Fortune Brands: Market Share Gains And Swift Recovery In Housing Market Can Drive Upside

Summary

• Fortune Brands' focus on entry-level demography is helping it gain market share, and the company will likely emerge stronger on the other side of the slowdown.
• The company will also benefit from a swift recovery in housing market helped by low interest rates and increased remodeling spend due to consumers spending more time at home.
• I believe the company can beat estimates and see ~29% upside in the next 12 to 18 months.

In normal times, when you see unemployment in low teens, it is very difficult to be positive on consumers. But, this time, it is different. With recent stimulus measures, more than two-thirds of laid-off workers are making more money than when they were employed. These measures have helped preserve consumer balance sheets, and we may see a swift recovery in consumer spending as the U.S. economy continues reopening over the next couple of months and unemployment dips. The recent correction in stock markets has made available plenty of opportunities to buy high-quality consumer companies at reasonable valuations. I am looking for companies that are executing well, gaining market share, and having a reasonably strong balance sheet to weather this recession if things go south. Fortune Brands Home & Security (FBHS) is one such name.

The company reported its better-than-expected Q1 results in April. The company's Q1 revenues grew by 5.63% to $1,402 mn versus the sell-side consensus of 2.27% growth or $1,358 mn in revenues. The company's operating margins expanded 142 bps, driven by volume leverage and cost control. Better-than-expected topline growth and margin expansion helped the company post 29% EPS growth in Q1 2020, which was much better than sell-side consensus ($0.81 actual versus $0.66 consensus). The company's plumbing sales were impacted by approximately six weeks of closure in China and unfavorable foreign exchange which decreased its sales by ~$32 mn. Sans this impact, the company's sales growth would have been ~8%. Also, COVID-19 started impacting U.S. sales in late March. While the company hasn't quantified its impact on U.S. sales, I believe, without the impact of COVID-19, the company's growth rate would have been in high single-digit to the low double-digit range.

The company is taking market share, and it will emerge much stronger on the other side of the macroeconomic cycle once conditions start returning to normalized levels. The biggest concern for the company going in this downturn was its kitchen cabinet business. Kitchen cabinets are usually large ticket discretionary purchases that can be deferred during a slowdown. So, there were worries about the potential decline in their sales. However, a couple of factors have made this cycle different.

Over the last few years, the company has been working on expanding its entry-level value product line and developing the low-cost capacity to cater to this segment of the market. The company, for example, has launched Aristokraft for the new construction end market and Mantra for its dealer network. The demand at lower price points remains high in both new construction as well as dealer side.

In the new construction business, recent order trends at entry-level builders like D.R. Horton (DHI) were much better than at the high end of the spectrum like Toll Brothers (TOL). For example, on its last earnings call, D.R. Horton talked about new orders declining ~11% in April, while, for Toll Brothers, net signed contracts declined ~64% y-o-y between March 16 and April 30th. When the recovery starts, I believe entry-level homes will continue to see a higher level of demand. So, Fortune Brands' newly launched Aristokraft brand focused on entry-level homes is poised to do well.

In the dealer business, there is a significant market share gain opportunity as Chinese imports exit the market. Last year, the U.S. government imposed significant tariffs and anti-dumping duties on Chinese cabinets. Chinese products were mainly sold through the dealer channel where Fortune has a meaningful presence. The company's recently launched Mantra product line is well placed to gain share in this channel.

The company reported an ~8% increase in Cabinet segment sales in the first quarter. While I anticipate some decrease in the second quarter due to lockdown and its impact on consumer demand, market share gains may cushion some of the downsides in the near term, and the sales will likely bounce back much stronger once the conditions normalize.

The company's plumbing segment is usually considered more defensive due to smaller ticket size and somewhat less discretionary nature of the purchase. This segment is also benefiting from market share gains helped by a focus on entry-level demographics, customer-centric innovation, expansion of product offering with partnerships and adjacencies, as well as geographic expansion outside of the U.S.

In the back half of the last year, the company's plumbing segment posted low double-digit growth. In the first quarter, its growth slowed to 2% due to COVID-19-related shutdowns in China and foreign exchange headwinds. If we remove the impact of these two factors, the plumbing segment growth rate would have been closer to ~9%.

The company also has a door and security segment which is relatively small and contributes ~17% of segment operating profit. It posted mid-single-digit growth in the last quarter helped by strong growth in decking sales. The company recently acquired Fiberon and is rolling out new Fiberon distribution. This, coupled with capacity expansion and investment in the company's bicoastal facilities, will help growth in this segment over the next few years.

Estimates and Valuation

While management didn't provide official guidance, they noted that, based on April sales trends, second-quarter sales could be down 10% to 20% for the company. The company's CFO Pat Hallinan also told that he believes mid to low teens seems like the more plausible realm of that spectrum. The sell-side consensus is currently at -14.20% for Q2 sales, which I believe is reasonable and in line with management commentary. As April is likely to mark the bottom and conditions are expected to improve as the year progresses, sales decline should moderate in Q3 and Q4. Sell side is expecting y-o-y declines to moderate to high-single digits in Q3 and mid-single digits in Q4. However, I believe the recovery could be much faster.

The new construction market is seeing a sharp recovery helped by lower interest rates. At a recent J.P. Morgan conference, most of the homebuilders noted that new orders in May have improved sequentially versus April. Meritage Homes (MTH) even commented that they expect flat new orders in May. Entry-level homes are seeing much better trends, and Fortune Brands is well set to capitalize on this trend with its Aristokraft brand.

On the remodeling side, consumers are spending more time at home. It is likely to accelerate their spending on home improvement projects, which should help Fortune Brands. As discussed before, with generous unemployment benefits and stimulus money from the government, many consumers are making more money than when they were employed. This, coupled with a cut-back in other spending like travel and eating out, also bodes well for the home improvement spending.

I am expecting a V-shaped recovery in the housing industry due to these factors and believe that the company can post flattish sales in the back half this year. A 5.6% growth in the first quarter, a 14.2% decline in the second quarter, and flattish sales in the back half of this year give us $5.625 bn in revenues. This equates to a $139 mn decline in revenues. Management has guided for decremental margins between 20% and 30% for the full year. Assuming 25% decremental margins, we will see a ~$35 mn decline in operating profit versus the last year. The company's adjusted operating profit was $764 mn last year. Subtracting $35 mn, we get an operating profit of $729 mn for the current year. The company's interest expense last quarter was ~$22.1 mn. Annualizing it, we get annual interest expense of $88.4 mn for the current year or profit before tax of $640 mn. Assuming a tax rate of 25%, we get a net income of $480 mn. Average diluted shares outstanding were ~141 mn for the first quarter. I believe the company will resume share buybacks later this year as the things normalize, but even if we assume diluted share count at 141 mn, we get an EPS of $3.40.

For FY2021, I believe end markets will completely recover and the company will return to high single-digit top-line growth by Q1 2021. This, coupled with extremely easy comparisons in the second quarter, can push the top-line growth to low double digits in FY2021. Assuming an 11% revenue growth, we have $6,244 mn in revenues or $619 mn increase. A 25% incremental margin gives us $155 mn (25% of $619 mn) in incremental operating profit, which equates to $0.82 increase in EPS if we assume 25% tax rate ($0.82 = 155*[{1-tax rate(25%)}/shares outstanding (141 mn)]. This gives us $4.22 in FY 2021 EPS [FY 2020 EPS of $3.40+$0.82 increase = $4.22].

I believe the company can grow its revenues in the mid to high single-digit post FY 2021 helped by market share gains and strength in the housing market. This can help it grow its EPS in mid-teens. Before COVID-19, the stock was trading at more than 20x P/E.

I believe the stock can trade at a P/E of ~20x in a normal macro environment. Applying a P/E of 20x to our FY2021 EPS estimate of $4.22, we get a target price of $84.4, which gives us ~29% upside from the current level.

Catalysts

A faster-than-expected recovery in housing and home improvement market and continued market share gains due to Chinese imports exiting the market can help the company beat sell-side estimates and act as an upward catalyst for the stock.

Risks

The company derives ~6% of its revenues from China, and the deteriorating U.S.-China relation poses a risk.

Analyst’s Disclosure: I/we 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.