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Morningstar | Weak Market Share Gains for Narrow-Moat James Hardie in 1Q; Looking Fairly Valued After Sell-Off

Muted market share gains in narrow-moat Hardie’s important North American fibre cement segment disappointed the market in the first quarter of fiscal 2019 but were in line with our expectations. Investors had expected gains in share to drive a better showing than the 5% increase in North American sales volumes, which rose to 591 million square feet, or mmsf. Shares sold off accordingly, down 6.5% on the day as the market rethinks the trajectory for future share gains. We still think increased market share for Hardie’s fibre cement will be harder to come by,  with engineered wood siding alternative LP Smartside getting traction in the U.S. market. Thus, we still expect no increase in share for Hardie in fiscal 2019, followed by a gain of 8% of share over the coming decade. While considerable, our forecast for share gains still trails management’s long-term aspirations for 31.5% terminal market share. We maintain our fair value estimate of AUD 21.20 per share and note that Hardie shares now look fairly valued, having previously rallied into the result.

While smaller in size, the Asia-Pacific fibre cement segment delivered 7% year-on-year EBIT growth, which is roughly in line with our full-year expectations for 6.6% EBIT growth for the segment. Meanwhile, Europe performed well, with the Fermacell acquisition having been completed early in the quarter. While it is early days, first signs are encouraging, with net sales in Europe of USD 95.4 million reflecting strong sales growth of 8% on a pro forma basis, excluding the tailwind from foreign exchange translation. EBIT came in at USD 11.4 million, excluding transaction and integration costs, leading to an underlying EBIT margin of 11.9%, ahead of our expectations for 10% margins. While we’ve upgraded our margin expectations for Europe in fiscal 2019 to 11.9%, we had already assumed further margin accretion in Europe, and remain comfortable with our 15% forecast for fiscal 2028.

Strategic pricing acted to lift prices ahead of our full-year forecast, with North American average selling prices rising a strong 5% to USD 725 per thousand square feet. Observed prices at U.S. big-box retailers are congruent with this result, with exterior pricing improving by approximately 6%. However, the vast majority of sales are via the trade channel, and thus retail pricing in retail channel does not provide the entire picture. With the large retailers typically passing on Hardie price increases in full, however, pricing data from the retailers is to some extent instructive of effectiveness of the broad pricing strategy.

However, the underperformance of the interiors range in North America drove a positive mix shift impact on pricing. Management expects some reversal in the remainder of the year, bringing prices in line with the prior guidance of 2%-3% growth. We also expect this to occur, given the mix shift effect on price growth in the quarter. With market index growth for exteriors estimated at 5.7% and management speaking anecdotally about outperforming this, total sales volume for the segment of 5% implies essentially flat interiors sales. Thus, mix shift back to more normalised interior product sales will be accompanied by moderating average selling prices towards the guided range and our forecast for 3% growth.

In the U.S., housing construction activity continues to improve in 2018, with the degree of improvement critical in Hardie achieving our base-case North American volume expectations for 7.5% growth in fiscal 2019. So far so good, with an acceleration in construction activity in the first half of calendar 2018. The first quarter saw single-family starts grow 7.7% year on year to 195,000, up from 7.0% growth for fourth-quarter 2017. Second-quarter 2018, which corresponds with Hardie’s first-quarter fiscal 2019, was equally bright with activity further hastening, with 8.4% growth to 257,900 starts. We still expect a 7.4% increase in single-family starts to 915,000 in calendar 2018, and so things look largely on track.

But we see some risk on the horizon for Hardie, starting in fourth-quarter fiscal 2019, corresponding to first-quarter 2019 for housing starts. We expect a further acceleration in construction in 2019, with our forecast of 1.15 million single-family starts a steep 26% increase in activity off an already improved showing in 2018. Should activity fail to gather further steam, our forecasts could prove too optimistic. A continuation of 7% growth in activity through 2019 to a peak in activity of 1.3 million single-family starts in fiscal 2024, versus our 1.4 million starts expected for that year, yields an AUD 20.65 per share fair value estimate, and thus shaves off approximately 4% of value.

Meanwhile, competition remains another potential challenge. We note the improved volumes of competitor Louisiana Pacific, which saw volumes for its LP Smartside strand product during the corresponding quarter up 18%; it is thus participating in both the upswing in building activity and the reduced market share of vinyl. We expect the product’s continued growth will persist as a headwind to the return of strong market share gains for Hardie in coming years.

Input costs in North America were higher in the period, as we had expected. While certain inputs were significantly higher in the period, including pulp and freight, which climbed 20% and 29%, respectively, repricing provided more than sufficient offset, with gross margins expanding 3.7%. We note that management does not expect input price pressures to abate in the near term and we still expect raw material cost inflation of 5.4% in fiscal 2019. Should commodity pricing remain elevated, or even increase, we see profitability and thus valuation remaining intact. Hardie’s brand equity, the source of its narrow moat, provides the necessary pricing power for the business to pass these costs onto customers.

Meanwhile, Asia-Pacific EBIT was largely in in line with our expectations for 6.6% EBIT growth for the full year. However, strong volume growth of 15% to 117.1 mmsf drove this growth in EBIT while no gains in price were achieved. Pricing remained flat at USD 753 per msf. While said volumes are well ahead of our expectations and therefore are pleasing, we did expect to see sharper pricing during the period. As such, we expect these two divergent outcomes to reverse in coming quarters, with volume growth moderating and returning to an annual pace of 1.2% in fiscal 2019, and pricing to improve for 4.2% price improvement.