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.
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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