One of my favorite themes headed into this year was the expected recovery in residential and non-residential construction demand.
I keep track of a number of factors within the manufacturing segment: ISMs, PMIs, factory orders, new/existing/pending home sales and the Architectural Billings Index. All of these metrics have shown improvement throughout the year. Both the ISM and PMI reports have been comfortably above the expansionary level mark of 50 for more than a year and the most recent ABI report showed inquiries at the highest level since 2005.
But more importantly, I listen to company conference calls and in 2Q there were several companies that indicated the environment was showing signs of life. Companies like Ingersoll-Rand (IR) , Lennox International (LII) , Armstrong World (AWI) , United Technologies (UTX) and Johnson Controls (JCI) all pointed to green shoots. Even the disappointing quarter from Eaton (ETN) showed improved bookings in each of its electrical divisions, which was confirmation of the trend.
What’s likely helping the trend is the fact that interest rates have stayed low -- much lower than I expected. In fact, if you ask me what’s the biggest surprise year to date, it's the 10-year bond yield at 2.36%, down from 3% seen at the end of last year. There are a lot of factors weighing on bond yields, such as the geopolitical issues, the continuation of QE by the Federal Reserve, the unknown of tapering back some of these QE efforts and the fact that Europe is teetering on going back into recession as Russian sanctions have put pressure on this region. Japan has decelerated from its recent recovery and China remains a wildcard on whether it can grow at its targeted rates.
As a result, Treasuries are seeing a flight to safety and that is bidding up bond prices and pressuring yields. While that is putting pressure on the bottom line of financials (and my bullish bank call from earlier this year), it is leading to higher loan growth and the improvement in the overall economy. That's because low interest rates help affordability for the consumer and U.S. corporations. This trend of low rates could last longer than expected given that Europe isn’t likely to see a quick recovery, Japan remains in a malaise following the BOJ’s decision to raise its consumption tax and the geopolitical issues in the Middle East are likely to remain elevated. China remains a wildcard, but the PBOC’s commitment for its 7.5% GDP target will likely continue to lead to targeted stimulus efforts. Still, it’s pretty clear that this region needs to be watched closely.
So, the United States is the best of the lot, showing better manufacturing data and a pretty resilient consumer, with auto sales at new cycle highs, retail sales mixed-to-improving and housing showing signs of life (today’s housing starts showed a nice ramp higher, up 15.7% y/y to an annual rate of 1.09 million). GDP has seen a snap back in 2Q to a 4% rate from the 2.1% decline in 1Q and consensus is looking at 3% growth in the second half (some are calling for higher, at more like a 4% clip). Corporate earnings for 2Q were strong, seeing 10% bottom-line growth and 4.5% revenue growth and if the economy continues to progress as I expect, earnings could continue to beat -- and on higher revenue growth, which would be the pleasant surprise.
If you think rates stay lower for longer and the U.S. economy continues to show improvement while the rest of the world muddles along, it’s probably worth looking back at some of the housing plays, especially after hearing what Home Depot (HD) had to say today on its conference call. The company reported better-than-expected earnings, revenues, same-store sales, average ticket size and transaction and notable strength in HVAC, tools, appliances and lumber. HD posted an acceleration in all three of its U.S. businesses, including the 10th-consecutive quarter of above-average corporate growth in its professional segment.
I’ve recommended Toll Brothers (TOL) , Stanley Black & Decker (SWK) , Weyerhaeuser (WY) , Masco (MAS) , Home Depot and Lowe’s (LOW) in the past, and for Action Alerts PLUS we’ve either owned them at one point or have written about them.
I like the USG (USG) story here. USG is a way to play the resi/non-residential theme. It is a manufacturer and distributor of building materials like drywall and joint compound for the repair and remodel markets, with 81% of its revenues coming from the U.S. market, 11% from Canada and 8% from the rest of the world. I like the end-market exposure and the North American-centric revenues and valuation. I also think the company is positioned to see a snap back in demand. We didn’t see it in 2Q because weather was still uneven and demand mixed, but I think 3Q sets up well.
On its 2Q call, management said it expects mid-single-digit growth in commercial construction and repair and remodel markets in the second half and it specially called out green shoots in improving steel product shipments in its distribution segment, which is a leading indicator since these products go into new commercial buildings ahead of wallboard and ceiling products. I expect the top line to be mixed (volumes were barely above 2% in 2Q and well below the 6% expectation), but margins to remain strong, especially since contracted wallboard contracts were priced at the beginning of the year with a 9% increase y/y. As demand comes back, the company should return to its historical operating leverage of the 35-50% range, with upside likely on both pricing and volumes. Margins also have upside in the 2015/2016 timeframe from reduced overhead and capex costs, as it remains laser focused on expense management until the demand trends pick up meaningfully.
I thought the commentary from wall board producer Continental Building Products (CBPX) was encouraging. The company said that volumes picked up in July, with shipments up low-single digits (there were declines in Canada, but that was more than offset by strength in the U.S.) and guidance of low-single-digit gains for the second half of the year. Shares are down 20% from highs and trade at an attractive valuation at 15x forward P/E (I'd argue earnings are depressed) and 8.7x EV/EBITDA. Expectations remain pretty low and any pickup in volumes would be meaningful to the earnings power of the company. The anecdotal information out there from the companies I listen to suggest its coming.