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Morningstar | Masco Reports Solid 2Q Revenue Growth, But Rising Input Costs Pressure Margins; EPS Guidance Lowered

We expect to maintain our $44 per share fair value estimate for narrow-moat Masco following its second-quarter earnings release. Masco's reported revenue grew 11% year over year (6% organic) to $2.3 billion, which was about in line with the consensus estimate. However, a 21% increase in adjusted EPS to $0.75 missed the consensus estimate by $0.02. While Masco's EPS growth looks impressive, most of this increase was the result of lower interest expense, a lower effective tax rate, and a decreased diluted share count versus the year-ago quarter. Adjusted operating profit grew just 2% on an 11% increase in revenue, due in part to input cost inflation, and adjusted operating margin contracted 150 basis points year over year to 16.5%. Still, cost headwinds were mostly anticipated by the company, and management only modestly reduced its full-year adjusted EPS guidance to $2.52 (at the midpoint of guidance) from $2.56 previously. The guidance change was mostly because of restructuring-type expenses in the windows segment, which is expected to linger into the third quarter.

Masco's decorative architectural segment grew revenue 22% year over year, but much of this increase was due to the Kichler acquisition, which closed in March. Excluding the acquisition, segment revenue still increased a solid 6%. Operating margin declined 200 basis points to 20.5% due to Kichler's lower margin profile and higher input costs. The plumbing segment grew revenue 9% (6% excluding favorable currency) due to broad-based volume growth, but adjusted operating margin, which declined 210 basis points to 19%, was negatively impacted by rising input costs, mix, and growth investments. Cabinet sales grew 13% excluding the Moores divestiture (up 7% reported), and adjusted operating margin was only down 10 basis points to 12.3%. Excluding currency and the Arrow divestiture, Windows revenue was in line with last year (down 7% reported), and adjusted operating margin declined 460 basis points to 4.2%.

The second-quarter performance of Masco's cabinets business was comparatively strong relative to close peer Fortune Brands. Fortune Brands' cabinets business reported a 2% decline in revenue year over year (1% increase excluding the contribution of exited businesses in the prior year), and its adjusted operating margin contracted 90 basis points year over year to 12.7%. Fortune Brands' cabinets business is in the midst of restructuring as management repositions the business to better serve higher-growth end markets.

The underperformance of Masco's windows business was primarily driven by the firm's efforts to improve its U.K. business by reducing headcount and addressing other operational inefficiencies. An increased warranty reserve for Milgard windows also played a role. Management now expects full-year segment operating margin to come in about 100 basis points below the 2017 margin (6.8%) due to additional costs that will be incurred to restructure the U.K. business and incremental costs associated with new product launches.

In our view, Masco runs a shareholder-friendly capital allocation strategy. The company announced it will increase its quarterly dividend from $0.105 per share to $0.12 per share beginning in the fourth quarter. The company has also repurchased $265 million worth of shares year-to-date, and management noted that it could allocate another $200 million to share repurchases or acquisitions over the remainder of 2018.