MasterBrands Inc.
A Spinoff of Fortune Brands
MasterBrand Inc.
Disclaimer
Black Opal Research is a financial newsletter that provides our take on different publicly traded businesses to obtain feedback and test our own thesis. We believe this process keeps us accountable for making educated investment decisions with our own money and no one else's. Please note that nothing in our articles should be considered as financial advice. We always urge our readers to seek qualified financial advice before investing in any of the companies we analyze. It is important to conduct your own research, fact-check, and evaluate.
Full disclosure: We currently hold a position in MBC with an adjusted cost basis of $9.10.
Summary
Management
Dave Banyard:
Employed at the company since 2019, leading the Cabinets segment before the spinoff from Fortune Brands.
Previous CEO role did not benefit investors during his tenure.
Competitive Advantage
Market leader with predominantly fragmented smaller players.
Possesses the largest distribution network.
Offers a differentiated product compared to its largest competition.
Margin of Safety price point
Intrinsic Value (Ten Cap): $19.29
DCF Entry: $ 4.00
Intrinsic Value (DCF): $ 8.00
Current stock price: $ 11.09
The Company
MasterBrand Inc. is the largest residential cabinet manufacturer in North America, accounting for approximately 24% of the total market share. The company has a long history of growth through acquisitions, culminating in its spinoff from Fortune Brands at the end of 2022. MasterBrand claims to possess the largest distribution network in the industry and has established long-term relationships with dealers who handle cabinet design and installation for end-use customers.
MasterBrand produces three distinct lines of cabinets, which differentiate it from its largest competitors who manufacture only one or two of these lines. The three lines are Stock, Semi-custom, and Custom Premium. The majority of their revenue, around 50% in 2022 (as per the chart from the 2022 Investor presentation), is generated from their stock/in-stock line. Furthermore, approximately 65% of their revenue in 2022 came from the renovation and remodel segment.
The company has historically expanded its business through acquisitions, targeting current consumer trends and developing brands across all market channels within the cabinet industry. Over the past 24 months, they have focused on streamlining and automating processes to enhance efficiency throughout the organization. Several examples of these initiatives are explicitly mentioned in their annual report and shareholder meetings. In the coming years, they aim to increase profitability through these initiatives while reducing debt.
The Market
MasterBrand estimates the size of the cabinet market in North America to be approximately $11 billion annually. This market is expected to grow at a rate of 2-5%, although projections from different research reports vary significantly. Nevertheless, there is strong demand for new homes, and consumers seem to be resilient in the face of inflation and interest rate increases. This may lead homeowners to opt for renovating their existing homes rather than purchasing new ones due to the higher cost of homeownership in the foreseeable future.
The cabinetry market is divided into three categories: Stock, Semi-Custom, and Custom, with Stock cabinetry constituting the largest portion of the market. Over the past five years, there has been an increasing number of imports in this space from countries like China, offering lower-cost manufacturing. MasterBrand currently estimates that import cabinets represent 15% of the total market, equivalent to $1.65 billion.
The cabinetry market is highly competitive, with companies vying for market share through brand recognition, competitive pricing, product quantity, and ease of installation. Some of the largest players in the North American market include Ikea, MasterBrand, and Cabinet Works Group. MasterBrand estimates its own market share to be around 24% of the overall market.
The Event
In recent years, MasterBrand has experienced significant increases in both top-line and bottom-line results due to heightened demand during the pandemic period. However, as economies reopened and interest rates began to rise, the renovation trend started to recede, impacting earnings in 2022.
Apart from the macro environment impacting the business, MasterBrand was recently spun off from Fortune Brands in December 2022. Typically, when a business is spun off, it gives investors pause and may negatively affect the share price of the smaller company. While we speculate that pension funds, mutual funds, and indexes exiting may be contributing factors, we cannot be certain. Additionally, MasterBrand assumed a significant amount of debt to pay the special dividend to Fortune Brand shareholders as part of the separation.
Moreover, as we entered 2023, interest rates began to rise, and the entire home building segment has been perceived to be negatively impacted. Rising interest rates generally dampen excessive spending, resulting in less renovation activity, particularly among those with lower annual disposable income.
The Evaluation
Ten Cap Evaluation
At Black Opal Research, we value businesses as if we were going to purchase the entire company. Our Ten Cap analysis is straightforward, ensuring that if we acquired the entire business, we would achieve a return of our entire initial investment over a ten-year period. This analysis does not factor in any growth metrics and assumes that the business will remain steady and constant over time.
In 2022, MasterBrand generated approximately $235 million in cash flow from operating activities. The company invested a total of around $55 million in the business, with only a portion considered maintenance capital expenditures. The financial report does not clearly specify the breakdown between maintenance and growth capital expenditures. Assuming a significant portion of the manufacturing business requires maintenance to sustain operations, we estimate maintenance capex at 70% of the total capex, giving us $38.5 million in maintenance capex.
To obtain the owner earnings figure, we use the Operating Cash Flow, subtract the Maintenance Capex, and add taxes. This represents the pre-tax free cash flow of the business as if we owned it entirely. $235M - $38.5M + $58M = $254.5 million.
Currently, MasterBrand has approximately 128.0 million shares outstanding. Therefore, the current owner earnings per share generated by MasterBrand is $254.5 million / 128.0 million = $1.918 per share. To achieve a return of our invested capital in the business (assuming we own the entire company) over a ten-year period, our current entry price would need to be at or below $19.18 per share.
DCF Evaluation
We believe that a DCF evaluation is not the appropriate method to value this business at present. Several reasons support this opinion. Firstly, future growth in this competitive environment is difficult to determine. Opportunistic acquisitions remain a possibility, as seen in MasterBrand's path to becoming the largest cabinet manufacturer in North America. However, such acquisitions would result in sporadic growth from year to year. It is worth noting that this is a highly fragmented industry with numerous small manufacturers, and individual acquisitions would not significantly impact earnings. Over the long term, entering new complementary markets could potentially generate 2-3% of earnings growth annually over the next decade.
MasterBrand is also focused on streamlining and creating efficiencies within its supply chain. The company aims to align its businesses with those of its distributors to make the ordering and selection process more efficient. Management believes this will provide them with a competitive advantage over other manufacturers while driving margin expansion. They have set a long-term goal of achieving an operating margin of 14-16%,and they are currently operating at around 9%. If executed properly, reaching this goal would significantly boost profitability even if revenues remain flat. We believe this goal is attainable.
Lastly, there will always be a need to replace cabinets and build new homes in the future. We expect this market to grow at least in line with inflation on an annual basis, and possibly faster. Estimates for the organic growth of this market vary widely, with some reports including furniture construction, appliances, etc. However, we do not place significant emphasis on these numbers, as predicting the future is uncertain. We anticipate a growth range of 2-5%.
In conclusion, our earnings growth rate for our DCF valuation is 8% per year. Based on this growth rate and a 15% discount rate, we believe the business is currently worth $8.00. We would consider investing in this business at around $4.00, allowing for a 50% margin of safety for our investment.
Summary
We view MasterBrand as a straightforward and easy-to-understand business that consistently generates free cash flow. The company's growth will likely be gradual unless the management team embarks on a significant acquisition spree targeting smaller manufacturers or enters complementary markets with their excess free cash flow.
We have concerns about the competitive advantage they claim to maintain, as we believe it is not as strong as the management team portrays it to be. While we understand that homebuilders may have costs associated with switching manufacturers, the expense of retraining and selecting a new manufacturer is not excessive. Additionally, this industry has low barriers to entry, and any other large manufacturer servicing the renovation or homebuilding market could leverage their existing distribution footprint to enter this market.
From an investment perspective, we believe it is best to value MasterBrand without growth assumptions and focus strictly on free cash flow. We anticipate that the management team will prioritize debt reduction and then aggressively repurchase shares or return free cash flow to shareholders through dividends. While this outcome is uncertain, it could be a prudent use of capital in a potentially stagnant industry. We will be attentive to any updates on these initiatives during future earnings calls.
Please note that we have purchased shares in MasterBrand with an adjusted cost basis of $9.10.