Patience Still Required For James Hardie
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Higher costs still feature for James Hardie's ((JHX)) North American fibre cement business. The company delivered first quarter net profit of US$61.7m and both volumes and margins fell short of expectations.
Brokers are somewhat comforted that margins appear to be on a path to recovery but remain cautious about the company's performance, with several stating they prefer to await further evidence before before taking a more positive stance.
The main disappointment for Ord Minnett was the volume growth in North America, as capacity constraints compromised the service. Furthermore, management suggests the second quarter volumes could also be underwhelming.
The broker assumes the share price will recover in the second half, although growth in FY18 as a whole should struggle to exceed the market index. This is at odds with management's 6-8% primary demand growth (PDG) target and medium-term assumptions.
The decline in first quarter margins in North America was attributed to higher production costs, only offset somewhat by higher prices. Management suggests manufacturing performance is showing signs of promise and unit costs are improving. Ord Minnett expects margins to improve through FY18, resulting in a full year outcome of 22.5%.
Credit Suisse concedes it was a tough year. The broker counts up four solid profit downgrades, which have tested the patience of some of the shareholders and, for a stock that more prides itself on manufacturing excellence, the recent performance warrants a de-rating of the multiple. Nevertheless, Credit Suisse advises not to throw the baby out with the bathwater. The company is about the long-term game.
Volume growth in market penetration will ultimately drive value. While near-term margin issues should not be ignored, the broker asserts these have little impact on the net present value, because costs can easily be optimised as a company gets closer to terminal market share.
The company had previously foreshadowed a relatively weak first quarter margin in North America but has confirmed that month-on-month unit costs are falling, so the trend is positive, and, as usual, North American earnings margins should improve as the year progresses.
Credit Suisse agrees margins should sit around the 22.5% range. The company is also past the peak start-up in terms of its plant, although this is running below capacity until inefficiencies are completely ironed out.
The broker does not doubt that the company incurred some damage to its reputation FY17, as it was unable to meet market demand and customers in certain regions turned to competitors. In context, 95-97% of those customers have returned to the business now that inventory is sufficient to meet demand, according to management.
Citi found volume growth of 2.4% disappointing in North America against system growth of 6.7%, which implies negative PDG of -4.3% and the soft order book that management flagged suggests that risks exist to top-line growth through the balance of FY18.
Credit Suisse defends the company's explanation of a soft order book, noting Texas had been particularly weak and some of competitors are also reporting the renovations market was down -4% over the past quarter. Such conditions are largely out of management's control and the broker remains confident the growth trajectory will turn positive.
Macquarie ascertains that, while US margins showed little improvement, the plant is stabilising and that is now driving an improvement in the unit cost of manufacturing. The broker believes, following product outages, that the company does have work to do to lift service levels but its competitive capability does not appear fundamentally impaired. Macquarie takes a more cautious approach to margins in FY19 and continues to believe the investment case has merit at current levels.
Citi believes capital expenditure will accelerate dramatically and remain elevated throughout FY19 and FY20. The broker asserts this is necessary to meet PDG targets, but negative free cash flow yield in FY18, and a continuation of a poor performance on this front in FY19-20, could trigger a de-rating of the valuation multiple premium.
Given forecast quarterly average capital expenditure more than doubles through the balance of FY18 and remains elevated, Citi queries whether this can be managed without a drag on margins, notwithstanding the impact to free cash flow.
All up, the broker believes the focus on the price/earnings ratio and the enterprise value/operating earnings multiples ignores the poor free cash flow forecasts for the next three years and the disappointing net profit growth experienced over the last few years, given the company's inability to fully participate in the US housing recovery. Hence, a Sell rating is maintained.
UBS is more upbeat, albeit disappointed with North American volume growth. The broker reduces profit forecast by -2% in FY18 to reflect this but retains an expected operating earnings (EBIT) margin of 22%, although expects the company to only achieve the top end of its target range as it exits the fourth quarter of FY18.
Manufacturing performance appears to have turned the corner and the broker notes a material lift in inventory in the period suggests the company should be in a better position to use its sales efforts in coming quarters. Hence, UBS is not concerned about PDG or market penetration.
The broker does not believe current trading levels in the stock are warranted on a medium-term view, despite the underperformance in North American fibre cement earnings, and expects the company will deliver as the housing cycle continues to recover.
Deutsche Bank agrees the significant manufacturing cost impost should start to unwind and drive improved earnings. The broker continues to rate the stock a Buy, given the potential upside to the current share price, US market growth, a robust balance sheet and a re-invigorated management team.
There are four Buy, two Hold and one Sell (Citi) on FNArena's database. The consensus target is $19.89, suggesting 12.8% upside to the last share price. Targets range from $16.00 (Citi) to $22.50 (UBS).
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