Fortune Brands Stock: Banking On Innovation For Superior Returns (NYSE:FBHS)

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Fortune Brands Home & Security (NYSE:FBHS) is trading at a steep discount to the market. It is trading at a forward P/E of 10x and an EV to EBITDA of 8x. The company’s five-year average forward P/E is 17x, and its five-year average forward EV to EBITDA multiple is 11x. This company has lost 30% of its value in the past year. It may be good to open a position in the stock at current prices and add to the position on any further weakness.

18 companies in the top 147 top holdings in the Vanguard Industrials ETF (VIS) have lost over 30% of their value in the past year [Exhibit 1]. The Vanguard Industrials ETF (VIS) holds 351 companies in its ETF. The ETF trades at a weighted average P/E of 20x, which is in line with the weighted average P/E of the S&P 500.

Exhibit 1: Top Losers in the Vanguard Industrials ETF

Top Losers in the Vanguard Industrials ETF

Top Losers in the Vanguard Industrials ETF (iexcloud.io, author compilation)

Fortune Brands Spinning Off Cabinets Segment

The company operates under three segments – Plumbing, Outdoors & Security, and Cabinets. Fortune Brands has decided to spin off its Cabinets business in a tax-free transaction. The Cabinets business’ performance has been uneven over the past 13 years [Exhibit 2]. The segment’s revenue growth is volatile, with an average growth rate of 8.3%. The growth rate skews to the right, with the median less than the mean. The standard deviation for the revenue growth rate is a very high 8.2%, again highlighting its revenue volatility [Exhibit 3].

Exhibit 2: Fortune Brands’ Cabinets Segment Revenue and Operating Margin

Fortune Brands' Cabinets Segment Revenue and Operating Margin

Fortune Brands’ Cabinets Segment Revenue and Operating Margin (sec.gov, author compilation)

Exhibit 3: Average, Median, and Standard Deviation of Cabinets Segment Revenue Growth Rate

Average, Median, and Standard Deviation of Cabinets Segment Revenue Growth Rate

Average, Median, and Standard Deviation of Cabinets Segment Revenue Growth Rate (sec.gov, author compilation)

The Cabinets segment’s average operating income margin is 6%, with a high standard deviation of over 4% [Exhibit 4]. This business comes with good operating leverage, which means the company has high fixed costs, which plays to its advantage when times are good. Operating income will grow faster than revenue when the cabinets market is growing. But, its high fixed costs can become a liability when its revenue contracts. In short, the Cabinets business is very volatile with indefensible margins. Overall this new business would have a much higher beta and deserve an EV to EBITDA multiple of between 6x and 8x. The spin-off of the Cabinets business may not be a good enough reason to invest in the stock.

Exhibit 4: Average, Median, and Standard Deviation of Cabinets Segment’s Operating Income

Average, Median, and Standard Deviation of Cabinets Segment's Operating Income

Average, Median, and Standard Deviation of Cabinets Segment’s Operating Income (sec.gov, author compilation)

Water Innovations Segment is the Crown Jewel

The volatile performance of its Cabinets segment is stark compared to its plumbing segment’s steady revenue growth and higher margins. The company has grown the revenue of its plumbing segment at an average rate of 10% between 2009 and 2021. Over the years, the company has improved the operating margin of its plumbing division. That segment now has an average operating margin of 18.66% [Exhibit 5].

Exhibit 5: Fortune Brands Revenue and Operating Income from Plumbing Segment

Fortune Brands Revenue from Plumbing Segment

Fortune Brands Revenue from Plumbing Segment (sec.gov, author compilation)

The company has generated an average operating margin of 21% for its plumbing segment between 2015 and 2021. For the quarter ending March 31, 2022, the plumbing segment (renamed Water Innovations in March 2022) had an operating income margin of 23.19%. The Water Innovations segment is the most vital business unit within Fortune Brands. After the Cabinets spin-off, Fortune Brands Home and Security will be left with its Water Innovations and Outdoors & Security division.

The Outdoors & Security segment had an operating income margin of 12.1% in the quarter ending March 31, 2022. It had a margin of 11.44% in the same quarter of 2021. It is safe to say that the Water Innovations segment is the crown jewel of Fortune Brands Home and Security. The Water Innovations segment derives its competitive advantage from its brands and product designs. In the Q1 FY 2022 earnings call, the CEO highlighted the strong sales growth in its House of Rohl faucets. The CEO also stressed that demographics and demand remain favorable for the housing market. I agree with the CEO that the kitchen, bath, and the outdoors will remain a priority for homeowners, and they like to invest money in well-designed fixtures that will make a statement and will be a joy to use daily.

Modest Dividend of Fortune Brands with Some Excessive Share Buybacks

At its current stock price, the stock yields 1.8% and pays $1.12 per share. In this current interest rate environment in which the 10-year U.S. Treasury yields 3.4%, and the S&P 500 yields 1.6%, Fortune Brands’ dividend yield is low. The company has a very conservative payout ratio of just 18.6%. But, when the market recovers, this company should provide good price appreciation that could quickly compensate for the low dividend yield.

I have always maintained that share repurchases benefit management more than benefits shareholders. It is a form of financial engineering that could weaken the company in the long run. Product and service innovation is the best way to add value in the long term, but innovation may take a long time and yield uncertain returns. In a recent article, Fortune magazine criticized companies for doing share buybacks when worker pay has not kept pace with inflation. Share buybacks exacerbate inequality in this country and may even threaten our fragile democracy. Also, companies cannot claim excellent ESG credentials when CEO pay is so much more than the average worker’s pay and the worker’s pay is not even keeping up with inflation. For once, I agree with Elon Musk, who recently said that ESG is a scam.

Many companies buy back shares when they are high and show restraint when the share price is low. This indiscriminate use of shareholders’ cash is not prudent. For example, the company spent $456.66 million in share repurchases between October 1 and October 31, 2021, with an average price paid per share of $94.53. The stock is currently trading at $61.89. The company spent $455.68 million on share repurchases in October 2018 and paid an average price per share of $47.94. The company has done excessive levels of share buybacks during specific years. For example, in 2016 and 2021, the company spent 65% of its operating cash flow on share repurchases. In 2018, the company paid 115% of its operating cash flow on share repurchase. At the beginning of 2016, the company had 157.59 million outstanding shares. As of February 2022, the company has 134.17 million outstanding shares.

There is a follow-the-herd mentality among C-level executives at most companies in the U.S., especially when it comes to share buybacks. They may also fear that an activist investor may cause trouble for management if they hold too much cash on their balance sheet. But, management could pay the excess cash as dividends to shareholders. Most companies in the U.S. also believe that if there is a deep economic crisis or volatile conditions in the debt markets, the world’s more powerful bank (the U.S. Federal Reserve) and the U.S. Congress will ride to their rescue [Fed Put]. I would like to see companies spend less than 20% of their operating cash flow on share repurchases and should wait for the opportune time to do so.

Technical Indicator Seems to Highlight Stock’s Weakness

The stock is trading near its 52-week low, and the Relative Strength Index [RSI] is at 31 – an oversold signal. The Money Flow Index [MFI] is not at oversold levels at this time, with a reading of 41 [Exhibit 6], but may get there on any further sell-off in the market, potentially providing a good entry point for this stock. But, the MFI has recently bounced off near oversold levels, so it remains to be seen if this stock has any further downside.

Exhibit 6: Fortune Brands Home & Security MFI and RSI Technical Indicators

Fortune Brands Home & Security MFI and RSI Technical Indicators

Fortune Brands Home & Security MFI and RSI Technical Indicators (Seekingalpha.com)

Covered Call or Cash-Secured Put Options Strategy

If you already own the stock and holding on to double-digit gains, a covered call strategy may be attractive to generate some income. July 15, 2022, $65 strike price call last traded at $1.50 and has a bid of $1.45. At the $1.45 price selling, a covered call would yield 2.2%. The market reacted positively to the 75 basis points hike by the Federal Reserve. If this market momentum continues, there is a probability that the call will be assigned and your shares called away at $65. You would realize the gains in the stocks plus the amount of the call premium. I sporadically use covered calls, especially on my holdings with over 50% gains and I look to earn a call premium of at least 1%.

If you want to buy the stock, selling a cash-secured put strategy may be appropriate. But, this strategy may not be suitable if the current market momentum continues, since it may not yield a good premium.

Exhibit 7: July 15, 2022, $65 Strike Calls May Yield a Good Premium

Covered Call with July 15, 2022, $65 Strike Calls May Yield a Good Premium

Covered Call with July 15, 2022, $65 Strike Calls May Yield a Good Premium (E*Trade)

Conclusion

Water Innovations is the crown jewel of Fortune Brands Home & Security. The company is trading at a cheap forward EV to EBITDA multiple of 8x. Shareholders will get a “dividend” from a tax-free spin-off of the company’s Cabinets segment. If there is a recession in the U.S. shortly, the company’s Water Innovations should hold up fairly well, as seen by its performance during the recession of 2007 to 2009. Fortune Brands Home & Security may be too cheap to ignore.

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