Description

OC Update – 4/6/2015

• The purpose of this post is to update and add to my Long thesis that was posted on 1/6/2015 and to counter some of the bear arguments. This post is only addressing OC’s roofing business which is the key to the thesis.

Update

• Since 1/6/2015 – OC is up ~17% vs. SPX being up 4%, XHB 11%, MAS 9.5% and MHK 20%

• My thesis centers around asphalt prices declining and stable shingle pricing

•  Initially my base case assumed asphalt prices will be down 20% and pricing will be stable

• As of the end of March asphalt roofing flux prices are down 30% in all regions where OC operates.  Further, roofing flux numbers are settled on a monthly basis – therefore we should expect to see a further leg down when April pricing is released.  As of mid March (per Longbow) – OC bought ~70% of the asphalt they need for 2015 production

• Pricing has been stable throughout this period – with unprecedented discipline among manufacturers. In fact, all manufacturers have price increase letters for early May

• Price increase letters do not guarantee prices will actually increase in May – but it is another evidence of strong discipline among manufacturers

• My base case scenario assumes flat pricing

• Demand among distributors has been solid in the first quarter. Per internal surveys, demand is up low single digits this quarter, despite harsh winter conditions

• Keep in mind that most distributors and manufacturers are budgeting for flat volumes in 2015

• As mentioned before, manufacturers have not been offering discounts/rebates to distributors this winter. Historically, manufacturers provide discounts in the winter, as asphalt prices are seasonally lower due to decreased demand from the paving industry.  Therefore, distributors have been refraining from stockpiling inventory ahead of the spring selling season

• Inventory levels among distributors are relatively low. BECN mentioned in a roadhshow last week that their inventory levels are ~20% below where they would like to be at this point in the season and that they are currently replenishing inventories

• Q1 is expected to be weak, as distributors have curtailed purchases. Therefore, Q2-Q4 will be much stronger this year compared to 2014 as shingle purchases will be equally weighted between the quarters. I am currently assuming 9c EPS for Q1 but $2.30 for 2015

• Results from a proprietary distributor survey conducted the week of March 30 – April 3 among 40 distributors in OC regions:

• Q1 demand up low single digit

• 50% of respondents believe pricing will be up in May, 40% believe it will be flat while the rest do not know

• 75% of respondents claim that pricing in Q1 was flat compared to Q4 14, 20% say it was higher

• 95% of respondents believe that pricing will not go down in the next several weeks

Background on the industry and 2014

• Before I dissect the bear thesis. I think it is important to understand what the winter pre-buy programs have done to the industry and what happened in 2014

The winter pre-buy

• Historically, distributors bought most of their inventory for the year during the winter. They did that mostly due to discounting by manufacturers (as asphalt prices are seasonally low in the winter).  See below a through explanation of the winter pre-buy from the OC Q3 2014 call:

“..probably the most critical time of the year for establishing a really great year of performance in Roofing is from the middle of December probably to the middle of May. I mean, that tends to be the time of the year where a lot of decisions get made that have big impacts on volume and pricing and the timing of volume and pricing for the following year. So, in our history we have given incentives in the first quarter to encourage distributors to bring in inventories of our product. I'd said on a number of calls I think going back probably two years or three years, as a manufacturer we saw three good reasons to do that. One is typically this time of the year, asphalt cost are a little bit less expensive because of paving demand. The second reason historically has been that we don't run our assets as strongly in the winter as we normally did in the summer because of end-use market demand being shut off by bad weather. And then the third reason is you want your customers to have some inventory when the snow breaks and spring comes because that's the beginning of roofing season and it's very hard for us to forecast. We rather have some inventory forward deployed. A couple of years ago in 2012 when we had had a challenging year in terms of margins, we were pretty explicit in talking about the fact that for the most part we were not seeing that those three variables were driving good decisions for us around winter discounting. So, we haven't typically seen nearly as much asphalt cost relief in the winter as what we might have seen say, 5 years or 10 years ago. Obviously, the way the first quarter incentives have been structured by us as a manufacturer, we've encouraged our distribution partners to purchase well beyond their first quarter needs. And actually I would say you had created some speculation in the market or speculative buying behaviors in the market where people are buying in the first quarter on expectations that they can carry low-cost inventory deep into the year. And then obviously, the third reason is still a valid reason. We would like our distributors to have product out there at the beginning of the season ”

• After manufacturers reduced pricing in the winter for the pre-buy programs they would usually announce price increases for the spring to raise prices back to the prior (pre pre-buy) levels

• It is obvious that the pre-buy practice is not very healthy. Distributors stockpile inventory expecting a certain demand environment without the ability to actually project storm or re-roofing demand at the high selling season (spring-summer)

• The low demand environments in recent years (see below) and the mismatch between expectations and demand have caused inventory gluts across the channel and an almost impossible situation for manufacturers to manage supply to meet demand

• Finally, often changes in the pricing of shingles were also a source of instability and volatility in margins

2014

• 2014 was a terrible year for manufacturers and distributors alike. I think it is critical to understand what happened in 2014 in order to form an opinion on how 2015 will unfold. Most of the bears on the buyside/sellside resort to the easy conclusion of poor industry structure or poor management by OC as reasons for the significant margin deterioration in 2014 (13.3% vs. 19.6% in 2013).  But that is an oversimplification

• At the end of 2013 – most of the industry participants were relatively upbeat regarding 2014. The housing industry was recovering (starts were up 18.5% 924.9 in 2013 vs. 780.6 in 2012). 2013 housing starts ended on a very strong note with a SAAR December number of 999k beating analyst estimates of 985k and in December Zelman was projecting total starts for 2013 at 915 (well below the actual ~925k).  2013 was a bad year for the shingle industry where demand was down 3%. The strong housing momentum at the end of 2013 caused most of the industry participants to be relatively upbeat into 2014. These were the comments regarding 2014 demand from OC during their Q3/Q4 2013 call:

Q3 2013 - “So it's not hard to get to low single-digits or mid-single-digits growth in Roofing and if we could get some of that I think that would help top line in Roofing and obviously very good margins”

Q4 2013 - “ The Roofing business will deliver another strong year in 2014. We anticipate market growth in new construction with flat or potentially improving re-roof demand”

“We've said that we think Roofing will have another great year”

• In fact, most industry participants would agree that at the end of 2013 they were expecting/projecting ~120-125msqft of demand in 2014 (up ~2-6%) but instead industry demand was 107msqft (down 9%)

• 2014 also started with a very harsh winter.  The northeast, midwest and parts of the south experienced one of the coldest winters to date with heavy snowfall

• At the end of 2013 – OC was trying to signal to the other manufacturers in their earnings call that they would not discount in the winter. OC was trying to take the lead and force the industry to refrain from the bad habit of the winter pre-buy due to the reasons I mentioned before:

Q3 2013 – “Our winter offer this year is pretty much in line with where we were last year. So we feel comfortable that we started the year with the business on a solid basis and that at least for now we feel comfortable that our pricing is stable in the marketplace relative to last year. Michael did say in his comments, we're expecting to see less volume in the first quarter at those numbers. So probably as a result of weather, maybe as a result of expectations of our customers that last year buying a lot of product in the first quarter maybe didn't help them in terms of their facing the market, and then what happens in terms of fiscal years and year ends and some other things that cause customers to need to buy products at different times of the year”

Q3 2013 – “We're certainly heading into the winter setting that kind of goal for our team that we would like them to manage the winter discounting in a way that we sustain our position in the marketplace but that we still come into next year with good margins and position our customers with good inventories heading into the spring selling season”

• 2014 turned out to be a disaster due to all the factors mentioned above

• OC decided not to discount while some of its competitors (mainly GAF) did

• Most sellside guys point to Tamko as the bad player in Q1 but Tamko is regional and does not have enough power to affect industry behavior. It was the GAF winter discounting that caused OC to lose share

• OC lost significant share in Q1 as distributors stockpiled in the winter

• OC decided to win its historical market share (~22%) back through spring and summer discounting (in contrast to the normal practice of a spring price increase)

• Distributors bought more inventory than they needed as they were expecting strong demand which exacerbated the discounting by OC to recapture share

• In addition, the slow start to the year driven by the harsh winter and the high inventory levels at distributors added fuel to the fire of irrational erratic behavior we saw last year

My take on the bear thesis

• The bear thesis on OC has taken a slight turn recently. Initially, most sellside analysts brushed off the possibility of a significant drop in asphalt prices.  In my previous writeup I tried to address some of those arguments (such as less heavy crude being refined and the installation of cokers). The significant drop in asphalt is now a fact (see SunTrust note from 3/31) so bears now argue that manufacturers will not be able to pocket the raw material benefit and will have to pass it to consumers

• Why do I think that manufacturers will pocket most if not all the benefit this year?

1. Unprecedented pricing discipline by manufacturers

• GAF, the largest shingle manufacturer with 40% market share, announced a price increase at the end of last year.  They were the only manufacturer that passed a price increase and distributors have been buying at higher prices from GAF since then (per CEO of BECN)

• For the first time in 15-20 years there has not been a winter pre-buy because manufacturers did not discount in the winter

• The bear thesis claims that the fact that there was no pre-buy is not a sign of discipline by manufacturers but an unwillingness by distributors to stockpile inventory in an environment of potentially falling prices (due to lower asphalt)

• The CEO of BECN refuted that claim during a roadshow with investors last week.  He said that BECN would have replenished their inventories if manufacturers discounted

• Per proprietary surveys and conversations with industry participants, I learned that in recent weeks distributors have been purchasing again and replenishing inventories ahead of the spring

2. Some manufacturers have high inventories of asphalt and supply agreements that will keep their asphalt prices high for most of the year (Tamko for instance) thus they are less likely to drop prices

3. Demand expectations are low – 2014 was the weakest year in the last 20-30 years with respect to demand (107 msqft). All industry participants I spoke to are expecting flat demand in 2015

• There is less chances of inventory gluts like we saw last year

4. Oligopolistic nature of the industry – GAF, OC and Certainteed control 85% of the market

• Recent meeting with the CEO of SGO FP in NYC (3/2 part of their Q1 roadshow) confirmed their discipline to pricing this year

• OC have stated they intend to hold firm on pricing

• GAF has been the firmest on pricing (per CEO of BECN, a Tamko contact and 2 distributor contacts)

5. 2009 as a case study:

• In 2009 industry demand dropped from 135 msqft in 2008 to 120 msqft (11% decline). However, the industry stayed disciplined with pricing (flat throughout that period)

• The bears argue that this was due to the significant price increases in 2008 due to the rise in crude prices that year and its psychological effects on 2009

• They claim it was easier for the manufacturers to keep pricing flat as they were still trying to offset the effects of high crude

•  Another bear argument is that demand was still strong in 2009

• 3 counter claims:

1. If 2008 was a tough period that caused manufacturers to be disciplined and push numerous price increases and the effects were felt in 2009, one would expect the tough environment in 2014 would cause similar discipline in 2015

2. Distributors and other participants knew in 2009 that asphalt prices were weak and dropping significantly. See below the 2008-2009 asphalt PPI. Wouldn’t they be more incentivized to ask for discounts after the massive price increases they incurred in 2008?

3. Demand in 2009 was stronger than in 2014 but it was still down 11%. Isn’t this the ideal environment for prices to decline?

6. All manufacturers have announced a May 1st price increase

• Price increase announcements are not guarantees of price increases, but if manufacturers intend to lower prices why would they send letters announcing a price increase?

7. Distributors do not want prices to go down

• Distributors get hurt the most when prices decline as their inventory value decreases and their gross margins decline

• If manufacturers are disciplined on price they will face little opposition from the distributors – especially after the tough year they had last year. In fact, most distributors announced a price increase for May as well

• A distributor survey among 40 distributors that was conducted last week found that 95% of distributors expect pricing to be either up or flat

• Inventories – bears agree that distributor inventories are low but some believe that manufacturer inventories are elevated and it is a question of time until they will have to discount to move their inventory

• My thoughts:

1. OC has curtailed production and their inventory levels are not high

2. When I spoke with the CEO of SGO FP and the head of SGO FP’s NA operation (3/2) – they said that they do not have elevated inventories

3. Commentary regarding GAF is anecdotal at best because the company does not allow their employees to speak with the street. However, earlier in the quarter in a roofing tradeshow GAF representatives dismissed the notion of them having elevated inventories that would be a problem

4. The manufacturing process of shingles is not fixed cost intensive. Therefore, it is rather easy for the producers to run their assets at a slower pace. If some manufacturers decided to continue building inventory it is only to have sufficient stock in case demand picks up as distributor inventories are low and regional storms can create severe shortage. In case demand does not pick up – manufacturers can decide to reduce production during the spring (peak manufacturing season)

5. The large manufacturers have the ability to move inventory between regions to accommodate regional demand. Therefore, some regions might have elevated inventories but those are strategic elevated inventories

6. Distributors have been replenishing inventories – BECN admitted that they’re inventories were 20% below where they want them to be and proprietary surveys suggest the same. We are seeing distributors replenish inventories these days.

• Another popular bearish claim is that the capital investment for an asphalt roofing plant is relatively low and at mid to high single digit margins manufacturers can gain 15% + ROICs on their investments

• My thoughts:

1. This industry is not fixed cost heavy. In fact, most of the costs are variable (mainly raw materials). Manufacturers do not really need to invest significantly in new plants to increase production. In fact, the industry sold 173 msqft in 2006 with roughly the same manufacturing footprint that currently exists. Additional manufacturing capacity is not necessarily needed for manufacturers to produce more and try to take share until they reach profitability that will meet their return hurdles (per the bear thesis)

2. Between 1999 and 2008 OC’s roofing EBIT margins averaged 5.8%. Between 2009 and 2014 margins averaged 19.8%

• Based on the bear thesis in the past 5 years producers should have been flooding the market with product causing prices to fall until manufacturers margins drop to mid to high single digit. This could have been done without significant investment as all manufacturers have ample capacity and industry demand is close to an all time low and 38% below peak

3. Bears are ignoring the fact that the large manufacturers have better economies of scale and higher margins than the small manufacturers (in contrast to Citi’s opinion). Last year, while OC’s roofing margins were 13% smaller manufacturers had low single digit margins

•  Speculation is that GAF’s margins were lower than OC’s and that is why they laid off 100 employees

4. Bears are also ignoring the basic dynamic of oligopolistic behavior. Which have caused margins to more than double since 2008 due to the significant consolidation in the industry when GAF merged with ELK

5. Shingles from GAF/OC/Certainteed sell at a premium to other shingles. Therefore, there is value to the brands and quality of the large players

6. Even if this thesis has legs it is more likely that any capacity additions would be absorbed by stronger end market demand, as we are 20% below normalized volume levels and 38% below peak. Thus margins can stabilize around 20% in the foreseeable future

• Motivation – While last year GAF did not follow OC’s attempt to refrain from winter discounting and alongside weak demand and elevated inventories created a glut that resulted in lower margins industry wide. This year the situation is different. Manufacturers know that the 2009 scenario of elevated profitability levels is very likely

• The bears argue that an urge to take away market share by manufacturers will prevail – but looking at the outcome scenarios in a game theory matrix within the context of last year suggests a different outcome

• OC last year sent a frightening message to the industry – they will protect their share even if it will require them to take a significant hit in profitability. Their action from last year changed the outcome in this theoretical game theory matrix.  This year if a producer decides to reduce price and take share – it is most likely their share gain will be temporary as others will react in the same way OC did last year. Therefore, the only way to significantly improve profitability this year is to stay disciplined with respect to pricing. Further, the magnitude of the potential increase in profitability due to the lower asphalt pricing just makes this decision easier – stay disciplined and increase profitability significantly vs. try to take share – reduce profitability – lose the share gained later in the year

Management

• Most of the bears on the sellside / buyside base a good part of their thesis on OC’s management team. They claim they are poor operators and terrible communicators. In fact, when I started doing my work the bull thesis around the name assumed activist involvement

• I am not trying to defend OC’s management team. I met them several times and did not walk away enthusiastic. However, there are a few points to be made:

1. The initial disappointment with management (2011/2012) was caused by the composite business and the volatility surrounding it

• Today we know that the turmoil was caused by changing dynamics surrounding Chinese participants that have now stabilized and were not in the control of the management team

2. The roofing shingle industry purchasing habits were completely distorted (see winter pre-buy section). No management team can project or manage their business in a lean efficient way where 50% of industry demand is pre-bought on speculation. Luckily, there is no pre-buy this winter and hopefully this new habit continues for the foreseeable future

3. OC is the 2nd / 3rd largest manufacturer of asphalt shingles. They are about ½ the size of GAF. They do not have enough power to really affect demand or pricing patterns. OC sometimes tries to take a leading role as they are the only public manufacturer and are thus able to use their earnings call and statements to communicate to their competitors.  However, the industry will rise or fall with GAF’s decisions

• GAF refuses to allow its employees to speak with investors or analysts (I had several conversations with GAF HR about their policy). Therefore, most analyst’s “checks” into manufacturers with respect to “color” or inventory levels are anecdotal at best. CertainTeed also does not allow employees to speak with investors outside the Saint Gobain formal communication chain

4. No doubt management’s main issue throughout the years has been their communication strategy. They would meet investors, convey a certain message and then completely miss their targets

• Poor communication is a problem and a red flag but there are 2 main reasons why I do not think this is an issue:

1. Management decided to change their communication strategy. They did not give 2015 guidance and have significantly lowered expectations for Q1 2015

2. The bull thesis does not rely on significant actions by management or any outrageous execution. If pricing is stable this year the bull thesis will play out

Valuation

• Part of the bear thesis is that the bull thesis is currently priced into OC’s stock

• OC is currently trading at ~15x consensus 2016 earnings while MAS is trading at 17x, FBHS at 19x, MHK at 17x, AWI 20x

• The bears would argue that OC should trade at a discount to peers. I disagree

• MAS, MHK and AWI are facing FX headwinds. AWI has structural problems in their flooring business. MAS has one of the worst management teams in the industrials/materials space. Their installation business has been losing share and is a poor performer and the cabinets business will not be profitable in 2015 after promises to bring it to profitability since 2011. FBHS and MHK are mainly repair & remodeling businesses and have less growth potential than businesses exposed to starts or depressed markets (like roofing)

• OC currently generates ~70% of profits from businesses that are significantly below peak or normalized volumes. Roofing is 40% below peak and 20% below normalized levels. Insulation, which is tied to housing starts, is about 33% below normalized levels and 50% below peak. Insulation margins are also more than 1200bps below peak. The earnings potential from an end market recovery is significantly greater in OC than any other of the large cap building product names. This should be rewarded with a higher multiple

• Sellside estimates are very low. Since the company reported Q4 earnings – analysts have reduced Q1 estimates (due to lack of winter discounting and low Q1 roofing volumes) but have not adjusted their Q2-Q4 numbers to make up for the shift in purchasing habits.  This caused analysts taking down Q1 estimates by 28 cents but keeping Q2-Q4 estimates flat.   On an annual basis, analysts took down 2015 numbers from ~2.30 to 2.06

• Consensus numbers are too low and my current conservative estimates assume 2015 EPS of $2.30 in 2015 and $3.50 in 2016 vs consensus of 2.06 and 2.82

• Sellside analysts’ view seems wrong– if OC decided to reduce manufacturing in Q1 and not to discount in the quarter – an action which resulted in a ~26c hit to EPS – wouldn’t they do it if they expected to generate higher earnings later in the year?

• Sellside currently assumes that lower asphalt prices will not fully benefit OC (consensus assumes ~15% roofing margins in 2016 and 2017) and the stock is trading below peers. How can the upside be priced in?

• My updated PT is $60 based on the fall in asphalt prices (higher than my initial assumption) and applying a 17x multiple to my 2016 estimated of $3.50(similar to MAS and AWI which have their own issues)

Last Points - Citi

• Recent Citi note (4/1)  - raised some of the bearish points regarding the high ROIC at low-mid single digit margins and a skeptical tone regarding OC’s ability to pocket the relief from Asphalt. I believe some of the bears are basing their views on Citi’s work.  I think it is completely valid to take the other side of the trade on OC but I think that there are significant flaws in the work by Citi:

1. Citi (like Longbow or Jefferies) uses DOT asphalt prices for their analysis. The DOT numbers correlate with roofing flux numbers, but are different.  These numbers do not accurately reflect asphalt prices. Up until February and possible later these numbers suggested that asphalt prices aren’t down

2. The recent Citi note assumes that asphalt costs for OC in 2014 were $400-500m based on a 2010 disclosure (I am assuming $600m). I think the main reason for his low asphalt cost number is that he fails to adjust for the difference between 2010 prices and 2014 prices, which were 26% above 2010

3. The 4/1 Citi note is titled “Throwing Our Hat in the Ring on the Great Roofing Debate…”  - but they already did in the 2/2 Citi note titled “4Q14 Better Than Feared, But (Asphalt) Hope is One Heck of a…Thesis” in both notes he raised his PT but stayed negative

• The short term (1-3 years) bear thesis for the stock has to do with prices going down.  Despite the reports’ negative titles, they do not make the call that prices are going to drop

4. The April Citi note has two points that make me scratch my head in confusion. It claims that Citi’s checks indicate that distributors price expectations aren’t meeting those of manufacturers and one of them may eventually break. He also mentions that distributors worry that shingle prices are going to fall if manufacturers attempt to move inventory through lower prices

• Both points are completely contradictory to what I heard from the CEO of BECN, my conversations with distributors and my proprietary surveys

• In fact, after reading his note I ran another survey (2nd survey in 2 weeks) and again 95% of participants expected pricing to either stay flat or increase. I decided to dig further and called a contact at Tamko – he said that he expects some of the May price increase to stick and that demand will be stronger than what he initially expected given what he has seen so far this year

5. Citi’s valuation assumes a 2x discount on EV/EBITDA compared to comps and claims that this discount has been the historical discount

• The note claims that this relationship stands because OC’s capex/sales is higher than comps. In 2015 OC will spend $355m in capex out of which $55m is for a US non-woven facility. If I use $300m as normalized capex (in recent years OC has been investing in their composite business – an investment cycle that is ending) Capex/Sales for OC is 5.5% vs. AWI at 5.9%, MHK at 5.9%, MAS at 2.1% and FBHS at 2.9%

• It is not clear to me that OC is substantially above peers with respect to capex/sales. Further ~70% of profit is tied to businesses that are significantly below normalized volumes vs. peers with a significantly lower percentages. This alone should improve that ratio for OC when volumes recover. Further, the higher growth potential should reward OC with a premium to peers not a discount

Catalyst

.