Masco: High Rates May Benefit Performance And Valuation (NYSE:MAS)

Shares of Masco (NYSE:MAS) have been a decent performer this year, rising about 8%, though lagging the gains in the broader market. With shares having fallen over 10% since August, I think an opportunity is presenting itself for investors. While Masco is exposed to housing, it could actually benefit from higher interest rates, in a way the market may not be fully grasping.

Masco operates two primary segments, plumbing which is about 60% of its business, with about two-thirds of that faucets and showers. Decorative architecture is the remaining 40%; this unit is really a paint business – paint, led by the Behr Bran, accounts for about 80% of the unit’s sales with fixtures and lighting the rest. About half of plumbing’s sales are wholesale, the rest go through channels like retailers and e-commerce whereas decorative generates over 80% of sales through retailers. Masco generates about 80% of its revenue in North America, 12% in Europe, and the remainder across the rest of the world.

What is essential to note that is plumbing gets 83% of its business from repairs/remodeling with just 17% from new construction. Decorative gets 97% of its revenue in the repair/remodel market. As such, while Masco has some exposure to new housing construction volumes, it is much more tied to what existing homeowners do to their house – this is an important distinction, that I view positively and will discuss in more detail below.

First, taking a look at actual results, Masco is performing well. In the company’s second quarter, it earned $1.19 in adjusted EPS, up 3% from last year even as sales fell by 10% to $2.13 billion, thanks to health margin expansion. Adjusted gross margins rose by 320bp to 36.2% while operating margins rose by 2% to $404 million. As a consequence, adjusted net income rose 3%, despite near-term demand that management labelled “challenging.”

It is unusual to see margins expand when demand is soft and revenue falling. However in 2021-2022, supply chains were problematic, and as you can see the costs to produce plumbing fixtures soared, rising more quickly than companies could pass on. As input costs have begun to normalize and the company has pushed along more pricing, it has been able to recapture lost margin.

In 2021 and 2022, Masco saw a boom in demand but lost margins, leading it to earn $3.70 and $3.77 in adjusted EPS respectively. This year, management expects sales to fall 10% as home improvement activity slows with plumbing falling a bit faster (10-12%), but it raised its EPS guidance by $0.02 to $3.50-$3.65. meaning EPS will only fall by about 3-5%. Typically, businesses see earnings fall more quickly than revenue given some costs in a business are fixed – to see 500bps of outperformance speaks to the power of recapturing that margin.

Given the surge in all housing activity immediately after the pandemic, it is not surprising to see demand moderate a bit this year as there was likely some pull-forward in demand that is now normalizing. Many remodeling projects are also discretionary; in the face of inflation and economic uncertainty, some households may postpone upgrading the kitchen or a bathroom for a year. However, there are reasons to expect growth in demand for Masco’s products to rebound and growth for several years to come.

First, because of under-building following the collapse in housing in 2008, America’s housing stock is aging. The median home has aged nearly ten years to 40 years old since 2005. While the structure of a house can last for many decades, we all know that tastes change, and many components of a house have shorter lifespans. What was a stylistic bathroom in 1978 or even 1998 may be looked at with horror by some buyers and owners today. Older homes require more remodeling and repair work, by virtue of their age.

Because of this, a $25-40k kitchen remodel generates a 72% return on investment for the owner, according to Axios. The projects that Masco supplies products for are as much an investment as consumption, helping to increase the home value and build more home equity. This can help support activity even during periods of economic uncertainty.

However what is unique about this current environment is not that prudent home remodeling can add value, but that it can be the cheaper, or even the only option, for owners who want a change. This is why I said MAS could be a beneficiary of higher rates. In 2020-2021, there was a surge of homebuying and refinancing activity when mortgage rates fell to 3%. Today, they are well over 7%. This change can make it extremely expensive to move.

Low-rate mortgages are essentially “golden handcuffs” for many homeowners. They are saving a lot of money on their housing every month, but they are locked into their house. If you own a home and want to move because the kitchen or bathroom is not up to your taste, your monthly payment will rise dramatically. Below, you can see the monthly mortgage payment on a 30-year mortgage across rates and mortgage values.

If you bought a roughly median home a few years ago and wanted to upgrade a bit, I highlighted the box where you may sit (a $325k mortgage at 3.75%) and where you would go (a $400k mortgage at 7.5%). That move will increase your monthly mortgage payment by $1,290, or over $15,000 per year. Even staying at the same price point would increase your annual mortgage payment by over $8,500 in all likelihood.

Higher rates make the idea of redoing a piece of your house and staying where you live with your low mortgage rate much more appealing. While rates may not stay at 7+% forever, they seem unlikely to head back toward record lows soon, if they ever do. As such, I expect we may see a sustained structural shift in preferences away from moving and toward re-modelling. I am not arguing no one will move – sometimes you have to when a job moves or you have more children. But on balance, there should be a mix shift. This will be a favorable tailwind for Masco that can persist for many years.

Importantly, this is not just a hunch – we can see this preference playing out. While it has risen, the supply of existing homes on the market is much lower than pre-COVID. Far fewer people are trying to sell their homes to move. Because rates have trapped consumers into their homes, I expect to over time see more remodeling work, and in this way, Masco is a unique beneficiary of higher rates.

Now I will note that about 10% of Masco’s business does come from new construction, and this is likely to be a headwind. The amount of single-family construction has already begun to fall in response to lower rates. Apartment construction has held up, but new permits have been falling, so this will likely fall. Given this is a small part of the business, I view this as a very manageable headwind and more than offset by the tailwind the remodeling business has. In fact, lower new supply will by necessity push some buyers into buying homes older than they prefer and re-model parts of it, so even as Masco loses on the new construction side of the business, its primary business will see some of that demand.

Overall, Masco has favorable long-term dynamics, and thanks to normalizing input costs, it is handling this period of lower demand well. Its balance sheet is also strong with net leverage of just 1.8x, and it expects to convert over 100% of net income to free cash flow. Management targets a 30% dividend payout, using the remainder for M&A and repurchases.

Accordingly, it has a 2.2% dividend yield, which I view as secure and likely to rise modestly over time. It has used the boom years to repurchase stock, and the share count is down 21% since the end of 2019 and 3% this year. After buying back just $25 million in stock in Q2, I would expect to see purchases accelerate later this year and next year, allowing low-to-mid single-digit share count declines.

I expect the $3.50-$3.65 in EPS this year to be the company’s low-point as these secular tailwinds begin to take hold. Over the next twelve months, I expect EPS to be back towards $3.75 as sales begin to recover and margins gain hold. Over the next three to five years, this favorable secular backdrop combined with steady share count reduction should enable high-single digit earnings growth.

At 14x earnings, I view MAS as attractive given its uniquely defensive and growth characteristics in the face of elevated interest rates. Currently, the S&P 500 has a forward multiple of 19x. Given the potential for sustained growth, I believe this discount is compelling and while shares may never reach a market multiple given its “housing” connection, I expect shares can trade to $60, or about 16x forward earnings as it continues to report solid results, creating a 15% return opportunity.