Description

“Despite a relatively short history as a public company, we regard FBHS as one of the bellwether names in our coverage universe”

– Barclay’s February 2013

“FBHS is considered to be a "best in class" home products company with strong brands that have leading market positions in cabinets, plumbing, and security and storage products.”

– RBC January 2014

“We believe that Fortune is among the best positioned names within our building products coverage.”

– Credit Suisse June 2017

Trader Talk: Opportunity to buy best in class building products company at an attractive valuation on macro fears where a defensive business mix should hold up better than peers in the event of a housing downturn

Description

Fortune Brands (FBHS) is a leading manufacturer of home and security products, with a focus on plumbing fixtures, cabinets, doors, and security. FBHS’s segments have leading market shares and well-known brands including Moen, Masterlock, Therma-Tru, and Fiberon.

Thesis

FBHS is a consensus “blue-chip” business that has fallen along with other building products companies due to cyclical fears and, to a lesser extent, minor operational misses. At ~12.5x 2019 EPS and under 10x 2021 EPS, I believe FBHS shares are attractively priced in all but the most draconian housing scenarios and can rally substantially as FBHS executes and housing fears prove exaggerated.

Regarding housing macro, I do not believe a significant contraction in housing is likely. First, new residential construction is below mid-cycle, there remains significant pent up demand from years of underbuilding, and strong demographic trends favor an above mid-cycle demand picture. Second, repair and remodel (R&R) trends are normal and R&R is generally far less cyclical than new constructions. Regarding FBHS specifically, while the cabinet segment has been under pressure in recent years, FBHS’s Global Plumbing Group (GPG) and Doors and Security (D&S ) segments, which comprise ~50% and ~25% of operating profits respectively, are high-quality businesses that have consistently outgrown their end markets, own widely respected brands with leading market shares, and boast mid-teens to low-twenties operating margins. Finally, in the event we do enter a significant housing contraction, FBHS’s ~56% R&R and ~16% international mix, reasonable leveraged, and high-margin product focus make FBHS’s earnings far less cyclical than most building products companies.

I believe FBHS has 50-100% one-to-two year upside, similar to many building product stocks, without comparable downside EPS risk if the housing market enters a modest cyclical downturn.

Valuation

Note: I do not provide a model here as there are dozens of sellside sources. However, roughly speaking my numbers are more conservative on the Cabinets segment, in-line on Doors and Security, and more bullish on GPG and capital redeployment.

Upside – If housing remains strong or accelerates into 2020/2021, I believe FBHS can earn ~$4-$4.50 in 2020 and $5-$6 in 2021, depending upon M&A outlook and shareholder buybacks. This is modestly above the Street but inline with management’s 2021 guidance. Assuming a 14-18x multiple implies 50-100% upside on a one-to-two year basis.

Downside – If housing enters a modestly severe downturn, I believe FBHS operating profits would at worst fall ~30% and EPS to ~$2.50. 12x yields ~$30, down 35%. I believe my estimate of a 30% decline in operating profits is conservative in all but a “once in fifty-years storm” housing environment

Risks

Severe Housing Downturn – In the unlikely event home prices fall substantially and new construction and R&R severely contract, building products will not be a good investment (Captain Obvious comment...).

Continued Pressure in Cabinets – Cabinets is the lowest-quality segment in FBHS, facing threats from Chinese imports as well as a fragmented domestic market. However, cabinets are only ~25% of EBIT and FBHS has been proactive addressing their issues.

Poor Capital Allocation – FBHS generates significant FCF. M&A and buybacks are significant features of their earnings growth story, and poor decisions could lower outer year estimates.

Catalyst

Spring Selling Season – While early, the US spring selling season is off to a decent start in 2019, with NAHB sentiment index improving from a rough Q4 and most homebuilders reporting sequential improvement in January and February. If new home construction appears set to improve and grow in 2019, I believe FBHS shares can rally.

Cabinet Anti-Dumping Case – The American Kitchen Cabinet Alliance, which includes Fortune Brands, recently filed a trade case against China with the ITC. Timing and ultimate impact are unclear, but a positive resolution could boost FBHS’s shares.

Good Capital Allocation – FBHS believes they have ~$3B (~$1.7B in FCF + additional available leverage) in capital investment capacity over the next three years versus a current market cap of ~$6.5B.

Housing Macro

I will keep this section informal as I believe any macro forecast should be taken with a grain of salt. The big points are 1) US new residential construction is still well below mid-cycle and in an undersupply while all previous large housing contractions came after a period of oversupply and 2) R&R spending is far less cyclical than new construction, hence I believe any slowdown in housing is likely to be modest even in the event of a recession.

For the general housing bull thesis, the gist is that since 2008 the US has significantly underproduced homes directly into a wave of demand from millennials, which creates a strong fundamental backdrop for rising home prices and continued strong new home demand. While there can be ups and downs along the way, particularly around credit, rates, and employment, I believe the general “up and to the right” trend for US housing has strong fundaments and is likely to continue for years. My old VIC post goes deeper into details here: https://www.valueinvestorsclub.com/idea/US_Residential_Construction_Equities/1936185598

Point #1 – Housing Still Below Mid-Cycle

Note: I show Permits as they are the leading indicator. Starts are a trailing indicator – you need a permit to start construction.

In general, long-term housing demand tracks population growth with a 20-30 year lag plus or minus immigration plus replacement demand from destroyed homes. People are born, they tend to live in pairs with a roof over their heads, but first they have to grow up and leave their parents homes and along the way the US typically sees immigration and some homes are destroyed. It’s as simple as that. As a rough reference, the US needs ~1.5MM starts per year. As you can see from the two above charts, we are still below 1.5MM. Further, we are well below a level that has seen a significant housing contraction, particularly on a population adjusted basis. All substantial contractions in US new residential construction have come after periods where we built significantly above trend – it’s not a shock big busts tend to follow big overbuilds. This doesn’t mean we can’t see a big housing contraction – crazier things have happened – but my point is there is no logical reason for the US housing market to contract sharply without some sort of exogenous variable (massive inflation, global financial meltdown, world war, etc.) throwing things into the wringer.

Point #2 R&R Less Cyclical and Not Above Trend

I apologize for the hodge-podge of charts above, but historical data on R&R spend is hard to come by.

In general, R&R is a GDP to slightly above GDP growth with a strong “replacement driven” component that makes it significantly less cyclical than residential construction. Home prices and general macro conditions certainly matter – who remodels a kitchen if you just lost your job and the price of your house dropped 30%? – but most recessions see a modest, “down a few percent” pullback in R&R, including times when housing permits have fallen 20%. Even in 2006-2009, when permits fell 73%, R&R fell only ~20%. Further, R&R was coming off a credit-fueled bubble in the mid-2000s from poorly underwritten HELOCs, where as today HELOC originations are well below prior levels with considerably tighter underwriting standards. Pulling it together, R&R has historically been significantly less cyclical than new construction and I believe the current R&R market is at or slightly below trend.

FBHS Segments

Global Plumbing Group – The Golden Child

GPG is the “crown jewel” of FBHS’s portfolio and represents ~50% of whole co. operating profits. GPG manufactures plumbing fixtures and accessories, particularly faucets, and is led by the Moen brand. GPG is the largest US plumbing business with ~30% market share. The US plumbing industry is an oligopolistic market where the three leaders (FBHS, Delta, and Kohler) have substantial branding, distribution, and R&D advantages and are actually growing share at the expense of private label and imports.

The “secret sauce” to the plumbing fixture market is that they are design focal points that catch the eye and add value to users yet are small percentage of the overall cost of R&R or new construction projects. For example, the average kitchen remodel is ~$20,000 with ~$6-8k in cabinets and $4-$6k in installation. However, the average faucet is around $250, with a low-end faucet competitor around $100. As a small percent of the overall bill but an area where design and “coolness” are noticeable, Moen gets to compete more on service/quality than price, enabling Moen to push through consistent price hikes. Moen’s pricing power, combined with a manufacturing process focused on design and assembly rather than raw material conversion, has enabled GPG to reach a consistent low 20s operating margins, even in periods of significant raw material price increases. Further, GPG is the most global of FBHS’s segments, with international sales at ~28%, and FBHS has successfully established itself as market share leader in key emerging markets such as China.

I believe GPG can continue to grow sales and EBITDA at a HSD pace for years and their high-margin, diversified business mix should be relatively robust in the event of a housing contraction. Last downturn, in the “fifty-year storm,” FBHS’s plumbing sales fell ~27% with margins contracting to ~14%. (Unclear what level plumbing margins were in mid-2000s.)

Doors and Security – The Good but Kinda Random Cousin

D&S is a mix of three separate, seemingly unrelated yet still fundamentally sound businesses – Doors, Security, and Fiberon. The Doors and Security segments were historically reported separately until Q3 2018, while Fiberon was acquired in 2018. Doors is essentially Therma-Tru, a manufacturer of fiberglass entryways. Therma-Tru is a fundamentally different business than public “door” peers DOOR and JELD. Therma-Tru is a market share leader in the design-heavy, higher ASP front door market whereas as DOOR/JELD primarily operate in the commodity, lower ASP interior door market, hence the prior Doors segment had operated at a 13-15% margin the last three years vs. DOOR/JELD at 6-8%. (The front door is the “grand entrance” to your home. The door to the closet in the guest room… not so much.) Doors were previously projected to earn ~$80-$100MM in 2019/2020.  Security is mainly Masterlock, which has ~85% share of the padlock market and a leading position in safes/safety products, along with a few smaller safe/storage brands. The segment has limited impact from housing, is more of an annuity, and was previously projected to earn $90-$110MM in 2019/2020. Fiberon is a recent acquisition in the non-wood decking space. It was a “growth” acquisition – little initial EPS benefit but significant growth opportunity over time. TREX is a direct public comp and currently trades ~18-20x EBITDA. Fiberon’s exact EBIT breakout is unclear but initial guidance implied ~$20MM in EBIT by 2020.

D&S is an overall good segment with a mid-teens margin and I estimatea  modestly above cycle growth rate. Last downturn, Doors sales fell ~35% and operating profits turned slightly negative. However, the Doors segment contained Simontons windows at the time, which when sold in 2014 had roughly ~$300MM in sales yet only $13MM in EBITDA despite a housing upturn, a sign it likely weighed significantly on segment profits in the downturn. Security sales fell ~16% last downturn and margins bottomed at 9% before quickly rebounding to 11-12% from 2010 onwards.

Cabinets – That Family Member You Wish Wasn’t Invited

Cabinets is frankly FBHS’s worst segment and I do not believe results will be particularly good anytime soon. Fundamentally, it faces a host of issues that are unlikely to abate: they sell a commoditized product that is manufacturing intensive; 34% of sales are to HD/LOW; there are few barriers to entry with low upfront costs and components can be shipped globally; and they face competition on the high-end from custom and semi-custom builds while facing Chinese imports on the low end, which have grown to ~15% of total industry volumes. To top it all off, sales fell 45% last downturn, though FBHS did trough at roughly breakeven versus MAS’s cabinet segment which to a -9% operating margin at one point. In a word, yuck. Cabinets were a modestly better business in the 1990s and 2000s but I think the market has fundamentally changed and imports are going to continue to eat away at profitability.

With that in mind… I simply write off any chance this segment ever turns in my estimates. The segment has hovered at ~$2.4B in sales and 9-11% operating margins for ~$200-$270MM in EBIT the last four years. FBHS (annoyingly…) guided to modest sales growth and ~300bps margin recovery in the next two years. While I believe FBHS is unlikely to hit these targets, I am less worried that EBIT falls precipitously as much as I think it’s a drain on resources and FBHS would be better off divesting it. I estimate it stays flattish in an ~$200-$250MM range. In a downturn, I assume an ~50% decline to $115MM in EBIT.

Taking a step back, my point here is that Cabinets is lousy business, but 1) the rest of the business is very good and 2) the stock is already very cheap. When you are buying a “best in class” asset at an ~35% discount to the market, there are going to be things you don’t love about the setup. Cabinets weak outlook (along with scary macro headlines) is something not to like, but I do not view as a deal breaker.

Housing Recession Earnings

If housing does contract, I estimate a realistic worst case would be a 20% contraction in new residential construction and a 5-10% drop in R&R. For GPG, I assume an 10% topline decline with 35% incrementals yielding ~$330MM. For D&S, I assume a 15% decline with 35% incrementals yielding ~$130MM. For Cabinets, I assume EBIT drops 50% to $115MM to be conservative. Assuming $60MM in corporate expense and 135MM shares yields $2.42 per share.

I believe my estimates are conservative.

I do not provide a “once in fifty years” earnings scenario because, frankly, I have no clue what it looks like. I assume “pretty ugly” (I’m a genius) and that the stock will be crushed. However, even in this unlikely event, FBHS has reasonable leverage and GPG is fundamentally sound enough that even in a housing crisis I believe FBHS would still generate modest postive FCF.

Further Reading

Improving America’s Housing 2019: https://www.jchs.harvard.edu/sites/default/files/Harvard_JCHS_Improving_Americas_Housing_2019.pdf

Catalyst

Spring Selling Season – While early, the US spring selling season is off to a decent start in 2019, with NAHB sentiment index improving from a rough Q4 and most homebuilders reporting sequential improvement in January and February. If new home construction appears set to improve and grow in 2019, I believe FBHS shares can rally.

Cabinet Anti-Dumping Case – The American Kitchen Cabinet Alliance, which includes Fortune Brands, recently filed a trade case against China with the ITC. Timing and ultimate impact are unclear, but a positive resolution could boost FBHS’s shares.

Good Capital Allocation – FBHS believes they have ~$3B (~$1.7B in FCF + additional available leverage) in capital investment capacity over the next three years versus a current market cap of ~$6.5B.