In an ever-increasing
line of housing-related companies reporting soft quarterly results and/or
provide guidance below expectations, insulation (30% of revenue), roofing
(39%), and composites (31%) company Owens Corning (OC 53.03, -2.41, -4.35%) became the latest name to
succumb to the weakening residential construction space. Recall that yesterday,
Tiles Shop (TTS 6.26, +0.05, +0.72%) and Masonite (DOOR 56.92, -0.49, -0.86%) both came up short of earnings
expectations as the downturn in new housing starts in the fourth quarter negatively
impacted their results.
So, heading into OC's earnings report this morning, there was an abundance of evidence indicating that the slowing housing market became a potent headwind in the fourth quarter for these types of companies. Despite the fact that it managed to exceed its Q4 expectations, which it reduced in its Q3 earnings report and call, the main story this morning for OC revolves around its outlook for 1Q19 and FY19.
Virtually every home construction and remodeling company has shared the sentiment that 2019 is going to be much more difficult than 2018. If we had to aggregate and form a consensus from management teams regarding the outlook in this market, we would summarize it this way: Conditions materially weakened in the fourth quarter with particular weakness in December as rising rates and worries over the economy stifled demand. However, the environment is showing signs of stabilization now with evidence suggesting the market has bottomed. Going forward, we expect a more challenging, yet stable year as compared to 2018, which was a very solid year for the housing and construction market in general.
OC seems to fall in line with that commentary, stating that it expects a flat macro outlook for the North American residential insulation business, as well as flat U.S. asphalt shingle market demand with industry shipments slightly below last year's levels. However, the company's actions, including a recent shut-down of an insulation production line, might suggest the company is feeling a bit more cautious than others in the industry. During its earnings call this morning, management commented that the decision to shut down its Santa Clara, CA line in 1Q19 is consistent with running the business for long-term profitability, but, that the curtailment will have a significant effect on EBIT for the insulation business this quarter.
While every home construction business is affected by commodity prices, OC has been hit especially hard by rising asphalt costs -- which it anticipates will continue throughout 2019. Specifically, in Q4, it faced about $240 mln of inflation and transportation costs. Although it was able to more than offset this via $255 mln in price hikes, the company said that improved volume growth and operating performance in its composites segment will be canceled out by ongoing inflation.
Lastly, the company's growth rates over the past few quarters have been inflated by its February 5, 2018 acquisition of Paroc Group, which is a European producer of mineral wool insulation. This pushed its Q4 growth rate to +23% for its insulation business, compared to -5% in composites and -3% in roofing. As OC now begins to lap financial results that included the Paroc business, its growth rates will track lower
Q4 Results & Outlook
For the quarter, OC generated EPS of $1.38 (+24% yr/yr), exceeding the $1.27 consensus, with revenue up 7.3% to $1.72 bln, also edging out the $1.69 bln expectation. As we noted above, the top-line growth was primarily generated from its acquisition, in addition to price increases.
All three of its operating segments achieved double-digit EBIT margins, something OC had not achieved in its history on an annual basis. That's the good news. Unfortunately, EBIT margins declined on a yr/yr basis in two of its three segments, with EBIT margin in composites falling to 12% from 15%, and to 15% from 19% in roofing. Again, due to the Paroc acquisition, EBIT margins for the insulation business improved to 16% from 13%.
Outside of the main headline numbers, one metric that really caught our attention was free cash flow, which plummeted by $400 mln, coming in below its expectations. The main drivers of the decrease were higher inventories, due to inflation and the deceleration of demand it experienced in the second half of the quarter, and a purposeful build in synthetic roofing under-layments in advance of potential tariffs.
Looking ahead, OC expects its insulation business to drive positive EBIT in Q1, albeit, at a level that substantially lags last year. The main culprit here will be lower volumes due to weaker demand and the aforementioned production curtailment. Likewise, in the composites business, OC anticipates Q1 EBIT to decline from last year, despite the fact that volumes have picked up at the start of the year. Unfortunately, stubborn inflationary pressures are offsetting the improved demand. Finally, for roofing, it sees a relatively flat U.S market but, it believes it can outperform the market thanks to favorable geographic mix and a higher share of industry shipments this year.
Price increases and strong performance from its Paroc Group acquisition helped drive the upside Q4 results. However, excluding the impact of that acquisition, OC's results basically mirrored those of other home construction companies. The fact that Q4 was challenging, though, is not the main story as that was completely expected. Rather, OC's commentary and outlook for 1Q19 and FY19 is what investors are focusing on.
While the company sees housing construction stabilizing from the sharp declines in Q4, it is anticipating a no-growth environment with inflationary pressures continuing. That commentary is not dissimilar from others in the industry. What is different, however, is that it is taking the major step of shutting down a key production line this quarter in order to manage costs and fight off inflationary pressures. This action suggests that OC is perhaps more cautious about macro conditions, and/or, that it sees inflation as a bigger threat than other home construction companies.