Screening For Building Materials

Includes: AAON, AOS
by: Erik Dellith

I haven't been paying that much attention to the homebuilders. I've just been too concerned about the backlog of foreclosure homes, the spread in price between new and existing homes, and so on, to really feel comfortable diving into this industry. Sure, I've missed out an amazing rally among some of these issues, but, to me, it hasn't been worth the risk. But the recent trend in real estate gives me a reason to take a look at building-products companies.

The Fed has committed to keeping interest rates low until the unemployment rate sinks to 6.5%. The unemployment rate has trended lower since hitting its peak of 10% in October 2009, thanks, in part, to the accelerating pace at which the economy has been adding jobs. The unemployment rate currently hovers around 7.9%. Given the recent pace of job creation, the number of unemployed, underemployed, and people out of the labor force who would like to be working, I see interest rates staying low for a while, and that should continue to help keep mortgage rates low. At the same time, more people on payrolls provide support to a strengthening real estate market.

Whether we are looking at the residential spending part of the US GDP release, monthly new home sales, existing home sales, or the decline in foreclosure inventory, we see indications of an improving real estate market. This is not to say that things are going great, simply that they are getting somewhat better.

With that in mind, I want to create a screen to highlight companies that stand to benefit from an improving real estate market. I begin by focusing on the 28 industrial companies that operate in the building products industry.

On average, these shares have climbed more than 15% over the last three months, while the S&P 500 Index has advanced about 10% over this period. With gains of that magnitude over such a short period of time, I'm concerned about valuations. We are going to filter for stocks where the P/E ratio is less than the industry average. This drops the list to eight names.

That's a reasonable number to start working our way through, but there are many reasons why a stock might not have kept pace with others. We want to make sure that these are growing. We require revenue in the trailing twelve-month ((NYSE:TTM)) period to be stronger than the industry average. This drops our list down to four names.

While I acknowledge that no one can tell the future with any degree of certainty, I would still like some indication that the companies will continue to grow. Thus, we require that analysts expect the company to earn more next year than this year. We end up with two companies. Here's a quick look.

AAON Inc. (NASDAQ:AAON) is involved in the manufacture and sale of air conditioning and heating equipment for residential and commercial markets. In the TTM period, its revenue climbed 7.4%, easily overshadowing the industry norm of 3%, according to data from Reuters. The company also has superior profit margins. For example, its TTM operating margin stands at 11.6%, much wider than the industry average of 5.1%. This has helped the company to report return on investment ((NYSE:ROI)) that also is superior to the industry mean: 14.5% versus 3.8%. And analysts expect the company to continue to grow, with EPS climbing at an average annual rate of 10% going forward. Yet, shares remain priced at a discount to the industry benchmark. Its P/E is 28 in an industry with an average reading of 32. Watch for its earnings release on March 11.

A.O. Smith Corp. (NYSE:AOS) manufactures and sells water heaters and boilers to the residential and commercial markets. TTM revenue growth of 13.4% trounced the industry average of 3%. As with AAON, A.O. Smith also has industry-leading profit margins. Its TTM operating margin stands at 12.1%, considerably wider than the industry's 5.1%. ROI here comes in at 9%, which is also much better than the average of its peers (3.8%). Looking down the road, analysts expect the company to grow its EPS at a 20% clip. Clearly, such a fast growth rate is not sustainable over long periods, but it paints a relatively rosy picture for nearer-term prospects. AOS shares, with a P/E of 19.9, seem to be a bargain relative to the industry.

While I provide a quick glance at these companies, interested investors need to take a closer look to determine if these stocks are appropriate for their individual portfolios.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.