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Morningstar | MAS Updated Forecasts and Estimates from 08 Feb 2019

Home improvement and building products companies, such as narrow-moat-rated Masco, had a more challenging 2018 than many firms had anticipated going into the year as new residential construction and repair and remodel activity moderated, and inflationary headwinds thwarted margin expansion goals. Last quarter, Masco lowered its full-year 2018 EPS guidance due to softening demand and cost pressures. However, the firm had a great fourth quarter and topped the high end of its 2018 EPS guidance range by $0.06. While management anticipates tariffs on "list 3" Chinese goods will increase from 10% to 25% on March 1, and new construction and R&R spending could be slower in 2019, they expect full-year 2019 sales to grow 3% to 5% (about 2% to 4% including currency translation headwinds) and adjusted EPS to increase 8% (at the midpoint of guidance) compared with 2018. While we appreciated management's cautious stance, we think this guidance could prove conservative if the housing market and R&R spending comes back to life and/or the tariff increase fails to materialize. While we tempered our near-term sales growth and margin expansion assumptions, our longer-term outlook is unchanged. As such, we've maintained our $44 per share fair value estimate. Despite a nearly 7% increase in Masco's stock price following its positive earnings release, we still think the stock is undervalued.

Masco's fourth-quarter reported sales increased 10% year over year (5% organic) to $2.0 billion, which came in about 2% higher than Wall Street's expectations. The firm's strong top-line growth was primarily driven by the plumbing and decorative architectural segments. Consolidated adjusted operating margin expanded 150 basis points to 15.4% due to improved price/cost, deferred investment spending, and operating leverage. Adjusted operating income growth and a lower share count propelled adjusted EPS 56% higher year over year to $0.64, which easily beat the $0.56 consensus estimate.

Management noted that a step up to 25% tariffs will introduce an additional $150 million of costs that would need to be mitigated by increased prices, supply chain adjustments, and/or productivity initiatives. That said, $150 million represents less than 3% of Masco's cost of goods sold, so offsetting these costs is by no means insurmountable, in our view. Management seemed more concerned about the impact higher prices could have on consumer demand.

Management's 2019 guidance assumes mid-single-digit growth in repair and remodel activity and new residential construction growing at a low-single-digit pace next year. With mortgage rates moderating and cautiously optimistic commentary from large homebuilders about the early spring selling season, we believe new residential construction could surprise to the upside in 2019. However, only 15% of Masco's revenue comes from residential new construction, with the remaining 85% driven by R&R spending. We think overall improving housing sentiment could spur an increased level of consumer confidence, which could, in turn, cause R&R spending to come in better than Masco currently expects.