Masonite International: The Market Is Not Pricing This As A Cyclical Company (DOOR)

Investment Thesis

Masonite International Corporation (NYSE:DOOR) is a cyclical company. While it delivered a 30 % ROE for FYE Jan 2023, its long-term performance and value should be viewed through a cyclical lens.

There is a strong correlation between DOOR revenue and the US Housing Starts. As such I would peg DOOR’s cyclical performance to that of Housing Starts. While the current performance is good, it does not reflect the poorer long-term cyclical performance.

Based on the cyclical lens, there is no margin of safety at the current market price. The market is pricing DOOR as if it can continue to grow revenue and improve its margins.

Thrust of my Analysis

I am a long-term value investor. When I analyze and value companies like DOOR, I try to see where they will be in 5 to 8 years’ time.

To get a picture of the mid-to-long term future, I start by looking at the performances over the past decade. In this context, I like cyclical companies because the historical performances are good indicators of the future due to their cyclical nature.

DOOR is a leading designer, manufacturer, and distributor of doors for the residential and non-residential markets. For the FYE Jan 2023, the North American residential market account for about 79 % of its revenue.

I will show that there is a strong correlation between its revenue and the US Housing Starts. The US Housing Starts is cyclical.

I will also show that its Gross Profit margins are correlated to revenue. At the same time, SGA margins are relatively “sticky”. This meant that in the downtrend leg of the cycle, it would be challenging to be profitable.

When the Housing Starts downtrend, I would expect DOOR revenue to follow suit. Projecting its performance based on the past few years’ results will lead to misleading valuation. A more appropriate approach is to based it on the normalized performance over the cycle.

Cyclical company

The US Housing Starts are cyclical with no long-term growth in the average annual Housing Starts of 1.5 million units. The latest peak-to-peak is from 2006 to 2022. Refer to Chart 1. The Housing Starts over the past few months have been declining. These are signs that the Housing Starts are entering the downtrend leg of the cycle.

Even if you dispute that the Housing Starts is going into the downtrend, you should not forget that there is no long-term growth in the annual average Housing Starts. Projecting DOOR performance based on the 1.5 million units of Housing Starts would give you a picture of its performance over the cycle.

While there is no growth in volume, there is long-term price growth of 4% per annum.

Chart 2 compared DOOR revenue over the past 20 years with the Housing Starts. You can see that DOOR revenue tracks the Housing Starts with a 0.73 correlation.

This meant that the US Housing Starts can explain half of the changes in DOOR revenue. I considered this a surprisingly significant correlation. This is partly because Europe accounted for 10 % of its FYE Jan 2023 revenue. The non-residential market also accounted for 10 % of its total revenue.

While there was double digits revenue growth over the past 2 years, this is due to the tailwinds from the uptrend leg of the cycle. When the US Housing Starts enter the downtrend leg, I would expect DOOR North American revenue to follow suit. As this is a large part of the total revenue, I would expect DOOR’s total revenue to decline as well.

More importantly, DOOR is a cyclical company. Its long-term performance and valuation should be based on this cyclical perspective.

Note to Chart 2:

a) Each index was derived by dividing the values for each year by the respective 2002 values (base of 1.00)

b) Due to the changes in the FYE, the years refer to the calendar year. Thus 2022 was based on the FYE Jan 2023 results.

Valuation of cyclical companies

Damodaran has this to say about valuing cyclical companies:

“Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable… than it is on firm specific characteristics…the biggest problem we face in valuing…is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluation.”

To overcome the cyclical issue, we have to normalize the performance over the cycle. Damodaran suggested 2 ways to do this:

• Take the average values over the cycle.
• Take the current revenue and determine the earnings by multiplying it with the normalized margins.

The challenge with the first approach for DOOR is that the size of the company currently is far greater than that in 2006. I thus adopted the second approach when looking at its value over the cycle.

Cyclical performance

I have mentioned that DOOR revenue tracks the Housing Starts with the downtrend from 2006 to 2009 followed by the uptrend.

However, the profits were very much affected by unusual items such as impairments and restructuring charges. From 2006 to 2022:

• DOOR Earnings before Tax (EBT) was a total loss of USD 677 million.
• If the unusual items were excluded, we have a total positive EBT of USD 911 million.
• DOOR during this period expensed USD 1.59 billion for unusual items. About ¾ of the expenses were incurred during the downtrend period of 2006 to 2009.

To track the earnings over the cycle, it makes more sense to look at EBT before unusual items. I would then treat the unusual items such as impairments separately.

I looked at 3 metrics to track DOOR performance over the last cycle – revenue, EBT before unusual items, and Gross Profitability. To plot these 3 metrics on the same chart, I converted them into indices. Refer to Chart 3.

You can see EBT before unusual items and Gross Profitability show very similar patterns as that for the revenue.

Notes to Chart 3:

a) Each index was derived by dividing the values for each year by the respective 2006 values (base of 1.00)

b) Due to the changes in the FYE, the years refer to the calendar year. Thus 2022 was based on the FYE Jan 2023 results

To get a better picture of the trends, I tracked the Gross Profit margins and Selling, General and Administration (SGA) margins against revenue as shown in Chart 4.

• Gross Profit margins have improved during the uptrend. There is a 0.87 correlation between the Gross Profit margins and revenue from 2006 to 2022.
• SGA margins deteriorated. The SGA margin in 2022 was higher than that in 2006. The relatively “sticky” margin from 2010 to 2022 meant that DOOR incurred proportionately more SGA expenses to sell more. If the Company had been more productive, the SGA margins would be reduced with higher revenue.

For those statistically inclined, I have tabulated in Table 1 the correlation between revenue and the various metrics.

The high correlation for the Gross Profit margin means that when revenue declines, so will the Gross Profit margin. Not exactly a good sign for a cyclical company.

You can see that the correlation for the SGA margin of -0.25 is not significant. It means that the SGA margins do not vary with revenue. This is bad news for DOOR because when revenue declines, the Company will face relatively high SGA expenses.

You should not be surprised by the SGA findings as the Company is addressing this:

“In December 2022, we began implementing a plan to improve overall business performance that includes the optimization of our manufacturing capacity and reduction of our overhead and selling, general and administration workforce…”

Financial performance

Historically, in the downtrend part of the cycle, not only did revenue decline but there were also impairments. You would want DOOR to be financially sound going into the downtrend of the coming cycle so that it can withstand these 2 impacts.

My key concern about DOOR is that it currently had a Debt Equity ratio of 1.44. I normally avoid companies with a Debt Equity ratio of more than 1.0.

However, this is partly offset by the following:

• It has an average interest coverage ratio (EBIT/interest) of 7 over the past 2 years. Based on Damodaran’s synthetic rating approach, its Debt would be rated A (Fitch).
• It currently has USD 297 million in cash. This is about 13 % of the total assets.
• Over the cycle it generated about USD 2.1 billion of Cash flow from Operations. This was sufficient to fund its CAPEX and acquisitions. There was extra to fund some of the share buyback. Refer to Table 2. Of course, it also increased its Debt. But looking at the overall picture, I would consider this a good capital allocation plan. While there was an increase in Debt, the funds were used partly for share buyback as well as to increase cash and other investments.

Notes to Table 2:

a) The majority of the Others were for other financing and investing.

b) The CAPEX and acquisitions were nets of sales of PPE and divestments

Valuation

I looked at 2 Scenarios:

• Scenario 1 – Normalized one over the cycle. I assumed that the normalized revenue is when the Housing Starts = 1.5 million units. The other parameters were based on the average values from 2006 to 2022.
• Scenario 2 – Contrarian one where the long-term performance equals the average performance of 2019 to 2022. There were major acquisitions in 2018 and I assumed that this had changed the business fundamentals.

I valued DOOR using the single-stage Free Cash Flow to the Firm (FCFF) model where:

FCFF = EBIT(1-t)(1-Re).

EBIT = Revenue X (GP margin – SGA margin).

t = tax rate.

Re = Reinvestment rate as determined from the fundamental equation of growth where growth= Return X Reinvestment rate.

Return = EBIT(1-t)/TCE

TCE = Total Capital Employed = Equity + Debt – Cash

In both Scenarios, I assumed that the long-term growth rate = 4 % based on the long-term GDP growth rate.

The key input metrics and values are summarized in Table 3 while the details of the valuation method are shown in Table 4.

The value of DOOR is:

• USD 8 under Scenario 1.
• USD 88 under Scenario 2.

There is no margin of safety under both Scenarios. I would consider Scenario 2 as highly unlikely since it assumed that DOOR is not a cyclical company. I am more inclined to follow Scenario 1.

Notes to Table 3:

a) Revenue based on 2022 adjusted for long-term Housing Starts. I assumed long-term Housing Starts to be 1.5 m units and 2022 Housing Starts to be 1.55 m units. The margins and capital efficiency were based on the 2006 to 2022 average.

b) Based on the 2019 to 2022 average.

Notes to Table 4:

f) The cyclical TCE is higher than the current one. As such, I assumed that there would be additional capital required that has to be deducted from the computed value of the firm.

o) The WACC was derived based on a Google search of the term “DOOR WACC” as shown in Table 5.

Limitations and risks

You should consider the following when looking at my valuation:

• Impairments.
• Cyclical WACC.
• Residential markets.
• Improvements

Going into the cycle, I would expect some impairments. I have not accounted for this in both Scenarios. In my valuation model, I derived the earnings from Gross Profit minus SGA. Thus, any impairments would have to be accounted for separately. This meant the DOOR is more over-priced than what was computed.

The WACC was based on the current situation of high risk-free rates and high risk premiums. Since I am looking at the performance over the cycle, the various parameters in the WACC should also be based on the values over the cycle.

Table 6 gives you a sense of the differences (based on Damodaran datasets). The cyclical WACC will be lower than the current ones. As such the values presented are conservative estimates.

Not all the revenue came from the residential markets. There is the European and non-residential markets which may not by cyclical. A more accurate picture would be to value these non-cyclical segments separately from the cyclical one. Then use the sum-of-parts valuation to determine the total value of DOOR. However, the value from Scenario 1 is so much lower than the current market price that there is nothing to gain by doing this.

Looking at Charts 2 and 4, you may argue that there have been some improvements in the operations. The current peak margins are higher than those in the 2006 peak. So, I should adjust the cyclical values for the higher peak values. I did try to do this but found that while the Gross Profit margins were higher, the SGA margins were also higher (deteriorated). The result was a lower EBIT.

A higher Gross Profit margin and a lower SGA margin will certainly increase the value. I know that the Company is addressing the SGA but until there are numbers to show the improvements, I would not attempt such a projection.

Finally, my valuation assumed that there is no significant change in its business and product profile. Its growth was partly been due to acquisitions and this could change the future business profile. If the non-residential and European segments get bigger, its valuation may be better represented by Scenario 2. But currently, there is no evidence of this.

Conclusion

DOOR serves the building materials sector. This is a cyclical sector and you should not be surprised that its revenue is cyclical. The challenge is identifying the macro parameter to link DOOR cyclical performance.

I have chosen to use the US Housing Starts as the macro variable – there is a strong correlation between DOOR revenue and Housing Starts. There is also a strong correlation between the revenue and Gross Profit margin.

At the same time, I have the following concerns about DOOR as a cyclical company:

• Its SGA margins are more “sticky” and it may not reduce proportionately with revenue. Coupled with the strong correlation between revenue and Gross Profit margins, DOOR will have problems with profitability in the downtrend leg of the cycle.
• Historically there were impairments of goodwill during the downtrend leg of the cycle. Given that there were acquisitions during the past decade, there is a risk of impairments in the future.
• It has a 1.44 Debt Equity ratio. On the positive side, its high Debt Equity ratio is offset by its strong synthetic Debt rating, good cash position and capital allocation plan.

The above analysis shows that there are issues with DOOR’s fundamentals when looking at its performance over the cycle. While its performance over the past two years was good, they are not a good indication of the long-term cyclical future.

At the same time, my valuation of DOOR through a cyclical lens shows that there is no margin of safety. I would not invest in DOOR stock based on these 2 reasons.

You may disagree with my view that the Housing Starts has entered the downtrend leg. This is not critical as 70 years of Housing Starts history have shown that there is no long-term growth in the average annual Housing Starts. My valuation was pegged to this long-term annual average. So it does not matter when the downtrend starts if you have a long-term perspective of DOOR. The key is that DOOR is a cyclical company.

Even if you ignore the cyclical evidence and value DOOR as a non-cyclical one, Scenario 2 shows that there is no margin of safety. There is additional reason why I would not invest in DOOR at the current price.