Inefficiencies plagued James Hardie in the December quarter and FY17 guidance is downgraded. The key is whether the company continues to take US market share and secures price increases.

-Inefficiency associated with rising costs as capacity ramps up
-Top line growth supported by cycle while inefficiencies expected to recede
-Better plant performance in FY18 expected as expansions come on stream
 

By Eva Brocklehurst

Gross profit margins were weak at James Hardie ((JHX)) in the December quarter, amid supply challenges in the North American fibre cement business. Operational inefficiencies were in evidence, as the company deals with a ramp-up in capacity and the inefficiency associated with tight supply. Cost growth was ahead of broker expectations.

UBS reduces FY17 profit forecasts by -7%, to reflect poor plant performance and higher costs through the second half in the North American fibre cement business. This implies a margin of 21.5% in the March half, and overall group earnings growth of 2% for FY17. The broker continues to envisage a solid backdrop for earnings momentum in FY18, providing valuation support at current levels. Nevertheless, given the market's expectations, UBS believes there is little room for poor execution.

In the face of these headwinds, Macquarie believes securing price rises will be important going forward. The company is targeting an inflation-offsetting price increase of at least 3% going into FY18. While the broker acknowledges the frustration of another downgrade in guidance, it cautions about losing sight of the big picture. Brownfield expansion is coming to an end and this should support efficiency improvements. All of this is occurring within a growing market in which the company is taking share.

Downgrade To Guidance

FY17 guidance has been narrowed and downgraded, to a range of US$245-255m from US$250-270m. Macquarie believes top line growth is supported by cyclical factors and expects the operational inefficiencies will recede in FY18. Meanwhile, increased capital expenditure, while impinging on free cash flow, is in keeping with the company's longer-term strategy, and solid returns are expected on these investments over time.

Management is confident operations will improve as most of the expansions come on stream in early FY18. While management is pointing to a better performance in FY18, Macquarie is more interested in the step-up in FY19, driven by plant performance. Extra capacity should alleviate distribution inefficiencies but better plant performance will be the key to driving a sustaining performance.

The new plant being built in Tacoma is aimed at improving efficiencies in the north-west of the US, enabling growth in northern California, a strong market for the company.

The broker also believes that as the company moves to greenfield expansion, operational disruption associated with capacity growth should recede. The company's measure of market share is in the target range of 6-8% and this is a key positive, Macquarie's view, as it points to improved sales.

Overweight Texas

CLSA observes that, realising it was caught short as demand surged, the company accelerated its start-up capacity and now forecasts it will spend US$600m over the next three years to build this capacity. The broker points to the likelihood of an oil-induced slowdown in Texas where employment has finally turned lower and there is a slowing in single family housing production.

The company, the broker reminds, is overweight Texas earnings and, within that state, overweight Houston, where about 40% of Texan houses are built. CLSA, not one of the eight stockbrokers monitored daily on the FNArena database, retains a Sell rating and $17 target.

While trimming forecasts to reflect a deeper trough with regard to inefficiencies in manufacturing and a step-up in costs, Credit Suisse continues to believe FY18 will be better. With an unwinding of the issues in manufacturing, a return to price growth in fibre cement should pave the way for a sharp inflection in North American margins.

The broker believes there is value in the stock on a risk/reward basis but acknowledges it may be range-bound until visibility improves regarding the timing of a recovery in margins. North American volume growth of 10% pleased Credit Suisse. With primary demand growth within the 6-8% target range, and in the absence of supply constraints, the broker suspects volume growth improved in the quarter.

The broker notes the company is working through a backlog of orders and tight production capacity meant that sales orders were missed. This is now beginning to unwind. Credit Suisse has an Outperform rating. Deutsche Bank also believes that the -4.7% negative margin impact related to production costs will not be present in FY18.

As a result the broker expects FY18 US fibre cement EBIT margins of 27%. Deutsche Bank estimates primary demand growth of 5.7% in the December quarter, noting management believes this will reach mid to high single digits in FY17.

Volume Growth And Price Increases Needed

Morgan Stanley found the costs endured in the quarter surprising, given the point in the cycle, and suspects there are earnings risks still in train for FY18. Part of this risk appears to come from lower tax assumptions, where the market appears to be assuming a strong rebound in US earnings, without a commensurate increase in tax take. Having said this, the broker concedes the lower base provides easier comparables to achieve high teens growth in FY18.

While the broker considers the stock is challenged by further executive changes, solid volume growth in the core business is still expected. The broker notes, on the conference call, management acknowledged that not all costs embedded in FY17 would roll off in FY18. The 3-4% price increase indicated by management is in line with the broker's expectations.

Ord Minnett believes the December quarter results are indicative of the large task that lies ahead for the company and that price increases are needed to offset cost inflation. The reversal of manufacturing and freight inefficiencies will be pivotal if the company is to deliver margin expansion in FY18.

Citi also highlights the sub-optimal nature of manufacturing performance. The announcement of another senior management departure, Mark Fischer, who has been with the organisation since 1993, combines with many senior departures over the last few years and makes the broker questioned why a high performance organisation has been unable to retain some of its best performers.

The broker downwardly revises forecasts again for FY17 to reflect higher-than-expected plant commission costs and slightly more modest growth in the US new residential construction market. Citi suspects that while the favourable exposure to the US housing cycle remains, a materially higher-than-usual capital expenditure profile in FY18-19 poses a risk that James Hardie could miss out on leverage in, what will be, the critical growth years of the US housing cycle.

FNArena's database shows four Buy ratings and three Hold. The consensus target is $21.12, suggesting 5.9% upside to the last share price. Targets range from $18.65 (Ord Minnett) to $22.50 (UBS).
 

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Boral and CSR will disband their joint venture in bricks on Australia's east coast. Brokers declare the decision a win for both parties.

-Deal multiple considered supportive of CSR's building products expansion
-Well timed transaction for Boral, allowing easier transition to infrastructure activity
-Affords CSR greater control over property and plant
 

By Eva Brocklehurst

Boral ((BLD)) and CSR ((CSR)) will disband their joint venture in bricks on Australia's east coast, with CSR acquiring Boral's 40% stake for $133.9m including $7.5m in loan repayment. The JV was initiated in April 2014 and from Boral's standpoint the bricks business is now considered non-core.

Deutsche Bank believes the deal is 3% accretive for CSR and 2% dilutive for Boral in FY17. Boral continues to own the Midland brick business in Western Australia, which the broker expects to break even at best. After the JV divestment, Boral’s FY17 net debt is reduced to 0.9 times net debt/EBITDA (earnings before interest, tax, depreciation and amortisation).

The move to full ownership of the east coast bricks business is in line with CSR's strategy to grow its building products business and the broker finds the FY17 enterprise value/EBITDA multiple attractive, particularly given its view Australian housing activity will remain robust for the next 18-24 months.

The main downside risks Deutsche Bank envisages for Boral are declines in the Australian & US housing sectors and increased import competition in cement. For CSR the downside risks include softer aluminium prices, a slower recovery in Viridian Glass and a decline in the Australian housing sector.

Credit Suisse downgrades CSR's rating to Neutral from Outperform. The acquisition reduces the relative importance of the highly volatile aluminium business, while the broker also notes financial discipline was maintained and the acquisition multiple commensurate with near-peak cycle earnings.

The broker believes housing is approaching its cycle peak and, in conjunction with the emerging competitive threat in plasterboard, remains cautious on the medium-term outlook for CSR. Importantly, revised aluminium assumptions suggest that Tomago aluminium smelter, part owned by CSR, will be near break-even in 2019. The broker does not consider this development is appropriately reflected in the prevailing share price, despite the potential for a favourable outcome in terms of Tomago's electricity contract renewal.

For Boral, while the company has been criticised for a lack of capital discipline over the past decade, Credit Suisse believes this is a well-timed transaction, citing management's awareness of the cycle and the losses incurred in the bricks business in FY12-13 when housing last troughed.

Cash proceeds should improve an already under-geared balance sheet. The broker surmises that surplus balance sheet capacity could be used for acquisitions in the US, investment in a cement import terminal in Victoria or investment to enhance its quarry position, as well as capital management via a buy-back.

Post this transaction, Boral retains its WA brick business, which the broker suspects will eventually divested. Credit Suisse flags the precipitous decline in WA housing activity, which implies there will be some variable views around asset valuation, and estimates the value of this business at $25-75m.

Boral should continue to benefit from strong residential construction activity and the emerging road and infrastructure cycle, complemented by an improving US business and strong momentum in gypsum. While all this adds to the stock's appeal Credit Suisse looks for a cheaper entry point and retains a Neutral rating.

Macquarie considers the valuation outcome of the sale reasonable for Boral, with its medium-term outlook supported by an elongated residential cycle which is making the transition to infrastructure-driven activity easier to manage. At the upcoming AGM the broker suspects there could be some negative impact from an aggregate of 12 days of more than 10mm rainfall across key markets in Sydney and Melbourne, but expects positive commentary on residential activity and the outlook for infrastructure.

CSR, meanwhile, may be buying a cyclical asset near the high point in its earning potential, but Macquarie believes the transaction reflects a reasonable valuation. A key support for the acquisition is the exposure to a more resilient detached residential building market. It also affords CSR greater control over the property and plant, the broker asserts, as CSR's position in bricks is attractive in the context of the property angle it offers while the structural challenges in the industry are likely to remain.

Boral has a $6.76 consensus target on FNArena's database which signals 8.9% in upside to the last share price. Targets range from $6.07 to $7.10. There are two Buy ratings, three Hold and one Sell (Morgan Stanley). For CSR there are two Buy, one Hold and three Sell. The consensus target is $3.58, suggesting 1.4% downside to the last share price. The dividend yield on CSR's FY17 and FY18 forecasts is 6.8% and 6.0% respectively.
 

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Brickworks has raised expectations for its investment portfolio and expanded margins in building products but several brokers note that beyond FY17, the cycle is turning.

-Full order book currently and unprecedented activity in land and development
-Favourable east coast market but significant restructuring in Western Australian operations
-Despite investment portfolio, exposure to residential construction cycle is substantial
 

By Eva Brocklehurst

Brickworks ((BKW)) has laid a solid foundation in FY16, beating earnings and dividend expectations for its investment portfolio and expanding margins in building products. Management is positive regarding Australia's housing outlook but provided no formal guidance with the results.

Deutsche Bank notes the order book is full and there is an unprecedented level of activity in the property trust in terms of land and development. Given housing demand on the east coast is robust, the broker expects further FY17 EBIT (earnings before interest and tax) margin expansion of 290 basis points to 13%.

All states delivered an improvement except for Western Australia. Land and development was driven by revaluations and new developments in the trust are expected to contribute $16m in gross rental income per annum. The trust is also expected to generate sales from land of $90m in late 2017. The first section of Oakdale West is likely to be sold into the property trust in FY17 and Deutsche Bank believes further upside for the stock exists when the development application is approved.

Investment earnings beat Macquarie's estimates but the broker is preparing for the turn, expecting housing activity will slow over 2017 and weigh on demand going into FY18. The negative effect of a slowing cycle is likely to amplify the impact of rising energy costs on brick operations. Gas prices are an issue for 2018, the broker contends, with increases of around 30% expected. Gas contributes 20% to brick production costs and the volatility in the price represents a risk.

While the company's cash flow improvement is positive, it includes a substantial increase in the receipt of dividends and distributions and when this is excluded, Macquarie calculates receipts from customers net of payments to suppliers actually declined 15%. Meanwhile, the pipeline of property realisations and low volatility profits from investments should support the business in the medium term.

While favourable conditions prevail on the east coast, Brickworks has engaged in significant restructuring of its operations in the west, following a rapid downturn in market conditions. The less efficient Malaga plant will close and the Cardup plant will be re-commissioned.

Macquarie finds the specialised building systems business, which Brickworks has now established, is an interesting development which, although in its infancy, should bring more diversity to the portfolio. Brickworks is employing a distributor business model for a range of lightweight panels, sheets and facades.

While building products will continue to benefit from both volume growth and price rises in the short term, Morgans is conscious of the fact that a peak is near and, henceforth, there will eventually be a PE multiple de-rating across building product companies.

The broker acknowledges the company's cross-holding in WH Soul Pattinson ((SOL)) makes it more than just a building products business but, nevertheless, it has considerable exposure to residential construction and obtained good leverage to the cycle over the past few years. The broker believes, with the stock now trading at a 3.5% yield and at a FY17 price/earnings ratio of 14x, the top of the cycle is nigh and the positive outlook is factored into the share price.

Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, envisages continued growth over the medium term as Oakdale Central and Rochedale are completed, upgrading FY17 forecasts by 4.5% to reflect the near-term momentum in building products and contributions from the Oakdale estates. However, the broker downgrades its FY18 expectations to reflect softening building activity and increasing gas costs.

The broker's forecast contribution from the investments division for FY17 and FY18 is also lowered, largely on the back of lower expected contributions from TPG Telecom ((TPM)), offset a little by increases to New Hope Coal ((NHC)) forecasts. The broker has a Hold rating and $14.03 target.

Citi suspects there is increased risk of the share price underperforming in FY17, although the well documented spread between dwelling starts and completions means earnings should remain robust, supported by property development, especially in a low interest rate environment. Catalysts may come from the AGM in November, or a pick up in underlying new residential construction, as well as an improvement in the market value of WH Soul Pattinson, of which Brickworks owns 42.7%.

As an aside, Deutsche Bank observes the cross-claim brought by Perpetual ((PPT)) against Brickworks and WH Soul Pattinson continues. The discovery process has commenced and will take some time to be completed. Brickworks incurred $2m in costs in FY16 related to the Perpetual litigation.

The FNArena database shows one Buy (Deutsche Bank) and three Hold ratings. The consensus target is $15.09, suggesting 14.2% upside to the last share price. This compares with $16.45 ahead of the results. Targets range from $14.00 (Citi) to $17.53 (Deutsche Bank).
 

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Brokers are positive about James Hardie's strategy in the US but remain wary of the amount of time and financial investment required.

-FY17 profit outlook within reach, underpinned by US housing market growth
-Expanding capacity amid plans to identify further opportunities outside fibre cement
-Are consensus capital expenditure assumptions too light?
 

By Eva Brocklehurst

James Hardie ((JHX)) has provided detailed presentations as part of its US investor tour, highlighting the company's market potential and plans to expand. FY17 underlying profit guidance in the range of US$260-290m is maintained, unsurprising for most brokers given the recovery going on in the US housing market.

The company is rolling out capacity expansion and assessing greenfield projects for construction over 2-3 years at an estimated cost of US$70-120m.

Ord Minnett remains of the view that the company will deliver strong volume and earnings growth in coming years but not without significant investment, from both a financial perspective and in terms of management time.

James Hardie is expanding its management roles and seeking to improve retention in the ranks and, with the changes, the broker suspects there is increased risk of distraction and disruption within senior management.

There is a temptation to get bogged down in the detail of the company's plans and forget about the big picture, Credit Suisse suggests. The housing cycle is still experiencing a strong tailwind and new capacity is expected provide a robust platform for further growth. Near term, the broker identifies risks around this new capacity coming on line and the potential for increased inefficiencies.

The commissioning of four new brownfield facilities will be followed by greenfield capacity and the balancing act required has the potential to create margin volatility, the broker asserts. FY17 capital expenditure is expected to be around US$100m which should increase in FY18-19 as costs ramp up, although the specific timing and magnitude is unclear.

Credit Suisse believes the company's FY17 profit outlook is within reach, underpinned by margins at the top end of the 20-25% range and broader US housing market growth. The fundamentals also support a rating agency review, in the broker's view, with the potential for an upgrade to investment grade in the next 12 months.

James Hardie re-stated its 35/90 strategy, which is an aspirational target to grow fibre cement's share of the US cladding market to 35% and its share of that market to 90%. Deutsche Bank notes, for fibre cement to achieve the 35% target management has now stated an 8% primary demand growth (PDG) target per annum. The broker calculates, on this basis, James Hardie would achieve the 35% target by FY25. Deutsche Bank currently forecasts PDG of 6% in FY17 and 8% in FY18.

Deutsche Bank notes the company is currently trying to identify another three opportunities outside of fibre cement to drive growth beyond FY25. In addition, an increased focus in selling fibre cement to geographies where James Hardie currently has no presence is intended to drive longer term profitability.

Citi also notes the focus on people, tactics and markets with little change in strategy. The broker believes the company is unique in that it offers market growth, enviable margins, robust cash flow and a transparent management team.

The business may be large but management is demonstrating and acknowledging the challenges of being high growth, the broker observes, and the clarity that management has shown with regard to the issues suggests that any necessary change will be via modification and adjustment rather than major dislocation.

Citi believes the company has the capabilities and capacity to gain further market share in the US while the biggest risk in the short term is a faster-than-expected recovery in the US housing market, as this may upset the trajectory of the company's plans if it becomes short on capacity. Citi expects US housing starts to grow a double digit rates over the next three years as the market recovers.

Morgan Stanley recently downgraded the stock to Equal-weight and the investor briefing underlined its view that consensus capital expenditure assumptions for US$80m per annum over the next three years are too light. The broker expects expenditure of US$130m in FY18 and US$210m in FY19.

Morgan Stanley believes margins need to improve by 50 basis points from the first quarter North American fibre cement margin to obtain FY17 net profit of US$275m - the mid point of guidance - and suspects this may be too high.

This broker also cites the potential for inefficiencies to creep in from the ramping up of new production lines. While higher utilisation of the plant through FY17 may mean lower than average seasonality, Morgan Stanley still expects a decline in margins over FY17.

On a positive note, the broker likes the strategy to increase the share of the interior market to 50% from 40% over the medium term, with product additions and greater revenue targeted across the portfolio.

There are four Buy ratings, two Hold and one Sell (Ord Minnett) on FNArena's database and not all brokers updated after the US investor tour. The consensus target is $21.84, suggesting 6.3% upside to the last share price. Targets range from $18.60 (Ord Minnett) to $25.00 (UBS).
 

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-Main advantage is in home renovations
-Little stock price upside likely near term
-Strong market share and balance sheet
 

By Eva Brocklehurst

Morgans has taken up coverage of DuluxGroup ((DLX)), highlighting the company's quality portfolio of well known brands, including its eponymous paint, Selleys sealants and adhesives, Yates garden products, Cabot’s wood stains and B&D garage doors & openers.

These brands are some of the most recognised and trusted in the housing and renovations industry and hold market leading positions in their respective categories. Yet the main advantage, from the broker's perspective, is that the business is skewed to the maintenance and home improvement segment, this being 65% of its revenue.

The renovations segment does not have the peaks and troughs that are evident in the housing construction category. The company's strategy is centred on home improvement, and while forgoing some of the potential upside from the recent strength in building activity, earnings are expected to be shielded in any pull-back.

Building activity in Australia has risen to record highs in FY16 but recent data suggests activity is weakening. Nevertheless, any slowing in housing over the next few years is not expected to have a major impact on the company's earnings growth. Morgans expects 7.2% earnings growth in FY16 and 6.3% in FY17.

The balance sheet is strong, despite the planned outlay of $130m on a new paint factory in Melbourne. This plant will be completed by the end of 2017 and will produce nearly all the company’s water-based decorative paints. The existing Rocklea factory will focus mainly on production of solvent-based paint products.

In addition, the company will construct a new distribution centre in Sydney to replace two existing centres. The facility will be built, owned and operated by Linfox to Dulux specifications and should open in late 2016. To Morgans, this merging of the two distribution sites makes sense given lower operating costs and increased efficiencies and is expected to be positive to net present value.

The broker kicks off its coverage with a Hold rating, as the qualities of the company appear reflected in the current share price, but would reconsider its view on any share price weakness. Target is $6.18.

Morgans suspects there is relatively little potential share price upside in the short term but there should be an opportunity in the future for investors to pick up the stock at more favourable price points. The broker believes a small premium in valuation is justified given the dominant market share, strong brand and solid financials.

Dulux holds the number one market position in the Australian paints market with a current market share around 40%. The business has proven to be stable over time, with relatively defensive earnings. Morgans believes it has the ability to pay down debt quickly if necessary. The broker also likes the fact the company is continually innovating, making a number of improvements and adding new products to the market each year.

Paints, coatings and adhesives are distributed through retail and trade channels. Product is stocked in over 800 retail outlets across Australasia and sold via 240 ore more trade centres and depots. Garage doors & openers are marketed via dealers and the cabinet & architectural hardware sells mainly to the trade.

In December, Deutsche Bank observed the company's commentary contained a softer outlook for 2016, in relation to new housing as well as the commercial & infrastructure markets. The broker maintains a Sell rating. Morgan Stanley shares the same concerns, with an Underweight rating, believing the potential for earnings upside is factored in and growth is expected to be trending flat by FY18.

Citi, on the other hand, does not share the fears about a downturn in the housing cycle, given the company has a healthy balance sheet and a dominant market share in paints. Morgans, too, acknowledges the company is exposed to a subdued macro economic environment, but points to its record of growing earnings despite very tough conditions during the GFC.

The FNArena database shows one Buy rating (Citi), with four Hold and two Sell. The consensus target is $5.86, suggesting 6.2% downside to the last share price. Targets range from $4.25 (Deutsche Bank) to $6.88 (Citi).
 

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