Our rating on Masco Corp. (NYSE: MAS) is BUY. We believe that Masco’s recent transformation makes it better prepared for economic turbulence resulting from the COVID-19 pandemic. Masco recently sold its cabinet and window businesses. The new focus on the paint, faucet and lighting businesses should ultimately raise margins and make sales less cyclical. Higher profitability should allow the company to raise its return on capital and eventually pay out a slightly higher percentage of steady-state earnings as dividends. The remaining businesses sell lower-priced products that are more closely tied to home repair and remodeling activity than the legacy exposure to big-ticket building products. In addition, Masco has reduced debt.
While Masco’s earnings are likely to be more volatile than a company that sells food, cleaning supplies, or healthcare products, we believe that management’s initiatives under CEO Keith Allman make the business less vulnerable than it would have been a year ago and less vulnerable than many investors perceive.
We remain optimistic that low interest rates will buoy the U.S.
On October 28, Masco reported 3Q20 net revenues of $1.98 billion, up 16% from the prior year. The company had strong sales in do-it-yourself paint, which delivered growth at a high-twenty-percent rate.
Adjusted earnings rose 73% to $1.04 per share. GAAP earnings from continuing operations rose 88% to $1.05 per share.
The 3Q adjusted operating margin increased by 400 basis points to 21.4%. Our estimate was 17.5%. Adjusted operating income dollars grew by 43% to $425 million. Our estimate was $324 million. The StreetAccount consensus was $328 million.
In the Plumbing division, sales of $1.14 billion. Consensus was also $1.04 b billion. The Spa business rebounded and the backlog grew as consumers invested in their homes. Operating profit in the Plumbing segment was $271 million. Our estimate was $194 million. Consensus was $195. Operating margin was up 510 150 basis points to 23.8%.
Our estimate was 18.8%. Do-it-yourself painters made the most of their time sheltering-in-place to do some painting. Sales in that part of the business were up in the high twenties. Professional paint sales declined in the mid-single digits as homeowners were reluctant to have contractors in their home. The Pro business did improve sequentially from 2Q. We believe that DIY is about three quarters of Masco’s paint business at HD.
EARNINGS & GROWTH ANALYSIS
MAS expects plumbing sales to range from up 8% to up 10%, and Decorative Architectural sales to be up 8% to up 10%. The company expects segment margins to be approximately 19% for Plumbing and 17% for Decorative Architectural Products.
There is upside to this estimate depending on the path of the economic recovery and how strong sales come in.
The company has mentioned five drivers of market growth. And weeks of confinement may lead many to invest more in having a safe and pleasant place to live.
FINANCIAL STRENGTH & DIVIDEND
Profitability has improved over the years and both Moody’s and Standard & Poor’s rate the company’s debt in the BBBs, which is investment grade. The repositioning of the product portfolio should make the earnings less cyclical. Masco had $2.3 billion. This includes cash and the full capacity on the revolver.
In 3Q equity was $341 million. We will be more concerned with interest coverage since the balance sheet may be sensitive to transaction-related accounting issues. Adjusted EBITDA was 8.85-times interest expense, on a trailing 12-month basis, at the end of 3Q. Management’s goal is for debt to be less than 2.5-times EBITDA, which should keep the company in our Medium range and keep credit ratings in the BBBs.
The company borrowed approximately $600 to refinance high-coupon debt and reduce interest expense. MAS reduced debt by $106 million in 2018 and $200 million in 2019. The company does have about $400 million of debt maturing in April 2021.
One covenant kicks in if net debt is more than 4-times adjusted EBITDA. The company was at 1.1-times at the end of 3Q. Interest coverage, adjusted EBITDA/interest expense must be greater than 2.5-times. The company was at 8.85-times, by our calculation, at the end of 3Q.
Masco generated $883 million of cash in 2019 and $1.03 billion in 2018. This is up from $751 million in 2017 and $789 million in 2016. In 2019, the company had lower net income and a drag from working capital changes.
The company repurchased $331 million in 2017. The company authorized a new $2 billion repurchase plan in September 2019. MAS repurchased about $600 million of shares in 1Q20. The company had approximately $900 million remaining under that authorization at the end of 3Q20. In the 3Q call, management announced plans to resume share repurchases with the objective of spending about $100 million in 4Q.
Dividends in 2017 totaled $0.405, 2018 dividends were $0.44 per share and 2019 dividends were $0.50. The new dividend, which has now been declared, will be an annualized $0.56.
Our 2021 dividend estimate is about 20% of our 2021 EPS estimate, which is consistent with the company’s 20% payout target. The yield is a modest 1%.
It planned to contribute substantially more — about $64 million – according to the annual report. The COVID-19 epidemic may change this plan.
MANAGEMENT & RISKS
COVID-19 is still a major risk, particularly if this second wave of infections results in government regulations that restrict transportation of the company’s products and prevent the company’s staff from going to work. The pandemic could still restrict sales and production overseas. Masco could be hurt if quarantines restrict professional painting and remodel projects or restrict sales through Home Depot and Lowe’s. To be sure, the pandemic did cause HD and LOW to restrict store traffic, but demand remained strong. The pandemic has increased unemployment and it is likely to reduce discretionary spending. While the unemployment rate has declined from its peak and government stimulus checks boosted demand it is unclear how many jobs will be permanently lost and how the pandemic will change discretionary spending. Our expectation is that consumers will put more value on having a safe, clean home.
The company’s return on capital was 26% (by Bloomberg’s calculation) at the end of 2019 compared with a weighted average cost of capital of 9%, for an impressive 17 percentage point Economic Value Added spread.
Tariffs are another source of cost pressure that could be difficult to fully offset.
The company’s 2019 sales to Home Depot were $2.5 billion, about 37% of sales.
PricewaterhouseCoopers has been Masco’s auditor since 1959.
MAS shares are up 12% this year. We think the shares should trade above their historical average multiples for the next several years, as the business should be less cyclical going forward.
The company is reducing the cyclicality of the business and improving profitability. The prepandemic increase in our long-term, structural operating margin estimate, reflecting the repositioning of the business, should allow Masco to raise its ROE and pay out a slightly higher percentage of steady-state earnings as dividends. There is some upside to this target, and we will consider raising our estimate depending on how the economic recovery evolves.