Description

MASCO CORP (MAS US) – LONG @$56

Disclosures

I and/or others I advise hold a material investment in Masco. Everything expressed here is only my own opinion, it should not be relied upon, nor should be considered investment advice. Always do your own independent research.

Background

• Masco is a US based manufacturer and distributor of branded home improvement and building products, primarily faucets and paint, focused on the repair and remodel segment of the housing industry. 

• During the US housing crisis of 2008/09, the company went nearly bankrupt due to excessive debt and exposure to new construction; post the crisis, a new management team transformed Masco into a less volatile and higher returns business, shedding its most cyclical assets and focusing on its two higher returns and more stable plumbing and decorative paint businesses.  

• The business today sells primarily low-ticket items, that are defensive in a residential housing downturn, earn high returns (18-19% EBIT margin) with low capital intensity (2.5% capex/sales). 

Investment Thesis

• Transformed company post GFC: since 2013 Masco started a process of overhaul of its portfolio, improving its returns and stability profile by divesting its more cyclical and lower margins businesses (Insulation installer, Cabinetry and Windows) whilst retaining its higher returns and more stable Paint and Plumbing businesses.

• Portfolio tilted towards less cyclical business: the company also tilted its exposure towards the repair & remodel markets (90% of group) and reduced its new construction exposure to only 10% of the group

• Paint and Plumbing are high quality growing businesses: both paint and plumbing own strong brands, sell low ticket items, have leading distribution capabilities and generate high margins (18%+) with limited capital intensity (capex/sales 2.5%); furthermore, they benefit from secular tailwinds such as aging of the housing stock and demand for smart and energy efficient home products. 

• Savvy capital allocators: on top of improving the company’s business portfolio, management has repurchased 25% of outstanding shares in the last 5 years; noticeably management long-term incentives scheme is tied to increasing 3-years group ROIC, which averaged 17% in the last 3-years. 

• Solid financial algorithm and high returns: the business should grow topline between +4-8% p.a. broken down as +3-5% organic and +1-3% bolt on acquisitions; overall EPS should compound at around +10% driven by an additional +2-4% annual buyback; capital intensity is low (2-2.5% capex/sales) and CFROI is high (>20%). 

• Attractive valuation: the stock performed YTD similarly to more cyclical names exposed to housing (housebuilders), despite its high exposure to more stable repair and remodel end markets (c.90% of revenues); trades on 14x P/E and a FCF yield of 7.0% with FCF/share growth >10% p.a.

Key Risks

• Customer concentration: the Home Depot is the company’s largest customer, accounting for 36% of sales, through its exclusive distribution in the US of Masco’s paint Brand Behr.

  • Mitigants: The Behr-Home Depot relationship on decorative paint has been enduring for 40 years and is symbiotic: HD benefits from the exclusivity of a popular high performing brand to drive store traffic, whilst Behr benefits from HD’s world class distribution network. 

• Raw material inflation: like other coatings company, Masco is exposed – in the short term – to volatility in raw-material prices, particularly oil derivatives and TiO2.

  • Mitigants: Over the mid-term, Masco’s strong pricing power allows it to recoup cost inflation and restore its high teens EBIT margin. 

• Cyclicality: the company is still exposed to the housing cycle, particularly in the US (80% of sales).

  • Mitigants: importantly, the company is heavily exposed to the more stable repair and remodel end markets than in the past. 

Investment Thesis in Charts

Group CFROI improved since 2014 through divestments and focus on higher margins Plumbing and Paint.

The group is more resilient, with 90% exposure to repair & remodeling and a focus on low-ticket items.

The stock still trades on undemanding P/E, despite a much-improved returns profile. 

Brief History

• The company was founded in 1929 by Alex Manoogian, the inventor of the world’s first single handle hot/cold faucet; the business was listed in 1936, as Masco Screw Product Company, selling parts to the automotive industry. Only in 1952 the business started to operate in the plumbing industry, as the founder designed first single-handle hot/cold faucets, now known as Delta. 

• During the period 1996-2002, Richard Manoogian, son of founder Alex, went on an acquisition spree, over-stretching the business.

• During the Great Financial Crisis (2007-2009) the company greatly suffered and the stock collapsed -80%.

  • From 2014, a new management team was put in place to overhaul and restructure the business, shedding the more cyclical and low margins part of the portfolio: 

  • In 2015, the company spun out Topbuild, a cyclical installer and distributor of insulation products.

• In 2019-20, the lower margin windows and cabinetry businesses were divested respectively for $725mn (to MI Windows and Doors in Oct-19) and $1bn (to ACProducts Inc, in 2020). 

• The benefits of the restructuring process post the 2008/09 recession, are well visible in the CS HOLT chart below, breaking down the evolution of Economic Profit by segment over time.

• As of today the business is focused on two high margin, resilient end markets: Plumbing Products (60% of EBIT, 18% margin) and Decorative Architectural Products 40% of group EBIT, 19% margin). 
• Importantly, even at the depth of the financial crisis, both Paint and Plumbing operating margins remained positive around 10%, whereas Cabinets and Windows fell into a large loss (-35% margins). 

Key Exposures

• The business reports across two divisions, Decorative Architectural (or paint) and Plumbing; the former is slightly more profitable than the latter, but both earn margins well in the high-teens. 

• Masco is primarily a North American business (c.80% of sales), exposed to the repair and remodeling end markets (c.90% of group).

• The company operates 30 manufacturing sites in the US and 10 overseas, the latter exclusively for the plumbing business. Most of the international facilities are located in China, Germany and the UK. 

Historic Financials

 Industry Context 

• From a macro standpoint, most US housing exposed stocks have suffered a significant derating since the Fed started to raise rates meaningfully, and US mortgage rates spiked. 

• It is though important to bear in mind that new construction accounts for only 10% of Masco’s revenue; 90% of the group is exposed to the more resilient Repair & Remodel end market, which is underpinned by several secular tailwinds, such as ageing housing stock, favourable demographic, and increase demand for energy efficient homes.

• Additionally, it is important o tbear in mind that the long-term housing fundamentals remain supportive in the US, as shown in the charts below.

• Furthermore, Masco today operates in two of the highest quality sub-segments within the Building Products space – namely Paint and Plumbing – if we are to consider they operate in (i) highly consolidated markets, (ii) have strong pricing power, (iii) require little capital to grow, (iv) are less cyclical and (v) have a low level of commoditization (see below Credit Suisse ranking, where 5 is the highest score, and 1 the lowest).

• Within the plumbing segment, Masco specializes in faucets and shower heads, where the top three players control 75% of the market: Masco’s leading brand Delta controls 25% share, and is the number 2 player behind Moen (30% share). Private label penetration is stable around 20%, as customers do care about brand and product innovation (for example digital temperature displays on shower fixtures). 

• In Decorative Architectural/Paint, Masco owns the Behr brand, which is exclusively distributed by The Home Depot in North America. 

• The Behr brand serves primarily DIY customers (70%), but experienced strong growth in the last few years in the PRO segment too (30%). 

• Masco’s closest peer in the paint segment is Sherwin William’s Consumer Brands business, which supplies Lowe’s and is a long single digit grower with low-teens margin business. 

• However, I believe Masco’s Paint business is higher quality than Sherwin’s CB business for three reasons: (i) it grows faster thanks to its rapidly growing PRO business at Home Depot, (ii) its margins are in the high-teens, that is 300-500bps higher than Sherwin’s DIY business and (iii) it is less asset intensive, thanks to the Home Depot partnership. 

Business Model

• Masco Plumbing and Decoarative Architectural divisions focus on small ticket items sales.

• Indeed, both faucets and paint are small ticket items that cost on average around hundreads of dollars, compared to bainet and windows which average in the thousands; thus Paint and Plumbing sales tend to be less cyclical, and are not usually tied to large remodelling projects: faucents need to be replaced when they break and paint jobs are usually not delayed as they significantly impact the value of a property without requiring a large upfront investment. 

• In terms of customer types, the portfolio is equally balanced between DIY and PRO contractors; having said this, the Paint business is more skewed to DIY customers (c.70%) as PRO paint is a nascent category that reached around 30% of total paint sales; the opposite is true of the Plumbing business, which is skewed more towards contractors customers. 

• The group goes to market primarily via its retail relationships and through the trade/wholesale channel; eCommerce is a smaller but growing channel, particularly for the plumbing business.  

• The group hosts a portfolio of brands the most important being Delta Plumbing and Hansgrohe in the plumbing division and the Behr brand in the Decorative Paint division. 

•  Delta Plumbing was founded in 1954 and is the strongest faucets and shower-head brand in North America: it manufactures and sells a range of plumbing products to both professional contractors and via the retail channel. Delta’s average price point is slightly below Fortune Brands’s Moen but well above American Standards and other lower end brands. The Hansgrohe brand was founded in 1901 and is Masco’s leading overseas brand which is available in c.140 countries. 

• Importantly, in Plumbing, pricing power is strong, as brand awareness, service and product quality are all important factors in the purchase decision. As evidence of this pricing power, one can look at Plumbing margins which tend to expand when brass metal prices fall, and are retained at high level when metal prices fall. 

• The Behr paint brand is the leading brand in the DIY coatings market and was acquired by Masco in 1999.

• The brand controls circa 30% of the DIY coatings market and more recently has made inroads into the PRO market too, through a join effort with its exclusive distribution partner The Home Depot.

• Similar to plumbing, coating businesses enjoy strong pricing power as usually paint is a small portion (15%) in the overall cost of a paint job (85% of cost is labour).

• Key competitors to Masco are other well established paint manufacturers such as Sherwin Williams, PPG, Benjamin Moore (controlled by Warren Buffet) and RPM International. 

Relationship with Home Depot.

• The Behr and Home Depot relationship started 40 years ago, it goes all the way back when Home Depot was just starting out in 1978, when there were only two HD stores. 
• Behr was one of the first suppliers to Home Depot and is exclusively sold in the home improvement retail giant stores. The exclusive partnership allowed Masco to leverage Home Depot’s distribution channel gain market share along with Home Depot’s continued store expansion. 

• This partnership allowed Masco to allocate more resources into research than sales and marketing, improving the quality of the product, whereas other coatings competitors had to invest also in distribution (store space) and logistics arrangements (whereas Masco relies on HD formidable supply chain). 

• The Behr brand is deeply ingrained within Home Depot, as their decades-long relationship not only includes shelf space in the stores but also mind share with Behr salesforce located inside the Home Depot stores. 

• Masco’s Behr brand has effectively become Home Depot’s house paint brand (whereas other competitor brands hace channel conflicts, ie other customers and/or their own stores). 

• Competitors brands sold at the Home Depot are lower quality alternative to Behr (such as PPG’s Glidden brand); alternatively other competitors are exclusive to Home Depot’s competitor Lowe’s (such as Sherwin’s DIY brands). 

• Paint is hugely important category for Home Depot is it drives strong traffic and has a very strong attachment rate (ie customers don’t buy only Behr paint, they also buy Home Depot’s high margin accessories such as brushes, tapes, tins, tarps etc). 

• Home Depot and Masco’s interests are well aligned and this is evident in the success they had with the launch of the PRO paint product, which has been growing double digits for many years and today accounts for 30% of Behr total paint sales; the Behr brand is the perfect partner for Home Depot to gain market share in the PRO segment because Behr does not have a company owned store footprint already catering to it. 

• Importantly, the relationship with Home Depot regulates how profits are shared in period of raw-material inflation: Masco is assured dollar cost recovery, which during period of high inflation translates into margin compression, and conversely during deflationary environments sees margin expansion.

• This is best explained via an example: if there’s a 5% price increase in architectural paint, that translates into 100bps of margin dilution, but no impact on dollar profits.

Management & Remuneration

• Keith J Allman – was named CEO in 2014 and was the driving force behind the overhaul of the business post the GFC; he is only the 4th CEO to lead the company since its founding and joined Masco in 1998.

• John Sznewajs – was named CFO in 2007 and is poised to retire in May 2023; he joined the company in 1996 and served in a variety of roles in treasury, corporate development and finance. 

• Management remuneration can be split as follows: cash bonuses worth 20% of overall target compensation, a long-term incentive program worth another 20% and finally restricted stock units and stock options worth between 20-23% each. 

  • The annual cash bonus award depends on reaching specific targets for EBIT (80% weight) and Working Capital/sales (20% weight)

  • The LTIP award is dependent on ROIC (40% weight) calculated over a 3-year period and cumulative EPS (40% weight). 

  • Restricted Stock Units are awarded based on the performance percentage achieved on the LTIP ROIC criteria.

  • The value of stock options granted annually approximates the RSU target opportunity for each executive.

• I believe this is a sensible set of remuneration criteria, balancing growth with ROIC; I wish there was an element tied to cash conversion or FCF/share, but nonetheless it is certainly a reasonable set of criteria for this business and well aligned with minority shareholders’ interest. 

• Importantly, management leadership seems to be fostering a good company culture, as evidenced by the strong rating on Glassdoor.

Financial Algorithm 

• Management disclosed a long-term growth algorithm which appears conservative and sensible: the topline should grow organically at +3-5% p.a. and be augmented by bolt-on acquisitions worth 1-3% p.a, for a total revenue growth of between 4-8%.

• Margins are currently in the high teens and should not expand much more: management clearly stated that it aims in each of the two businesses to outgrow the market (which means share gains) and moderately expand operating margins (that is indicated in the range of +10bps p.a)

• In addition, management targets to buyback 2-4ppt of EPS growth p.a, bringing total average annual EPS growth around 10% p.a. 

• The targeted dividend payout of 30% leaves shareholders with an additional dividend yield of 1-2%. 

Capital Allocation:

• Since taking over as CEO, Keith Allman achieved several important milestones which markedly improved the quality of the business: it reduced balance sheet leverage by 2x turns and divested low margin cyclical business at attractive multiples (cabinets at 9x EBITDA and windows at 11x EBITDA).

• Furthermore, since 2014, the dividend has increased every year and buybacks reduced the diluted shares count by 25% compared to FY13. 

• Such measures increased the group CFROI and ROIC markedly relative to the last decade.

• Going forward capital allocation priorities shouldn’t change, management aims to first reinvest in the business, through capex/sales of 2-2.5% and working capital around 16.5% of sales.

• Financial leverage should remain below 2.5x of gross debt/EBITDA and excess FCF after paying the dividend will be deployed into bolt-on acquisitions and buybacks. 

Historic TSR 

• • This is a business that over the last 10 years generated nearly 14% TSR p.a, well in excess of the global index. 

Amongst its peer group, Masco is the second-best performing stock, a tad behind market leader Sherwin Williams.

Why The Opportunity Exists

• The stock certainly suffered from (i) macro concerns over US residential housing (ii) several quarters of commodities driven inflation, particularly on the paint side (recall Sherwin raised prices cumulatively by over 30% in the last 4-6 quarters) and (iii) potential over-earning during Covid-19 (note consensus already expects EPS do be down YoY in 2023). 

• Furthermore, I believe the stock is still considered a cyclical low returns building product business, and investors aren’t fully appreciating the extent to which the portfolio tilted to higher returns, more defensive end markets, post the divestitures.

• Finally, I would note that this stock isn’t for everyone: the customer concentration risk is very noticeable (35% of sales tied to Home Depot), however having dug more deeply into the relationship I am comfortable that there are not incentives for both parties for the status quo to change.  

Valuation

• The stock trades on a 7% FCF yield in 2023, which is quite attractive in my view both in absolute terms and relative to history.

• Recall, this business is less cyclical than other coatings or building products businesses, as it sells more defensive products (plumbing, paint) that hold up better during recessions. 

Shareholders

Notable on the registry are the long-term quality investment house MFS (#2) and Impax Asset Management (UK Quality boutique with ESG focus). 

Main Research Sources:

• 10K and other company filings

• Transcripts

• Fairlight Asset Management write up

• Credit Suisse HOLT

• Value Investor Club reports

• Sellside brokers reports

Catalyst

Continued good execution and biuybacks
End to rising rates and normalization in US housing related stock perception