Fortune Brands originally was a roll up of diverse businesses undertaken by American Tobacco. Within Fortune Brands was a roll up of housing related businesses. They are not commodity businesses, but they are not fantastic franchises. The business has grown nicely over time and there has been a real shakeout in the industry with plant closures and downsizing. Due to the point in the housing cycle, there is a nice opportunity for the business to expand margins dramatically and grow sales from this point in time.
1. FBHS is a mixture of cyclical and noncyclical businesses tied to housing. The plumbing and security segments are steadily profitable, while cabinets and door & windows are steadily cash flow positive but exposed to more competitive pressures in a weak market. None of these are capital intensive and the businesses have not ground to a complete halt due to remodeling and repair.
2. The combined value of purchased businesses from 1999-present cost $2.3bn and in 1999 the business produced ~$300m in EBIT. At the right point in the cycle, FBHS and its stable of businesses will be worth substantially more. The business is cash flow positive and has ample interest coverage and ability to pay down debt. Even in the current depressed state, the plumbing business alone is today worth ~$8/share, 65% of the current share price despite amounting to$3,000m in revenue right now. I looked at operating margins going from 1988-2010 and the average was 13.45%, not including standalone SG&A. If you ignore the past decade of mega boom and mega bust, average operating margins from 1988-1999 were 15.36%. You can even discount normalized margins to the 10-11% range to account for stand-alone expenses and increasing leverage of home centers over time, but the business has been consistent over long stretches of time.
The extremes can illuminate driving forces, and when I looked at American Woodmark, the home centers (HD, Lowe’s) were clearly capturing all the pricing from demand growth during 2002-2006. What does this mean for FBHS? When I first started thinking about the effect of HD and Lowe’s on margins for housing related companies, I was worried. It was clearly an issue at AMWD. FBHS seems to be in a stronger position based on sustaining margins and abstractly based on its diverse product lines and distribution channels. Operating margins from 2002-2006 fluctuated between a range of 14.81% and 16.60%.
I was originally reluctant to use margins from the 1990s since home centers were not as dominant and manufacturers would have had more leverage over mom and pops (please correct this assumption if it is wrong, I was toting around my Batman lunchbox and wearing overalls during the 90s). I think the 1990s may offer a better depiction of margins since there wasn’t a bubble mentality. While it certainly doesn’t capture the entire competitive landscape, FBHS was able to maintain its historical margins from the 90s into the housing bubble. There is currently heavy promotional discounting in the cabinet segment, although this is an industry wide phenomenon that will likely prove transient.
Historical sales figures are only of moderate use since the business lines have expanded over time. Below is a table detailing acquisitions made by FBHS:
Simonton Windows (SBR)
In 1999, the company did $1,872m in revenue and $300m in operating income. In 2006 the company did $4,694m in revenue and $695 in operating income. The parent company was very acquisitive over this period. The total amount spent on acquisitions between 1999-2006 cost about as much as the current enterprise value and doesn’t even include a takeover value for the businesses that prior to 1999 were generating $300m in operating income.
If you factor in the $848m impairment taken in 2008 as reflecting fair value of the acquired assets (now worth $1,472m), the implication is the value of the pre-1999 business is $908m, 3x EBIT or ~8-9x earnings figuring $520m in debt @ 10% rates and 35% tax rates. I’m not sure how valuing an asset at a time of absolute pessimism reflects fair value and the same applies in a time of absolute optimism.
FBHS acquired a window company for $600m at the top of the housing bubble and paid $924m (>2x revenue) for a door manufacturer in 2003, which combined accounted for $753.3m of $848m impairment charge in 2008. Granted that looks dumb, but the normalized incremental sales growth that would have resulted is obscured. My point is that conceptually, revenue will not revert to the mean in an absolute sense. Slide 16 of the aforementioned presentation claims revenue has had a CAGR revenue growth rate of 4% organic and 9% total (9% is accurate, 1989-2010 had 9.24% CAGR per my data). Broadly, growth could outpace GDP since new housing construction creates a broader base of housing stock that gets repaired and remodeled.
I don’t know what revenue will look like exactly, but if they generate $4bn in revenue sometime in the next few years with 10% EBIT margins, 10% interest rates on $520m in debt, and a 35% tax rate, we’re looking at $226m in net income against a $1.9bn market cap. My expert guess is it will trade at more than 9x earnings when this occurs and that I’m low balling margins, revenue, and interest expenses. Management’s bullish scenario for a recovery to 1,500,000 housing starts is to do $5bn in revenue with 15% EBIT margins. I’m not particularly confident in management’s ability to achieve this as I am for the economy’s ability to achieve this simply through improving. Even if you figure 12% EBIT margins sometime in the next several years on $5bn in revenue with some of the debt repaid, it currently trades at a mid single digit PE multiple.
It’s not that easy though, because the business has to survive and it has to be capable of holding off competition for at least the next several years. The $520m in debt is broken down into a $350m term loan, $150m revolver, and $20m industrial bonds. In the first half of 2011, operating income at the FBHS segment of Fortune was $70m. Even if interest rates were actually 10% like I treat them, there is 3x coverage based on annualized EBIT. Using FCF as a metric for debt repayment ability, the business could be debt free within 3-4 years. The actual debt terms are:
“Interest on the Term Loan and the Revolver will accrue at the Adjusted LIBO Rate (as defined in the Credit Agreement) for the interest period plus a margin of between 1.0% and 2.0%, depending on the Company's leverage ratio as of its most recently ended fiscal quarter. The maturity date for the Revolver is the earlier of the fifth anniversary of the funding date and December 15, 2016. The maturity date of the Term Loan is the fifth anniversary of the funding date. The Term Loan must be repaid in installments on each anniversary of the funding date. The amount of the required amortization is five percent (5%) of the initial principal amount of the Term Loan on the first anniversary of the funding date, ten percent (10%) of the initial principal amount of the Term Loan on each of the second, third, and fourth anniversaries of the funding date and the remaining principal amount of the Term Loan on the final maturity date of the Term Loan.”
So LIBOR plus 200 is an interest rate of 2.38% as of 10/12/11 (I assume 3 month LIBOR). On $520m in debt, that is just $12m in interest annually. I use $50m because I’m lazy, figure why not, and assume managements can always find ways to spend money they don’t need to. So actual interest cover (EBIT/Interest) is 10x+, which is a nice cushion considering EBIT is very low. Repayment rates are also much below annual cash flow and the business can generate FCF well in excess of the $350m necessary to pay back the principal on the term loan.
If you look at each segment of the business, you can see that some of the product lines are less cyclical than others (not previously disclosed until Form 10 for spin, but I suspect the superior performance of plumbing and security have been fairly constant over the years).
Windows & Doors
Windows & Doors
The plumbing and security segments held up well (write down in security segment included in operating income). Margins in the plumbing business remained robust. This is probably the jewel of the company since replacing a faucet is a necessity if it breaks as well as something that can be replaced without redoing an entire bathroom or kitchen. If you carve it out and assume the other divisions cover interest and corporate expenses, the plumbing business alone could be worth $1.3bn assuming 35% taxes and 15x 2010 earnings ($86m).
On the downside, the company has discretion in capital expenditures has produced free cash flow even through the recession. I recalculated earnings based on EBIT since historical results include related party interest, which is just one way to transfer earnings to the parent, and just used a flat $50m interest expense and 35% tax rate. In 2010, FCF was $137m based on that calculation. From 1999-2003, capital expenditures outpaced D&A charges, but in every other year going back to 1989 the opposite was the case. Historical Fortune Brands filings do not break out the details for capital expenditures beyond their allocation to a segment. There is a high probability that the higher capital expenditures during 1999-2003 were related to growth and not maintenance.
One of the biggest issues in the housing sector is customer concentration. The home centers category is basically Home Depot and Lowe’s. There is potential that this figure is understated since the international channel is basically Canada (12 of 17 points) where Home Depot and Lowe’s have a presence. Not selling to them would be like Coke or P&G products not being sold in Walmart. As demonstrated with American Woodmark’s results, Home Depot and Lowe’s are very capable of throwing their weight around. Below is the breakdown of FBHS’s revenue by channel:
Percentage of 2010 Sales
Mass Merchant and Other Retail
Home Centers do not dominate sales, although they are major customers. There has been promotional activity in cabinets in the past year mentioned by FBHS and AMWD. Historically, FBHS has maintained their operating margins in a normalized environment where as AMWD saw compression throughout the housing expansion due to excessive dependence on two customers.
The plumbing and security segments are not as dependent on housing starts as the doors & windows and cabinets segments. In the context of a weak economy as well, plumbing and security are less likely to be deferred. Anyone could last several years with ugly or worn out cabinets or doors, where as most people use their faucets or lock things up daily. Total revenue dropped 36% from peak to through (2006-2009), where as housing starts fell 65% during the same period and a broader recession occurred. Is the business steady? No. But it is not exclusively dependent on new home construction and therefore is capable of generating profits even if housing doesn’t return immediately upon purchase.
In the Form 10, FBHS reveals what percentage of sales by division comes from Home Depot and Lowe’s. The cabinet, plumbing, and window & door segments got 24%, 30%, and 22% of their sales, respectively, in 2010 from Lowe’s and Home Depot combined. The smallest division, security, doesn’t have a number attached to it for how much revenue is generated from Lowe’s or Home Depot. So I think that the home center share of 26% is probably accurate.
The long-term growth rate of the business, both organically and through acquisitions, has been positive 4% and 9% CAGR respectively. Going back through Fortune 10-Ks, increased sales in the division that is now FBHS were consistent. In many years, at least part of this growth is attributed to line extensions and new products. While it may require additional manufacturing lines or other additional capital goods, bending metal pipes in more modern designs or updating the materials or finishes used in cabinets, doors, or windows don’t not require massive spending.
In 2010, Master Lock and Moen each got more than 25% of their sales from international markets. Both are portions of the security and plumbing divisions respectively, although meaningful portions. Moen has show rooms in China, South America and recently opened one up in India. Moen is probably trying to appeal to class conscious Chinese. I’m not particularly opinionated about the subject of business expansion into China. Faucet technology isn’t the source of competitive advantage, although that makes it all the easier to knock off.
There are numerous embryonic expansion plans for different areas around the world. Perhaps this will be paid more attention, as an incremental $50m in revenue is a lot more meaningful to a company the size of FBHS than it was as a division of a conglomerate.
Moen has a good reputation, which I believe is a driving factor in purchases of plumbing products. Here and here on Consumerist.com, the online presence for Consumer Reports, are very positive reviews for customer service. I consider this to a relatively reputable unbiased site for consumer feedback. The manufacture of a quality product with some pricing power is borne out by steady operating margins and sales in the plumbing division, but support in the form of customer service is comforting. People want products that they know (or at least think) will last several years, minimized a 10% price differential or competition from private label options.
The two major cabinet manufacturers in the US are Masco and FBHS. FBHS claims to have the #1 position in kitchen & bath cabinetry with $1,189m in 2010 revenue vs. Masco’s $1,464m in 2010 revenue from its “cabinets and related products” segment which also includes storage and home entertainment cabinets. FBHS also claims to have the #1 faucet brand in the US, although plumbing revenue lags Masco (Delta, among other brands). While Masco’s revenue is greater, FBHS has performed much better with operating margins and maintain sales:
Other competitors in the plumbing field include Pfister, which is hidden within a segment of Stanley Black & Decker, and American Standard, which is currently owned by private equity. What is interesting about the cabinet numbers is they are not driven by major write-downs, but restructuring at both companies. In 2008, Masco’s cabinet division took a $59m impairment charge in the cabinet division, but was still profitable. Masco’s cabinet division negative operating income in 2009 is just reflective of poor performance. In 2010, they had several charges in the cabinet division related to closing plants, product lines, and integrating some divisions totaling $171m pretax, so the division had negative cash flow. They closed down a product line that generated $200m in sales in 2009, which indicates how poorly the business is doing. They expect another $35m in charges in 2011 related to restructurings started in 2010.
The FBHS cabinet division has somehow spectacularly outperformed, at least in part due to restructuring starting in 2006. From 2006-2010, total restructuring charges at FBHS amounted to $166m spread over all divisions, reducing manufacturing plants and employees by 40%. This pales in comparison to the havoc going on at Masco, and is at least a relatively (literal sense) reassuring sign about management at FBHS. Masco is retreating from product lines while FBHS is plowing ahead. FBHS has also had much more consistent profitability with its plumbing division.
FBHS took its asset impairment bath in 2008 for $848m, but this was related to doors & windows and security. The bulk was related to a $924m acquisition in 2003 and a $600m acquisition in 2006 (dumb & wow that’s dumb, to be confused with doors & windows). My point is that operationally, FBHS has performed quite well versus peers and considering its business environment. As for acquisitions, the risk from overpaying for acquisitions is quite distant considering the current state of the housing market and surrounding pessimism.
I focus on cabinets because there is a lot of easily comparable data on a pure play (AMWD) and 2 companies that break out the divisions (FBHS, MAS). Cabinetry seems like a fairly commoditized product, so results are more reflective on how well the business is being run (you’ll never be able to tell me Hershey or Coke have smart management, just that they are not stupid). I don’t doubt there is a certain preference for high quality products among those who can afford it, but I don’t think I could have told you a cabinet brand before I began researching the sector. FBHS has the Omega brand, which is purportedly higher end, but they have several lines of cabinets for every budget. Based on 2008-2010 declines in cabinet revenues of 23%, 35%, and 32% for FBHS, MAS, and AMWD respectively, FBHS is offering the most competitive product in terms of a combination of qualitative appeal and manufacturing costs.
I’m not sure I have value to add on the subject of the windows & doors or security division. The security division makes locks that I remember using on my gym locker. It has produced steady cash flow since 2008 (limit of disclosure on segment information). This business should continue to hum along with minimal capital expenditures, as basic lock technology isn’t changing. Management states there are opportunities to leverage the brand names into other security related products.
FBHS claims to have the #1 position in fiberglass doors, which maintain temperature better than alternatives. It is likely driven by a mix of new construction and remodeling with a weighting towards new construction. The business received a boost in 2010 from energy credits. The segment I refer to as windows & doors is really called “Advanced Material Window & Door Systems.” Advanced material sounds nice and energy efficient. I don’t have an opinion either way if this constitutes a competitive advantage, except that the division is focused on product lines that will remain relevant opposed to less insulated window & door systems. Plenty of door manufacturers can retool product lines to make advanced material doors.
This business should just continue to hum along and do fine. In this order from the Form 10, the company states their opportunities are to: invest in profitable organic growth initiatives, add-on acquisitions, or share repurchases. I’d be thrilled to see the company pay down debt and repurchase shares. Organic growth initiatives make sense since they do have international opportunities that will receive more attention as a standalone company.
As I said above, the risk of some really boneheaded acquisitions is limited due to the depressed market for housing related businesses. That doesn’t mean it won’t happen. The way it would become stupid would be if the company started taking on debt. Debt is cheap though, so it might make sense. Based on their past acquisition history, they are bad at timing the market cycle. I think a reasonably priced acquisition in today’s market would make management look very smart a few years out. Many of the business lines FBHS produces are in already consolidated industries.
Management is really just saying what people probably want to hear. I can’t say that just because share repurchases are mentioned that management is genuinely thinking of executing a repurchase. That being said, the share price would have to be dramatically higher before a share repurchase looks uneconomic.
Management instituted a poison pill past 15% ownership for the first year. Usually I don’t care for such actions. Bill Ackman, who has been very positive for public shareholders with past investments, still holds a stake. It remains to be seen if he sells, although the business looks cheap right now. Pershing Square owns more than 10% and I believe typical poison pills are designed at the 10% level, so I don’t think the 15% threshold offers any insight.