LED lighting products-to-extension leads manufacturer Luceco (LUCE) has risen by 80% since floating on the stock market in October 2016.

Its shares at 235p aren’t cheap. They trade on 20 times next year’s forecast earnings. It also faces market headwinds in the UK where it generates 86% of sales. However, our interview with chief executive John Hornby reveals compelling reasons why this fast growth story still has considerable upside potential.

Fundamentally Luceco operates in a structural growth market for LEDs and has massive growth potential outside of the UK for its broader product set.

Investment bank Berenberg believes Luceco’s lower-cost Chinese manufacturing capability enables the company to be ‘highly price competitive’.

It also believes the company’s dominant market share position in niche, low-growth but highly cash generative electrical accessories markets will help to fund its potentially lucrative expansion ambitions.

‘We believe these are cash cow businesses, producing excess capital that can be reinvested in higher growth and higher return projects,’ says Berenberg.

WHAT DOES LUCECO DO?

The £378m business operates four brands: Luceco (LED lighting), BG (wiring accessories), Masterplug (extension cables and portable power) and Ross (TV wall mounts).

The electrical accessories business (which is everything apart from the Luceco brand) accounts for about three quarters of group sales.

Its products are sold through retailers and trade wholesalers and growth is leveraged to activity in housebuilding and commercial construction, as well as housing RMI (repair, maintenance and improvement).

Major customers include Screwfix and B&Q which are owned by Kingfisher (KGF), as well as Homebase, Sainsbury’s (SBRY), Travis Perkins (TPK), Grafton (GFTU) and Wolseley (WOS).

Although housebuilding activity remains resilient, Luceco faces the risk of a slowdown in demand from consumers. Many of which are at the mercy of rising inflation and have less money in their pocket after paying the bills each month.

Retail accounts for a quarter of the electrical accessories business. The bulk of sales (65%) come through the trade channel.

Builders’ merchant Grafton recently said its trading continue to be good, albeit flagging concerns about pressure on incomes ‘which may temper growth in spending on housing RMI’. Last month plumbing specialist Wolseley said the UK RMI markets were ‘weak’.

SEEKING GREATER GEOGRAPHICAL DIVERSIFICATION

Hornby acknowledges the near-term risks and says Luceco’s challenge is to expand internationally in order to reduce the UK sales concentration.

‘We are a Chinese manufacturer supplying globally rather than a UK company supplying from China,’ claims the CEO.

In 2016 Luceco derived 4% of sales from the Middle East, the same from Europe and 6% from other parts of the world excluding the UK.

Hornby hopes to take the BG wiring business into Europe at the end of 2018 once it has got approval to sell electrical goods in that region. It is also working on the ‘internationalisation’ of the Masterplug range where it already sells into Europe and the US, alongside the UK.

He hopes to achieve economies of scale by marketing existing product to new customers in different countries. A possible head start might be achieved through buying a company such as a German lighting business which already has a market position, thereby giving Luceco instant market access.

Acquisition targets are unlikely to have Chinese manufacturing capabilities, says Berenberg. Its analysts believe Luceco could get market access via M&A and improve operating margins within the target business at very little incremental cost by using its own Chinese factory.

Hornby says labour is much cheaper in China than the West. He also says Luceco might be one of the few Chinese-based manufacturers to actively want to invest in the manufacturing process in order to lower costs in the future.

He claims there is a shift in the big retail and distribution space who now to want to buy FOB (free on board), where ownership of goods transfers to the buyer as soon as the items are on board a ship.

‘It means they don’t have to go via importers’ warehouses, so they skip a part of the supply chain,’ he comments, adding that Luceco is one of the few ‘joined-up’ firms in its space in terms of manufacturing and supply.

FROM ZERO TO HERO IN THREE YEARS

The LED business was launched in 2013 and accounted for one quarter of group sales in 2016 at £33m. Berenberg forecasts that figure will hit £64m in 2018, implying a continuation of very impressive growth rates. Luceco only has a 4% market share in the UK so there are still plenty of opportunities.

Interestingly, we note a drop in LED component costs has enabled Luceco to offer a lower priced product in a fast growing market. These types of lights are an estimated four to five times more energy efficient than traditional lighting.

Berenberg says the company’s rapid expansion has depressed free cash flow. It believes the cash profile will improve over the coming years.

We remain big fans of Luceco, having first highlighted its attractions in Shares at 150p as one of our Great Ideas on 20 October 2016.

It is worth noting a valuation anomaly with investment fund EPE Special Opportunities (ESO:AIM). We calculate its shares at 305p are trading at 7% below the value of its 24.3% stake in Luceco. That means you can get exposure to the lighting firm at a discount and get EPE’s other interests for free through buying its shares.

More upside to come. 

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