Long shares of Owens Corning (OC).Like many companies in the building products space, OC has been decimated over the past year, falling 48% and now trades at levels not seen since early 2016.OC has been written up numerous times on VIC, most recently in 2Q17 by 85bears which provides great background on the company.The stock now trades at 8.5x my normalized EPS estimate which I think is too cheap for a company that has leading positions in fairly well structured industries, does not face an obsolescence threat, and has a recurring revenue nature to a decent chunk of (residential roofing is the largest segment and the bulk of demand is replacement driven).Applying a 13x multiple, shares look to have 50% upside.
2017 was a very good year for Owens Corning.The roofing segment produced its best ever performance driven by storm damage related demand (hail damage in 1H followed by hurricanes in 2H).Input costs (asphalt, an oil derivative) were benign for the better part of 2017.Re-roofing demand, supported by an aging housing stock in the US, was strong.An while new residential construction represents less than 10% of shingle demand, the outlook for medium term outlook for homebuilding seemed promising - while 2017 showed growth in continued growth in housing starts, new single family home completions sat ~20% below the 30-50 year average (following nearly a decade of under-build post the GFC) despite population/household growth.
Similarly, the insulation segment benefitted from volume and price growth in the US residential business (today US residential is 30% of the insulation segment).OC guides to 50% operating leverage in its US residential insulation business implying significant profit growth should a sustained homebuilding recovery ensue.Beyond the US resi business, OC used cheap debt to make two acquisitions ($1.65 bn in total; ~10.2x pre-synergy EBITDA/ 8.4x post-synergy) in the insulation segment during 2017, Paroc (European mineral wool) & Pittsburg Corning, diversifying the business away from what was primarily a US residential insulation business (was 60% US resi prior to these transactions).
The composites business had its best ever performance in 2017 driven by strength in the asphalt shingle market (15-20% of revenue) as well general strength in the global industrials end market.
This strong performance was reinforced at OC’s December 2017 Investor Day which promised brighter skies ahead and further bolstered by US corporate tax reform (though OC won’t be a full tax payer for a couple of years).Coming into 2018 based on mgmt guidance, the market was looking for $975-1025 mn in operating profit.
Fast forward to 2018 -
Roofing: Storm demand dropped off following above average years in 2016-2017.On OC’s 3Q call, it guided to US shingle demand being off 10% vs. 2017 (and basically in-line with the multi-year average - see table in the Q&A section..I can’t format anything ever).In addition to weaker volumes, input cost inflation plagued OC during 1H as asphalt price increases (oil) and transportation costs were a persistent headwind.
Insulation: US homebuilding has been weaker than expected in 2018.Culprits include: decreased home affordability (driven by both inflation in new build costs and interest rate hikes) and to a lesser extent labor shortages, shortage in buildable lots, etc.While US homebuilding represents 34% of the business, it had the most expected upside coming into 2018 (given the expectation of price lead revenue growth driving high incremental operating margins).
The glass fiber business has suffered from 1) demand shortfall in the roofing segment (2) melter shutdowns in 2Q and (3) cost inflation.
On its 3Q call, OC guided to $855 mn in OP (unch vs. prior year despite first time inclusion of acquisitions) which takes into account a significant hit in 4Q
By segment - commentary & valuation assumptions:
See valuation tab in Q&A for normalized EPS model
As shown in the shingle demand tab in the Q&A section, I assume a US shingle market of 130 million which essentially assumes remodel/new construction demand in-line with 2018e levels and weather/storm demand to be in-line with the multi-year average.With an aging housing stock, it seems reasonable to assume that we should see steady (albeit modest) growth in the remodel business (age of the average home is ~40 years which compares to low to mid 30s in 2007/2008).Similarly I assume OPMs of 19.5% which is the company’s 10 year average segmental margin.While OPMs are high, the structure of the industry is favorable with the top 3 players controlling ~80% of the market (GAF has 40%, OC has 20%, Certainteed has 20%).While roofing distributors have consolidated (ABC has 25% of the US market; Beacon has 20% up from less than 10% a decade ago) this doesn’t seem to have hurt the manufacturers - having gone through BECN’s earnings and transcripts, they seem supportive of pushing through price hikes in inflationary periods.While BECN has some private label products, it doesn’t do shingles.Given that asphalt shingles have an expected life of 20-25 years (and represent ~20% of the cost of a roofing job; bulk of cost is labor), it makes sense that brand matters in the business.OC produces asphalt shingles out of 35 manufacturing facilities suggesting that it would be a significant undertaking (both from a capital & managerial perspective) to backward integrate.That said, to the extent that distributors continue to consolidate and gain more buying power, this could incrementally have a negative impact on OPMs.
For the insulation business, I assume a relatively flat result vs. 2018 expected figures but give the company credit for incremental synergies from the Paroc & Pittsburg Corning acquisitions (to be fully realized in 2019).This is the segment with the most upside should the US housing market approach estimated normality.The acquired businesses represent nearly 1/2 of OP and have a more stable margin profile than the US residential business.Paroc, which was acquired from CVC for E900 mn (+28% vs. the E700 mn CVC paid for the business in 2014) looks to have produced EBITDA in a fairly narrow band of E73-82 million over during the 2013-2017 period.Similarly, Pittsburg Corning’s EBITDA margins have ranged from 25-27% over the past 4 years.As goes the US residential insulation (34% of segment) business, I am effectively assuming that it stays relatively flat.1/3 of the US business is replacement/renovation with the remainder being new construction.While things have certainly cooled in homebuilding land, given that SFH starts still seem to be 15-20% below the long term average (despite a growing population & increased HH income), I don’t expect to see a large, sustained decline and ultimately expect that we will see continued growth.The US residential business is a well structured industry with OC having 40% share of the fiberglass insulation market (and similar to roofing, the top 3 competitors have ~80% of the market).There are two large publicly traded distributors/installers (Installed Building Products and TopBuild) which together have garnered the bulk (60+%) of the installation/distribution business (up from sub 40% 5-6 years ago).While there has been minimal encroachment into manufacturing though IBP did buy a small manufacturer, Advanced Fiber Technology ($18 mn in annual revenue) so this is something to keep an eye on.
Composites has had an OPM ranging from 5 to 14% (2017) over the past 6 years.The business struggled historically as significant Chinese capacity came online (2003-2008).The industry has since consolidated with the top 5 players now controlling ~80% of the market globally with OC occupying a leading position (strongest in NA/Europe with 34 and 23% m/s respectively).OC has exited some of its poorest performing facilities.Mgmt guides to a sustainable mid teens OPM.I take a more conservative approach - using 11-12% OPM in normality.
Should the single family housing starts return to its 50 year average, I estimate that normalized EPS could be $1-1.25 per share higher than shown.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.