The Moat Show Ep. 7: Masco with Morningstar's Brian Bernard

On The Moat Show, we uncover the companies with economic moats, one stock at a time, by bringing on analysts from Morningstar to share their in-depth insights with you.

The views and opinions expressed herein are those Brian Bernard of Morningstar as of 4/18/24, and are not intended as financial advice, a recommendation to buy or sell any securities mentioned, or any call to action. Actual future performance of any securities mentioned is unknown. Certain statements may constitute forecasts, projections, or other forward-looking statements which are valid as of the recording date, for illustrative purposes only, subject to change without notice, and do not necessarily reflect those of VanEck or its employees.

COULTER: Hello and welcome to another episode of The Moat Show where we uncover companies with economic moats. I bringing on analysts from Morningstar to share their in-depth insights. In this episode, we'll be discussing Masco with Brian Bernard, who's director of industrials equity research at Morningstar. Thanks for joining us. Brian, I'm excited to have you on.

BRIAN: Yeah, thanks for having me.

COULTER: To begin, I kind of want to talk a little bit of background. For our viewers who may not already be familiar with Masco, can you provide a brief overview of the company market it operates in and some of the key milestones that have led to their position as the leader within the market?

BRIAN: Yeah, definitely. So, Masco has been around for quite a while. Actually. It was founded in the 1920s, but it began as a machine parts manufacturer for the auto industry. It didn't enter the building products space until the 1950s, when the the founder acquired the rights to a single-handed handle foster design. And that was the start of its Delta Plumbing Products brand, which is well-known today. And then over the subsequent decades, they expanded into other adjacent building product categories. They got into cabinets that the first acquisition was in the 1980s, and they got into installation and services and paint in the ‘90s. Behr Paint was the big acquisition in ’99, and then windows in the 2000s. More recently they divested some of those businesses. They spun off the installation services business that's now called Top Build. It's a publicly traded company. That was in 2015 when they spun it off and then about five years ago they sold their windows and their cabinets business. And so now they're left with two segments, the plumbing segment, and then the other segment is their decorative architectural segment, primarily the Behr paint coatings brands, but also they have some builder hardware and they did a lighting acquisition, Kitchler is the brand there. So yeah, that's where we are today with Masco.

COULTER: Wow, that’s great. I hadn’t realized they’d been around for so long and I, I certainly have some of those products in my own home. So it's interesting. From a, you know, sort of investments style, you know, many investors today, you know, they like to view companies through sort of the a growth or a value style lens, if you will. So, you know, given that Masco is a common name in some of the Morningstar value style indexes, can you briefly explain the types of characteristics that evaluate a company like Masco might exhibit?

BRIAN: Yeah, so, it's you know, it's definitely a mature company. It's primarily tied to the U.S. repair remodel market. You know, that repair and remodel market over the long run grows a kind of mid-single digit pace. So you wouldn't expect outsized growth numbers from Masco. In fact, over the last ten years, revenue growth has averaged roughly 5%. We expect similar top-line growth over the next ten years, a bit faster earnings growth. Obviously, there'll be some operating leverage on that. That volume growth and share repurchases. So from a growth perspective, you know, that really kind of I think falls more in value. And then if you look at historical valuation multiples, I think that puts the firm squarely in the value category as well. You look at the five-year average forward price to earnings and the EBITDA multiples, those are 15 and 12 respectively. So again, I mean, usually you don't see too demanding valuation multiples for a Masco

COULTER: You know, from a competitive perspective, I know when I walk through my local I'm accruing story, right? There's seemingly countless options in terms of things like plumbing and lighting fixtures and paint. Can you explain a little bit about how Masco has been able to stand out from its competitors and how it's achieved, one of Morningstar's most exclusive ratings – a wide moat rating?

BRIAN: Yeah, absolutely. So, that wide moat rating, we do assign that to both segments. So again, that's plumbing and the decorative architectural. The primary source would be the brand intangible assets primarily for Delta and Behr. You know that that brand intangible assets in our view supports leading or near leading market share for those brands and pricing power. When I say pricing power, I mean quantitatively, what that means is, you know, over we've observed over time that Masco has been able to increase prices more than inflation, that supports profit margin stability. Put it another way, you know, the power of that brand, they're able to price higher than a lot of the brands. Consumers are willing to pay a premium for those for those branded products. Just kind of digging into that intangible assets a little bit more here. You know, how do you get that? It's really a history of manufacturing, differentiated, innovative products, products that consistently have better esthetics, you know, functionality, durability than much of the competition. And, you know, when you can deliver that year in and year out that really supports strong relationships with their trade partners, you know, their big box retailers, for example, and their wholesalers and also customer loyalty.

You know, speaking of loyalty, if we look at the latest builder brand survey from Zonda, which is a good survey that kind of just see how brands are ranked from builders and contractors, you know, Delta enjoys very strong, brand familiar familiarity with the trades really along with the other leaders. Moen Which is owned by Fortune Innovations and Kohler, which is a private brand. And just so you know, just over half of that plumbing business does go through wholesale to the trades. You know, then if you look at for plumbing, a little bit under 20% of that is retail. The rest of that is going through e-commerce or dealers. But for that retail, you know, next, like you said, when you're in a big box retailer like a Home Depot, Lowe's, Menards, you know, take a look when you're in the plumbing section looking at faucets, shower showerheads and just take note of that shelf space for Delta. You know, it's you're going to see very strong shelf space for these products along with more and cooler. Again, along with Moen and Kohler those are their main competitors. But, you know, they're going to have far more products available then, you know, lesser brands like American Standard or private label. With the Behr paint going back to that survey, again, that gets very strong results with the trades, you know, for familiarity most use brand really only trades Sherwin-Williams which is very strong within their trade group. But a little bit different than plumbing is that Behr, the paint is mostly do it yourself and from that perspective you know they get very high marks from Consumer Reports a lot of times getting ranked higher than Sherwin-Williams. So that really, really supports that brand. One thing that's unique about Behr paint, though, is that in coatings is that it's exclusively the Home Depot. This is a relationship that really has existed since the Home Depot began in the seventies and only had a couple of stores. We think that's a symbiotic relationship, right? I mean, Honda it, Home Depot likes it. It has a very strong brand. can take market share both the do it yourself, but you're making a push for the professional as well. And we think that does actually have a cost advantage for Masco relative to competitors because their competitors, Sherwin-Williams, you know, PPG, Benjamin Moore, you know, they have to build out this expensive store footprint to really kind of get, you know, more of that professional market, whereas Masco really can rely a lot of that on Home Depot, you know, especially like their own logistics. They built their manufacturing distribution around the Home Depot’s world class distribution. So we think overall that that that that really kind of drives a cost advantage for Behr. And then, you know, before I finish on the note, just one thing that's interesting is that before 2019, we actually had a narrow moat rating on Masco. And that's because remember back then they had the cabinets and the Windows businesses. We thought that those were no moat businesses. You know, they were they didn't have that differentiation. They were more cyclical. it really sort of diluted Masco's overall competitive position and consolidated basis. But then, like I said, they sold those businesses and after that we're left with really the true crown jewels of the business and we upgraded to a wide moat then.

COULTER: Yeah, that's really interesting. You know, when I think about Masco, the company that the name Masco doesn't really resonate that much for me and stand out. But then when you think about the brands underneath it, you know, Delta plumbing fixtures and whatnot, Behr paint, those are those are brand names that I that I know. And I imagine probably many people in the country know as well. So it's interesting that to kind of view it, you know, that such brand recognition underneath sort of the layer of Masco.

Moving forward a little bit. I want to touch on something you just kind of mentioned here as regards to, you know, the spin off or the sale of sort of their windows market. You know, and what are your reports? I read you mentioned sort of you mentioned feature acquisitions and how that could be a potential dilution, if you will, of the firm's moat over time. So kind of what are your views on Masco's acquisition strategy and, you know, should the company you know, how should the company balance growth, you know, through acquisitions versus organic growth of brand names that they already own and operate in?

BRIAN: It's a good question. You know, in our view a company that's very acquisitive, there is there is a heightened risk of, the potential to dilute the moat, you know, if that's just if they're buying no more businesses or they overpay or there's execution issues and, Right, Like we just talked about for Masco, there was there was a history of that. Right. You know, we had that narrow moat rating because they got into that cabinets and window space. But I would say, you know, since those divestitures, Masco has been generally, I would say more disciplined. You know, they're they've made acquisitions, but they're more smaller bolt on with an adjacent products. Between 2020 and 2023, they made a handful of acquisitions again, mostly in kind of plumbing. Nothing going into a new product, completely new product category. You know, spent 40 million over that timeframe, which to put that in perspective, that's roughly 1% of sales over that period. So, I would expect them to continue to make these small bolt on acquisitions. I think it's important for them to, you know, they help with their growth strategy to continue to expand that plumbing product set and expand its international footprint. I mean, certainly you're going to need some help with or with M&A to do that. But I really I don't see it as really too much of a risk when you're making those types of acquisitions. And like I said, though, it's going to be a part of their strategy. You know, management put out long term financial targets, and part of their growth algorithm is acquisitions. They expect to add over a long run 1 to 300 basis points from acquisition. So again, it's going to be it's going to be a good driver of growth. But again, if they continue what they're doing, we're not overly concerned there. But to take a step back, just looking at their overall capital allocation strategy, I would say it's been especially under the current management team, it's been around for, you know, over a decade now. It's been balanced. I would say it's actually, you know, it's shareholder friendly, too, because if we look over kind of that time period, we calculate that really, you know, 70% of shareholder capital has been allocated via dividends and share repurchases, 25% of the capital expenditures. And then really only a small amount, 5% has gone to acquisitions. Now that's another divestitures, right, that I Cabinet's in in the Windows kind of brings back down a bit. But again, it's shareholder friendly, I'm not too concerned about the acquisition activity and I think they'll remain disciplined and I'm not expecting anything unusual or than to stray from that strategy going forward.

COULTER: Zooming out a little bit, you know, maybe take a look at the bigger picture of housing in the U.S. And that's sort of been a big theme here the last few years, you know, where we've seen higher home prices, higher mortgage rates. And, you know, and that's really kind of created a challenging environment in terms of, you know, home affordability. And so I want to hear your thoughts on how have these factors impacted Masco's business strategy in operations and how do you see these factors evolving going forward?

BRIAN: Yeah, another good question. So to answer that, you just want to give viewers an understanding of what the business model, you know, where they have most exposure. So the most recent disclosures that 88% of their revenue is tied to the repair and remodel market, the remaining 12%, the new construction. So repair remodel spending is far less cyclical. The new construction I saw, as I said earlier, it's growing at a mid-single digit pace over time. You know, we have a downturn is starting to be it'll drop but you're not going to see big gap down like you do for construction spending. Conversely, though, you know, during recoveries, you're not going to see outsized kind of rebounds, but it's a nice, nice, steady business. And then one thing we like about Masco, especially now during uncertain economic times, is that within that repair and remodel category, their products skew more towards lower price points that have somewhat of a break fix dynamic or to put it another way, they're less discretionary, right? So like again, we think of things like faucets, showerheads, paint, these aren't really expensive items. And the comment on the break fix right is that faucets, brakes, showerheads get kind of gunked up over time, right? Paint fades or maybe, you know, kids throw juice on the wall or something and you need to address that. So again, there's a component of that that's less discretionary. You know, there's other manufacturers that have high R&R exposure, but they're manufacturing decking cabinets. I mean, those are a type of things that when you have uncertain economic outlook here, people are going to defer that. So we do like that that category. We think that that makes them more insulated from downturns.

Now, that being said, last year organic revenue did decline 8% for Masco. And we saw softness across both residential construction, obviously, but repair and remodel spending also softened as well. You know, new construction spending that's clearly been affected by poor affordability. Right. Home prices are still historically high. Mortgage rates, you know, are more than double now. They're still kind of sticking around 7%. So that is really sort of curtailed that market, although there's you know, I think there's some really optimistic and new residential construction in single family. But certainly there's been an impact there. And then if you look at repair remodel spending, that's been negatively impacted by a lower housing turnover. So what I mean by that is there's been fewer existing home sales, right? You think about that, you know, and what's been driving that, one of the main things here is that, like I said, with the mortgage rates going 7%, that, you know, the majority of homeowners have mortgage rates below 5%. So it's what we call that rate lock-in effect, they're just they're discouraged from putting out their homes in the markets. That's been that's been a headwind, I would say, with, you know, with the inflationary environment. I think consumer confidence has kind of taken a hit. And you also have to remember that it's been we're just facing very challenging prior year sales comparisons, repair and remodel spending just surge during the pandemic years. And so I think we're seeing some normalization there.

Now for 2024, management is expecting roughly flat revenue growth, and that's based on the North American repair and remodel market that's flat to down low single digits. We're really more optimistic. We forecast 2% revenue growth in 2024 for Masco. We think that the repair and remodel market will modestly surprise to the upside. Like, I mean, when I say now I'm talking like 1% growth, but we're seeing some signs of stabilization. You know, we're hopeful that maybe we hit the trough with existing home sales net turnover, well, in likely get much better, but it's going to could be better than what it was last year. So that's I think that's a bright spot. And then single family, new construction again, that's you know, it's only 12% of the business. But still, you know, there's still some you know, it's still important for the business. We think there's going be 4% in single family starts this year. The fact of the matter is that homebuilders have, you know, have lowered prices. They're putting in sales incentives. They're doing mortgage rate buy downs where you can essentially you can get a mortgage rate that's 200 basis points below the prevailing market rate. And that's what we're looking for 2024. And then if you look longer term, we're more optimistic that, you know, single family starts. We think that that's we get a rebound in 2024, grows in the mid-single digit percentage over the next few years. Multifamily. I didn't talk about that. That's going to be down pretty big this year because we have just a ton of inventory being delivered. But, you know, I think you're going to be see a year where that really kind of settles down. But I think, again, you're going to see multifamily return to growth just because that is, you know, we have an undersupply of affordable homes. A lot of times, you know, that is a more affordable option. Kind of question mark we're immigration goes but if that end of that that is a driver that'll be another catalyst for more multifamily construction and then just you know our economics team sees lower interest rates over time that'll help there. So, but multifamily is not I mean that's still not a big portion of Masco's business. And then finally with repairing remodel spending, you know that's the big driver there. We think that

that's going to return to mid-single digit growth here over a longer run. There's several long-term secular tailwinds. You know, aging housing stock, right? The again housing stock. The median home is now over 40 years. So you're going to have more projects, favorable demographics. Right. Increased acceptance of smart home, energy efficient products. You know, you're seeing some of that more kind of smart type products for Masco's plumbing products. So you take that all kind of together. You know, we think, you know, that that repairer model market's going to be, you know, good growth over the long run.

COULTER: So you mentioned, you know, they'll repair remodeling accounts for the majority of Masco's financial performance, only to your view on what the outlook that segment is and and sort of your views around the growth prospects for for Masco in the next few years.

BRIAN: Yeah, so like I said, you know, a lot of their growth prospects tied to that repair and remodel market, we forecasted they're going to grow at a mid-single digit percentage over the next ten years, outperforming that repairing remodel market by 100 basis points. So what's really how do they outperform that that market? There's a couple key growth initiatives that that we're really excited about for the company. Now, the first is with the Behr paint, like I said, that's a leader in DIY, right? Do it yourself. But you know, over the last ten years they really shifted towards that professional market share. So they started with no market share, now they have 10% market share. So they're really gaining ground there. And I think their sweet spot with that. But that professional market is really… last year your peer professional. Peter you know, I think they can get some market share there from the Sherwin-Williams, PPG, etc. But I think the sweet spot there is really going to be with your general contractor that does all sorts of things in the homes and is going to the Home Depot and is buying a basket of diversified goods. So, they’re picking up, you know, lumber tools and paints. I think that's a nice growth driver for that business. And then within plumbing, I think we're going to continue to see them moving into I think I mentioned it's early, but moving into adjacent products and growing internationally, I think that that's where that M&A is going to be important, where you're going to see bolt on acquisitions there to help get there. But I think those are kind of the drivers that really are going to help it, Masco, Outperform that repair and remodel market over the next decade.

COULTER: Great. I mean, that's fantastic insight and sort of where they work, where they sit now and kind of, you know, what might come in the next year or two.

Sort of last thing I also want to hit on, you know, your growth, which we can just discussed now. I also want to hit on sort of some of the risks and uncertainties out there that you see. So, you know, what would you from what would you say from your perspective is the most significant risk or uncertainty facing. Masco? You know, in the near term, medium term? And how do you view the company in how positioned are they, the sort of manage these risks?

BRIAN: You know, we talked the M&A risk, again, I think it's something to keep an eye on, but I'm not too concerned there. I mean, look, the biggest risk is if we have a prolonged downturn in that repair or remodel market, Right. I mean, they're going to feel the pain if that happens. Now, again, they're better positioned in some of these companies that are more focused on those big ticket discretionary products, like I said, cabinets, decking, for example. But that's the biggest risk for this company. One thing I want to say, though, is that, you know, when we do have these downturns, especially when we have downturns, we're tied for to new construction, a lot of times you'll see the homebuilders will sell off. You know, people are investors are concerned about affordability, mortgage rates going up. And you'll see Masco gapped down in line with the homebuilders, which I don't think and this has happened several times since I've covered the company. I don't think that that should happen. Obviously, with that repair remodel exposure. So I think that when you see that, that's an opportunity for Masco. So I think that's the biggest risk. You know, one other thing that comes up I would like to address is that, you know, we talked about the exclusive relationship with the Home Depot, and there are some costs that some clients will say, wow, that's like extreme customer concentration. Right. What happens if they decide to go with Sherwin-Williams, for example, or they're concerned that there's PPG products there? What about the competition there? And I'd say, look, I mean, the Home Depot, I think very, very much likes that they have arguably the top brand in DIY, right? Yes, they do have PPG products. But if you go in the store, walk in, you'll see that they that there's far more shelf space for home furniture for Behr. And I think you can tell that there's just more investment there. So I don't see that as a risk, you know, But, you know, that does come up.

COULTER: Interesting. Well, Brian, great. You know, with that, we're pretty much out of time. So but it's been a fantastic conversation. So thank you again for sharing both your time and your insights here with the city, Brian. And thank you to all of our viewers as well. See you next time on The Moat Show.

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