0%, and it continues to do so today, when rates are close to 4%. Growth outlook back then were higher than today as well. Hence, relatively speaking, I expect the market to realise this and adjust GBERY valuation lower. The path to this downwards re-valuation could be easily sparked by even the smallest disappointments in the upcoming results. GBERY stock's valuation would have to drop significantly for me to become a buyer, and the company's growth outlook would have to improve markedly thanks to a rebound in sales volumes and the introduction of successful new products. On the latter, I would appreciate management releasing more details for investors to better quantify how much they contribute to the overall earnings. For instance, 2023's new product introductions that emphasize installer productivity are intriguing for sure, but their potential significance is still unclear. The stock received a hold rating from me overall. Overall, I put a hold rating on the stock.

FY22 overview

Since GBERY already released its 4Q results in January, I won't restate them. However, for FY22, it's worth noting that GBERY's EBITDA margin fell slightly short of the guidance provided with the January sales. After reviewing the FY22 results, I remain skeptical about the construction industry's near-term outlook to the unfavorable macroeconomic conditions and the increasing interest rates.

Growth headwind

While easier year-over-year comparisons could theoretically boost growth rates in 2H23, I still foresee a number of headwinds in FY23. To begin, one example would be the weakening European construction industry and the ongoing shift in focus from sanitary to heating. Constant destocking and challenging comps vs last year are also likely to negatively impact growth in 1H23. Given the current cost deflationary climate, the lack of the customary April price increase has me even more concerned. If we put everything together, it seems like there is no room for upside surprise here, if we assume costs to remain at the current levels in 1/2Q23. During the call, the management emphasized their plan to retain the current prices as long as it doesn't harm their market share. However, I would think pricing might get negatively impacted instead if there is an extended period of cost deflation.

Margin

Lack of price increases and lack of official margin guidance really muddy the margin outlook for FY23. A simple comment from management to keep margin at a "high level" was also not helpful, in my opinion. Given the historical defensibility of GBERY margins, I am giving it the benefit of doubt that it will recover back to its mid-term target of 28-30%. If it doesn’t, then I worry the narrative for GBERY to protect its margin might be impaired in the short-term as it would mark the second consecutive year of a below-target margin.

Outlook

Although the destocking process at wholesalers is ongoing, management noted that it is much less of a short-term challenge now. This messaging strikes me as more cautious than the message sent in January, when management declared that destocking was complete. It's possible that management is trying to correct unrealistic assumptions. However, management is confident that 4-6% annual sales growth and EBITDA margins of 30% are within reach in the long run. Management emphasis on the impact of pull-forward demand and installers' shifting priorities away from hygienic toward thermal solutions gives me pause, as such, it reaffirms my view that management is adopting a more cautious tone for guidance. That's why I believe consensus has moved to ignore any potential gains in the near future, which could set the stage for a surprise beat. That said, I like to bring up my initial point on valuation. At 25x forward PE, the stock price is not cheap, and any disappointment would cause a precipitous decline. In sum, I anticipate an equity story where GBERY needs to show they can deliver before the share price will react, even though guidance might imply upgrades to estimates.

Conclusion

While GBERY is a solid company with a dominant market position, substantial ROIC and market share, consistently high margins and strong free cash flow generation capabilities, the current growth outlook and interest rate environment make its current valuation too high. Although management is confident that 4-6% annual sales growth and EBITDA margins of 30% are within reach in the long run, there are several headwinds in FY23, such as the weakening European construction industry and ongoing shift in focus from sanitary to heating, constant destocking, and challenging comps. The lack of price increases and official margin guidance further muddy the margin outlook for FY23. The stock's high valuation and potential for disappointment make it a hold rating for now, with the need for GBERY to show they can deliver before the share price reacts.

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