Is Too Much Expected From James Hardie?

This story features JAMES HARDIE INDUSTRIES PLC. For more info SHARE ANALYSIS: JHX

Brokers suspect investors will require patience when it comes to James Hardie as the company once again disappoints with its FY17 result.

-North American fibre cement margins below expectations
-Longer-term value created by volume and market share gains
-Are consensus expectations excessive?
 

By Eva Brocklehurst

James Hardie ((JHX)) may well reward patient investors, Credit Suisse ascertains from the FY17 results, but patience is the key word. Several brokers reduce forecasts to reflect higher unit costs in the North American business. Nevertheless, while micro level issues beset the company, demand remains solid and the housing outlook for the US is little changed.

To be fair, Macquarie observes management miscalculated capacity requirements and, in a growing US market, this led to significant constraints just at a time when the focus was on lifting sales efficiency and the effort to displace vinyl siding was intensifying.

Management responded with an aggressive build of capacity, adding 700m square feet of production to the network in FY17 compared with the 300m that was added in the preceding seven years.

Operating earnings (EBIT) grew by 1% in FY17 off an 11% rise in sales. Margins in the North American fibre cement business were 19.6%. No specific guidance was provided for FY18 but the company expects to be within its 20-25% operating earnings target range through the year.

Credit Suisse believes investors are justifiably frustrated with the leverage story which is now pushed out for at least another year. The broker expects no change in the longer-term value, which is being created by volume and market share gains not by optimising costs and maximising margins, and the stock is likely to be range-bound until margin confidence improves.

FY17 may well be the year James Hardie would like to forget, Ord Minnett agrees, as top-line growth was held back by capacity constraints and many issues combined to weigh heavily on the North American fibre cement business. The broker expects a recovery will take hold in the second quarter although volume growth is expected to be modest in the first quarter.

Capital Expenditure

Capital expenditure was US$101.9m in FY17m with around US$62m relating to maintenance expenditure and the balance for capacity additions. Management has guided to maintenance capital expenditure of US$100m per year over FY18-20.

The company has flagged investment in a new plant in Tacoma will feature in FY18 and another in Alabama will also account for a significant portion of growth capital expenditure in coming years.

Macquarie notes the elevated maintenance expenditure is designed to catch up with higher operating rates from the plants over the last three years. This expenditure should now taper off while increased expenditure in infrastructure is principally aimed at safety improvements.

UBS continues to envisage a further one or two quarters of execution risks around plant performance before returning to the upper end of management's guidance. The broker likes the stock for its exposure to the recovery in US housing and the structural growth that fibre cement provides in the wood-look siding market.

Margin Outlook

For the first time since the June quarter of FY13, Ord Minnett observes operating earnings for North American fibre cement came in with margins below the bottom end of management's 20-25% target range.

The weakness was attributed to a decision to skip price increases, along with issues from plant performance and start-up costs. Freight inefficiencies were once again blamed for higher unit costs but brokers expect this should abate once the plant network is optimised.

Citi deems the company's impressive reputation has been accompanied by irrational optimism, as consensus normalises US margins for operating issues. The broker believes this has led to estimates that do not reflect the company's corporate maturity. The broker expects ongoing investment of gross margin to bring safety standards, governance and corporate infrastructure in line with ASX50 peers.

The broker also suspects investor expectations of long-term North American operating earnings margins beyond the top of the company's targeted range have been responsible for a sustained price/earnings multiple of 22x since the housing recovery began in 2012, and a more modest mid-cycle peer multiple may be more appropriate.

UBS reduces FY18 net profit estimates by -9% following the revelation about plant start-up costs and continued investment in maintenance. The broker's forecasts imply an operating earnings margin for the North American fibre cement business of 22%, with the outcome dependent on the company returning to more normal investment costs in the second half of FY18.

Deutsche Bank also reduces margin expectations for FY18 to 23% from 27%. The broker agrees costs are likely to main above historical levels because of the medium term investment required in infrastructure and annual capacity expansions that are required to support market demand.

The broker continues to believe the company will increase it share in the growing US siding market at margins at, or above, guidance range once current manufacturing issues are resolved.

Macquarie suspects North American headwinds are slowly easing and margins should trend higher as capacity pressure is resolved. In the context of higher capital expenditure going forward the broker does not envisage any prospect for capital management in the short term.

There are four Buy recommendations on FNArena's database and three Hold. The consensus target is $20.98, suggesting 5.9% upside to the last share price. Targets range from $18.70 (Ord Minnett) to $22.54.
 

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