Description

Opportunity

 Owens Corning (NYSE:OC) is at a unique time in its history which offers investors intriguing value (10% free cash flow yield) with optionality in all three of its business segments that can create 50%+ upside to the current stock price. For the first time that in many years, all three of OC’s segments are well positioned, and we are on the cusp of a sustained run-up in Insulation and Roofing EBIT, which are depressed well below long-term averages.

 OC’s three businesses are set up better now than they have ever been. In Roofing, the slow and steady consolidation of roofing distributors has created a more rational selling environment, including the elimination of the “winter buy” dynamic. In Insulation, utilization has returned to levels where manufacturers can start earning real profits. And in Composites, after significant capacity addition, utilization is inflecting higher and the new entrants are finished wreaking havoc on supply. OC is primed to return to more normalized margins from the still depressed levels we see today.   OC margins over time: 

 Management has had the habit of providing very low guidance over the last couple years despite substantial outperformance versus expectations, and it seems the street and investors have fallen victim yet again in 2017. Fool me once, shame on me, fool me twice, shame on you, fool me seven consecutive quarters, you must be OC. Don’t let yourself be fooled… 

 Owens Corning (“OC” or the “Company”) is a world leader in composite and building materials systems, delivering a broad range of high-quality products and services. Its products range from glass fiber used to reinforce composite materials for transportation, electronics, marine, infrastructure, wind-energy and other high-performance markets to insulation and roofing for residential, commercial and industrial applications.   

Business Overview

 Owens Corning operates three related businesses:

 Roofing

 OC is the second largest manufacturer of asphalt shingles in the U.S. – the primary products manufactured in this segment are laminate and strip asphalt-roofing shingles for residential single-family homes. OC sells shingles and roofing components primarily through home centers, lumberyards, retailers, distributors and contractors in the United States. Demand for products in this segment is generally driven by both residential repair and remodeling activity and by new residential construction. Roofing damage from major storms can significantly increase demand in this segment; as a result, sales in this segment do not always follow seasonal home improvement, remodeling and new construction industry patterns.

End market exposure: Repair and remodel (73%), new residential (11%), commercial & industrial (16%).

 Insulation

 OC manufactures products including thermal and acoustical batts, loosefill insulation, foam sheathing and accessories;, and it sells its insulation products primarily to insulation installers, home centers, lumberyards, retailers and distributors in the United States and Canada. Demand for insulating products is driven by new residential construction, remodeling and repair activity, commercial and industrial construction activity, increasingly stringent building codes and the growing need for energy efficiency. Sales in this segment typically follow seasonal home improvement, remodeling / renovation and new construction industry patterns.

 End market exposure: NA new construction (40%), NA C&I (24%), NA residential repair and remodel (20%), international (16%)

 Composites

 OC manufactures glass fiber materials for a variety of end market uses: building and construction, transportation, consumer, industrial, and power and energy. Demand for composites is driven by general global economic activity and, more specifically, by the increasing replacement of traditional materials such as aluminum, wood and steel with composites that offer lighter weight, improved strength, lack of conductivity and corrosion resistance. This segment is a GDP+ grower, and has grown at 1.6x global industrial production growth over the past 30 years. OC is largest global producer, followed by several Chinese players (Jushi, Tianshin, etc.), as well as Johns Manville and PPG.

 End market exposure: International (61%), NA C&I (28%), NA residential repair ad remodel (8%), NA new construction (3%)

 Thesis

 Roofing

 Storms

 Weather is a significant driver of roofing demand – according to OC estimates, major storms and storm-related re-roofing has driven ~30% of shingle volumes over the past 20 years. In 2016, we saw a meaningful step up in both major storms and other weather events relative to the prior 3 years. The 45mm sq. ft. of shingles delivered in 2016 was a 61% increase over 2015, and a 45% increase over the 2013-2015 average. The bears point to this to argue that we should see a step-down as these “abnormal” storm events fail to recur in 2017.

 In actuality, and as no surprise to the followers of roofing stocks for more than a couple years, 2016 was actually more demonstrative of a normal storm year, not an abnormal one. The years 2013-2015 were actually 17% below the typical storm-driven levels: 

 In addition, while it is still early in the season, there is reason to believe that this year could shape up to be an even higher storm-demand year than average. Hailstorms in Texas are running well above normal, and rains in California will likely drive some “Other Weather Events” volume as homeowners are forced to re-roof as their roof-patches fail. Beacon Roofing recently suggested as much on its most recent earnings call in describing near-term demand: 

“…more favorable weather conditions in our northern and western markets; some carryover of the 2016 storm demand; a number of early 2017 storm events and stronger reroofing demand in many markets…” 

• Beacon Roofing Supply, Q1 2017 Earnings Call 

Discussions with other channel participants corroborates Beacon’s commentary, and leads me to believe that there is still some spillover demand flowing from last year’s storms in Texas. While I do model a modest reversion in storm-related activity in 2017 (as presented below), based on all of the above the fears of a massive snap-back are overblown.  2017 is looking a lot more like “normal” and there is upside weather optionality if storm activity picks up. 

Other Roofing Drivers 

Anyone who follows the housing sector knows that the 1.2mm expected housing starts in 2017 is well below trend (see chart below).  The fundamentals for housing are still incredibly strong and show potential to continue for several years. Unsurprisingly, OC’s new construction shingles are 98% correlated with U.S. housing starts.

 At the same time, age-related re-roof demand remains below trend, and given the housing boom we saw in the early 2000s, we are now slowly entering a phase of above-normal age-related roofing demand that really only just began in 2013.  Roofing companies can benefit for many years from the echo boom of the late 1990s and early 2000s building booms. 

 Guidance

 OC has been extremely conservative on their roofing guidance over the past several quarters, as the table below demonstrates – the differences between commentary and actual results are stark. Continuing the trend, management has guided 1H17 to be flat, after reporting +37% volumes in Q1. This implies Q2 volumes of -19%, and while there was certainly some pull forward ahead of the March price increase, it seems clear that management commentary is consistent with prior conservatism. OC has set the bar extremely low for 2017. 

  Conservatively, this leads to flat roofing volumes in 2017, driven by: 

• 10% new construction growth (long tail)

• 5% growth from age-related re-roof demand (early cycle)

• A return to the 17 year average for both major storms and other weather events (upside from incremental storms)

 Beyond 2017, it is of course impossible to predict what storm demand will be, but both the new home and repair/remodel segments should continue to drive solid growth for the next several years. Given the strength of the cycle, mid single digit volume growth for roofing over each of the next few years is reasonable.  Yet the street volume estimates over the next three years are 2%, 3% and 0%.  The skew is upside to consensus revenue. 

Oil! Run!  It’s Causing Havoc 

Oil causes a lot of confusion for OC investors by skewing the analysis of both roofing price and margins.  There is a raw material pass through component of roofing – as asphalt (an oil derivative) is a major cost of sales (~25%).  Thus, when oil price falls as it did in the last couple of years by 50-60%, roofing prices saw significant declines also from the pass-through component.  But this does not matter if OC’s costs deflate by similar amounts. 

More recently, as oil price has started to recover, the market is very concerned about margin pressure in roofing because the recent asphalt price has been negative (see paragraph above for explanation as to why).  OC and its competitors have announced price hikes in response to rising input inflation, just as they cut prices when input costs fell.

 Bears would have either outcome is bad for OC, whether oil is up or down.  In their view, down oil drives negative shingle pricing and up oil drives lower margins.  In fact, neither is true.  As can be seen from the chart below, there is no perceived relationship between the price of oil and OC’s Roofing margins. To the extent there is a relationship, it is a perverse one (R² = -7%). OC actually grew roofing EBIT margins through shingle price declines in 2014/2015. We are now seeing the reverse dynamic play out in OC’s results – as asphalt has picked up off the bottom, we have seen OC price pick up sequentially, and should continue to increase as the March price hikes continue to roll through and as the June 1 price hikes kicks in.  

 What truly drives margin in roofing is demand.  Re-roofing, new home construction, and year over year moves in storms.  And outside of the massive housing recession in 2006-2010, roofing margins have remained strong.  

Insulation 

Insulation is a commodity, and like any commodity, pricing is driven by supply / demand. Looking at the US PPI Insulation Materials Index (see below), insulation pricing has been fairly volatile over time. These peaks and valleys are driven by supply gluts and tight utilization; when capacity tightens, OEMs are able to pass along meaningful price increases, as can be seen in the PPI data. The last two rounds of tightness led to 20% and 30% price increases (2006/2014) from trough to peak. 

While there is no industry source that tracks insulation capacity utilization, you can patch together a picture from OC calls, discussions with distributors, and private competitors. This analysis and OC commentary suggests that capacity utilization for insulation today sits in the low-90% range, and OC controls roughly 2/3 of industry spare capacity. It takes approximately two years to greenfield a new insulation plant, and no competitors have announced plans to do so. Greenfield capacity is not justified at current prices, according to both OC and private manufacturer commentary, and industry margins have substantial room for improvement before any new capacity plans are considered in the industry. 

Given the strong housing demand environment discussed above, we are about to enter a period of very high capacity utilization. 

 All insulation OEMs (including OC) announced 5-8% price increases in January and are implementing another round of price increases in June. OC management’s guidance of $160mm EBIT expansion in the segment for 2017 assumes zero incremental pricing from the June increase – an extremely conservative assumption given the dynamics discussed above. 

“But as you probably know, there was an announced price increase out in the market currently from the fiberglass manufacturers. Demand is good. The market's better. So really in every case as we have a rising tide, I mean, our ability and our confidence that the industry, in fact, improves in that regard gets better… And we think their ability to realize price obviously goes up at a time when single-family demand which, as you know, is a large portion of their incremental demand. As that single-family demand increases, it gives them greater ability to realize price increases.” 

• Installed Building Products Q1 2017 Earnings Call

 We are on the cusp of a major run-up in insulation pricing which could take insulation margins back over 20% (where they last were in 2003-2006 when utilization spiked) from ~7% today. 

 OC’s recent history with TopBuild (NYSE:BLD) further confirms the tight capacity thesis in insulation. TopBuild is an insulation distributor that carried OC product until early 2016. OC and BLD had a long-term supply contract in place until BLD terminated the relationship. OC lost 6% of its insulation volumes, and filed a lawsuit against BLD. Here is management commentary on the situation from their 1Q16 earnings call: 

“In effect, we've positioned our assets to benefit disproportionately from the next uptick. So I think as long as we see continued growth in housing, which is the consensus expectation, it is certainly our expectation, we'd expect as we work our way through 2016 overall tightening in the market would provide us the opportunity to replace those pounds at good margins and good prices, and that 2017 and beyond we'd still be a very, very good shape in getting to our goals for the business.” 

• Owens Corning Q1 2016 Earnings Call

 On May 5^th, 2017, BLD announced it had settled the lawsuit with OC, paying OC $30m for the contract breach. There is some speculation as to the motivation for settling, but the most reasonable one is that supply tightness forced BLD to source from OC again. This suggests that 1) industry utilization is in fact very tight, and 2) OC could win back a meaningful amount of volume at very favorable pricing. OC’s commentary from last year appears to have been tremendously prescient. 

Composites 

While Composites is OC’s second largest segment ($2bn/$260m in sales / EBIT in 2016), it gets the least attention from investors. Composites is actually a solid industrial business, earning mid-teens margins and growing above industrial production - driven by a secular shift away from metal/wood toward glass fiber materials.  The secular shift can drive volumes for years to come. 

2017 started out strong with HSD core composite volume growth (ex-roofing). Guidance for 2017 currently assumes $25mm EBIT growth vs. 2016, driven exclusively by lower furnace rebuild costs.  However, HSD run-rate growth is sustainable given strength in U.S./Eurozone Manufacturing PMIs (U.S. / Europe together comprise 75% of composites revenue). Management’s guidance is embedding zero dollars of incremental margin for the rest of the year. 

 Industry supply is also set to benefit over the next few years.  Significant composites capacity was built in China through 2009, but there has been very little additional capacity built there since.  Also, many Chinese facilities face capital intensive re-build expenditures to maintain production levels.  They will either temporarily idle capacity to do required maintenance, or forgo the capex and permanently shut capacity.  The China capacity situation sets up a favorable long-term supply picture for the industry: 

 Valuation and Estimates 

OC is trading a touch below it’s historical trading averages at 15.5x / 8.1x EPS / EBITDA on consensus numbers, making it one of the cheapest stocks in the buildings products universe. Ex-NOL (~$5/share), the stock is trading at 14.4x EPS, and has compounded EPS at 18% since 2010. 

In 2018, OC can achieve the following: 460mm of Roofing EBIT, 280mm of Insulation EBIT, 320mm of Composites EBIT, driving 940mm of EBIT including corporate. Assuming a 36% tax rate, this drives $5.30 of EPS, or ~$5.50 of FCF. Assuming $5/share of NOL value, OC trades at a ~10% FCF yield.  

 Breaking down the path to upside scenario: 

Step 1: Numbers Above Street

 The street is modeling $4.50 of EPS in 2018 – from a little bit of benefit in roofing/insulation as already discussed, and continued composites growth, a more realistic value is ~$5.30, or 20% upside from street.

 Step 2: Normalized Insulation Margins

 Insulation margins were over 20% in the mid-2000s and were in the mid to high teens range historically.  Insulation margins in 2016 were 7%, and every 1% increase in margin drives ~$0.10 of EPS. The street is modeling 9% insulation margins for 2017. From this number there is $0.60-$1.00 of EPS upside without any incremental revenue growth. Normalizing insulation margins drive an incremental 20-30%+ upside.

 Step 3: Multiple Re-Rating

 OC is trading at a depressed multiple relative to comps, and a normalization in Insulation margins would be a catalyst to get this multiple up. A more reasonable multiple based on peers is 18x EPS, which compared to OC’s current valuation of 15.4x, would drive an additional 20% upside. 

Rolling this all together drives an upside of 70%, or $105 fair value. 

Balance Sheet Optionality 

A quick note on the balance sheet: OC has $2.1bn of net debt or 1.9x EBITDA, and currently generates ~550mm of free cash flow. The analysis above assumes no M&A or balance sheet deployment, which provides another source of upside.  In the meantime, the balance sheet will continue to delever quickly from its already low levels.  

Risks 

• Recession

• Weather volatility

• Short-term commodity volatility

• Housing softness

Catalyst

Catalysts 

• Insulation price increase realization

• Roofing price increase realization

• Guidance revisions through the year

• More weather events

• Continued new home construction growth