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Fund manager stock pick: Reece Australia Ltd (REH) and ARB Corporation Limited (ARP)
Current share price: Reece-$29.25; ARB-$4.13
Projection: Reece-$33; ARB-$4.70
Fund manager: Frank Villante, Souls Funds Management

Possessing an ability to not merely survive but grow substantially in a down-turned market, bathroom retailer Reece Australia has succeeded in defying the odds and overcoming the drop in housing construction, which has fund manager Frank Villante reaching for superlatives.

Villante believes that Reece’s shares are at least 15% undervalued because the business has been delivering consistently well during challenging times. He argues that his projection for the Reece share price of $33 in 12 months is conservative, maintaining it could easily reach $35.

In the past 12 months Reece’s shares rose from $17.50 to $29.25.

Villante predicts “the real sizzle will happen a couple of years down the track when the housing market in NSW, Victoria and South Australia come back to life. If these guys can do what they do year in and year out in a tough market, their earnings will grow dramatically when times get a bit better.”

Reece’s revenue increased from $0.5 billion to $1.3 billion from the end of the 2001 financial year to June 2007 “and it hasn’t been to the detriment of the earnings of the business in a net profit or dividend sense,” stresses Villante.

“Over that same period the number of bathroom showrooms grew from 180 to 350 – an aggressive, organic store roll out strategy, which has contributed heavily to its growth.

“Reece has a long operating history in the management and distribution of products to target trade customers – namely plumbers. But increasingly Reece is broadening its customer base to include the refrigeration, heating, ventilation, air conditioning and irrigation markets.

Villante credits Reece’s board and management, in particular executive chairman, Alan Wilson, who has been involved in the company and this sector for much of his working life, for driving the growth of the business. “Alan understands the industry and the competitive dynamics within it,” says Villante noting that “most people would look at a plumbing supply company and say it has to be inherently cyclical but the reality is that over the last 10+ years Reece has managed to grow revenues and profits”.

Villante admits that there are lots of potential pitfalls inherent within Reece’s aggressive store roll out strategy: the selection of poor sites and a difficult labour market potentially posing the highest risks.

“The question is always, does this company have the systems, controls, checks and balances to manage a growing and expanding business,” he says. “The skills required to manage growth are very different from those needed to manage a more sedentary revenue and bottom line. Reece has exhibited a great ability to manage growth and its track record in a challenging environment speaks for itself.”

Villante’s second tip, ARB Corporation, which manufactures four-wheel drive accessories sold domestically and internationally, has seen its shares increase from a low of $3.43 to a high of $4.75 over the past year. It currently sits at $4.13.

Villante predicts that its shares could reach between $4.70-$4.90 in 12 months’ time.

Over the last 10 years ARB’s sales – of such items as shock absorbers, bull bars, puncture repair kits, cruiser accessories, rear protection bars, traction jackets, driving lights and shell canopies – have achieved compound growth per annum of 14%; net profit has increased by 19%. Lastly, return on equity, averaging 24% over this period, is well above the broader market of almost half that rate.

ARB has a 10+ year track record of growing domestic and international sales. The company has a manufacturing base in Kilysth, Victoria and recently established a cost-competitive manufacturing base in Thailand. Thirty percent-plus of its revenue per annum is from its international export market.

ARB Corporation has historically sold to four-wheel enthusiasts, who’ve traditionally purchased different types of accessories than the alternative market for four-wheeled drive vehicles, the Mums and Dads who drive their kids around the suburbs. But because four-wheel drive utilities have become so popular, ARB Corporation’s market has broadened considerably.

Villante concedes that the increase in fuel prices has meant that the demand for large four-wheel drive cars has decreased substantially. But conversely the overall demand for four-wheel drive utilities has risen.

“There are a couple of changes happening in the four-wheel drive market,” says Villante. “The growth in four-wheel drive utilities is due in part to changes in technology in the engine. A lot of four-wheel drive utilities can be run on either a turbo diesel basis or a traditional unleaded petrol basis.

“In the larger four-wheel drive sector the auto companies are changing and evolving their offering and later this year Toyota will be bringing out a new model; a large four-wheel drive that uses a turbo diesel engine, which makes it dramatically more cost efficient.

“So there’s every reason to believe that sales in this sector will return quite strongly.”

Equating ARB to the Black Knight in Monty Python who had its legs and arms cut off and still survived, Villante says that the company has demonstrated its ability to survive its greatest threats; spikes in petrol prices and the cost of raw materials, unfavourable movements in the Australian dollar and a skills shortage.

“The management is very dynamic, pragmatic and experienced and when something detrimental occurred it learnt to become adept at evolving its business model to deal with it,” says Villante.