Sunday, November 10, 2013

Beacon Roofing Supply Will Have a Better Year in 2014

It's been a volatile year for the roofing industry, and over the last three months, investors have seen more downside. Roofing materials distributor Beacon Roofing Supply (NASDAQ: BECN  ) is down 11.5% in the last three months, and building products manufacturer Owens Corning (NYSE: OC  ) fell 5.5% in the same period -- all in a year when many commentators thought this sector would outperform. 

It's complicatedA resurgent housing market should lead to a marginal increase in new residential roofing demand, while the underlying reroofing demand should provide its usual support. Indeed, these conditions looked like they were in place for 2013, and analysts built a fair amount of optimism into their expectations. So what went wrong?

First, the US has had some unusual weather patterns in recent years. In previous years, hurricane Irene (and to a lesser extent Sandy) helped to generate reroofing demand, while this year's weather has been far more clement. Worse yet, according to Owens Corning, those storms pulled forward reroofing work that homeowners might otherwise have planned to do this year. And this spring's bout of wet weather further hurt roofing activity, because contractors simply couldn't work.

Second, rising mortgage rates have slowed new home sales' growth. For example, according to the U.S. Census Bureau, new home sales were at a seasonally adjusted annual rate of 390,000 and 421,000  in July and August respectively, where the average for the first six months of the year was 445k.

For a number of reasons, you shouldn't give up on housing just yet, but the roofing market remains weakened in the short term.

Problems leaking into Carlisle Companies and Owens Corning
A combination of these developments has dampened market conditions, and ultimately the operational performance of companies in the industry. It's difficult to be a supplier to roofing contractors when end demand is weaker than expected, because it can leave suppliers with too much inventory on their hands. 

For example, Owens Corning had previously expected that the full-year market shipments would be flat.  But in its third-quarter results from Oct. 23  , the company now forecasts that "... we came into the year thinking the overall roofing market should be about flat for the full year, it's down mid-single-digits year-to-date, and we think it'll be probably down mid-single-digits for the full year."

Moreover, Owens Corning has been affected by unusual variations in regional demand caused by the factors discussed above. It argued that US industry volume growth was stronger in Western and Atlantic markets, with weakness in Central regions. Unfortunately, Owens Corning has stronger market share in the Central regions, and weaker in the Western and Atlantic. In response, it appears to have decided to keep margins up at the expense of volume growth. Its roofing sales were flat in the third quarter, while its EBIT margins improved to 20% as EBIT rose 15.6% to $96 million.

Carlisle Companies (NYSE: CSL  ) also has a major construction materials division that supplies roofing products to Beacon. It appears to have taken the opposite approach to Owens Corning, and gone for volume growth instead of  keeping pricing and margins up. In discussing its third quarter results on Oct.22, Carlisle disclosed:

Pricing was negative 3% while volume was up 14%. We also experienced very healthy growth in Europe, where sales were up 11%. Both new construction and reroofing drove sales growth in the quarter.

Carlisle also argued that the pricing difficulties were due to excess capacity in the industry, but that underlying demand remains "very strong." It may well be, but it's also likely that the industry was geared for even stronger growth.

Which stock is the best pure-play on US roofing demand?For a play on a bounce back in North American roofing activity, Beacon may be your best bet. Carlisle is not really a pure-play roofing company, and Owens Corning has struggled to generate significant cash flows over the last few years. Moreover, Owens Corning doesn't have the kind of long-term structural opportunity that Beacon has to consolidate its industry.

Beacon will give its next set of results toward the end of November, and you shouldn't expect too much from them. Having chosen to buy inventory from its suppliers ahead of price increases, Beacon then suffered margin decreases as its growth lagged its previous quarter's forecasts. On the evidence of what Carlisle and Owens Corning just reported, Beacon may be in the middle of a tough quarter right now.

I don't want to be too negative on the stock. On the contrary, I'm looking for a potential buying opportunity. In the longer term, Beacon has many attractive qualities, and the roofing industry looks set for a better year in 2014. But for now, it's a good time to be a little cautious.

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