Masco's Shrink To Grow Transformation Looks Complete
When Masco's CEO Keith Allman took the helm in 2014 he said "I view myself as a transformational leader. That's how the board views me, and that's why they appointed me. I'm not a status-quo guy." (source: WSJ).
He's stayed true to his word over the subsequent five years. Today, Masco's transformation looks largely complete. It is less cyclical, with 90% of sales focused on repair and remodeling, and concentrated in high return brands high Delta and Behr.
Shrinking To Grow
Alllman transformed Masco using a rare strategy I call "shrink to grow." The prototypical implementation was at General Dynamics under Bill Andres, which is well documented in The Outsiders. Most recently, Starboard Value implemented it successfully at NortonLifeLock, which I wrote about last fall.
"Shrink to grow" is rare not because it is ineffective, but because most CEOs and boards prefer to preside over a sprawling empire rather than dominate a small niche. Anytime I see a CEO go against this grain, I pause to take a closer look. "Outsider" behavior can be a sign of good things to come.
Masco's roots go back to 1929 when founder Alex Manoogian started machining parts for the auto industry. In 1954 Masco began producing faucets under the Delta brand. In 1985 Masco dove into cabinets. In the 1990s they added paint, windows, and services.
Masco's sprawling businesses struggled in the financial crisis because it got caught with excess manufacturing capacity in a shrinking housing market. Operating profits were cumulatively negative between 2008 and 2011.
Keith Allman, a Masco employee since 1998, took over as CEO in the spring of 2014. By fall, he announced his first move: to spin off TopBuild, Masco's installation business. The services business didn't fit well with Masco's other product-based businesses. The company was also very cyclical. It had a hard time competing with mom-and-pop contractors, who'd undercut its prices. The only time it gained traction were when the housing market was booming and builders had so much work to finish they became temporarily price insensitive.
Along with the spinoff, Allman reduced corporate headcount by 40% and used the proceeds to buy back 50 million shares or 14% of the company. This immediately improved returns: Return on assets (op. profit / assets) went from 14% in 2013 to 21% in 2014.
In 2019 ROA came in at 30%, a meaningful improvement from 2018's 26% and a seismic shift from 2013's result.
2019's improvement was the result of selling the window business (UKWG and Milgard) for $722 million and the cabinets business for another $1 billion. Allman used the proceeds of the windows divestiture for a $400 million accelerated buyback and redeemed $200 million of 7.125% debt. The proceeds of the cabinets sale was likewise used for a $600 million accelerated stock repurchase in Q1 at prices between $39 and $40.
Allman did make one meaningful acquisition: he bought Kichler, a lighting company, for $550 million in 2018. That acquisition, like most, hasn't quite panned out. Kichler was hit hard by tariffs, so there's a chance it improves in the coming years.
Incentives
Before I get to what Masco looks like today and what it's forward returns might be, I think its worth looking at Allman's incentives. What makes a CEO undertake a shrink to grow strategy when they're not an owner-operator?
Allman's at-risk compensation is split between an annual performance bonus and a long-term incentive plan. The annual payout is function of operating profit (75%) and working capital as a percent of sales (25%). The long-term incentive is 100% tied to three-year average ROIC.
This is a good, though not perfect, incentive plan. Tying 75% of annual performance pay to operating profit does incentivize growth, even at low incremental returns. A capital charge would be helpful.
The three-year ROIC incentive is great and couldn't have hurt Allman's decision to whittle away Masco's low-return businesses so that the well-branded and high-return businesses could shine.
RemainCo: Less Cyclical and Higher Return
Masco's transformation couldn't have come at a better time than the absolute top of the market. Today only 10% of sales are tied to new construction. The vast majority are tied to repair and remodel. Entropy continues whether there is a pandemic or not, and homeowners can only delay maintenance for so long.
Masco anticipates a 20-25% hit to Q2 sales but a strong recovery after that. Q1 showed no signs of impact from the pandemic. From talking to customers, Masco thinks that there's pent-up demand that they'll see soon.
So far Masco has seen strength in DIY paint, which could be the signs of a shift to DIY remodeling and an increased interest in home decor now that we are all spending a lot of time inside. Wayfair's recent results certainly show people stuck at home are willing to spend to make their homes more livable.
The crux of Masco's transformation are its improved returns on capital. I went back through Masco's annual reports and pulled out the RemainCo's segment returns. They're plotted below versus the entire company's, as reported.
Over the last 15 years Masco's RemainCo operations have averaged a 31% return on tangible assets. That's a wonderful result. It's worth noting that this doesn't include an allocation for corporate overhead, which is currently running about $100 million per year and decreases the total company's returns by a few percentage points. I imagine that there are some stranded costs to pull out of this overhead, but so far there's been no announcement from management.
Even more compelling are the incremental returns the RemainCo has experienced.
RemainCo assets increased by $719 million while operating profit increased $546 million. That's a 76% incremental return, which is extraordinary. This speaks to the value of a well-branded product like Delta faucets and Behr paint. Undoubtedly, these results were aided by operating leveraged from highly utilized manufacturing plants.
Forward Returns
Masco is targeting 2-4% annual sales growth. That's unlikely to materialize in 2020, which will almost surely show a year-over-year decline, but seems like a reasonable goal for 2021 and beyond.
Masco's working capital averages 16% of sales, which implies Masco will need to reinvest 3-6% of earnings to fund this sales growth.
This is in-line with history. The RemainCo has reinvested about 6% of earnings to produce 5% growth. Masco's high returns on incremental capital mean that it can afford to pay out over 90% of earnings while still growing a few percent per year. Investors therefore get a decent payout while the businesses grows.
In a normalized environment, say 2021 or 2022, Masco looks capable of earning $1,200 in operating profit. That's based on a 34% ROTA for the Plumbing segment and 37% for the Decorative segment.
Subtracting $100 for corporate overhead (which I think could decrease), $140 for interest, and tax at 26% gets us about $700 million of net income. Capex approximates D&A, so earnings approximate FCF. All said, Masco currently trades at 15x earnings.
Let's say 10% is retained to grow 4% (slightly more conservative than history) and the remainder is paid out to shareholders via buybacks and dividends. Yield should be 6% (0.9/15). The stock's returns will be about 10%, plus or minus a change in its valuation multiple.
What's a fair PE? Probably somewhere between 15-20x. The stock traded around 20x between 2013 and 2018. It's a better now, so it should trade at a premium to its historical valuation. If the stock re-rated from 15x to 20x over five years, that would add 6% to annual returns, bringing total returns to 16%.
The stock's risk/reward looks asymmetric. It currently trades for $40. Its lowest average annual PE was 13x in both 2004 and 2006. That would put the stock at $34 per share. A 20x multiple places the stock at $52 per share. So, a downside scenario might be -$6 while the upside might be +$12.
Risks
Masco faces a number of risks. Chief among them is capital allocation. Whenever a company generates a significant amount of FCF like Masco does, there's the risk managers will spend it on acquisitions.
Allman's done a great job focusing Masco on its high return segments, but he also undid some of this by buying Kichler. So far, it looks like diworsification: Kichler weighed down the Decorative segment's ROA from 45% to 30% between 2017 and 2018.
I'd like to see Masco commit to a cannibal strategy like AutoZone or NVR and spend nearly 90%+ of net income on buy-backs year in and year out. Currently Masco's buyback is suspended indefinitely, but I don't think it will be terribly long before we see it return.
Another risk is Masco's reliance on Home Depot. 37% of sales go through Home Depot and another 10% go through Lowe's. Home Depot is the sole distributor of Behr paint, and competitors would love to get a piece of Behr's shelf-space. So far it has been a fruitful partnership and Home Depot heavily markets Behr on behalf of Masco.
The best way for a company to push-back against a distributor's bargaining power is to have a brand that customers demand by name. I'm unsure how many people ask for a Delta faucet as opposed to just "a faucet". Masco's 30% ROA in plumbing suggests that the brand does influence behavior. Still, I'd argue that Masco needs Home Depot more than Home Depot needs Masco.
Summary
CEO Keith Allman has executed a shrink to grow strategy at Masco that looks complete. Shrink-to-grow strategies are rare because they go against the mantra of "bigger is better". Usually they're only undertaken by activists or "Outsider" CEOs. There's no activist involved, so Masco's future capital allocation bears watching.
Today Masco consists of well-branded, high-return, non-cyclical brands and trades for a reasonable price. The business looks poised to compound at about 10% annually, which is good but not exceptional. Its valuation multiple looks more like to increase than decrease, but it doesn’t look obviously mis-priced. We like to look for “no-brainers” and Masco doesn’t qualify yet. We will continue to keep an eye on the stock in case it gets significantly cheaper or management signals what their future capital allocation will look like.
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