Building-Materials Stocks Look Constructive

 | Jan 16, 2014 | 5:30 PM EST
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Last week, we spoke about how homebuilding stocks could see a nice upside in 2014. In particular, we highlighted Toll Brothers (TOL) and DR Horton (DHI) as two standout players.

This week, we will expand on this housing-related theme and look at building material suppliers. These are the companies that supply the wood, roofing, cabinets, electrical and plumbing to the builders.

Overall, building material suppliers will benefit from the broader positive trends seen by the homebuilders. Low interest rates, rising job growth, increasing credit, growing consumer confidence and record housing affordability are leading to an improving home construction market. These trends firmed throughout 2013 and are expected to expand further into 2014.

Two building-materials-related firms that we find attractive are Masco (MAS) and Armstrong World Industries (AWI). Although both stocks have done well over the past few years, we believe there is more to come.

Both of these firms are leading players in their respective markets, and they are seeing rising revenue trends and growing levels of profitability. And we believe both will benefit from a strengthening of the housing market.

In Masco's case, the firm is benefiting from both the new-home construction and home-improvement segments of the market. Masco has a broad portfolio of paint, plumbing, cabinet and window products. All of these businesses are seeing rising demand. Revenue is slowly getting back above the $8.6 billion peak seen during the last cycle, after bottoming at $7.5 billion in 2010-11. Operating margins are also seeing a meaningful recovery and are back into solid double-digit territory again at 12%, compared with 8% at the trough of the cycle.

As a result of these improving numbers, we expect Masco to have a significant earnings recovery from its current depressed base. Consensus EPS estimates go from 2013's $0.80 to 2014's $1.11, 2015's $1.46 and 2016's $1.86. We believe the company's normalized earnings power is well above $2 per share. At a recent share price of $23.17, there should be upside. The stock has historically traded for 13x to 15x earnings.

Our second recommendation is Armstrong World Industries. The company is smaller than Masco, with $2.9 billion in annual revenues, and it has less upside than Masco. However, Armstrong has strong market shares in ceiling and flooring products, and its stock will participate in any rally. Its revenue is still at trough levels, but margins continue to improve each year as restructuring programs boost profitability. Operating margins should hit 12.5% in 2014, compared with 9.5% to 10% at the depths of the 2008-09 recession. We could see operating margins of 15%-plus in peak years.

Over the course of the cycle, we expect revenue to get back to a range of $3.5 billion to $4 billion. Earnings should be even better as management continues to reduce costs and shrink the share base. Earnings should top $5.00 in better economic conditions (a number of years out), and that would provide meaningful upside opportunity from the current $57.61 share price.

Neither of these companies will see the rapid and more volatile recoveries that we can expect from the homebuilders. In contrast, their rebound will be more gradual. Nevertheless, both Masco and Armstrong are solid companies that offer good potential in a more meaningful housing recovery.

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