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Investment Thesis
Fortune Brands Innovations, Inc.’s (NYSE:FBIN) stock is up slightly since my previous buy rating in September. The end-market outlook has meaningfully improved since then and, with lower-than-expected inflation, analysts have started betting on a rate cut as soon as the middle of next year. The improving end-market demand given moderating inflation and potential recovery in single-family housing should benefit the company’s revenue in 2024. Further, the company’s sales should also benefit from retail inventory destocking coming to an end, strength in the Connected product business, new product innovations, and market share gains.
On the margin front, the company should be able to grow margins with the help of operating leverage from sales growth, a favorable cost environment, and cost-saving initiatives. The valuation is also reasonable. Hence, I continue to have a buy rating on the stock.
Revenue Analysis and Outlook
After facing challenges from inventory destocking over the past year, Fortune Brands’ revenue growth has started to see sequential improvement in its sales growth in the last couple of quarters thanks to the normalization of inventory destocking and easier comps. In the third quarter of 2023, in addition to the normalization of retail inventory destocking, good contributions from the company’s recent acquisition of Emtek and Schaub Business, Yale and August Business, and Aqualisa Holdings also benefited the revenue growth in the quarter. Moreover, price increases also helped the company in partially offsetting volume decline due to softness in end-markets given the inflationary environment. This resulted in a 5% YoY increase in sales to $1.26 billion. Excluding the benefit of $119.3 million or ~9% from acquisitions, organic revenue declined 4% YoY. The organic revenue declines reflect a mid-single-digit volume decline which more than offset the low single-digit benefit from price increases.
FBIN Revenues (Company Data, GS Analytics Research)
Looking forward, I am optimistic about the company’s revenue growth prospects.
With inflation trending in the right direction and the talks of a potential reversal in the interest rate cycle in mid-2024, I expect 2024 to be a much better year for the company.
On the repair and remodel (R&R) side, the company began experiencing inventory destocking in the latter half of 2022, a trend that persisted until mid-2023. This resulted in the company witnessing lower revenue compared to the actual point-of-sales (POS) demand during this period. With inventory destocking now complete, the company’s sales should see improvement. Even in the absence of a substantial improvement in POS demand, just the company’s sales aligning with POS demand should contribute to year-over-year (YoY) growth.
Also, I expect the broader macroeconomic environment to improve moving forward with inflationary headwinds diminishing which should help improve consumer confidence and increase POS demand. Further, after the divestiture of its Cabinets business, FBIN’s current R&R portfolio consists of mostly smaller ticket items, and usually, spending on smaller ticket items sees a much quicker recovery compared to the large ticket items when the economy improves. So, the company is well-positioned going into 2024.
The long-term underlying demand drivers in the R&R market are also solid with high home equity levels due to appreciation in housing prices post-COVID and the rising median age of homes in the U.S. which should help the R&R market in the medium to long term.
The fundamentals of the single-family housing market are also solid and this market has held up better than expected despite mortgage rates at multiyear highs. This can be attributed to the significant underbuilding of new homes after the great housing recession of 2008 which has resulted in a tight demand-supply situation in the market. Thanks to pent-up demand in this market, I expect it to post a quick recovery once the interest rate cycle starts reversing. The company also faces easier comparisons in this market next year which should help Y/Y growth.
In addition to end-market improvement, the company should benefit from good execution and focus on product innovations which is helping it gain market share and outperform the end-markets. A good example of it is the company’s connected product offerings where it saw sales tripping from FY20 to FY22 despite the disruptions in the chip supply which limited the company to reach its full sales potential. Including recent Yale and August acquisitions, the company’s connected products sales have reached ~$250 million with 4.5 million activations for its connected products. The company expects connected products to be a significant growth driver in the coming years and is focusing on scaling and introducing new products in categories like Smart residential locks, Master Lock connected access for business, and Moen’s Smart Water Network. On its last earnings call, talking about the potential opportunity in the smart water business, the company’s CEO Nicholas Fink said:
I mean when you look at the Smart Water opportunity from a number of different lenses, it is pretty staggering, right? Just to start with just the pure — how much preventable water damage is there today. We think that’s $15 billion of claims a year. It’s greater than Fire and Burglary combined, right, so $15 billion of preventable water damage. I actually believe we’re going to grow that addressable market because we’re going to come up with more products that can address more types of preventable water damage. We can take that pretty much to zero. I mean we did a study with LexisNexis in 10,000 homes. We reduced 96% of the claims to zero, and the other 4% of claims, I believe, we reduced by over 70%. So pretty much going to zero.
There’s an ESG lens to it, right? In addition to saving, we think potentially trillions of gallons of water, there’s a huge energy component to processing and cleaning water. And so you take Mission Moen, which is really based on what we have in the market today, our commitment to save 1 trillion gallons by 2030, that according to the math available on the EPA website, so equivalent to us taking one million cars off the road for a year, right? And so you can start to see (inaudible) municipalities, right? It has a huge dollar value impact. And so the opportunity is huge”
I believe a recovery in the end market coupled with the company’s above-market growth opportunity through innovating and scaling connected products should help it deliver good growth in the coming years.
Margin Analysis and Outlook
In the third quarter of 2023, the company’s margins continued to face headwinds from sales deleveraging due to volume decline. The company was able to partially offset it through price increases, cost-saving initiatives, and deflation in input costs. This resulted in a 70 bps YoY decline in adjusted operating margin to 17.4%.
On a segment basis, the Water innovations segment adjusted operating margin declined 50 bps YoY due to volume deleveraging partially offset by cost-saving measures. The outdoor segment’s operating margin declined by 170 bps YoY due to lower volumes resulting in sales deleveraging. However, the Security segment was able to increase its operating margin by 170 bps YoY due to price increases, high-margin product mix, and operating leverage from higher sales.
FBIN Operating Margins (Company Data, GS Analytics Research)
Looking forward, the company’s margins should benefit from operating leverage from sales recovery as end markets improve. On its earnings call in October, management talked about seeing a path to margin improvement even if the end market is down to low single digits in 2024. The end-market situation has improved since then as inflation data reported in November was better than expected and this led to an increased probability of rate cuts next year. With my expectations of end-market growth next year, I believe the company can post good margin improvement next year. The medium to long-term outlook is also good with management targeting 300-500 bps operating margin improvement through initiatives like productivity improvement, near-shoring, site consolidation, etc. So, I am optimistic about the company’s near to medium-term margin growth prospects.
Valuation and Conclusion
Fortune Brands is currently trading at ~17.54x FY24 consensus EPS estimate of $4.19 and 15.06x FY25 consensus EPS estimate of $4.87. Over the last five years, the stock has traded at an average forward P/E of 15.89x. However, one needs to note that the company spun off its low-margin and more cyclical Cabinet segment late last year, and the remaining company has higher-margin and more stable businesses. Hence, I believe FBIN’s valuation multiples deserve a re-rating compared to its 5-year average. I believe the stock can continue to trade at a forward P/E in the high teen range. If we apply a 18x P/E multiple to the FY25 consensus EPS estimate of $4.87, we get a one-year forward target price of ~$87 which implies ~19% upside over the next year.
I believe the company has good growth potential over the coming years. The revenue outlook seems favorable thanks to the completion of inventory destocking and a more aligned sales growth with POS demand, improving end markets, strength in the connected products business, and product innovations and market share gains. In addition, margins should also expand with the help of operating leverage from sales recovery. Hence, given the good growth prospects and reasonable valuation, I rate the stock a buy.
