Recommendation: Long

Current Price: $40.61

Bull Price: $96

Target Price: $60

Bear Price: $29

Market Cap: $4.9B

Liquidity: 2.0MM shares or $81MM per day

• Description
  • Owens Corning (OC) is a manufacturer of residential roofing materials, fiberglass insulation, and fiberglass composites. US residential construction and repair and remodel spending (R&R) are the major drivers of OC’s profit. Roofing and insulation are concentrated industries (top 4 manufacturers are >75% of market) with high fixed costs and little threat from imports, which should yield strong operating margin in a normalized environment. The majority of OC’s business is US based. OC has ~$2.2B in federal NOLs versus GAAP taxes of ~$45MM in 2012.
• Thesis
  • OC has significant leverage to residential construction and repair and remodel  (R&R) spending; however, short term missteps in their composite and roofing segments weighed on 2012 profits and the stock price. Bears have focused on the roofing segment and fear margins will retreat from ~17% in 2012 to the high single digit range seen in mid-2000s. However, roofing OEMs recently have announced annual price hikes for early February as opposed to March/April in previous years, effectively shortening the winter pre-buy window . Channel checks indicate the scale of winter buying remains limited and pricing is holding thus far. If industry discipline holds at current levels, roofing margins will likely increase y/y. This will rebut the bear case and refocus investors on the insulation segment’s strong housing leverage.
  • In addition to the catalyst of roofing margin accretion, OC offers particularly attractive downside risk due to the very likely improvement in 2013 insulation EBIT. Even with roofing margins down 1%, 50% incremental insulation margins versus 90% YTD, and composite margins at 8% vs. 10% in 2011, OC is still likely to earn $2.30 in GAAP EPS and closer to $2.80 in FCF.
    • I believe 2013 EPS will be closer to $3.25 vs. Street at $2.30
  • I believe OC is an opportunity to make a lot of money if we are right and to lose little if we are wrong
• Valuation
  • In my base case, I assume long term roofing margins contract to 15%, strong growth in insulation, and modest growth in composites. I believe OC can earn $7.50 in 2016 EPS with FCF closer to $9.00. Applying a 12x multiple and discounting back three years at a 15% rate yields a price today of $59.18, which I view as conservative.
    • Alternatively, I believe EPS will reach $3.25 in 2013 and $4.75 in 2014. Applying a 12x multiple on my 2014 estimate yields a price of $57.
  • In my bull case, I assume roofing margins rebound to 21%, which yields $9.00 in EPS holding the rest of my base case equal. A 15x multiple on that yields a price of $135, which is discounted at 12% for three years yields a price today of $96.
  • In my bear case, I consider my Worst Case 2016 FCF value and 10x 2013 Street FCF of $2.80, yielding prices of ~$30 and ~$28, which I averaged at $29
• Worst Case 2016 FCF
  • Even if housing returns less robustly than I believe likely (~50% my base case growth rate) AND roofing margins settle at 12%, I still believe OC can earn $4.75 in FCF in 2016. Applying a 10x multiple, a 15% discount rate, and a three year time period yields a price today of $29.58.
• Risks
  • Continued pressure on roofing margins
    • Share battles between OEMs
    • Capacity expansion
  • A reversal in the housing recovery
  • Continued pressure on composite margins
    • Expanding Chinese capacity
  • A surge in oil prices, which would increase asphalt prices and could put sudden pressure on roofing margins
• Roofing Margins – Long Term
  • The big bear case on OC is that roofing margins have fallen y/y for three years, are unsustainably high, and will eventually crater in the mid to high single digits which they averaged in the mid-2000s
    • For a brief history, roofing prices soared in 2008 due to surging input costs. (Asphalt, roofing’s major commodity exposure, is a byproduct of oil.) However, in 2009, asphalt prices collapsed but roofing OEMs managed to keep the price hikes they had passed through in 2008, which resulted in margins surging to 28%. Margins have trended down from that peak level and are ~17% in 2012. Management has long term guidance of mid-teens or higher margins.
    • OC claims margins have improved structurally since 2006 due to OC-specific improvements and industry consolidation
      • OC believes it has improved its technology, removed $100MM in costs from its process, and its margins are now in line with peers
      • OC believes the industry consolidation, which has taken the space from >10 competitors in the 1990s to the top four with >90% share today, has resulted in an industry with better margins
      • In 2012, the Street originally expected >20% operating margins and OC missed every quarter
        • A competitor was aggressive with pricing to take share in Q1 2012, which resulted dealer inventories too high headed into the summer. Subsequently, demand was slightly weaker due to lower storm damage, which combined with excess inventories resulted in weak pricing.
      • Bears point to this consistent trend of weakness since 2009 and believe roofing margins could bottom in the high single digits
  • My take: I think residential roofing is a well situated industry. The top four players have 90% market share, high weight/volume to price makes roofing a regional business, and the fragmented dealer base (~1500) and price inelastic end users (Who knows the price of a roof?) all combined should support a solid operating margin. Having said that, OC has seen a remarkable improvement in profitability since 2006 and large margin volatility from year to year, so caution is warranted.
    • However, I am confident, given the structure of the industry, that roofing is at least a mid teens business in a recovering housing environment and possibly much better
• Roofing Margins – 2013
  • Recent channel checks indicate roofing price hikes are coming sooner this year, dealer inventories are lower than last year, and pre-buys appear rational. Importantly, no one has indicated that any player is attempting to slash prices to gain share.
  • If winter buying is limited and demand for roofing improves over the spring/summer due to increased Existing Home Sales, Housing Starts, and R&R spend, it is very likely OC’s roofing margin will improve y/y in H1 2013
  • If roofing margins expand y/y, it will rebut the bear case and I believe OC’s stock will rally
• Insulation
  • With ~50% exposure to US housing in 2011 and ~80% in a normalized environment, OC’s insulation segment offers strong leverage to a rebound in housing
  • In particular, the nature of insulation manufacturing should offer high incremental margins for the foreseeable future
    • There are only five producers and OC has >50% market share
    • Like roofing, it is uneconomical to ship insulation long distances via truck, resulting in more localized markets
    • Because the cost of running a line is very high (picture a giant furnace melting glass at 3000°F, blowing it like cotton candy into giant vats, and then compressing and packaging that material), producers are incentivized to run their facilities at very high utilization rates before turning on a mothballed line
    • In addition, it is not tremendously expensive nor time consuming to ready a mothballed line and due to the timing of insulation installation in a housing start insulation OEMs have good visibility into orders, both of which speak to an industry with rational capacity restarts
  • OC guided for incremental margins of at least 50% and are currently running at 90% YTD
    • I  model 75% in 2013, 65% in 2014, 50% in 2015 and 2016
  • In 2011, approximately 34% of insulation sales were to North American residential construction, down from ~60% in 2006. A further 22% was North American R&R, 24% North American Commercial and Industrial and 20% International .
    • Using a blended growth rate of 20% for North American new residential and ~5% for the other segments, I reach a revenue growth rate of 14% in 2013, 13% in 2014, and 12% in 2015 and 2016
    • OC increased prices over the summer and are increasing prices again this winter. If price hikes hold, my near term revenue estimates could be too low.
• Composites
  • Composites were ~40% of overall EBIT in 2011 and ~25% in 2012
    • However, as insulation grows, composites effect decreases
    • I estimate composites will be 20% of overall EBIT in 2016
  • During 2012, composites were also hit with an inventory destocking which reduced operating margin to ~5.5% versus 9-10% in 2010 and 2011
  • I model composites margins rebounding to 8% in 2013, 9% in 2014, 10% in 2015, and 11% in 2016
    • Note: OC is transitioning to a lower cost manufacturing base, which could boost margins
  • I model revenues growing 4% per year, which is below management’s guidance
  • I consider composites a small part of the OC story
• FCF vs. EPS
  • OC has sizeable NOLs, including $2.2B at the federal level
    • This compares to my 2016 GAAP tax estimate of $260MM in my $7.50 EPS base case
  • OC will pay a below GAAP tax rate for the foreseeable future
  • I estimate OC’s cash tax rate at 10% for the next decade, which is likely conservative