Description

I am recommending a short position in Masco (MAS) equity (currently at ~$20 / share), which I believe presents a compelling near-term risk / reward proposition, with total return potential of >40% over the next 3 – 6 months.  Masco is one of the largest pure-play building products companies with significant exposure to the residential construction market as well as dependence upon the consumer for remodeling.  Masco manufacturers branded home improvement and building products, including cabinets, faucets and plumbing products, paint, windows and various other products.  The Company portrays itself as 60% remodeling and 40% new construction (my view is that this tracks closer to 50% / 50%).  Masco also offers installation services to leading homebuilders. 

 

While Masco’s earnings have suffered over the past 12 months, I believe that a combination of continued housing weakness / consumer recession coupled with pricing pressure from home centers and continued raw material cost pressures, make the likelihood of further financial deterioration in 2H 08E - 09E for Masco quite likely.  While the Masco bull case largely relies on the Company’s scale and FCF dynamics, there are three primary reasons why I think shorting Masco equity is timely / actionable including: (i) European weakness is the next shoe to drop and data out of comparable businesses (Masonite in particular) would indicate selected Western European businesses will go through a very similar housing cycle to the US, (ii) repair and remodeling (R&R) spending will continue to weaken further than the Street anticipates – my peak / trough expectation is for -15% to -25% versus Street of -5 to -10% and (iii) 09E expectations of $0.80 - $0.90 are too high – in particular, Plumbing and Architectural Products categories are highly susceptible to the slowdown in 2H 08E - 09E. 

 

Masco currently trades at ~13x 09E EBITDA ($791MM), ~19x 09E EBIT / FCF proxy ($541MM) and ~41x 09E earnings ($0.45 - $0.50 / share).  While we believe Masco is a franchise asset over the longer-term, the near-term uncertainty creates a compelling short opportunity (or hedge to building products credit).  If there’s a reticence to take short equity exposure given the volatility, a suggested approach is to pair the Masco short equity with long building products credit (sam12’s write-up on PLYGEM posted on July 31st is a timely example - 17%+ current yield / ~50% upside appreciation potential once housing troughs / recovers).  In the meantime, Masco reports Q3 results on October 28th and I believe management will provide a muted Q4 08E outlook ($0.50 - $0.65 is the range provided – I think they will be in the $0.50 - $0.55 range) and provide a dour / realistic 09E outlook.  Ultimately, I believe the stock should trade at ~20x 09E EPS of $0.45 - $0.50 (versus Street expectation of $0.80 - $0.85) giving the stock a potential 1-year value of ~$10 / share (about 50% upside from current levels).  It’s also worth pointing out that ~20x 09E earnings is above the Company’s 15-year historical forward average of ~17.5x earnings. 

 

SHORT THESIS

 

-          EUROPE WEAKNESS AS NEXT SHOE TO DROP: Masco generates approx 20 – 25% of revenue from Western Europe.  As witnessed through recent comparable performance (Masonite in particular), Western European weakness is intensifying and will likely mirror the US housing downturn (especially in UK, Ireland and Spain). 

-          REPAIR & REMODEL WEAKNESS: The two segments that are helping Masco mitigate the new construction exposure (architectural products segment and plumbing systems) are heavily exposed to R&R.  Given the ongoing consumer pullback / unemployment trends, we anticipate peak / trough R&R spending to fall -15% to -25% vs Street expectations of -5 to -10%

o        Historically, 27% of home equity loans extended were used for remodeling.  From 03 – 06, this jumped to as high as 40% as homeowners took advantage of large home price appreciate and low interest rates.  Clearly a significant amount of demand was pulled forward during this period.  In turn, I expect remodeling to remain depressed for the next few years, reflecting a reversion to mean spending rates.  This trend is already emerging, as the level of cash-out financings has declined in the last two quarters, down 28% and 52% respectively

-          PLUMBING / ARCHITECTURAL PRODUCTS (STREET TOO OPTIMISTIC): Street estimates for Masco’s Plumbing and Decorative Architectural Products divisions are too optimistic (Street assumes top-line decline of -4% in 09E versus my estimate of -10% and -12.5%, respectively; Street assumes margin degradation of -20 bps in the aggregate for these two division versus my assumption of -190 bps)

-          LIMITED PRICING POWER: Masco operates in highly competitive segments w/ no little of rational pricing (especially on installation, cabinets and windows / doors / patios).  In fact, margin declines have been in force for the past FOUR yrs (well prior to the housing downturn) indicating limited pricing power

o        Approx 35% of Masco’s sales (total consolidated) go through home centers.  This severely limits pricing power and also makes Masco vulnerable to customer concentration risk

-          NEW CONSTRUCTION EXPOSURE: Masco has heavy exposure to new construction (40% per mgmt but I think this tracks closer to 50% given recent operating performance) in the home products segment which continues to track in the -30% to -35% range

-          COMMODITY EXPOSURE: Masco recently commented that rate of raw material increases has been unexpected and challenging to stay ahead of.  Key exposures include copper, zinc, oil-related inputs

-          MAS SHORT EQUITY CAN BE PAIRED WITH FIXED INCOME LONG EXPOSURE: Given the disparity in trading levels between building products equity and debt, I believe building products equity and fixed income will converge over the next couple months (equity will fall lower and fixed income will grind higher).  As a result, I believe there are multiple ways to opportunistically buy building products credit (names that trade for less than 6 – 8x 09E EBITDA) and short building products equity (names trading for >10 – 13x 09E EBITDA – particularly keeping an eye on the leveraged / over-leveraged equities with >4 – 5x of total leverage on 09E earnings power). 

 

TARGET PRICE / UPSIDE vs DOWNSIDE

 

-          UPSIDE CASE: Assume ~10% normalized FCF yield on ‘00 – ‘03 historical average FCF of $320MM post-dividend (or approx $0.90 / share), implies a share price of approx $9 - $10 / share over the next 3 – 6 months (>50% upside)

-          BASE CASE: Apply 25x earnings multiple to trough / 09E EPS of $0.45 - $0.50, implies a share price of  $12.50 (~40% upside) 

-          DOWNSIDE CASE: Apply 20x earnings multiple to ‘00 – ’03 average EPS of ~$1.10, implies a share price of $22 / share (~10% downside) 

 

BUSINESS OVERVIEW (5 divisions)

 

CABINETS / RELATED PRODUCTS – Kraftmaid, Merillat, Mill’s Pride (25% of 07 sales and 26% of EBIT)

§         With six cabinet companies, Masco is the largest w/ a 24% market share

§         Top three comprise 44% of the total pie with smaller local makers comprising the remainder

§         75% remodel and 25% new construction / 85% kitchen and 15% bathroom

§         Masco produces more than 20 lines in 300 styles across all price points (economy, stock, semi-custom, assembled and ready to assemble)

§         Sales channels: home centers (80%) and home builders (20%)

§         Production: 19 plants in NA and 13 plants in Europe

PLUMBING PRODUCTS – Delta, Hansgrohe, Peerless, Brasscraft, Newport Brass (29% and 25%)

§         Faucets account for majority of Masco volumes in this segment

§         Masco holds a leading 37% market share/ its Delta brand - $4Bln mkt

§         Other players include Moen (Fortune Brands) and Price Pfister (Black & Decker)

§         50% sales are remodel / 50% new construction

§         Other products include: spas, bath / shower units, plumbing system components, specialty plumbing products

§         Sales channel: largely through home centers >> notable that HD and LOW have been increasing their private label push in faucets and other plumbling products given higher margins (40% to mid-end and 25% to low-end, this is not a positive for Masco)

§         Production: 24 plants in NA and 25 in Europe / Asia

INSTALLATION AND OTHER SERVICES (23% and 14%)

§         Masco subcontracting biz is called Masco Contracting Services (MCS) >> super-fragmented industry and MCS is one of the largest residential subcontractors in the industry

§         MSC does installation of: (i) Insulation (~60% of segment sales) w/ other smaller things such as cabinetry, fireplaces, gutters and garage doors

§         100% new construction

§         Sales channel: 250 installation branches and 60 local distribution centers >> mostly into home builder / new construction projects

§         Given attrition concerns, management used company employees vs subcontracting labor >> this has caused revenue / margins to get hit hard (i.e. currently losing money)

DECORATIVE ARCHETECTURAL PRODUCTS – Behr, Kilz  (15% and 27%) and

§         Paint segment sold under Behr brand name (acquired in 1999) >> also does some decorative hardware but not meaningful

§         100% residential (75% remodel / 25% new construction)

§         Sales channel: sold exclusively to HD >> stores have in-store Behr kiosks  >> 400 employees wking directly w/ HD in order to assist training of sales associates and inventory management

OTHER SPECIALTY PRODUCTS – Milgard (8% and 8%)

§         Mfters and sells windows, doors and specialty fastener products

§         55% new construction / 45% remodel

§         Production: 27 plants in NA and 12 outside

 

Masco also generates >22% of its revenues from Europe.  While to date these markets have not suffered the same degree of residential and economic softness as the US, recent weakening macro trends will contribute to the sales decline in the next couple of years

	1Q07	2Q07	3Q07	4Q07	1Q08	2Q08
% Growth by Geography:
North America	(15.5%)	(11.8%)	(13.1%)	(14.7%)	(17.6%)	(19.5%)
Int'l	20.5%	14.3%	12.8%	11.5%	1.5%	5.9%
Int'l (local currencies)	9.9%	6.1%	4.6%	0.7%	(8.3%)	(6.1%)
Total	(9.6%)	(7.7%)	(8.6%)	(9.5%)	(13.9%)	(15.1%)
Geographic Sales Breakdown:
North America	80.6%	82.5%	80.4%	77.7%	77.4%	78.3%
Int'l	19.4%	17.5%	19.6%	22.3%	22.6%	21.7%
EBIT Margin by Geography:
North America	10.7%	14.1%	14.3%	8.7%	7.9%	9.7%
Int'l	10.6%	8.3%	11.7%	8.0%	9.8%	8.7%
Total EBIT	10.7%	13.1%	13.8%	8.6%	8.3%	9.5%

 

CAPITALIZATION

 

Masco’s capital structure consists of approximately $3.2Bln of net debt (>4.1x of net leverage based on 09E EBITDA / >6x EBIT) and $7.2Bln equity value (approx 360MM shares).  It’s worth noting that Masco’s CDS trades at approximately 325 which may suggest that fixed income investors (or rating agencies) believe the Company’s Baa2 investment grade rating will be lowered to junk in 09E – 10E.   

 

			EBITDA		EBIT
Capitalization			08E	09E	08E	09E
Price (9/3/08)		$20.00
FD Shares		360
Equity Market Cap		7,200	7.5x	9.1x	10.1x	13.3x
Debt		4,076
Cash		853
Enterprise Value		10,423	10.9x	13.2x	14.7x	19.3x

 

FINANCIALS

1	Sales:	2006	2007	2008E	2009E
1a	Cabinet Products – Sales	$3,286	$2,829	$2,360	$1,947
	% YoY	(1.1%)	(13.9%)	(16.6%)	(17.5%)
1b	Plumbing Products – Sales	3,296	3,391	3,292	2,963
	% YoY	3.8%	2.9%	(2.9%)	(10.0%)
1c	Installation Services – Sales	3,158	2,615	1,845	1,522
	% YoY	3.1%	(17.2%)	(29.4%)	(17.5%)
1d	Dec Arch Products – Sales	1,717	1,768	1,559	1,364
	% YoY	2.1%	3.0%	(11.8%)	(12.5%)
1e	Other Specialty Products – Sales	1,261	929	705	599
	% YoY	(9.8%)	(26.3%)	(24.1%)	(15.0%)
1	Total Sales	$12,718	$11,532	$9,761	$8,395
	% YoY	0.6%	(9.3%)	(15.4%)	(14.0%)
2	Gross Profit	$3,506	$3,152	$2,587	$2,200
	% Margin	27.6%	27.3%	26.5%	26.2%
3	Segment EBIT:
3a	Cabinet Products – EBIT	$122	$336	$127	$97
	% Margin	3.7%	11.9%	5.4%	5.0%
3b	Plumbing Products – EBIT	280	264	397	296
	% Margin	8.5%	7.8%	12.0%	10.0%
3c	Installation Services – EBIT	344	176	(3)	8
	% Margin	10.9%	6.7%	(0.2%)	0.5%
3d	Dec Arch Products – EBIT	372	384	288	232
	% Margin	21.7%	21.7%	18.5%	17.0%
3e	Other Specialty Products – EBIT	225	67	41	33
	% Margin	17.8%	7.2%	5.8%	5.5%
	Total Segment EBIT	$1,343	$1,227	$850	$666
	% Margin	10.6%	10.6%	8.7%	7.9%
3f	Corp Expense	203	181	140	125
3	EBIT	$1,140	$1,046	$710	$541
	Add-Backs (Extra Charge)	$432	$249	$0	$0
	D&A	244	248	250	250
4	EBITDA	$1,816	$1,543	$960	$791
	% Margin	14.3%	13.4%	9.8%	9.4%
	EBITDA Consensus - Low End			$1,000	$962
5	EPS	$1.22	$1.32	$0.50	$0.48
	EPS Consensus - Low End			$0.61	$0.81

 

RISKS

 

-          DIVIDEND YIELD: Masco pays a ~4.5% dividend yield (increased qtly for the past 5 years)

-          FREE CASH FLOW: Over the past 5 years, Masco has returned $5Bln in cash through dividends, stock buybacks and debt paydown.  Average FCF during 00 – 03 (relevant proxy for 10E – 12E period) was approximately $575MM per annum before taking into account the dividend ($321MM post-dividend)

-          SHARE REPO PROGRAM: ~33MM remaining under current share repurchase program (~9% of outstanding)

o        Masco repurchased ~8.5MM shares to date in Q1 – Q2 2008 (an additional 900k in July – noted on Q2 call)

o        However, w/ a stated larger commitment to dividend maintenance and increase, Masco may slow this rate of share repurchasing

 

Catalyst

- EUROPE WEAKNESS AS NEXT SHOE TO DROP: Masco generates approx 20 – 25% of revenue from Western Europe. As witnessed through recent comparable performance (Masonite in particular), Western European weakness is intensifying and will likely mirror the US housing downturn (especially in UK, Ireland and Spain).
- REPAIR & REMODEL WEAKNESS: The two segments that are helping Masco mitigate the new construction exposure (architectural products segment and plumbing systems) are heavily exposed to R&R. Given the ongoing consumer pullback / unemployment trends, we anticipate peak / trough R&R spending to fall -15% to -25% vs Street expectations of -5 to -10%
o Historically, 27% of home equity loans extended were used for remodeling. From 03 – 06, this jumped to as high as 40% as homeowners took advantage of large home price appreciate and low interest rates. Clearly a significant amount of demand was pulled forward during this period. In turn, I expect remodeling to remain depressed for the next few years, reflecting a reversion to mean spending rates. This trend is already emerging, as the level of cash-out financings has declined in the last two quarters, down 28% and 52% respectively
- PLUMBING / ARCHITECTURAL PRODUCTS (STREET TOO OPTIMISTIC): Street estimates for Masco’s Plumbing and Decorative Architectural Products divisions are too optimistic (Street assumes top-line decline of -4% in 09E versus my estimate of -10% and -12.5%, respectively; Street assumes margin degradation of -20 bps in the aggregate for these two division versus my assumption of -190 bps)
- LIMITED PRICING POWER: Masco operates in highly competitive segments w/ no little of rational pricing (especially on installation, cabinets and windows / doors / patios). In fact, margin declines have been in force for the past FOUR yrs (well prior to the housing downturn) indicating limited pricing power
o Approx 35% of Masco’s sales (total consolidated) go through home centers. This severely limits pricing power and also makes Masco vulnerable to customer concentration risk
- NEW CONSTRUCTION EXPOSURE: Masco has heavy exposure to new construction (40% per mgmt but I think this tracks closer to 50% given recent operating performance) in the home products segment which continues to track in the -30% to -35% range
- COMMODITY EXPOSURE: Masco recently commented that rate of raw material increases has been unexpected and challenging to stay ahead of. Key exposures include copper, zinc, oil-related inputs
- Q3 EARNINGS: Oct 28th release providing muted Q4 08 - 09E outlook