Description

Summary:

I believe Masco Corporation (“MAS”) is a cyclical stock trading at a full valuation multiple on peak earnings. The home improvement industry is already showing signs of slowing and the recent rise in interest rates will exacerbate the industry slowdown. MAS’s two biggest segments have revenues and margins above levels reached in 2006 (housing market peak) and so not surprisingly, the stock is also above prior peak (2005) levels. However, if my contrarian view is right and MAS struggles to meet analyst earnings expectations, there could be 25-30% downside in this stock.

Details:

MAS is a building products company which derives 83% of revenues from repair and remodel (“R&R”) and 17% of revenues from new construction. MAS has 4 segments: plumbing, decorative architectural products (paint), cabinets and windows/other. Of the 4 segments, plumbing contributes ~55% of EBIT and paint contributes ~37% of EBIT so those are the segments that I will dig into deeper later in the write-up.

First, I would like to address what I believe is a mis-understanding in the market about the home improvement industry cycle. Many investors think we are in early to middle innings of the recovery, but I think we are already in late innings. For example, Home Depot’s investor slides from June 2016 (available on their website) contain a chart of Private Fixed Residential Investment (“PRFI”) as a % of GDP. This chart shows PFRI as % of GDP was 3.6% as of Q4 2015 vs. a 60 year average of 4.5%. This chart implies there is ~25% industry upside if we get back to average. However, when one looks into the sub-components of PFRI, a different story emerges. In 2015 44% of PFRI was new structures and 32% of PFRI was improvements (the remainder is mostly broker commissions and other ownership transfer costs). New structure spending was 1.6% GDP in Q2 2016, below the average since 1959 of 2.6% and far below the 3.8% in 2005/2006. However, improvement spending was 1.2% of GDP in Q2 2016, which is above the average since 1959 of 1.0% and just below the 1.3% peak in 2005/2006. My conclusion from analyzing this industry data is that R&R spend (83% of MAS sales) is already at peak levels.

In Q3, many home improvement related companies (MAS, SHW, WHR, LOW) reported weaker than expected results. However, consensus seems to be that this was a temporary slowdown and the industry will return to prior growth rates. Given peak levels of R&R spend, I think the industry slowdown could last longer than expected. In addition, 30-yr fixed mortgage rates have risen from ~3.4% in Q3 to 4.0% in less than two months. I believe that this recent spike in borrowing costs (which happened after Q3 ended) could cause a slowdown in housing transactions over the next few quarters and thus jeopardize the industry growth re-acceleration investors are expecting.

The plumbing segment contributes ~55% of MAS’s 2016e segment EBIT and MAS’s best known brand in the segment is Delta. When the housing market peaked in 2006, MAS’s plumbing segment had $3.3bn of revenues and a 9.7% operating margin. Looking at 2016e consensus estimates, revenues are expected to be $3.5bn with a 18.7% operating margin. Over the last few years, MAS plumbing margins have had a benefit from falling metal prices, but with metal prices moving back up I believe this will now be a headwind to margins. Consensus expects margins to continue to increase modestly (19.0% in 2017e and 19.3% in 2018e) but I think there could be risk to the downside.

The decorative architectural products segment contributes ~37% of MAS’s 2016e segment EBIT. This segment is predominately paint supplied to Home Depot (sold under the Behr brand name). This segment is estimated to generate $2.1bn of sales in 2016e, which is above the $1.7bn level at the housing market peak (2006). Consensus margin estimates for this segment are 21.0% in 2016e, which compares to the 10-yr average of 19.6% and high of 21.9% in 2009. Margins in this segment tend to negatively correlate with oil/TiO2 prices so margins were ~18% in 2012-2014 and have expanded to 20.0% in 2015 and ~21% in 2016. Another big influence on this segment’s margins is the customer concentration with Home Depot. Home Depot accounted for $2.4bn (33%) of total MAS sales in 2015. While MAS doesn’t disclose customer concentration for this segment in particular, I believe Home Depot accounts for the vast majority of this segment’s sales. Given rising oil/TiO2 costs and Home Depot’s leverage, I think there could be downside to consensus margin forecasts in this segment (20.1% in 2017e and 19.6% in 2018e).

MAS currently trades at 21x 2016e P/E and 17x 2017e P/E. Consensus is expecting 23% EPS growth in 2017e and 14% EPS growth in 2018e based on 5% revenue growth in both years. For the reasons outlined above, I think consensus top-line and margin estimates could both be aggressive. While I am not expecting a big housing downturn, I think that even modest EPS misses could cause investors to realize that we are late in the home improvement cycle and this could drive valuation de-rating for MAS. As typical with cyclical stocks, I believe MAS would trade at a low P/E multiple if investors believed the industry were at peak levels. Note that at the last peak of the housing cycle (2005-2006), MAS traded at a 10-12x P/E. If EPS grows at 10% CAGR from 2016e-2018e (vs 18% consensus estimate) and the P/E compresses to 12x, MAS stock would be $22 (-31% downside).

Catalyst

Slower revenue growth and lower margins than consensus expectations will result in a lower valuation.