Finding Opportunity in Building Products and Home Centers

Dan Oppenheim
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Dan Oppenheim , CFA

(415) 889-5617

doppenheim@ssrllc.com

January 24th 2019

Finding Opportunity in Building Products and Home Centers

  • Noise-laden housing environment leads to attractive valuations. We’ve heard concern from investors as to the trajectory of housing in 2019 – primarily worries about slowing home price appreciation and turnover – and the impact on home improvement spending. Our view is that the housing turnover (existing home sales) will show sequential improvement in spring 2019 and that home price appreciation will slow from recent years, but will be approximately 4%. However, we believe that valuations of building products companies and home centers reflect a more pessimistic environment, with building products stocks trading at 8.0x 2019 estimated EBITDA (the low end of their typical 8-12x range) and with home centers at 16.2x 2019 EPS, a modest discount to their average multiple during stable housing environments.
  • Favor building products companies with sales driven by turnover, not price appreciation. We prefer building products companies with products linked to housing turnover, such as MAS (plumbing and paint together represent approximately 78% of sales), but would be more cautious with FBHS (cabinets represent 44% of sales and are tied to big-ticket remodeling).We would expect to see more confidence from investors as existing home sales improve in 2019and based on trends in MAS’ plumbing and decorative architectural products largely paint) segments.
  • ROIC goals for HD and LOW predicated on slower comp sales growth. The ROIC goals set by HD and LOW (40+% ROIC in 2020 for HD and 35% long-term for LOW) assume modest comp sales growth. HD’s ROIC goal assumes 4.5-6.0% comp sales growth from 2018-2020 (implies comp growth of 3-5.5% in 2019 and 2020, given 2018’s comp growth likely near 7.2%) LOW’s goal assumes 3% sales growth in 2019 (up 50 basis points from 2018, aided by improved merchandising, in-stock levels, and efforts to capture greater business from pro contractors). We think these sales assumptions are achievable in the current housing environment, as HD’s comp growth over the past 15 years has only fallen below 3% during the housing downturn. We favor LOW over HD.
  • Expecting existing home sales likely flattish in 2019, with 4% home price appreciation. We believe the mix of modest income growth, mortgage rates back below the average 2018 level, and slower price appreciation will lead to a 1% increase in existing home sales in 2019 and expect home prices to increase 4%. We continue to expect more challenges at the high end and on the west coast.
Exhibit 1: SSR’s Preferences Among Housing-Related Sectors
Source: SSR analysis

Finding Opportunity in Building Products and Home Centers

Concerns about home improvement activity reflect housing contracts signed at time of higher rates. Stock weakness reflected the concerns we heard from investors about the 6.4% sequential decline in seasonally-adjusted existing home sales in December, worrying about a sluggish housing market in 2019. However, we believe that the concerns are over-done, given that a) existing home sales in December reflect contracts signed in October and November, with 30-60 days between contract signing and closing with interest rates being at their highest level for 2018 in October and November, and b) December closings are typically the third lowest month of the year for non-seasonally adjusted sales, with only January and February being lower. Closings in December likely reflected contracts signed when mortgage rates were approximately 4.85%, approximately 30 basis points higher than the level from spring to early fall. Consumers are sensitive to moves in mortgage rates, with every ten-basis point move having the same impact on the monthly payment as a 1% change in the home price. We expect existing sales in January to remain at lower levels due to the high mortgage rates that prevailed in November, but then expect a pick-up in activity with February and March existing sales.

Exhibit 2: Likely to See Improvement in Existing Home Sales with Decline in Mortgage Rates
Note: Data reflects average mortgage rates from prior two months to reflect rates at time contracts were signed. For example: January 2019 rates reflect average of mortgage rates prevailing in November and December 2018.

Source: Freddie Mac Mortgage Market Survey and SSR analysis

More gradual price appreciation likely to favor low-mid ticket improvement projects. We expect the slower home price appreciation to lead to less big-ticket home improvement activity (full kitchen renovations), but would expect growth in smaller projects. Generally, rising home prices lead to confidence in values and a willingness to invest, with times of greater appreciation correlated with more big-ticket remodeling, whereas slower appreciation leads to smaller projects. As such, we expect better sales activity for items such as plumbing fixtures and paint, but more challenges for cabinets. Among building products companies, we favor Masco (MAS), as it generates 78% of its sales from plumbing and decorative architectural products (largely paint), whereas we think Fortune Brands Home and Security (FBHS) may see more difficulty, with 44% of its sales from cabinets.

Exhibit 3: MAS Focused on Recurring Projects; FBHS Has Greater Exposure to Big-Ticket
Source: Company reports

Comp sales growth implied in targets appears achievable; favor LOW over HD. HD’s ROIC goal assumes 4.5-6.0% comp sales growth from 2018-2020 (implies comp growth of 3-5.5% in 2019 and 2020, given 2018’s comp growth likely near 7.2%). LOW’s goal assumes 3% sales growth in 2019 (up 50 basis points from 2018, aided by improved merchandising, in-stock levels, and efforts to capture greater business from pro contractors). We think these sales assumptions are achievable in the current housing environment, as HD’s comp growth over the past 15 years has only fallen below 3% during the housing downturn. We favor LOW over HD as we see more potential for merchandising improvement at LOW, LOW’s relatively lower west coast exposure, and more attractive valuation.

Exhibit 4: Home Depot Can Reach Its ROIC Goals with Slower Comp Growth in 2019-2020
Source: Company reports and SSR analysis
Exhibit 5: Existing Home Sales to Improve over 2019, Likely Up Slightly for Full Year
Source: National Association of Realtors, Joint Center for Housing Studies, and SSR analysis
Exhibit 6: Building Products Comparative Valuations
Source: Company reports, Capital IQ, and SSR analysis
Exhibit 7: Home Centers Comparative Valuations
Source: Company reports, Capital IQ, and SSR analysis

©2019, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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