Housing – A Bright Spot, But Not Enough on Its Own

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Graham Copley

203.901.1629

graham@sector-sovereign.com

July 10th, 2012

Housing – A Bright Spot, But Not Enough on Its Own

  • There is more attention on housing today, as homebuilders post significant permitting increases and both demand and pricing are showing signs of life, as are the stocks – Exhibit 1. The sector touches all of our segments, but outside Building Materials, Chemicals and Electrical Equipment more than others. Valuation today suggests that Electrical Equipment and Coatings are discounting a better future, but that Commodity Chemicals is not, and all things being equal would be the more levered way to play a housing recovery.
  • We introduce a Building Materials index, but given the swings of the last 5 years, the historic statistical analysis is not as robust as for other sectors. The sector looks very expensive today and discounts a return to profitability seen prior to the crisis – we think this unlikely on new housing alone and we would need to see significant stimulus driven infrastructure investment to get comfortable with Building Materials current values.
  • Almost all of the companies with housing exposure are either too expensive on our valuation screen or too levered to other issues to be “risk free” options for housing exposure today. Those that screen as inexpensive and also have meaningful new home exposure are HUN, OLN, BGC and SWK. All have exposure to other sectors and to Europe.

Exhibit 1

Source: Capital IQ, and SSR Analysis

  • Setting aside the risk of a global slowdown, in which case we would not want to own anything today (with the exception of a relative opportunity in Metals) we would rather play housing through the cheaper Commodity Chemical names rather than the already expensive Building Material companies.
  • To justify values in the Building Materials sector we would need to see major infrastructure investment in the US in addition to a housing recovery. This is a post-election possibility, but again there are much cheaper ways to play this – through Metals and Mining and through E&C.
  • Our valuation work shows a very wide spread of expectations priced into industrial sectors that are by and large influenced by the same trends. Those who are focused on minimizing the risk by owning the housing “safe bets” are most likely missing the real opportunity and, additionally, face the largest relative downside if everything stalls.

Exhibit 2

Expensive

Cheap

Source: Capital IQ, and SSR Analysis

Overview

US housing starts have languished near a 50+ year low since the end of 2008 and while we have clearly bounced off the bottom, we are currently building houses at a third of the rate that we were at the peak of 2007 and at peaks in the early 1980s, 1970s and 1960s. The peak rates seen from 2000 to 2007 were unsustainably high and well above the rate of incremental family formation, but it is widely accepted consensus that the current rate (around 720,000 new homes per year) is below the rate of new family formation. The generally accepted view is that housing starts have to go up from the current level; the debate takes place around when and by how much. Over the last few weeks we have seen significant positive news – orders higher – some inventory shortages both on the new home front and on the existing home front, and more positive press than we have seen in a while.

However, the analysis is complicated; we have a surplus of new homes that need to be sold; we have existing home owners that would put houses on the market if we saw a recovery in prices; we have very different lending standards than we had in 2007, reducing the available annual pool of new buyers (with both a cyclical and a permanent component to that reduction); and, we have changed sentiment – perhaps it is not every American’s dream to own a house anymore – perhaps renting is fine for many more than before. AND…. real income is down and unemployment is high; without much stronger economic growth and job creation, perhaps the current rate of new home builds, or something slightly higher, is the “new normal”.

The Industrials and Basic Industries sectors are levered to new homes, whether it is as a supplier of raw materials, or as a supplier of pre-formed components, or as a supplier of the machinery and tools needed to build the houses. Furthermore, as housing starts increase, rail freight should rise and trucking volumes should increase. It is hard to see much leverage in Industrial Gases and E&C, but everyone else is in there somewhere.

The most exposed sectors in aggregate in our historic coverage are Electrical Equipment and Chemicals, and in other sectors exposure is focused in a more limited sub-set of companies where in some cases the leverage is significant. In this report we are introducing a “Building Materials Index” and not surprisingly this group has by far the greatest exposure. This is less robust than many of our other indices as the number of representative companies is small and all have had substantial financial problems, both recently and at other times in the past. The sector is not cheap and is discounting a substantial recovery in volumes and profits that probably cannot be satisfied by a recovery in housing alone. Aggregate exposure by sector is summarized in Exhibit 3

Exhibit 3

Source: Company Reports and SSR Estimates

The homebuilders themselves have adapted – terrible conditions in 2008 and 2009 resulted in write downs and restructuring – a great deal of it around land inventory and the reduced value of that land. Today the average new home in the US costs 40% less to build than it did in 2007, though much of that reduction is land value. However, homebuilders have improved processes, increased standardization and made some changes in material usage. They have also used the weaker demand environment to strike better deals with their suppliers. Returns have improved faster than housing as a consequence – Exhibit 4. Surprisingly the average new home size in the US has continued to increase, despite the more troubling lending and employment environment.

Exhibit 4

Source: Capital IQ and SSR Analysis

Looking at valuation there are a few points of interest, not least of which are the very high multiples of the Building Material companies themselves. These stocks are discounting a significant recovery in returns on capital – back to the levels seen pre-crisis. We think that this is unlikely to be achieved through new housing alone as it would require new build rates to return to levels above 2 million per year. To justify the current values in Building Materials we believe that there would need to be a significant step up in infrastructure spending in addition to housing.

The Coating industry is trading at all time high multiples and is discounting the idea that things are going to improve further, from already very high earnings and returns on capital. The Electrical Equipment space looks similar – new housing or other factors will have to accelerate meaningfully to drive the earnings that justify these values. The more PVC/material focused chemical companies are trading more on their exposure to natural gas and on cyclical concerns, rather than on their exposure to US housing. Some of the tool/machinery stocks that have housing leverage are quite undervalued today, having been dragged down by the general cyclical move out of the Capital Goods space.

In Exhibit 5 we show companies that screen cheaply on our mid-cycle (normalized) framework and those that have more than 5% of their estimated business driven by US housing. We have also highlighted those that have very limited exposure to Europe –
see our note dated June 25th
. We have not included the Building Materials companies in the table – they all have significant exposure to housing; they have minimal exposure to Europe and they are all expensive. The table shows that there are no stocks that appear in all three categories and it only shows a few of stocks that screen as very cheap and that also have meaningful housing exposure, HUN, BGC, OLN and SWK.

Exhibit 5

Source: Capital IQ, Company Reports and Presentations and SSR Analysis

What’s In A House

The average US new home is 2500 square feet and contains the following:

  • 55 cubic yards of concrete
  • 4.3 miles of electrical and other cable
  • 8,500 square feet of sheetrock
  • 4,800 square feet of lumber and plywood
  • 4,800 square feet of insulation
  • 4,000 square feet of siding
  • 2,700 square feet of glass in 20 windows
  • $5,000 of household appliances
  • 112 gallons of paint and primer.
  • 300 ft of PVC pipe and 150 ft of PVC guttering and downpipes.

In addition there is molding, landscaping, fencing, roofing, cabinets, bathroom hardware and others. The average material cost for a new home, not including labor, is around $94k. The average cost of construction including labor is close to $176k, and the costs break down as illustrated in Exhibit 6.

Exhibit 6

Source: NAHB

There is variation by region: new houses in the Northeast tend to be larger than in other regions, though not by much – Exhibit 7

Exhibit 7

Source; NAHB

The average cost of construction has fallen in the last couple of years, but not unexpectedly rose steadily until 2009 – Exhibit 8. Cost components that have fallen since 2009 include; framing, roofing, siding, drywall, tiles and carpet and trim material. Not surprisingly these are all components with a significant raw material component and with demand falling, suppliers have had limited pricing power. As housing demand increases it is possible that some of these lower costs will reverse. However, peak housing demand in the 2005 to 2007 period likely resulted in peak pricing for some raw materials and we would not expect to see housing recover to those levels at any point in the near or medium term future.

Exhibit 8

Source: NAHB

Exposure By Segment

We look at the four most levered sectors in more detail – Building Materials, Chemicals, Capital Goods and Electrical Equipment.

Building Products

As expected, this is the most exposed sector to New Home starts. The publicly traded companies make up a small proportion of the overall supply and our index components only have a combined market cap of $17 billion – the components are summarized in Exhibit 9 with an estimate of their new home exposure.

Exhibit 9

Source: Company Reports and Presentations and SSR Estimates

This group was hit very hard by the financial crisis and returns on capital were negative in all but a few months from early 2008 until mid-2011. Most companies are currently at or below break-even from a net income and EPS perspective. Like many others, this group had a pronounced negative trend to its return on capital trend, as shown in Exhibit 10. The step change in 2007 and 2008 is very clear and the obvious question is whether or not the sector can get back to the original trend line. In our analysis of normal value we have assumed that normal returns flatten out at around 5-6%, depending on the company. We do not think that this is conservative based on housing, as we do not see the housing start numbers from the period 2000 to 2007 as “normal”. If we assume 1m new homes may be closer to the new normal, these ROC targets are probably appropriate.

Exhibit 10

Source: Capital IQ and SSR Analysis

However, these more conservative ROC projections still result in an analysis that shows the group to be quite expensive today, after significant outperformance in June. At almost one standard deviation expensive, the group is discounting an expectation than ROC will rise well above our new “normal”. New home builds in the US are not going to do this alone: as shown in Exhibit 9, while new home exposure is high, it is not high enough. Current values are discounting some combination of new home increases and infrastructure spending increases. This group is more exposed to infrastructure spending than it is to new home builds, and it is likely that valuations have remained high post 2007 as much in anticipation of a stimulus lead infrastructure spend as in anticipation of a rebound in housing. Valuation is summarized in Exhibit 11.

Exhibit 11

Source: Capital IQ and SSR Analysis

If we then look at how the sector sits within our Skepticism framework, we have a negative SSRSI. The only other broad sector that shows this today is Transports. The Index has been much lower in recent months and as predicted in the stock prices, ROCs have improved. However, our analysis suggests that you should be cautious of any group where the stock appears in the bottom left corner of the left hand chart in Exhibit 12.

Exhibit 12

Source: Capital IQ and SSR Analysis

Chemicals

The Chemical Sector has significant exposure to housing both as a direct supplier of materials and as a supplier to intermediaries that ultimately sell on to housing. Plastics (structural as well as wire and cable), adhesives, paint and paint intermediaries, polyurethanes and other insulation products drive most of the exposure. The American Chemistry Council suggests that as much as 17% of new home construction materials are chemicals and plastics by value. This does not include carpet, which is 60+% chemicals by value, and laminated flooring which is more than 70%.

If the average house in the US has $94k of materials and we build 750k new homes a year today – the chemical value in new home construction is around $12 billion and would have been closer to $30bn at the peak.

The companies’ exposures break down as summarized in Exhibit 13. Given that a number of companies in our coverage group have zero exposure and are not shown below, we estimate that our overall chemical index has no more than 5% sales exposure to US new home builds. In aggregate a 50% increase in new home construction in the US would only have a 2.5% impact on sale to our group, but it would be as high as 15% for the most exposed and zero for the least. Incremental margins are high for most of these companies and the impact on earnings would be much higher than the impact on sales – roughly double on a percentage basis.

Exhibit 13

Source: Corporate Reports and SSR Estimates

Looking at valuation, and what appears to be priced into the sub-sectors, the largest proportional exposure is in coatings, but commodity chemicals, with its exposure to so many construction categories is not far behind. Moreover, an uptick in housing would provide incremental sales to coatings producers at already high incremental margins – which is good; for commodity chemicals it might tighten some supply/demand balances and drive pricing in addition to volume, which would be even better. Consequently the divide in valuation for the two groups looks strange in the context of housing exposure – Exhibit 14. Despite the degree of difference there is still not enough of a relative discount in Commodity Chemicals today to suggest that investors should buy the sector regardless – there is still plenty of downside here if the economy falters further, which would be our base case.

Note: There is a big difference between exposure to housing and exposure to new homes. The coatings companies have much higher exposure to exiting home upgrades and redecoration than they do to new homes. Insulation tends to be more of a new home exposure as does PVC, glass and wire and cable.

Exhibit 14

Source: Capital IQ and SSR Analysis

Capital Goods

The exposure to New Homes in Capital Goods is not nearly as broad as it is for chemicals, though it falls into many categories. In addition to lot and subdivision preparation equipment (i.e. heavy machinery), there are tools and HVAC. Stanley (SWK) has the greatest exposure, particularly if any significant pick up in housing triggered a confidence inspired replacement cycle in addition to the more linear relationship of more people employed in the business. A similarly induced replacement cycle in heavy equipment would help CAT and DE, with DE proportionally a little more exposed than CAT.

Exhibit 15

Source: Corporate Reports and SSR Estimates

Electrical Equipment

This sector generally has new home exposure at the low end – more commodity end – of its product base, but it is significant nonetheless. One or two of the companies in our group have no real exposure and we estimate that the overall US new home exposure for the group is around 6-7%, higher than the chemical space, but a part of that difference is higher proportional chemical sales outside the US. As a percent of US sales, we estimate that Chemicals and electrical equipment are similar at around 8%.

Exhibit 16

Source: Corporate Reports and SSR Estimates

We would like to thank Michael D’Amico for his help gathering the housing and construction data for this report and helping us understand how the industry works.  Michael is an intern at SSR this summer and will be returning to Bucknell in the fall to finish his undergraduate degree in Finance and Economics.   

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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