Hardening up - James Hardie

Thursday 29th August 2019

Australian-listed shares of fibre-cement leader James Hardie Industries (ASX.JHX) surged 14.1% last Friday, after the company released its June quarter results announcement, showing adjusted net operating profit increasing 13% year-on-year to, US$90.2 million, on the back of a solid performance from the key North American business. It was an impressive result, given some headwinds faced during the period, and we view the investment case positively.

Strength in the US business, and some relative optimism for Australia, caught the market offside and saw strong bids come into the stock. Lower interest rates in the US and Australia are likely to provide some support for the housing market, both for new starts and for the renovation market, both of which should benefit demand for James Hardie’s products.

As the saying goes, one swallow does not make a summer, and this was just the first quarter of the fiscal year, but it was a strong start. Some of the pressure on input costs has been alleviated, compared to some previous quarters when input costs were mostly significantly higher. Cost out initiatives are ongoing and the company noted that the implementation of lean manufacturing in its North American plants was progressing well.

We believe lifting market share from current levels in the US is achievable but a lot of the low hanging fruit has been plucked. To increase market share materially, the company will have to expand its business into non-metro areas, and as we have noted in prior coverage, that has some challenges. These include lower population density, lower average income and home values, a fragmented installation industry and a relationship-driven culture in local markets.

Accordingly, James Hardie will utilise a more targeted sales strategy. While there are some headwinds to navigate, we continue to believe in the quality of the business and the long-term market opportunity. As last week’s positive share price action showed, the de-rating of the valuation multiples ascribed to James Hardie, over the past year or so, has lowered the bar for outperformance of the shares.

1Q20 headline numbers

For the three months ended 30 June, James Hardie’s group net sales inched up 1% to US$656.8 million, as volumes increased 2%. This was propelled by higher net sales in the North America business and Europe, partially offset by lower net sales in the Asia Pacific business.

Gross profit came in at US$233.1 million for the quarter representing an increase of 5%, as the gross margin expanded by 1.5 percentage points to 35.5%. Group selling and general and administrative (SG&A) expenses for the quarter decreased 3% to US$101.5 million, with this largely due to lower Fermacell (the recently acquired European business) transaction costs, partially offset by higher labour costs.

Statutory group earnings before interest and tax (EBIT) in the quarter of US$132.5 million was marginally higher than the US$131.9 million a year earlier. There was a significantly smaller asbestos adjustment in the June 2019 quarter compared to a year ago. Asbestos adjustments can be volatile and primarily reflect the non-cash foreign exchange re-measurement impact on asbestos related balance sheet items.

Interest expense was higher for the quarter, largely because of a higher interest rate on Euro denominated debt. Reported net operating profit of US$86.5 million reflected a decline of 5% year-on-year, driven by the movement in asbestos adjustment, partially offset by the positive underlying performance by the North America and Europe businesses.

Looking at adjusted figures, which are the more closely followed metrics and adjusted group EBIT increased 16% to US$124.4 million. The Europe and North America businesses chipped in a US$12.5 million and US$6.3 million increase respectively. Those increases were partially offset by a US$3.5 million decrease in EBIT from the Asia Pacific segment. Group adjusted net operating profit increasing 13% year-on-year to US$90.2 million, primarily because of the higher adjusted EBIT, partially offset by increases in tax and net interest expenses. Operating cash flow surged 30% to US$140.2 million.

In the key North America segment, sales volumes rose 4% in a “down market” while the average net sales price per unit inched up 1%. Exteriors volume grew 5% amid healthy demand growth, and more than offset a 3% decline in interiors volume, although that itself was a decent improvement compared to the four prior quarters.

Net sales in North America came in at US$452.3 million, up 4% and it generated EBIT of US$113.5 million representing a 6% year-on-year increase. The EBIT margin expanded by 0.4 points to 25.1%. The company expects to see “modest growth” in the US housing market in its fiscal 2020 year, with new construction starts of between approximately 1.2 million and 1.3 million. Its EBIT margin in that market is anticipated to be at the top end of its 20% to 25% target range.

Conditions in the Australian market are tougher, and this weighed on the Asia Pacific segment. Volume declined 3%, with a softening of the Australian market only partially offset by “strong domestic sales volumes” in the Philippines. In US$ terms, the average net sales price per unit was 5% lower, due to the strength of the American dollar, but in A$ terms it edged up 2%. Overall, net sales decreased 8% to US$108.0 million and EBIT fell 12% to US$24.8 million, as the EBIT margin contracted 1.2 points to 23.0%.

Looking ahead in Australia, and the company is expecting its addressable underlying market to experience “high single digit” percentage contraction over the fiscal year. However, it believes its net sales will outperform the broader market helping cushion the impact from the challenging conditions. We expect volumes to be firmer in the Philippines. The EBIT margin for the segment is anticipated to be in the top half of the 20-25% targeted range.

Even after the Fermacell acquisition, the Europe segment remains a modest contributor for now, although it is anticipated to become a more meaningful part of the group over the next decade. In 1Q20, EBIT from the segment swung from a loss of US$4.6 million a year earlier to a US$7.9 million profit. At 8.2%, the EBIT margin remains low with scope for improvement. Looking ahead the company will introduce new products. is expecting margins to grow and expects slight housing market growth in its addressable market.

James Hardie’s fibre-cement product should continue to win market share, with its niche outpacing the broader building materials market and management tweaking the sales strategy. A cost-out initiative should defend margins. The Fermacell acquisition will diversify the business and provide a growth platform in Europe, where previously James Hardie has had comparatively little traction.

Disclosure: Interests associated with Fat Prophets hold shares in James Hardie

Greg Smith is the Head of Research at investment research and funds management house Fat Prophets.

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