Reece Ltd. Assigned #BB+# Rating With Stable Outlook On Morsco A Proposed Senior Secured Loan Rated #BB+#

Stocks and Financial Services Press Releases Wednesday May 16, 2018 17:44
MELBOURNE--16 May--S&P Global Ratings
MELBOURNE (S&P Global Ratings) May 16, 2018--S&P Global Ratings said today that it had assigned its 'BB+' long-term issuer credit rating to Reece Ltd. The outlook is stable.

At the same time, we assigned a 'BB+' issue rating and recovery rating of '3' to the proposed senior secured US$1,140 million term loan B (TLB) issued by Hamilton HoldCo LLC and Reece International Pty Ltd. The '3' recovery rating indicates our expectation for meaningful recovery of 55% in the event of a payment default. The issue rating is based on the proposed TLB documentation.

The issuer credit rating reflects our assessment of Reece's modest scale of operations compared with global peers' and leading position in the competitive and niche building materials distribution industry in Australia.

The acquisition of U.S.-based Morsco Inc. (B/Stable) is a significant event and will present execution risks associated with operating a business outside of Reece's home market. We view the U.S. marketplace as larger and more competitive and its scale is more fragmented.

However, Reece has a track record of stable profitability and free cash flow generation, driven by its leading Australian market position. Despite Reece's exposure to cyclical end-market demand over the previous five years, it has benefited from robust housing market conditions in Australia. The company's plumbing-related distribution focus generally requires minimal capital, and coupled with its solid penetration of the Australian plumbing supplies market, it has generated above-average EBITDA margins. The company's moderately conservative financial policies are in line with the 'BB+' rating.

We view favorably Reece's sizable network and long relationships with the plumbing contractor industry. In Australia, Reece specializes in the distribution of wholesale plumbing equipment, HVAC-R (heating, ventilation, air conditioning, and refrigeration), water infrastructure, onsite (large-scale projects), and irrigation products. Despite its modest scale relative to industry peers', Reece has the largest market share in Australia, capturing about 40% of the distribution of plumbing and building material products.

Bolstering its market share is its sizable branch network of 601 stores and six distribution centers across Australia, favorable economic conditions, and a presence in the populous and higher income housing markets of Victoria and New South Wales. Although Reece's operating model is capital-light, its operating expenditure is intensive. However, the low barriers to entry in the more competitive U.S. market will offset the strength of the group's domestic market presence.

The growing presence of well-capitalized competitors underpins the need for Reece to maintain its service quality and wide product range to maintain its competitive advantage. The company has grown its product range and its technological capabilities to enhance user convenience and inventory visibility.

Reece's entry into the U.S. market presents challenges despite its sound track record of managing its domestic growth strategy. In the U.S., the building materials industry has undergone a period of consolidation by financial sponsors. Reece's proposed acquisition of Morsco is the company's first acquisition in the U.S building materials market, significantly expanding its geographic reach.

Morsco has a narrow product range and high geographic concentration in the southern region of the U.S. The company's diversified customer and supplier base partially offset these risks. Morsco generates about 60% of its revenue from plumbing products to trades in residential and commercial. The remaining revenue contribution is from water, sewer, and storm products for utility, general, and municipal contractors; and from HVAC wholesale distribution.

Reece and Morsco operate primarily through a distribution model that allows for a highly variable cost structure. Further, Morsco's materially lower S&P Global Ratings-adjusted margins of about 5% are due to the fragmented and competitive building materials industry in the U.S. Reece is proposing to acquire Morsco from financial sponsor Advent International for US$1,440 million (about A$1,910 million). Reece will finance the acquisition with a seven-year US$1,140 million senior secured TLB, a five-year US$100 million revolving credit facility, and an equity raising of about A$600 million. The equity raising includes a A$300 million equity contribution by the Wilson family, who are the majority owners with about 76% of shares outstanding. This is a very high proportion of ownership by one family given that Reece is an Australian company listed on the Australian Stock Exchange. The transaction has an implied acquisition multiple of 14.4x pro-forma adjusted EBITDA before costs, for the 12 months ended Dec. 31, 2017. The transaction is likely to close in July 2018.

Our assessment of Reece's financial risk is weighted to the year ending June 30, 2019, onward, assuming completion of the transaction and inclusion of the majority of revenues and earnings from Morsco, as well as adjustments for operating leases. We have not assumed any synergy benefits and do not adjust for one-off integration or transaction costs.

Our rating incorporates our expectation that the company will manage its S&P Global Ratings-adjusted debt to EBITDA below 3.0x. We also expect Reece to manage its leverage within this range even with bolt-on acquisitions, as it participates in the broader industry consolidation.

Should Reece's debt-to-EBITDA ratio increase above 3.0x, we expect it to be temporary, with the company likely to promptly deleverage to levels below 3.0x, based on the company's track record. For example, the company funded the A$280 million acquisition of Actrol/Metalflex in 2014 with cash and a senior debt committed facility of A$250 million, which it paid down to A$100 million in three years.

The stable outlook reflects our expectation that Reece will continue to grow its market share in the plumbing and building products industry, and manage the integration and execution risks associated with its acquisition of U.S.-based Morsco.

We view Reece as a capital-light and cash-generative business. We expect its debt to EBITDA to remain comfortably below 3.0x and free operating cash flow to debt in excess of 15%. This provides the company with financial headroom to pursue strategic acquisitions and acts as a buffer against variable end-market demand.

We could lower the rating if the company's adjusted debt to EBITDA sustainably exceeds 3.0x as a result of debt-funded growth, higher-than-expected integration costs from its U.S. business, and a weaker operating environment following an industry downturn. We could also lower the rating if more intensive competition reduces Reece's market position in either of its plumbing segments of Australia and the U.S.

We consider an upgrade less likely over the next few years given the execution and integration challenges associated with Morsco and Reece's lack of track record operating in the U.S. However, over time, upward rating action could occur if Reece were to increase its scale and earnings diversity. We could also consider upward rating action if the company committed to a more conservative set of financial policies that enable it to sustain an S&P Global Ratings-adjusted debt to EBITDA of less than 2.0x.

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