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Morningstar | Narrow-Moat James Hardie Performs Well in 3Q 2019 Despite Soft U.S. Housing; FVE Unchanged

Narrow-moat-rated James Hardie delivered a solid third-quarter result in the face of weak U.S. housing starts during the period. While soft third-quarter U.S. housing starts make necessary a strong fourth quarter showing, our U.S. housing normalisation thesis remains intact. Our full-year adjusted net profit forecast remains largely unchanged at USD 301 million and sits just below the midpoint of management’s upgraded guidance range of USD 295 to USD 315 million. Our fair value estimate of AUD 21.20 per share is also unchanged and we continue to see value in Hardie’s shares which trade at an approximate 25% discount to fair value.

While U.S. housing starts for December are currently unavailable, we estimate North American market index growth was negative 1% to negative 0.75% in Hardie’s third quarter. Despite this, Hardie delivered 1% volume growth in North America, thus delivering 1% to 2% above market index growth, or PDG. While below management’s near-term target of 3%-5% annual PDG, it largely tracks our expectations for fiscal 2019. We continue to expect North American volumes to grow 4.1% in fiscal 2019. North American pricing and margins are also tracking our full-year expectations. Average pricing in the first nine months of fiscal 2019 was 3% higher year on year. EBIT margins of 22.9% also largely track our full-year expectations for 22.3%.

Asia Pacific volumes were well ahead of our expectations, up 12% in the first nine months of fiscal 2019. PDG in the Australian and Philippine businesses was sizable and we increase our full-year volume growth expectations to 12%, up from a prior 6%. Pricing continues to be less favourable in Asia Pacific, however, up 1% in AUD terms year-to-date and down 4% in USD terms. We therefore reduce our full-year expectations for AUD price gains to 1%, down from 3%. With volume and price expectations moving in opposing directions, our segment EBIT margin forecast of 20% unimpacted.

Our North American volume forecast of 4.1% is unchanged following the third-quarter result. We factor 3.5% growth in market volumes and 0.6% PDG for the fiscal 2019 full-year. However, with November U.S. single family starts down significantly on the prior year, falling 13.1% on a seasonally adjusted basis, a strong finish will be required in terms of fourth-quarter housing starts given the softness in the third quarter. Fourth-quarter housing starts will need to average around the 930,000 on a seasonally-adjusted basis to achieve this market growth rate. Management express their confidence that the third quarter housing market easing was transitory, however, providing some comfort. Hardie points to a continuation of accommodative macroeconomic conditions including an unemployment rate near 50-year lows and monetary policy settings that remain accommodative.

The Europe building products segment, which includes the Fermacell fibre gypsum business and the group’s nascent European fibre cement sales, are also largely tracking to expectations. Segment EBIT of approximately USD 28 million in the first nine months bodes well compared with our full-year segment EBIT expectations of USD 38 million.

In Truong’s first address to the market as CEO, he recommitted to the group’s pre-existing long-term goals. As such, the so-called 35/90 target remains in place in North America under which Hardie aims to take fibre cement exterior siding to 35% category share and maintain their 90% market share at the same time. Management are targeting annual above-market index growth in the vicinity of 6% to achieve this. In Asia Pacific, above annual market index growth in the vicinity of 5% is being targeted. Through the cycle, EBIT margins of 20-25% are targeted by management for both the North America and Asia Pacific segments. Meanwhile, Truong’s target for Europe is to create a EUR 1 billion business with EBIT margins in excess of 20%. While we remain positive on Hardie’s ability to increase its market share in all three of its geographies, we continue to see the group’s targets as ambitious and see Hardie’s North American market share peaking at circa 25%, up from current market share standing at 17%, and thus below the group’s 31.5% terminal market share target under 35/90.

Truong also announced USD 100 million in cost-out via lean manufacturing practices by fiscal 2022. The North American manufacturing network currently lacks standardised manufacturing processes, with standardisation across manufacturing plants to provide for efficiency gains. We remain cautious in factoring cost-out into operating margins, however, with management conceding that a substantial portion of savings would be reinvested into the business in the form of increased marketing spend and R&D to reinvigorate market share gains. We therefore await further detail before factoring potential cost savings into our forecasts.

The balance sheet continues to lack flexibility following the Fermacell acquisition, with net debt/EBITDA at 2.2 times at the end of the third quarter and thus above the group’s long-term range of 1-2 times. We continue to expect Hardie’s leverage to fall below 2 times net debt/EBITDA by fiscal 2021, however, with interest remaining comfortably covered at 7 times in the meantime.