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Morningstar | Narrow-Moat James Hardie Tracks Our Expectations in 2Q 2019 but Softens Guidance: FVE Unchanged. See Updated Analyst Note from 08 Nov 2018

James Hardie reported net profit of $69.5 million in the second quarter of fiscal 2019, largely tracking our full-year expectations. Greater uncertainty around U.S. housing construction activity through the remainder of the fiscal year, however, led James Hardie to downgrade its full-year guidance by around 6% to a range of $280 million-$320 million. Further, year-to-date market share gains have remained elusive in North America. The revised guidance and continued tepid gains in market share saw James Hardie's shares sold off an approximate 14%. Nonetheless, our outlook for Hardie remains unchanged. We reduced our full-year net profit forecast by 4% to $311 million because of the U.S. dollar's appreciation that will see lower translated earnings from Asia Pacific and Europe. But with U.S. single-family construction activity of 1.1 million starts still expected at midcycle, our valuation of James Hardie remains intact at AUD 21.20 per share. James Hardie shares now screen as cheap, trading at a 20% discount to fair value.

Year to date, James Hardie's important North American segment is largely tracking our expectations. First-half sales of $869.4 million resulted from volumes increasing 5% and strategic pricing initiatives drove a 4% increase in average selling prices. We've marginally increased our volume growth forecasts to 5.8% from a prior 5.2% for fiscal 2019. With little change in forecast volumes, our EBIT margin forecast of 22.5% in fiscal 2019 remains largely unchanged, however, and aligns with James Hardie's guided range of 22.5% to 25%. North America EBIT of $384 million is now expected.

Meanwhile, James Hardie's Asia-Pacific volumes were very strong, increasing 12% in first-half fiscal 2019. Full-year EBIT of $97 million is now expected for the segment. Further afield, the Fermacell acquisition is tracking our expectations with European EBIT of $19.9 million in the first half placing the segment well to meet our full-year forecast of $37.84 million.

In North America, exterior fiber cement volumes, which represent around 80% of the segment’s sales volumes, increased 7%. However, detracting from the result was weak interior fiber cement sales which declined 2% in the first half. Exterior volume growth featured "around 2%" of above market index sales--the result of market share gains. This implies that James Hardie's market index grew at 5%, closely tracking our forecast of 5.2% market growth in fiscal 2019. While the firm’s market share gains are tracking above our expectations for flat performance in fiscal 2019, James Hardie now concedes that its earlier guided range of 3% to 5% in above market index growth now looks out of reach in fiscal 2019. This disappointed investors and begs the question as to whether the 35/90 strategy, which would see James Hardie’s terminal market share come to rest at 31.5% is indeed achievable. We have upgraded our near-term volume growth assumptions, factoring 0.6% of above market index growth in fiscal 2019, pushing up our North American volume growth forecast to 5.8% from 5.2%. But we continue to see terminal share of around 25% for James Hardie in North America, with the current share price fully reflecting this more realistic terminal market share assumption.

Against a backdrop of weakening construction activity in Australia, volumes in Asia Pacific were strong. In Australia, our expectations were for 1.2% growth in volumes, with repair and remodel (R&R) activity having been expected to offset a 1.7% decrease in Australian detached housing completions. But market share gains more than offset a softening detached housing backdrop and drove stronger volume growth. However, we do not forecast continued market share gains in the second half. Rather, we see a reversion to market growth levels, which we forecast at 1.2%, yielding full-year volumetric growth of 6.7%. Moreover, we were underwhelmed by Asia Pacific pricing, where average prices have increased just 1% year-to-date. With inflation in raw materials and freight costs significant, we had expected price increases to approximate 5% in fiscal 2019. We now temper forecast price increases to 3% for the full-year, with EBIT margins now correspondingly lower at 20.3% and down from a prior 23.6%. Nonetheless, we continue to think Hardie’s intangible asset-led economic moat provides longer-term pricing power, and we see future price increases averaging 2.2% over the coming decade, helping to restore segment margins. As such, we continue to forecast Asia Pacific mid-cycle EBIT margins of 25%.

The balance sheet remains in decent shape at 2.2 times net debt to EBITDA. While this remains slightly above Hardie’s target range of 1 to 2 times following the Fermacell acquisition, we see this debt level as manageable with free cash flow sufficient to reduce debt over the medium term. We continue to forecast net debt to EBITDA of 1.8 times by fiscal 2021 before reducing further over the forecast period toward 1.3 times.