Summary
- Softening demand should impact revenue and margins in FY23.
- However, longer-term prospects look good.
- The stock is a good contrarian bet if one can look beyond the current slowdown.
Investment Thesis
Masco Corporation (MAS) is expected to face softening demand in the upcoming quarters, which should offset the benefits from pricing gains and negatively impact the company's FY2023 revenue. However, if we look at FY24 and beyond, there are several secular trends that could benefit the company, including increasing home equity and home prices, as well as an increasing number of US homes reaching the prime remodelling age of 20-39 in the coming years. The company is also executing well and its healthy balance sheet places it well to do strategic acquisitions at attractive valuations during the downcycle.
While the company's margins are expected to be negatively impacted by volume deleveraging in FY2023, it should be partially offset by disciplined cost management, productivity gains through the 80/20 rule, and pricing actions. Management is expecting decremental margins in the low 20%'s in this slowdown (versus typical 30%) due to these cost reduction efforts. However, once the economy begins to recover the incremental margins are expected to be ~30% which should help in long term margin expansion.
With a P/E of 17.08x on FY23 consensus EPS estimates (which will likely be the bottom of the cycle) and dividend yield of 2.04%, the stock looks attractive for long term investors who can look beyond the current slowdown.
MAS Q4 FY22 Earnings
Recently, Masco Corporation reported lower-than-expected results in its final quarter of FY 2022. Revenue for the quarter stood at $1.92 billion, down 4.9% YoY, and was below the consensus estimate of $1.93 billion. The adjusted EPS in the fourth quarter was down 3% YoY to $0.65 (compared to consensus estimates of $0.68). The decline in revenue was due to softening demand, partially offset by pricing actions. The adjusted operating margin declined 90 basis points YoY to 12.2%, primarily due to volume deleveraging, partially offset by pricing gains.
Revenue Analysis and Outlook
After experiencing strong revenue growth in the first half of FY22 and flattish revenue growth in Q3 22, the top line declined 4.9% YoY in the fourth quarter of FY22, primarily due to lower volume across most categories, partially offset by 9% gains from pricing actions. However, for the full year 2022, strong pricing actions fully offset the headwinds due to volume declines during the second half of FY22, resulting in 3.6% YoY revenue growth.
During the quarter, the plumbing sales declined 2.6% Y/Y. However if we exclude the currency impact, sales were up ~2% Y/Y as the sales decline in North America was fully offset by high single-digit growth in International Plumbing. International Plumbing benefited from Hansgrohe's market share gains in important geographies such as China, Germany, and France. Additionally, the segment's Spa business completed its extended backlog benefiting sales growth.
The Decorative Architectural segment declined 8% YoY. The segment's Pro paint business continued its strong performance posting mid-single-digit growth against a tough 50% comp from the prior year. DIY paint sales, on the other hand, declined by a low double-digit percentage, more than offsetting Pro Paints' revenue growth.
Masco's segment wise and geographic net sales (Company Data, GS Analytics Research)
Looking forward, demand is expected to soften as the market adjusts to increasing interest rates, persistent inflation, and tight consumer spending. Residential new construction is also expected to see a further slowdown, despite some relief in mortgage rates recently. Usually, new residential construction sees a steeper decline during a slowdown as compared to the Repair & Remodel business and we are likely to see a similar trend this time as well. However, the good news is that Masco has significantly low exposure to new residential construction (~10%) which makes it better positioned against some of its peers in building product companies that have higher exposure to new residential construction.
The company's plumbing segment should be significantly impacted in the next quarters, partly due to strong comps and partly due to the normalized backlog range of the Spa business. During the last few quarters, the segment's sales benefitted as it converted extraordinarily high backlog levels of the Spa business into sales. However, the backlog in the Spa business has now returned to the normalized 4-6 week range. So, this tailwind is now gone.
Things aren't great on the Decorative Architectural side as well. Usually, the company tends to see a shift towards DIY consumers during an economic softening as the consumers take on projects themselves rather than having projects done for them by Pro contractors. So, the shift towards DIY business tends to offset some of the softening on the Pro side. However, given the very high levels of DIY demand post-COVID, which is now normalizing, I don't think we will see a similar lift in DIY demand this time in the near term.
Management has guided for total sales to decline by 10% for the full year 2023, with plumbing products decreasing by 10% to 14% and a 5% to 10% decline in the Decorative Architectural segment. Overall volume decline is expected to be in the double-digit range, offset to a small extent by pricing actions. The North American R&R model is expected to be down low double-digits after three years of strong growth, while the international market, primarily in Europe, is expected to contract by high single digits.
So, Masco's outlook is not that great for FY2023 and this is not surprising given the current macro environment. However, the good thing about Masco's plumbing and decorative architectural businesses is that they tend to recover quickly post-recession given the recurring need for their products and heavy exposure towards aftermarket. Management has indicated that the company is likely to hit a bottom in FY2023 and return to growth in FY2024. So, the company's growth prospects for longer term investors who are willing to look beyond the current year are attractive.
Management plans to continue investing in the business during the slowdown. In the Plumbing business, the company is launching Hansgrohe's new product range of showers and faucets, expanding into an adjacent line of bath furniture, and continuing to invest in brand building in the international market.
In the Decorative Architectural Product segment, Masco plans to invest in its paint business to capture further market share in both the DIY and Pro markets. The company recently launched new paint categories such as aerosols, interior stains, caulks, and sealants, which have performed well. Masco plans to expand the offering to additional stores and expects further share gains in 2023. The company will also be launching Behr Dynasty Exterior for the summer painting season, expanding the lineup of the Dynasty paint line. To outgrow the market, Masco plans to add people on the street to get new customers to try its products, which has proven to be successful in the past.
I believe these initiatives will help the company gain share and it will emerge stronger on the other side of the cycle.
Further, while there are near-term headwinds, the long-term outlook of the Repair and Remodel market remains strong. The R&R market should benefit from structural dynamics such as home prices and home equity holding up better than expected. The existing home median sales prices have increased meaningfully over the last five years helping home equity. According to a research by Black Knight , homeowners in the United States who have a mortgage have experienced an average increase of over $92,000 in home equity since the start of the pandemic and home values in the country's 50 largest metro areas have increased between 19% and 66% . The level of home equity is a good indicator of how much homeowners are likely to spend on home improvement and once the economy stabilizes, I expect a good rebound in the R&R market. Furthermore, the average age of homes continues to rise, with almost 1.5 million homes reaching the prime remodeling age of 20-39 years in the next three years. This should also support R&R spending.
In addition to company specific organic growth initiative and good long term fundamentals, Masco's healthy net leverage of 1.8x should support any strategic M&As in new categories or geographies if such opportunities arise. This should further accelerate growth. So, I am optimistic about the company revenue growth outlook in FY24 and beyond.
Margin Analysis and Outlook
Adjusted operating margins declined 90bps Y/Y in the fourth quarter, reaching the lowest point since 2019. The decrease was primarily due to volume deleveraging, higher operational costs, and currency headwinds, partially offset by pricing actions and expense control. SG&A as a percentage of sales improved 20bps Y/Y in the quarter. For the full fiscal year 2022, total commodity and other inflation was in the low double digits, which coupled with supply chain challenges more than offset the benefits from significant pricing actions. This resulted in an operating margin contraction of 180bps.
MAS segment operating margins (Company Data, GS Analytics Research) MAS adjusted operating margin and adjusted EBITDA margin (Company Data, GS Analytics Research)
In the coming quarters, the company's margins are expected to be impacted by volume deleveraging. However, pricing actions, decreasing inflation, and the company's focus on driving productivity through its 80/20 mindset are expected to partially offset these headwinds.
There is a potential benefit if the inflation in raw material and other costs moderates as a result of the Federal Reserve's hawkish stance and slowing macroeconomic environment. However, management is not building moderation in input costs in the FY23 expectations. Overall, management has guided a decremental margin in the low 20%'s (versus the typical 30% the company usually sees) with pricing action and productivity saving offsetting some of the cost deleveraging.
However, once the revenue declines bottom, management expects the company to deliver ~30% incremental margins in the upcycle. So, if we think from a medium to long-term perspective, the company can post higher margins and profitability on similar levels of revenues on the other side of the cycle. Also, I believe a lot of commodity inflation we are seeing now is a result of supply chain issues and other Covid-related disruptions we have seen in recent years. This is unlikely to continue for long and I believe there should be some moderation in this inflationary headwind in the medium to long term which should help the company's margin. Hence, I am optimistic about the company's margin expansion prospects in FY24 and beyond.
Valuation and Conclusion
Masco is trading at 17.08x FY23 consensus EPS estimate of $3.27 and has a dividend yield of ~2.04%. While the company's P/E is higher than its 5-year average forward P/E ratio of 15.92x, investors should remember that cyclical companies tend to trade at higher multiples on trough earnings versus the peak earnings. Sherwin Williams ( SHW ), one of the company's peers in the paint industry, is trading at 26.85x FY23 consensus EPS estimates which is meaningfully higher than its 5-year average forward P/E of 17.37x .
I find Masco's current valuation attractive. While everyone is currently talking about a slowdown in the repair and remodel industry, the interest rate should peak sometime during the middle of this year and, towards the end of this year, discussion should shift towards the worst being already behind us. If we look at Masco's P/E multiple of 15.05x FY24 consensus EPS of $3.71, it is lower than its 5-year average. The company's growth prospects in FY24 and beyond are attractive with analysts expecting low to mid teens EPS growth in 2024 and 2025. There is also a good chance of Masco's P/E multiple re-rating higher as it continues to execute well and narrows its valuation gap with Sherwin Williams. I believe, investors with a long-term perspective who are able to look past the current slowdown can consider making a contrarian investment by buying the stock at its current levels.
For further details see:
Masco Corporation Is A Buy Despite Near-Term Headwinds