A New Wide-Moat Stock to Consider

Since Keith Allman was named Masco's MAS CEO in February 2014, the global leader in home improvement and building products has shifted its focus from the less attractive installation, cabinetry, and windows businesses toward the more valuable plumbing and decorative architectural segments. This strategy has significantly strengthened Masco, and we like that its prospects now depend on two wide-moat businesses that primarily operate in the repair and remodel market, which is far less cyclical than new construction and has increased at a 5% average annual rate over the past two decades.

Masco’s plumbing and decorative architectural businesses have solid long-term growth prospects, and we expect them to continue creating shareholder value for at least the next 20 years. As a result, we've upgraded Masco's moat rating to wide.

We’ve also upgraded Masco’s stewardship rating to Exemplary because of these corporate actions and because of the company’s balanced, shareholder-friendly capital-allocation strategy and its improving fundamentals under Allman's watch.

Acquisitions Helped Masco Transform Into a Powerhouse Masco's story began in 1929 in Detroit when Alex Manoogian founded auto-parts maker Masco Screw Products. The company gained exposure to the building-products industry in the 1950s when it created the Delta single-handle faucet, which used a ball valve to mix hot and cold water. Under the leadership of the founder's son, Richard Manoogian, Masco expanded into other building-product categories, including cabinetry (Masco acquired Merillat in 1985 and KraftMaid in 1990); spas (Watkins Wellness was acquired in 1986); building product installation (Gale Industries was acquired in 1995); hardware (Liberty Hardware was acquired in 1997); architectural coatings (Behr was acquired in 1999 and Masterchem [Kilz] was acquired in 2000); and windows (Milgard was acquired in 2001).

Now, the Company Looks to Slim Down When Allman was promoted to CEO in 2014, Masco had five reportable segments: cabinetry products, plumbing products, installation services, decorative architectural products, and windows and other specialty products. Combined, they generated $8.2 billion of sales in fiscal 2013.

The plumbing and decorative architectural segments have been the firm's least cyclical and most valuable. Based on our analysis, over the past 20 years, these two segments have accounted for almost all of Masco's cumulative economic profits (defined as invested capital multiplied by the spread between return on invested capital and the weighted average cost of capital). Conversely, the windows and installation businesses have destroyed value, generating cumulative economic losses. Masco's cabinetry business has fared better than the windows and installation businesses, but it has struggled to consistently earn excess returns.

Since taking the helm, Allman has remained steadfast in his commitment to deliver shareholder value by monetizing Masco's less attractive businesses to focus solely on the strongest ones, and we think shareholders have received excellent value so far:

• Since it was spun off to shareholders in 2015, TopBuild's stock price has since increased almost 310% compared with the S&P 500's 50% increase (as of Nov. 20, 2019)
• The Milgard windows and doors business, sold in the fourth quarter of 2019 to MI Windows and Doors, fetched $725 million, or about 11 times our estimate of the windows and other specialty segment's 2019 adjusted EBITDA.
• Masco expects to sell its cabinetry business to ACProducts for $1 billion, which is about 9 times our estimate of the cabinetry segment's 2019 adjusted EBITDA.

We've been pleased with the firm's balanced and shareholder-friendly capital-allocation strategy during Allman's tenure. Between 2014 and 2018, Masco generated about $3.8 billion of operating cash flow. Based on our calculations, management used almost 65% of this $3.8 billion to return cash to shareholders via share repurchases (approximately $2 billion used to repurchase 67 million shares) and to fund the dividend. Masco's annual dividend has increased at a five-year compound annual rate over 8% (we expect a $0.495 dividend in 2019).

Plumbing and Decorative Architectural Businesses Have Wide Moats Masco's plumbing and decorative architectural segments have comfortably outearned the firm's cost of capital and have each generated over $3 billion of cumulative economic profits. We believe intangible assets in plumbing and architectural coatings, along with the relatively low-cost Behr distribution and sales platform will support excess returns for at least the next 20 years, supporting a wide moat.

Plumbing Segment Has Strong Brand Equity We believe the Delta and Hansgrohe brands have more pricing power than lower-end brands and imports, which supports the segment's high-teens operating margins. Over the past decade, plumbing margins have benefited from the segment's ability to persistently raise prices more than input cost inflation. Delta products, which are known for pleasing aesthetics, innovation, and quality, focus on mid- to mid-high-end prices. Hansgrohe is sold in more than 140 countries, including the United States, where it is considered a premium brand with average prices more in line with Kohler and Grohe.

The plumbing segment generates approximately 65% of its revenue from the trade and specialty dealer channels. According to the 2019 Builder Brand Use Study, Delta bath fixtures and faucets are very well recognized by contractors (over 90% of contractors surveyed were familiar with the brand), and Delta ranked in the top three for brands most used (along with Kohler and Moen). New-home construction accounts for approximately 16% of plumbing sales. Because plumbing fixtures, such as faucets and shower systems, represent a very low percentage of total home construction cost yet are very visible to customers, homebuilders tend to opt for higher-end products.

Masco's plumbing brands also enjoy leadership in retail and e-commerce channels, which represent 25% and 10% of plumbing sales, respectively.

The Behr Brand Is Also Formidable The decorative architectural segment, which mostly consists of the Behr paint and primer brand, has been Masco's most profitable and highest-returning business. Behr is currently the leading brand in the nearly $5 billion U.S. do-it-yourself coatings market, with approximately 30% share, and it has been making inroads into the $8 billion professional market, where it has 6% share. We think two main factors drive Behr's strong financial performance. First, we think the Behr brand has built considerable brand equity, which drives repeat business and yields pricing power. Second, Behr's exclusive relationship with Home Depot HD, which is the largest home improvement retailer in the world, supports Behr's intangible assets and provides a cost advantage relative to main competitors Sherwin-Williams, Benjamin Moore, and PPG, which rely on a more cost-intensive sales channel.

Behr's reputation for award-winning quality at a reasonable price and its affiliation with and support from wide-moat Home Depot have built significant brand equity, which commands pricing power even when competitors become more promotional.

Given Behr's stronger quality ratings and lower prices compared with many Benjamin Moore, PPG, and Sherwin-Williams products, we think Behr has an opportunity to narrow the price gap between its products and the premium-priced competition over time.

From Masco's perspective, Home Depot's wide economic moat and market leadership provide a large and relatively stable sales channel for Behr products. Although PPG's Glidden brand is also carried by Home Depot, it's clearly marketed as a lower-cost but lower-quality alternative to Behr and is given much less display space in stores. We also think Behr's partnership with Home Depot provides it with a cost advantage relative to peers.

We think the Behr-Home Depot relationship has strengthened over the years as both parties work collaboratively to expand the brand and take share from competing paint brands across the DIY and professional markets. Behr's and Home Depot's joint effort to gain professional painter market share has yielded strong results thus far. Behr now has 6% share in the professional market and continues to grow. Given its cost structure, we think Behr is able to serve professional customers at a lower cost than its peers. Furthermore, Behr has enough manufacturing capacity to serve its expanding addressable market, which should result in faster capital turns.

The Behr-Home Depot partnership has endured for over 40 years, and we think this strong relationship can continue for at least another 20.