Sell-Off In James Hardie Undeserved

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

North American earnings dented James Hardie's performance in the second quarter as cost pressures were elevated. Brokers believe the sell-off in the stock presents a buying opportunity.

-Cost pressures considered cyclical, not structural
-Challenges from softer US housing activity making it hard to predict volumes
-Stock seen as a compelling buying opportunity
 

By Eva Brocklehurst

The Asia-Pacific region delivered for James Hardie ((JHX)) in the second quarter and Europe was in line, but a substantial miss on US expectations drove the stock down sharply. North American earnings of US$99.5m were below most expectations. Production costs rose, driven by raw materials and freight, and this reduced gross profit margins by around 360 basis points.

FY19 net profit guidance has been lowered to US$280-320m, reduced by -6% at the mid point. Morgan Stanley considers the cost pressures cyclical rather than structural, but lowers FY19 forecast by -4% and ascertains the guidance range is conservative.

The broker considers the stock trading at an attractive multiple relative to both peers and to history. Cost pressures may be featuring now but should not be capitalised, and there is attractive earnings potential over the medium term. Credit Suisse expects margin pressure will peak, taking a 12-month view, while share momentum will build slowly.

Deutsche Bank found the outlook the most disappointing aspect of the report. Freight and input costs continue to pose challenges for the near term but the margin is expected to normalise as price growth is achieved. The broker rates the stock a Buy, as US housing growth is still likely to continue, albeit at a reduced pace. Primary demand growth is also expected to recover into FY20.

Yet UBS suspects price growth will not aid margins that much in coming quarters, and reduces margin forecasts to 22% for the second half of FY19, and 23.5% in FY20 from 24.8%.

The broker retains a Buy rating, based on long-term growth estimates, but concedes this will not be appreciated by the market in the near term. UBS believes James Hardie's ability to grow well in a softening market is now more difficult. Challenges from softer housing activity, as well as substitutes such as vinyl, are making it harder for the company to predict volume growth.

Progress continues to be made with Fermacell and the one-off costs for Europe are now at the lower end of prior guidance. Going forward, management expects the European business to have margins of over 10%.

Asia-Pacific results were also strong, as FX headwinds were overcome. Moreover, the impact of manufacturing initiatives are clearly evident, Macquarie asserts. Ord Minnett points to the Australian business recording AUD-denominated revenue growth of 16%.

North America

The North American performance was most disappointing, as input cost increases resulted in a compressed gross margin. These pressures appear likely to continue, in Macquarie's view, with part of the downgrade reflecting expectations that inflation will now persist, whereas previously James Hardie expected pulp and other input costs would ease.

Several aspects disrupted US housing market sentiment over the quarter including weather, the US elections and rising interest rates. While the company had targeted volume growth of 10-11% in the second quarter it fell short at 8%, which is still respectable in Citi's opinion.

The broker calculates primary demand growth accelerated to 3-4%, while James Hardie has retained an assumption for FY19 housing starts of between 1.2-1.3m. Still, given the weaker performance the company has trimmed earnings margin guidance to the "top half of the target 20-25% range" from "top end of the range". To Citi, this implies a stronger performance in the second half.

Macquarie believes investors over-reacted to the result, as the US market support is reasonable and market share growth is gradually accelerating. Volumes grew 5%, showing some acceleration in share gains in exteriors, which grew 8%.

The main surprise for Morgan Stanley in North American volumes was the -6% decline in interiors, which management attributed to quarterly fluctuations. Management expects this segment to rebound to achieve a flat outcome in FY19.

James Hardie has a well-defined strategy to continue gaining share in exteriors but Ord Minnett decides on a more conservative stance, expecting primary demand growth of 2.5% in FY19 and 3.0% in FY20.

Buying Opportunity

Citi agrees the sell-off is overdone. US housing markets may have hit a soft patch but momentum is recovering and margins should be restored in the second half. The stock is trading at three-year lows and the broker believes it has become a compelling opportunity.

Ord Minnett expects upside for margins in the medium term as progress is made on manufacturing and operating improvements. The broker believes the sell-off in the shares is opportunity to invest in a high-quality business at a time when external factors are pushing on sentiment. Morgan Stanley agrees this is an opportunity to buy a quality business at an attractive multiple.

FNArena's database is unanimous, with seven Buy ratings for James Hardie. The consensus target is $21.37, suggesting 26.8% upside to the last share price. This compares with $24.08 ahead of the results. Targets range from $20.00 (Deutsche Bank) to $23.40 (Macquarie).

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