Why does the market love James Hardie? Just have a gander at those margins. The company’s engine room – the North American fibre cement division – produced an operating margin of 23% for the year to 31 March 2017. Across the entire company, which includes the fibre cement businesses in Australasia, the Philippines and Europe, the underlying margin was 18%. This is a very profitable business.
You don’t see margins like that every day – and very rarely in the building materials sector. Compare them with James Hardie’s listed Australasian competitors; Table 1 shows that the average operating margin for Boral, CSR and Fletcher Building is less than 10%.
The gruesome threesome look even worse next to James Hardie when you consider the bigger picture. The Australasian housing construction market is widely considered to be nearing the peak, if not already past it. Margins for the also-rans have expanded during the boom, and further upside would be a stretch.
Result reflects management stuff-ups
Still a better than average business
Risk of long-term margin decline
By contrast, North American margins at ‘Hardie’ – as long-serving chief executive Louis Gries calls it – fell from 26.4% to 23.0% in 2017. We’ll get to why shortly, but there’s probably upside – at least in the short to medium term.
Hardie also benefits from two other tailwinds. First, US housing construction is closer to the middle of the cycle than in Australia. US residential housing starts are forecast to be 1.2m–1.3m in the 2018 year – slightly less than half the 2006 peak but more than double the 2009 low.
Second, fibre cement cladding continues to take market share from inferior but cheaper products like vinyl. However, Hardie seems to have stepped back from its aspirational target to lift fibre cement cladding to a 35% share of the US cladding market (it’s around half that level now). Perhaps that’s because the engineered wood cladding produced by main competitor Louisiana-Pacific has proven to be a strong alternative for homebuilders.
|Most recent full-year result
(CSR/JHX 2017, BLD/FBU 2016).
Source: Company reports
Nevertheless, Hardie is still growing strongly. North American fibre cement volumes rose 13% in the 2017 year, while sales rose 12%. The problem was at the operating profit line, where earnings before interest and tax fell 2% as costs blew out.
The main reason for the higher costs in 2017 was – not to put too fine a point on it – a multi-year management stuff-up. Hardie seems to have sweated its assets following the US housing downturn. With product demand increasing, supply was too tight heading into the 2017 financial year.
Management set about ramping up capacity by a whopping 25% during the financial year. This spending on new capacity and restarting plants that were idled during the downturn proved costly. On top of that came higher costs from past under-spending on maintenance and safety. All this added up to inefficiencies as Hardie tried to meet customer demand.
It’s an important lesson for shareholders. Strong demand for a popular product can actually cause problems, as Bellamy’s Australia found out 18 months ago (see Bellamy’s Organic: When not enough is too much). Even well-managed companies like James Hardie can make mistakes.
In the end, a 2% decline in operating profit from the North American fibre cement division was hardly a big issue given strong sales – although the market appeared to treat it as such. The stock hit an all-time high of just over $23 in early May and it’s since fallen just 14% on the disappointment. James Hardie remains a highly rated stock, however, so further disappointments could incur the market’s wrath.
The weakness in North America was partly offset by a 22% lift in operating profit from the much smaller International Fibre Cement division (which accounts for 21% of sales). The strong performance was driven by the Australian and New Zealand businesses (that housing boom, remember?), offset by weakness in the Philippines. Table 2 shows the overall 2017 results for Hardie’s combined business.
|Year to 31 Mar||2017||2016|| /(–)
|U'lying revenue (US$m)||1,922||1,728||11|
|U'lying EBITDA (US$m)||438||431||2|
|U'lying EBIT (US$m)||354||351||1|
|U'lying NPAT (US$m)||249||243||2|
|U'lying EPS (US c)||56.1||54.3||3|
|Final div. (c)||US28c unfranked, down 3%,
ex date 7 Jun
Any discussion of Hardie can’t avoid an analysis of its asbestos liabilities. Here the news is good (at least for the company). Claims for asbestos injuries were 11% below actuarial estimates during the year, with the average claim size being 31% below estimates. The company has recognised asbestos liabilities of US$1.2bn on its balance sheet, 11% lower than the year before. The liability has now fallen for two years, although there’s no guarantee another wave of claims won’t cause it to blow out.
Consistent with its commitment to pay 35% of annual operating cash flow to the Asbestos Injuries Compensation Fund, Hardie will make a payment of US$102m next month. Excluding last year’s $91m payment – still a real cash cost – free cash flow was $279m.
Of course the market is fully aware that Hardie is a good business. Our job is to decide whether to buy – and here we hit a roadblock. A price-earnings ratio of 26 and an enterprise value to earnings before interest, tax, depreciation and amortisation multiple of 15 are hardly numbers that scream value.
We’ve probably been too conservative, though, and we're raising our Buy price to $15 a share (with the Sell price remaining the same). Our suspicion is that the market will generally be willing to pay more for James Hardie than we will.
It’s a fundamental tenet of capitalism that high margins tend to come under attack eventually. While Hardie dominates the fibre cement market in the US, it remains somewhat of a niche product. As fibre cement’s market share grows – something the market already expects – those high margins might be at risk. Louisiana-Pacific is proving to be a formidable competitor already.
The next three years will also see lower free cash flow as Hardie spends US$750m building more fibre cement manufacturing capacity. Apart from the management error this highlights, the worry is that – like so many building materials businesses – the investment is ill-timed. We’ve seen too many underinvest following a downturn, spend like crazy as the cycle matures, then watch helplessly as it turns down again a year or two later.
This, then, explains why we’re unable to muster the same level of enthusiasm for Hardie as the market. Greater competition, another US housing downturn or a third wave of asbestos liabilities are all risks to consider. If you’re a shareholder there’s enough reason to HOLD, but we recommend that you stick strictly to our 5% portfolio limit.