Description

Fortune Brands (FBHS) is a best in class building products manufacturer with strong brands and pricing power. Given the macro environment and rate hikes from the Fed, the home builder and building products sectors have declined significantly. FBHS is the baby being thrown out with the bath water. We believe an investment at these levels will yield an attractive IRR even if you assume a recession/housing market drop in 2023 and don’t give the company credit for their medium-term margin targets.

Business Overview

FBHS is a leading manufacturer of home and security products. The company currently operates 3 segments that focus on (1) plumbing fixtures, (2) cabinets, and (3) doors, decking and security products. FBHS’ brands have leading market share and include well-known names including Moen, Therma-Tru, Master Lock and Fiberon. The company sells its products through various channels including US big box home centers (30%), dealer & specialty retailers (25%), wholesale (25%) and builder direct (4%). The remaining 16% represents FBHS’ international business. Within the North America residential market, FBHS is 65% repair & remodel (R&R), which tends to be more stable and less cyclical, and 35% new construction (NC).

FBHS operates three segments:

• Water Innovation (36% of 2021 sales and 52% of 2021 Pre-Corporate Adj EBIT) -- Manufactures or assembles and sells faucets, accessories, kitchen sinks and waste disposals, predominantly under the Moen, ROHL, Riobel, Victoria+Albert, Perrin & Rowe and Shaws brands. ~32% of 2021 net sales were to international markets. The largest international market is China, which is about 20% of segment sales. Home Depot and Lowes represent ~21% of segment sales. Within the NA business, Water innovation is 60% - 70% R&R and 30% - 40% NC
• Outdoors & Security (27% of sales and 25% of Pre-Corporate Adj EBIT) -- Manufactures and sells fiberglass and steel entry doors under the Therma-Tru brand, storm and security doors under the Larson brand, composite decking, railing and cladding under the Fiberon brand, locks, safety & security devices, and electronic security products under the Master Lock and SentrySafe brands. Home Depot and Lowes represent ~30% of segment sales.
• Cabinets (37% of sales and 23% of Pre-Corporate Adj EBIT) -- Manufactures and sells a range of products including kitchen cabinets, bathroom cabinets, and organizational solutions under the MasterBrand portfolio (AOK, Diamond Brands, KitchenCraft, Homecrest, Omega and EVE). Home Depot and Lowes represent ~39% of segment sales. FBHS is currently in the process of spinning this business off into a separate publicly traded company.

Investment Thesis

FBHS is leading market player with strong brands, scale and pricing power in end markets with oligopolistic structures

Moen, Therma-Tru, Master Lock and MasterBrand all have the #1 market share positions in their respected categories. Fiberon is #3 in the composite decking space (#2 player in both the composite and PVC decking end markets).

FBHS top brands all operate in markets where the top 3 players make up more than 50% of the market share. Pricing power of the brands has allowed for margin consistency over time, even during extreme environments where inflation was high.

Brands matter to large retail customer like Home Depot and Lowes. For plumbing products, the retail channel will reserve 70% of their shelf space for brands vs other private label offerings. Moen’s investments in innovation and reputation as the #1 rated customer service differentiates the brand vs competitors. If you can provide good service, answer questions quickly and get orders filled, retail and builder customers will choose you over other brands.

The decking industry has historically not taken price and achieved margin expansion through operational efficiencies. This also means that prices have historically never declined, even during the GFC when utilization rates reached 30% levels.

70% of FBHS sales are through trade channels (builder / dealer), where it is a more fragmented environment (relative to home centers) and FBHS has more leverage over these customers here and is able to pass through pricing more easily vs the retail channel.

During covid and the subsequent high inflationary environment, FBHS was able to quickly pass-through pricing to offset cost, labor and freight headwinds, allowing all segments to maintain margins. Since 2020, FBHS will have taken an estimated $1.4B of price to offset ~$1.0B of cost inflation.

Constructive long-term tailwinds for NC spending and select products within the Outdoor & Securities segment

35% of FBHS’ NA residential exposure is to new construction. The US housing market is estimated to be underbuilt by 3 to 5 million homes . Given the severe undersupply of new homes relative to demand (household formations) and the fact that home vacancies are near all-time lows since the 1970s, the only solution to the housing shortage is to build new housing units which will benefit FBHS’s business.

FBHS’ Outdoor & Securities segment participates in the exterior door and composite/PVC decking end markets, both of which should benefit from secular tailwinds. Within the exterior door market, fiberglass doors continue to take share from steel doors and grows at 2x the rate of steel and 6x wooden doors. Composite & PVC recycled plastic decking is taking share from wood-based decking in the USA. Currently, 25% of all linear decking feet sold is composite & PVC, and the industry forecasts this to get to 50% over the next 10 to 15 years.

The other 65% of FBHS’ NA residential business is tied to R&R, which is less cyclical and more stable compared to new construction. We believe there is a misplaced concern that lower mobility will lead to lower R&R spend, given R&R spend has been much higher in recent history for movers versus non-movers. R&R spend has been tied to moves historically due to convenience and move frequency. However, the historical correlation will decline as homeowners stay in the same homes for longer (as many are locked into lower rates vs current rates) as the homes age, breakdown, require maintenance and improvement.

Since the 1960’s, there have been a few moments in time when the number of existing home sales declined while the 10-year rate (proxy for mortgage rates) increased. The period 1978 – 1981 is most similar to today’s environment given declining existing home sales and rising interest rates. During this period, nominal R&R spend grew 23.7% and declined ~11% (adjusted for inflation) cumulatively despite a nearly 50% drop in existing home sales.  This history would suggest that a reversal in R&R spending in the near term may not be as severe as feared by the markets.

FBHS’ valuation is disrupted due to concerns around a GFC-like housing downturn and the cabinet business spin-off overhang

On average, building products companies’ PE multiples have dropped 35% - 50% YTD. FBHS stock price has been dragged down along with the entire building products sector, driven by concerns around a GFC-like housing downturn given rising rates, declining affordability and high inflation.

Leading up the GFC, PE multiples for MAS dropped 17% and MHK dropped 30% from peak to trough, albeit earnings declined significantly as well.

There are several factors today that suggest a GFC-like housing downturn is unlikely:

• US is short several million housing units today versus being overbuilt by millions of units going into the GFC
• Home vacancy rates are near the lows of the 1970s versus during the GFC when they were near the highs given speculative ownership and buying of homes
• Rent vs buy was severely imbalanced in GFC where the cost of ownership was nearly double that of renting versus being at a much smaller premium today
• Unlikely to see as much selling pressure today vs the GFC because 90%+ of mortgages today are 20 -30 year fixed rate compared to ~50% during the GFC
  • Underwriting standards were extremely loose prior to the GFC with Alt-A, Option ARMs and other riskier mortgages the norm to help purchase increasingly expensive homes that people could not afford. The average loan-to-value system-wide was much higher at 57% versus 27% today

On April 2022, FBHS announced the spin-off of its cabinets division. Corporate spin-offs usually create an overhang due to the event uncertainty this creates until the event is completed. The new FBHS entity is viewed as the more attractive asset with better growth and margins compared to the Cabinets spin-co. As a result, existing and new investors may be waiting on the sidelines for more clarity around the separation before getting back into the stock.

Margin expansion opportunity for the Cabinets and Outdoor & Security segment

April 2021, FBHS released their 2020 – 2023 medium term outlook for growth and operating margin targets for each segment. We do not give FBHS full credit for achieving these targets and still get to attractive IRRs.

Water Innovation / Plumbing margin is currently above the 22% medium term target. The company expects brand and innovation to continue to drive/maintain margins

Outdoors & Security margins are currently ~15% vs medium term target of 17% - 19%. Recent acquisitions, including Fiberon and Larson, have margins below the segment average. Fiberon margins will expand as they move up the price spectrum (to mid-tier/premium) and expand their channels outside of wholesale. Larson margins will expand as they get fully integrated into the Therma-Tru business, which has margins above the segment average.

Cabinet margins are currently ~10% vs medium term target of 14%. Margin expansion will be driven by operational excellence and footprint rationalization.

Catalyst

Completion of Cabinet spin-off

Core operating performance