While the coronavirus pandemic has adversely affected many parts of the U.S. economy, the housing market has been a real bright spot. Migration to the suburbs has accelerated, and the combination of more time spent at home, more discretionary income, and higher home prices has resulted in elevated repair and remodel spending. Because of these factors, we were expecting a strong third-quarter performance from Masco, but the firm’s results exceeded our expectations.
Third-quarter revenue surged 16% year over year to almost $2 billion, as revenue from the firm’s plumbing and decorative architectural segments increased 13% and 19%, respectively, compared with the year-ago quarter. Masco realized significant operating leverage on this strong volume, and consolidated adjusted operating margin expanded 400 basis points to a very robust 21.4%.
While plenty of uncertainty remains, management expects another strong quarterly performance to conclude fiscal 2020. The firm expects fourth-quarter revenue to increase 8%-10% (excluding currency translation) year over year, with about a 17% adjusted operating margin. Excluding the effect of divestitures, we forecast Masco to grow full-year sales 6%, with significant margin expansion in 2020, which is remarkable considering management’s gloomy outlook heading into the second quarter.
Given Masco’s strong financial performance, management feels comfortable enough to resume its share repurchase program and expects to spend $100 million on buybacks during the fourth quarter.
After reviewing Masco’s third-quarter results and outlook, we’ve increased our fair value estimate about 4% to $55 per share, primarily due to our revised 2020 growth and profitability assumptions. Masco’s second-half 2020 performance will likely be stellar, but we think that such strong volumes are a pull-forward of future demand and not sustainable.
Business Strategy and Outlook
We think Masco’s financial performance over the past six years has been as much of a self-help story as a story of improving end markets. Masco almost entirely refreshed its senior executive management team in 2014. Since then, it has taken significant measures to build a stronger and more consistent business model. The firm divested its most cyclical and least profitable businesses (it spun off its installation business, now named TopBuild, to shareholders in 2015 and sold its windows and cabinetry businesses in 2019 and 2020, respectively). Management also executed significant cost-reduction initiatives and shored up the firm's balance sheet.
In our view, Masco's sale of its windows and cabinetry businesses is a positive development for the firm because we had long viewed its plumbing and decorative architectural businesses as the firm's crown jewels and key drivers of the company's valuation, while Masco's cabinetry and windows businesses have often been laggards that have been a drag on margins and returns on invested capital.
The health of the housing market, and to a much greater extent, repair and remodel, or R&R, spending in the United States are major drivers of Masco’s financial performance. After divesting its installation, windows, and cabinetry businesses, we estimate the firm's overall exposure to the R&R market is 89% of sales.
The housing market has been the bright spot of the U.S. economy so far during the pandemic, and our longer-term forecast of housing starts reaching over 1.4 million units by the mid-2020s hasn't changed. We believe favorable demographics coupled with the realization of pent-up demand will drive strengthening housing demand over the next decade. R&R spending may pull back a bit after a strong 2020, but we think 6%-7% annual spending growth will return over the coming decade before moderating to 4% growth longer term. We see a nice growth runway for Masco as the company capitalizes on improving end markets and internal growth initiatives across its remaining plumbing and decorative architectural platforms.
Over the past two decades, Masco's plumbing and decorative architectural segments have comfortably outearned the firm's cost of capital and have each generated most of the firm's economic profits. We believe Masco's plumbing and architectural coatings-related intangible assets and the firm's relatively low-cost Behr distribution and sales platform will support excess returns for at least the next 20 years, supporting a wide moat.
We believe the Delta and Hansgrohe brand names yield pricing power relative to lower-end brands and imports, which support the segment's high-teens operating margins. Over the past decade, plumbing margins have benefited from the segment's ability to persistently generate favorable price/cost spreads (that is, increasing prices more than input cost inflation). Delta products, which are known for pleasing aesthetics, innovation, and quality, focus on mid- to mid-high-end price points. Based on our analysis, Delta’s average price point is below luxury suppliers Kohler and Grohe, slightly below Fortune Brands’ Moen, and well above American Standard and other lower-end brands. Hansgrohe is sold in more than 140 countries including the U.S. In the U.S., Hansgrohe is seen as a premium brand, with an average price point more in line with Kohler and Grohe.
While there are examples of foreign competition taking share from incumbent plumbing fixture manufacturers in our coverage (new entrants such as Spain's Roca brand are taking market share from Australia-based GWA Group), we don't see increased imports as a material threat to Masco's core plumbing brands. There has been established foreign competition in the U.S. plumbing fixtures market for some time, and Masco has clearly held its own. Since the U.S. housing recovery began in earnest in 2010 (and through fiscal 2018), Masco's organic plumbing sales have grown faster than the U.S. repair and remodel market and adjusted operating margin expanded over 500 basis points to over 18%.
The decorative architectural segment, which mostly consists of the Behr paint and primer brand, has been Masco’s most profitable and highest-returning business. Behr paint is currently the leading brand in the nearly $5 billion U.S. do-it-yourself coatings market, with approximately 30% share, and the brand has been making inroads in the $8 billion professional market, where it has 6% market share. We think two main factors drive Behr’s strong financial performance. First, we think the Behr brand has built considerable brand equity, which drives repeat business and yields pricing power; second, Behr’s exclusive relationship with The Home Depot, which is the largest home improvement retailer in the world, supports Behr's intangible assets and provides a cost advantage relative to Behr's main competitors, Sherwin-Williams, Benjamin Moore, and PPG, that a rely on a more cost-intensive sales channel.
Because of its exclusive relationship with Home Depot, Behr has been able to expand market share without having to make costly investments in company-owned store space like Sherwin-Williams and PPG. Furthermore, we think Behr enjoys relatively low logistics costs because it has built its manufacturing and distribution facilities around a national home improvement behemoth with its own world-class distribution network. As such, Masco's decorative architectural segment generates much higher margins and ROICs than industry leader Sherwin-Williams, even with the segment's lower-margin hardware and lighting businesses, which accounts for approximately 25% of segment sales, and its far smaller scale (Masco's coatings business is one ninth the size of Sherwin-Williams).
We think Behr and Home Depot have a symbiotic relationship that has strengthened over the years as both parties work collaboratively to expand the brand and take share from competing paint brands across the DIY and professional markets. Furthermore, we think Masco has parlayed this long-standing and successful partnership to increase the penetration rate of other products at Home Depot (for example's Masco's Liberty shower door program win at Home Depot, which was announced in 2016).
Fair Value and Profit Drivers
After reviewing Masco's third-quarter earnings release and outlook, we raised our fair value estimate about 4% to $55 per share, primarily due to our stronger 2020 revenue growth and profitability assumptions. We think strong demand for DIY paint will continue through the rest of 2020 because Americans are spending more time at home, and painting is an easy and inexpensive project that can freshen home decor. Assuming government-mandated business closures don't resurface to the same degree as before, we're expecting plumbing sales will also rebound during the second half of 2020. We're now modeling Masco's revenue to increase 6% (from 3.5% previously) and adjusted operating margin to expand 180 basis points to 18.3% (from 17% previously) in 2020.
We see solid growth and profitability for Masco over our 10-year forecast horizon. In particular, we think Masco’s investment in the Behr pro paint offering will drive higher sales growth for the decorative architectural segment. We believe Masco’s efforts to contain costs through its lean business operating system should bolster Masco’s profitability over our forecast.
We project consolidated organic sales will grow at a 4% to 5% compound annual rate over the next decade, about in line with the long-run average range of R&R growth rates. Our growth projections consider stable R&R spending at or above the long-run average and organic growth initiatives across both of Masco’s remaining segments. Masco’s key organic growth initiatives include increasing Behr’s professional painter market share and extending the plumbing segment’s product portfolio. We also expect new product introductions in existing product categories and price increases to support sales growth over our forecast.
We see numerous factors supporting improved profitability over the next decade, including favorable product mix as customers trade up amid a renewed housing market recovery, less promotional activity at retailers due to improving demand trends, better operating leverage due to volume gains, new product introductions, and price increases that offset input cost inflation. After unusually strong profitability in 2020 due to surging volumes and cost reductions, we see consolidated operating margin peaking around 17% by the mid-2020s before fading to around 16.5% in 2029, which we view as a sustainable, long-run operating margin (that is, our midcycle assumption).
Risk and Uncertainty
The most substantial risk we see is a prolonged downturn in R&R spending and, to a lesser extent, residential construction. R&R spending is more resilient than new construction but still moves in the direction of the broader economy, and a downturn would likely weaken the company’s financial performance. Still, we think Masco has a durable business model as the company has consistently generated positive free cash flow, even during the last downturn.
Behr branded products represent the majority of the decorative architectural segment’s $2.7 billion of sales. Behr’s exclusive distribution agreement with Home Depot introduces significant customer concentration risk, although this has been a successful partnership for almost 40 years.
While Behr’s and Home Depot’s joint effort to gain professional painter market share should result in better long-term growth prospects if successful, elevated investment spending and competition from Sherwin-Williams, PPG, and Benjamin Moore to maintain share could result in lower returns on invested capital.
Masco acquired several of its core brands in the late 1990s and early 2000s, including Liberty Hardware, Behr, Milgard, and a majority stake in Hansgrohe. Masco's most recent acquisition is the Kichler lighting business it purchased in March 2018 for approximately $550 million. Although we think the company’s acquisition strategy to date has been satisfactory, there is no guarantee future acquisitions will be as successful. A variety of factors, such as unfavorable deal terms, integration issues, and subsequent acquisition underperformance, could destroy shareholder value. Still, management's commentary at its 2019 analyst day gives us confidence that the firm will maintain a disciplined acquisition strategy focused on relatively small, bolt-on opportunities.
Masco’s executive leadership team went through a complete overhaul, and with the exception of the CFO, all named executive officers began their roles after January 2014. Keith Allman has served as CEO since February 2014. Previously, Allman was group president of Masco’s plumbing and North American cabinet businesses (2011-14), president of Delta Faucet (2007-11), executive vice president of the builder cabinet group (2004-07), and in various managerial roles at Merillat Industries (1998-2003). Masco entered the kitchen and bath cabinet business in 1985 with its acquisition of Merillat. John Sznewajs began his career at Masco in 1996 and served in various corporate development and finance roles before his promotion to CFO in July 2007.
Under Allman’s leadership, Masco has executed on its commitment to create shareholder value. The TopBuild spin-off and restructuring activities have proved fruitful, and the company has consistently increased dividends and repurchased shares. While investments in Behr’s pro paint business, the Kichler acquisition, and other initiatives are in the earlier stages, we expect these strategies to create future shareholder value. Finally, we agree with management's decision to sell Masco's cabinetry and windows businesses because in future, Masco will be a less cyclical business with increased revenue and margin stability.
We've been pleased with Allman's and Sznewaj's capital allocation strategy. Given Masco's successful corporate actions, its balanced, shareholder-friendly capital allocation strategy, and its improving organic fundamentals under Allman's watch, we've upgraded Masco's stewardship rating to Exemplary.
The tax-free spin-off of Masco’s installation business, now known as TopBuild, has been accretive to shareholder value. On June 30, 2015, Masco shareholders received one share of TopBuild for every nine shares of Masco owned. This transaction resulted in a less cyclical Masco while also allowing Masco shareholders to decide if they wanted to remain invested in TopBuild, which is highly dependent on new-home construction. Since TopBuild's July 2015 spin-off, the stock has almost quadrupled in value and outperformed the S&P 500 by 230% as of end of October 2019.
Shareholders will also realize good value from the sale of Masco's cabinetry and windows businesses. Masco sold its Milgard windows business for $725 million, or over 11 times our estimated 2019 EBITDA for the windows segment; and the pending cabinetry sale will fetch $1 billion ($850 million cash and $150 million preferred stock), or about 9 times our estimated 2019 EBITDA for the cabinetry segment. Given the cyclicality and, at times, poor financial performance from both the windows and cabinetry segments, we believe Masco sold both businesses for attractive multiples. We also think the sale of these two cyclical businesses is well timed given where we are in the U.S. economic cycle.
Masco has undergone significant restructuring over the last several years, closing facilities and reducing head count by 45%. These cost-reduction actions resulted in $400 million in annual savings, and the company continues to use its lean business operating system to contain costs and drive better profitability. Since Allman took the CEO helm in 2014, Masco has increased its dividend every year and has purchased approximately 67 million shares (Masco's diluted average share count had decreased 13% since year-end 2013). We expect increasing the company’s dividend and opportunistically repurchasing shares will continue to be important facets of Masco’s capital-allocation strategy.
Masco has been investing in organic growth opportunities and has articulated its future acquisition plans. Gaining market share among professional painters is one of Masco’s key growth opportunities. The company has added product representatives in the field and Masco-employed staff at Home Depot stores that cater solely to professional contractors. This strategy is still less costly and capital intensive than the store-operated model used by competitors. So far, this strategy has resulted in strong growth, and Behr now has 6% market share in the U.S. professional market.
Masco is a global leader in home improvement and building products. The company’s $4 billion plumbing segment, led by the Delta and Hansgrohe brands, sells faucets, showerheads, and other related plumbing components. The $2.7 billion decorative architectural segment primarily sells paints and other coatings under the Behr and Kilz brands. Masco sold its Milgard and U.K. windows businesses in 2019 for more than $725 million and sold its cabinetry business for $1 billion in first quarter 2020.