In Friday’s Daily Alert, Ian Wyatt explained why he thinks the housing market is at the beginning of a recovery. Today’s recommendation is a creative take on the same prediction, recommended by Tyler Laundon in Small Cap Investor Pro.
“If you believe that we are at or near a bottom in home construction then today’s recommendation should be of great interest. This company also pays a 2.8% dividend, which should help support the stock price in the event of a broad market correction.
An Immediate Life Improvement
“As a previous owner of a contracting company and now a weekend warrior home renovator, I have a pretty good feel for what people want out of their existing homes.
“At the most basic level, we want them to be comfortable to live in and attractive to look at. Thankfully, there are two time-tested solutions that help homeowners get closer to serenity without breaking the bank. These are what I call ‘immediate life improvements’ for remodelers because they are relatively quick and inexpensive. For new construction projects these are essential parts of the building process.
“Today’s recommendation is a chemical company that makes essential compounds for both solutions.
Immediate life improvement #1: Spray foam insulation
“Northerners love insulation because it shields us from those blustery winters. And southerners crave it because it keeps the air conditioning bill down. Over the last decade, advances in spray foam formulations have brought the cost down to a point where it’s economical for most homeowners, whether for a remodel or new construction project.
“Spray foam insulation is often so much better than the alternatives — fiberglass or blown-in cellulose — that its use from a performance perspective is a no-brainer. Labor costs can be similar because it’s pretty efficient to spray in foam versus cutting and stuffing fiberglass. These days we also see spray foam insulation used in conjunction with traditional materials to match up the desired (or code mandated) R-value with the homeowner’s budget.
“The net result is that while housing starts are way down, the pounds of methylene diphenyl isocyanate, or MDI (the chemical used in polyurethane spray foam), per housing unit is steadily climbing. This is pretty convincing evidence that spray foam insulation is here to stay.
“The trend also suggests that a rebound in home construction could mean significant growth for the chemical companies that make these foams. Uses for spray foam also include structural, sculpting and flotation applications, so there is growth potential beyond housing.
Immediate life improvement #2: Paint
“A fresh coat of paint has to give the most bang for the buck when homeowners want to improve their house. It’s like a deep clean and a fresh look all at once — not to mention a necessary part of the process in new home construction.
“One of the necessary ingredients in paint is titanium dioxide (TiO2), a white pigment that helps give paint opacity and better coverage. Generally speaking, the more TiO2, the higher the paint quality and the fewer coats required.
“I believe any sort of uptick in new home construction, fix-and-flips and home improvement projects could lead to a dramatic increase in the amount of paint sold in the U.S. Like makers of spray foam, companies that manufacture TiO2 stand to benefit.
Why Housing Now
“In recent months you’ve likely seen improving numbers for unemployment and housing starts. You may also have noticed that many home building stocks have surged. The clearest measure of why this is happening is the National Association of Home Builders’ Housing Market Index.
“This index measures three things as reported by home builders: current single-family home sales volume; projected single-family home sales volume for the next six months; and current buyer foot traffic.
“Generally speaking, a reading above 50 is bullish for home builders while a reading below 50 is bearish. Note how low this index was over the past couple of years and the dramatic increase in recent months. We’re not in bullish territory yet, but we’re certainly improving.
“Moreover, record low interest rates coupled with a massive drop in home values has made housing much more affordable than at any point since before 1970, according to the National Association of Realtors.
“Of course this backward-looking data — compiled by those with a clear incentive to get Americans to build or buy homes — is no guarantee that housing will continue to improve and that housing-related stocks will surge higher. But it does support ample anecdotal evidence that the worst of the housing crisis is behind us.
How to Invest
“A good way to position ourselves for a housing rebound is to buy shares in chemical company Huntsman Corp. (HUN).
“At a market cap of $3.4 billion, Huntsman is larger than our typical investment. But it’s still a relatively small company, and its breadth of specialized product offerings, geographic exposure, a nearly 3% annual dividend and its attractive valuation right now make it the best way to get the exposure I want.
“As I mentioned earlier, Huntsman’s chemical formulations include paint pigments such as titanium dioxide (14% of revenues) and MDI-based polyurethanes (36% of revenues).
“Demand for these products should increase if more homes are built. If we see a big recovery in housing, demand for these products could soar since the chemical industry has adjusted to meet today’s reduced demand.
“Huntsman’s chemicals are also sold into three other markets: performance products (29% of revenues), textiles (7% of revenues) and advanced materials (12% of revenues).
“You’ll find various versions of its products in your house, cars, shoes, and in planes, energy exploration equipment, wind turbines and in just about anything else out there. If you’d like greater detail on any of these segments take a look at Huntsman’s most recent presentation here.
“Of the five segments, Pigments, Polyurethanes and Performance Products are the cash cows, bringing in 81% of revenues and 97% of EBITDA in 2011.
“Huntsman’s global reach is also a plus with 63% of revenues coming from developed economies in North America and Europe and the remaining 37% from developing regions in Asia, Africa and South America. Europe is a bit of a wildcard right now. But an improvement in Europe is consistent with my investment thesis that an improvement in the U.S. is good for Huntsman — so this exposure is not a deal-breaker for me.
“In August 2011, the entire chemical industry was hit hard when investors became concerned that rising input costs would hurt margins going forward. Huntsman, as well as larger competitors Dow Chemical (DOW) and E.I. DuPont (DD) fell between 25% and 55% by the end of the year.
“Huntsman was the hardest hit, in part because the company missed earnings estimates by a penny. The response from management was to simply state that the concerns were overblown and to buy shares of the stock at a deep discount. CEO Peter Huntsman alone purchased more than a million dollars worth of stock.
“All three chemical stocks have begun to recover as third-quarter reports showed that the previous concerns were indeed overblown — at least in the mid-term. Huntsman beat earnings expectation in the third and fourth quarters of 2011 and has had its credit ratings reaffirmed. The stock price has not yet fully recovered however.
“The company also turned in a pretty solid year. Revenues increased by 21% to $11.22 billion in 2011 and diluted earnings reached $1.02 per share as the company completed some restructuring initiatives. Looking out over the next two years, we should expect moderate sales growth of more than 5% annually, but much faster earnings growth. The consensus EPS is $1.80 in 2012 and $2.10 in 2013.
“Earnings growth should carry the stock back above $20.00, meaning at least 30% upside from here and as much as 50% higher should the stock reach historical highs.
“Right now, Huntsman trades with an extremely inexpensive forward P/E of 6.6 based on 2013 EPS estimates. That makes the stock a screaming bargain compared to competitors Dow and du Pont, which carry forward P/Es of 10.1 and 10.9, respectively.
“If we assume a comparable valuation, say a forward P/E of 10 on 2013 estimated earnings of $2.10, shares of Huntsman need to reach $21.00 to be on par with the competition. This is entirely reasonable.
“My price target for now is $20.00 and we’ll collect the 2.8% dividend along the way. As is our standard approach right now, take a first tranche and await receipt of a second recommendation to establish a full position. Our portfolio will record a cost basis of $14.25 for our first tranche.
“Action to take: Buy a first tranche of HUN up to $15.00. Price Target: $20.00. Stop Loss: n/a, waiting to fill second tranche.”
- Tyler Laundon, Small Cap Investor PRO, March 23, 2012