ZWS - Fortune Brands Innovations: Entering A New Era Amidst Serious Macro Headwinds

Summary

• Fortune Brands had a respectable fourth quarter, with in-line core revenue and slightly better margins, but 2023 guidance was weak as residential markets continue to decline.
• Destocking is hitting the plumbing fixtures business harder than it needs to, but there is an attractive longer-term story here in smart/connected devices.
• The proposed deal with Assa Abloy would add complementary assets at a very attractive price.
• Self-help can be a significant driver of rerating, but management's timeline may prove aggressive.
• I don't see a significant bargain here today, though there is a path to worthwhile rerating and higher share prices as markets recover and management executes on margin improvement.

Meaningful restructuring is never easy, but doing it in the teeth of significant end-market headwinds only intensifies the challenge. Fortune Brands Innovations ( FBIN ) isn’t going to have an easy time of it in 2023, as the residential market continues to weaken, but management’s decisions to split off MasterBrand ( MBC ), centralize operations to drive better core operating leverage, and acquire certain assets from Assa Abloy ( ASAZY ) all make sense for the longer-term betterment of the business.

I expect that FBIN will emerge as an attractively profitable company in a few years, and I really like the growth kicker that could come from the company’s efforts in smart/connected home technologies. Still, unless the company can meaningfully surpass mid-single-digit revenue growth, low double-digit adjusted free cash flow growth, and reach at least the low end of its multiyear margin improvement targets, I don’t see much upside beyond $70 today.

Closing Out The Old Fortune Brands

Fortune Brands Innovations reported somewhat complicated fourth quarter results due to the partial inclusion of MasterBrand, but management did what they could to clarify the ongoing operations and give investors a good sense of where the business is heading into 2023. On balance, while initial guidance for 2023 was weak, reported results were a little better than expected, with on-target revenue and modest margin outperformance driven by cost control and pricing leverage.

Revenue in the ongoing FBIN operations fell 7% year over year on an adjusted basis. Water Innovations led the contraction, with an 11% drop in revenue driven by high ongoing levels of inventory destocking in the residential plumbing space. Outdoors & Security declined 7%, with less intense destocking pressure but still ongoing demand weakness from the downturn in the residential housing market.

Adjusted operating income declined less than 1%, with margin up 110bp to 17.3%. At the segment level, profits declined less than 1%, with margin up 130bp to 20.1%. Water Innovations profits improved 5% (margin up 320bp to 24.0%), while Outdoors & Security declined 11%, with margin up 250bp to 18.4%.

Benchmarking these results to Masco ( MAS ), FBIN underperformed in plumbing (Masco’s North American plumbing business was down 1%), largely due to what I believe has been superior channel/sell-in management on the part of Masco (not letting the channel get overstuffed). The Outdoors & Security segment is harder to benchmark; Masonite ( DOOR ) hasn’t reported yet, and while JELD-WEN ( JELD ) did see 1% revenue growth in its North American business, it’s not a good apples-to-apples comparison, and likewise with the double-digit growth at Allegion ( ALLE ).

About That Guidance…

Given the earnings reports and guidance calls that had preceded FBIN’s fourth quarter report, including Masco, I don’t know that a big guide-down for 2023 should really qualify as a surprise. New construction is likely to decline at a high-teens rate (if not worse) in 2023, and a combination of higher rates, pulled-forward work during the pandemic, and lower housing prices is driving weaker demand in the renovation market as well.

In any case, FBIN management guided to a 5% to 7% revenue decline for FY’23, with Water Innovations down 5% to 7% (Masco guided to a 10%-14% decline), Outdoors down 6% to 8%, and Security (which is more of a repair/replace market than renovation) down 2% to 4%. Management also guided to 25%-30% decremental margin and adjusted operating margin of 16%-17% and an EPS range ($3.60 - $3.80) well below the prior average Street estimate of $4.10.

Not much in this guidance troubles me. The decremental margin seems a little high, but not unreasonable given ongoing supply chain inflation and the impact of production curtailments in the first quarter. If I’m going to criticize management, it’s that they didn’t better anticipate the weakness in residential and manage channel inventory accordingly.

Leveraging A GDP-Plus Core Market, With A Tech And Self-Help Kicker

As I mentioned in my recent article on Masco, the U.S. renovation/remodeling market has historically been a “GDP-plus” market, with spending growth tracking about 1% to 2% above underlying GDP, but growing about 6% a year over the last decade. I do believe that the pandemic pulled projects forward, but I likewise believe that an overall lack of housing supply and an aging housing base will be supportive for the market for the next 5 to 10 years. With FBIN leveraged to areas that tend to be priorities in remodeling (bathroom fixtures, kitchen plumbing fixtures, deck/patio), I see no reason why the company couldn’t expect to see baseline market growth of 3% to 4% over the longer term.

The extent to which FBIN can gain share and build upon incremental opportunities beyond that baseline growth will determine a lot of the upside in the shares. I like the company’s commitment to technology in the smart/connected home area, including leak detection/automatic shutoff and automation.

I’ve talked about leak detection before in reference to Zurn Elkay ( ZWS ), but it’s also relevant here. Water leaks can cause a lot of damage before they’re found, and I think there is an attractive growth market here in retrofitting homes with technologies that can monitor for leaks, alert homeowners, and automatically shut off water if a leak is detected.

I think property insurance will drive a lot of that growth. Homeowner insurance rates have shot up, largely due to higher loss severity for P&C insurers ( Allstate ( ALL ), et al). Higher insurance rates alienate customers and prompt angry letters to state insurance regulators, and I believe there’s more incentive now for insurance companies to highlight premium discounts attached to automatic leak detection retrofits (not all insurance companies offer discounts, and not in all states, but many do).

Other smart/connected home opportunities to watch include automated sprinkler systems that can monitor soil conditions without homeowner input and programmable shower systems that allow for significant customization.

On the self-help side, FBIN will be pivoting from a largely decentralized corporate structure to a more conventional centralized operation. Through this, management is targeting enhanced efficiency at all levels (management, procurement, manufacturing, distribution, et al), improved sourcing/supply chain integration (centralizing purchases and consolidating suppliers where possible), and improved SG&A leverage. All told, management believes they can leverage this for 300bp-500bp of incremental operating margin by 2027.

The Outlook

I’m bullish on several of the aspects of the FBIN story that management has presented, but I do think that 6% to 9% revenue growth could prove ambitious (out to 2025-2027). Slide the timeline forward a year, though, and I think 6%-plus growth from the end of FY’23 is certainly possible, along with longer-term growth close to 5%.

I’d also note that the acquisition of door/cabinet hardware and residential smart lock assets from Assa Abloy should be solidly positive for FBIN if the deal closes – I believe smart locks fill a clear hole in FBIN’s portfolio today and at a good price.

I’m not too worried about execution on the margin targets, though my expectations are that the company will come in on the lower end of the target range, at least at the 2025/2026 point. Relative to the adjusted endpoint in FY’22, I’m expecting around one point of EBITDA margin leverage through FY’25, and over the longer term I’m looking for low-double digit FCF margins that should drive low double-digit FCF growth on mid-single-digit revenue growth.

Discounting those cash flows back to today, I don’t get a very compelling fair value. My EV/EBITDA approach (where margins and returns drive the multiple) is more accommodating. I can get to a mid-$60’s fair value with a 12x multiple based on likely margins/returns in FY’23. If I give the company credit for reaching the lower end of the target margin improvement range, the multiple bumps up to 13x and the fair value moves into the low $70’s.

The Bottom Line

Giving partial credit for those margin improvements several years ahead of schedule is probably too bullish, but I do think it gives a sense of what can happen if management executes on its self-improvement initiatives. At this point I do think the shares already price in at least some of the post-23 recovery and I don’t find them truly compelling. Still, I can’t say that I don’t see a path to more worthwhile upside and if these shares were to sell off on weaker 2023 numbers, it’d be a name to revisit.

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