James Hardie Industries - Q2 2016

Transcript

Louis Gries (CEO)

Okay, good morning, everybody. Thank you for joining the second quarter result. I'll walk through this, or we'll walk through it the same way we always do. I'll take you through the just high level business result, and then Matt Marsh, CFO of James Hardie, walk you through the financials, and then we'll come back to question and answer. So we'll go to the first page. That's a group overview. I guess the pertinent things on the slide as far as the little graphs go, we are flat on net operating profit adjusted. We are up 12%, so like I said, Matt will go through the financials, and you'll see how that arithmetic worked out.

On the higher volumes, we did have higher volumes in all businesses, but I think everybody who follows Hardie knows we're not satisfied with the volumes we're getting out of the U.S., so I'll cover that when we get to the U.S. We did have average higher net sales price in all businesses as well, in local currencies. Obviously, everything outside the U.S. gets translated into U.S. dollars. So in U.S. dollars, some of the currencies, I mean, some of the pricing was down, but in local currency, which is, you know, reflects more of the market position, everyone was up. Plans continue to run well. Basically, the businesses right through the company continue to run well. Half year EBIT, 25.6.

Most of you would have seen for a quarter, it was 24.8, so we'll talk about that a bit. That's U.S. and Europe, and then a dividend of $0.09. So going to the next slide, go through the U.S. Net sales up 8% in the quarter, 7% on volume, just 1% on price. Right off the bat, on the volume, we think our market index around 5-7 right now, so we're running flat to the market index. So PDG's flat, so that's kind of the headline for the company, I think both internally and externally. Price, you know, we took a 2-3% increase last year. We're only seeing about 1% come through. That's partly because of the FX in Europe and Canada.

A big part, actually. And then there's also mix isn't working for us this year to the degree we normally have gotten help from mix, and that's because HardieBacker is actually growing faster than the exterior products this year. And our ColorPlus product, which basically is a value-add feature going right on top of some of our products shipped into the market, that's been flat. So those two things basically means mix isn't helping. It's not really hurting, it's just not helping. On the EBIT line, we are getting help from lower freight, lower pulp, and lower gas relative to last year. And at least for the time being, or the short term, we expect that to continue.

Going to the next slide, you can see the last data point does fall just below the 25%, top of the range. The biggest thing is the U.S. business ran 26% plus. The Windows loss, the Windows business that we're starting up, we put in our U.S., Europe fiber cement results. The losses in that business increased this first half as planned, as we start participating in more markets with our window offering. So again, the U.S. business, 26% plus, and it brings the number you see down to about a 24.8%, when you deal with the FX and the FX out of Europe and the Windows loss. Top line growth, I guess I already covered.

We're just tracking with market index now, so it is going up, but it's not going up in market share this year, which is something we're addressing, obviously. Average price, I also covered. Trend is still good, but again, we're only getting 1% this year for those reasons I talked about. Asia Pac had a pretty good result. Probably the market's good in Australia. Our business is well set up. Our Scyon product line continues to grow, which is the main initiative in the business. What pulled the result down a little bit was the Carole Park start up.

The large high throughput line we put in Carole Park didn't start up as planned, so there's some inefficiencies on both the cost of goods sold in the business due to the less than planned start-up. And we did have to delay orders, and so some of that, not a lot of it, spilled into the next quarter. So that's the overview of the businesses, and I'll hand it over to Matt for the financials.

Matt Marsh (CFO)

Good morning. So we're on slide 12. The group's second quarter results, as Lou said, net sales are up about 2% on a reported basis. Volumes were up in all the operating segments, and I'll show you those when we go through the segment results here in a minute. He's also talked a little bit about higher average selling prices in local currencies year-over-year. Gross profits are up about—Sorry, gross profit margins are up about two hundred and forty basis points, primarily as a result of the US plant performance. And then we're getting help on input costs, almost across the board on our key inputs are all down year-over-year. SG&A expenses up about 3%, really driven by two things, both stock compensation and FX losses.

You'll see that at the half year as well. Adjusted net operating profit for the second quarter is up 2%, that's on EBIT up 11%, so the operating businesses are up. That gets compressed as a result of both higher income taxes, as a result of the mix of earnings in high tax jurisdiction countries, primarily the US. And then gross interest expense is up about $5 million in the quarter, corresponds to the higher level of debt. If we go to the half year, you see net sales up for the half year, up 2%, gross profits up 11%, EBIT up 25%, and net operating profits up 22% for the half year, all in comparison to the first half of a year ago.

Similar, you know, drivers and dynamics, if you will. Volumes up in the segments, sales prices up in local currencies, compressed a bit by foreign exchange. We get some tailwind on plant performance, which is contributing to the gross margin rate increase of almost two hundred and seventy basis points, as well as lower input costs. SG&A, again, up very similarly, up about 3%. You have about $4 million, half of almost literally half of it's foreign exchange, and the other $2 million is stock compensation as a result of the change in the share price. Then you can see very similar dynamics on net operating profits. Strong EBIT growth of 25% growth, offset by income tax, gross interest expense being up corresponding to the debt.

You'll see about a $6 million swing and a favorable swing in other income and expense. Some of that's unrealized foreign exchange. About $4 million is unrealized foreign exchange, and about $2 million is the gain on sale for the pipes business here in Australia. Foreign exchange here in Australian dollars. You can see the impact on the lower left side of the chart, your lower right. So a total foreign exchange impact of about $41 million on sales, almost $9 million on EBIT, and $5 million on net operating profits. The strong dollar is having an effect on our results in both Aussie dollars as well as Canadian exchange.

We're seeing that through price and the European results when we translate those, and you can see the impact that that has on a percentage basis year-over-year. Now, we wouldn't typically talk about foreign exchange, but we felt like foreign exchange is certainly material enough to changing some of the operating discussions that we thought we'd highlight it a little differently this quarter. On input costs, so they've stabilized quarter to quarter, but year-on-year, we're still getting lower input costs that are positively contributing to both gross margin rates and EBIT rates, so you can see pulp's down about two versus a year ago. Cement prices are up.

The cement industry in the U.S. continues to be positioned well, and pricing continues to trend up, and we expect that to continue. Gas is down over 20%. You can see electricity is down a little bit. Electricity is kind of stabilized. So it gives you a sense on input costs. So for the second quarter and half year, in the segments, you can see the U.S. and Europe segment, first half and quarter EBITs were up 20% and 25%, respectively, primarily on plant performance, a little bit with volume, but the real leverage that we're getting as a result of the plants performing better and input costs being down.

Asia Pacific results, in local currencies for the first half were up 8% for the quarter and 11% for the first half, in local currencies, versus a year ago. It's a combination of higher volume year-over-year. They got about 6% price, which is a combination of list price changes that they executed, plus they're getting favorable mix. And then offset a bit by the production cost. Production costs primarily are two dynamics. One is they buy their pulp in US dollars, they're getting foreign exchange. And Carole Park, which Lou mentioned earlier, is we had some of those costs built in into the result, and they're running a little bit higher than even those. The other two segments, R&D. No real change in R&D.

We continue to kind of be within this 2-3% range of our sales. You, you'll see some fluctuations, very consistent with prior quarters. On general corporate costs, you'll see that they're up 4%. Like I said earlier, that's $2 million of foreign exchange, $2 million of realized exchange losses. The actual increase in labor and marketing programs is also up, but you know, that's not driving the result. Income tax, we're estimating for the year to be 26.2%. Again, I'd say similar to last quarter, I think this is adjusted a bit, but pretty consistent. Rates are trending up, obviously, as we earn more in higher tax rate jurisdictions like the US, our effective tax rate goes up. The...

You know, we're paying income taxes, as we've said, in prior results in Ireland, the US, Canada, New Zealand, the Philippines. Australia, we don't pay income taxes as a result of the deduction we get from the asbestos contribution each year. On cash flow, for the first half of 2016, $85.5 million of operating cash flow in comparison to $34.1 million a year ago. As primarily a result of the operating segments performing well and contributing operating cash flow. That's also as a result of a lower contribution year over year to AICF. You can see a net change in working capital of a couple million dollars, about 20% on a rate basis.

AR and AP moved against us, so AR was up along with our sales. Payables went down primarily because of the capacity expansion projects that we were purchasing last year, and our CapEx is obviously down year over year, so our payables balance comes down accordingly. And then you'll see that those are largely offset by a reduction in inventory. Lower CapEx, as I mentioned, you know, almost 80% less CapEx, about $34 million in the first half. I'll show you a chart in a minute on those. As we wrap up our capacity expansion projects in the US and in Carole Park, obviously, we've been signaling and telling you that we'll spend less on CapEx, and that'll continue to remain.

I'll show you that in a minute. And then you can see on the financing side, a decrease in the dividend and increase in the share buyback, in the first quarter, primarily. And then, obviously, we're drawing on debt, so here's CapEx. About $42 million of CapEx in the first half, compared to about $117 million a year ago. That's almost all related to the capacity projects last year versus this year. That $15 million that you see there related to capacity is just wrapping up those three projects, Cleburne, Plant City, and Carole Park, respectively. Those are more or less done, so the CapEx that you should expect, you know, on a go-forward basis is gonna largely be maintenance CapEx.

On the balance sheet side, no real change to our capital allocation strategy or our balance sheet priorities. You know, strong margins and operating cash flows, you know, continue to drive the strategy. Our allocation remains the same, so we're funding organic growth first. Obviously, we're committed to the ordinary dividend within our payout ratio, that's reflected in today's $0.09 declaration. You know, the priorities below that remain the same, so flexibility for strategic or M&A, as it comes up, being able to withstand market cycles and then additional distributions above that.

But as I said at the last result, the additional distributions above the ordinary is something that we're starting to pull back on, and we have done so over the last six to nine months. On liquidity, we've got about $600 million of banking facilities, $590 million to be precise. Good sufficient liquidity, almost 44%, and almost a two-year weighted average maturity. We're working on strategies to extend that, and you know, we remain well within our one to two time target on the balance sheet, but I'm happy with where we are on the debt side, and I feel like we've executed pretty well with respect to debt. So the balance sheet's you know, in good shape.

We've got about $84 million of cash as of September, almost $600 million of banking lines, more than sufficient liquidity. We had a $500 million net debt, which is right where we thought it would be and right where we'd like it to be. So it's in that one to two times net debt adjusted for asbestos range. On slide 23, for fiscal 2016, we've adjusted guidance to $230 million-$250 million of adjusted NOPAT. It's primarily a reflection of where we see the PDG coming in for the first half and for the year.

You know, we know that the range that consensus was at was kind of in this $252-$270 range, and we think the $230-$250 is more reflective of what we see for the year, so with that, I'll open it up for questions.

Louis Gries (CEO)

Do you want to use the microphone for questions?

Matt Marsh (CFO)

It should work.

Michael Ward (Analyst)

Hi, Michael Ward from CBA. Just Louis, in the release, you talk about the issues around PDG not being an external issue. I was just hoping you could elaborate on that a little bit, please.

Louis Gries (CEO)

Yeah, I mean, the housing market's fine. I don't think there's been any shift externally between the, you know, products that are fighting for share. I think when you have a reduction in PDG, that doesn't mean you're losing share, it means you're not gaining share at the same rate you had been, and I think that's the situation we're dealing with. Most of you would have seen LP produced results below the market index, so at least for this half year, we don't think it's an LP situation. We really think that our programs against vinyl, we haven't run them as well, and probably as broadly as we need to. So that's the adjustment we're trying to make in the next couple of quarters.

Michael Ward (Analyst)

The management change in the context of all that?

Louis Gries (CEO)

Yeah, the management change, you know, basically, it was triggered by the, you know, the business running well, but not growing at the rate we expect it to grow at. Went through the, you know, the analysis, external versus internal, and then internal, how much was game plan design and how much was game plan execution? And we just feel like, with the two divisions, really the northern division being the growth division against vinyl, we just weren't getting the traction we needed in our programs up there. We looked at the resources available in the company, and we just felt like the going back to a national structure was the best structure, considering what we were trying to accomplish and management resources available.

Michael Ward (Analyst)

Okay. Also, just on the gross margins, there's some interesting detail in the release again, around both the U.S. and Asia-Pac. I think you say the production cost benefit in the U.S. is sort of two point five basis points or something. I was just wondering if you can split that between sort of raw materials and whether or not there's how much of that might be from improved manufacturing efficiency.

Matt Marsh (CFO)

Probably one-third, two-thirds. One-third's raw material, two-thirds inefficiencies. Keep in mind, first half this year versus first half last year, the you know, network didn't run well last year. And so the comp is just a an easier comp on top of the plants ran just a lot better, the first half of this year in comparison. So you're gonna get more favorability in the first half for plant performance than you know, than you will for the full year.

Michael Ward (Analyst)

Then in APFC, it's the other way around. It's sort of minus two and a half or so. When would we expect that Carole Park should actually be a positive contributor to that?

Louis Gries (CEO)

Yeah, my guess would be starting next year. I think they still have a little bit this year, I mean, this quarter. And hopefully next quarter, they'll work through the rest of it, and by fiscal year 2017, we'll get the benefits of the new line, both in service position and in lower unit costs off that line.

Michael Ward (Analyst)

Okay. Thank you.

Andrew Johnston (Head of Basic Industrials and Services)

Thanks, Andrew Johnston, CLSA. Louis, could you comment on regional primary demand growth and how that's varied across different regions?

Louis Gries (CEO)

Yeah. You know, what I can tell you, Andrew, is we went through the business, and we asked plenty of people to tell us if we were benefiting or kind of being hurt by regional mix, and it balanced out almost perfectly. So, this isn't a regional mix story. From again, from an external perspective, I think our PDG in the North is less than it should be, and that's where most of the vinyl is. So, you know, when I say it's internal, that's what I'm saying. There's been a lot of speculation about the Texas market and being not so good and other markets being real good, and when you average it all out for Hardie, it comes out about... It's fine. The regional mix isn't hurting us.

But the vinyl is biased toward the North, and I think our market share development programs in the North haven't been as running as well as they need to for us to move forward on 35/90 I think a lot of that's short term, say, next couple of years, is just running the programs better. I think there'll be some tweaks as we get into kind of smaller segments or tougher value proposition type segments, whether it be small markets or things like that. But I think right now, our programs are good. We just have to run them better.

Andrew Johnston (Head of Basic Industrials and Services)

You may have already sort of answered this question, but is there any buildup in inventory in the channel over this last quarter that would cause you to be more concerned?

Louis Gries (CEO)

Yeah, we saw those comments and on the results, we don't feel like it's affecting us at all.

Andrew Johnston (Head of Basic Industrials and Services)

And just with more focus on growing, getting PDG back to where you want it, there doesn't seem to be a lot of increase in SG&A. So what sort of increase in terms of percentage terms so far this year, and perhaps looking at the next year, what sort of increase in sales and marketing expenses have you had, and do you expect to have?

Louis Gries (CEO)

Where are we so far?

Matt Marsh (CFO)

Yeah, we've been in the 6-8% range. Most of that SG&A, you know, increase is within the segments. There's a little bit of increase in the, you know, in corporate. I'd say corporate is gonna run lower than that, you know, probably in the 3-5% range, but both in Asia Pacific and the US and Europe, they've been running, you know, in the five to upwards of even, like, 8%, and we expect that that'll continue.

Louis Gries (CEO)

So we do have some organizational holes we're working hard to fill. Some of them are in the field, and some of them are, you know, in areas like product and segment management. But it's not a big spend to get back on track. We do have to spend some to get our PDG kicked up. But it's not like there's no trade-off being made here where we're gonna trade growth for EBIT or ... You know, it's on the margin. The amount of cost that needs to go into the business, it's real dollars, but that's not the fix. You know, spending twice as much on SG&A is not the fix. The fix is running our programs better.

Having said that, there's a few gaps, capability-wise, that we need to address.

Speaker 12

I probably had a similar question ultimately. It was just trying to get a better understanding of how much front-loading was in that marketing spend. You're suggesting that there was none. Could you talk us through how you see the payoff over the several quarters that you quote, how that will develop?

Louis Gries (CEO)

...Yeah, I mean, the payoff for Hardie is real easy. I mean, we get paid well, we get paid very well for volume. So if you're starting something from scratch, like for instance, right now we have a top-of-the-market initiative, something like that, that might run negative for three, four years, okay? But that isn't what we'd be talking about. We're not looking at top-of-the-market to deliver our PDG. We're looking for our existing programs, either in new construction or repair and remodel, to deliver more with roughly the same resources. Say, you know, you were looking for an estimate, say, another 7% or 8%, 10% more resources, but again, not double.

With our margins, when the volume comes, the payback is, you know, pretty quick.

Speaker 12

Yeah. And then perhaps just a broader question around the market and capacity. There's been a lot said about labor and its ability to deliver 1.3 million starts next year. How would you see that across your business mix, both R&R and new?

Louis Gries (CEO)

Yeah, I would say we hear the same things directly from builders and residents. So, there does seem to be a shortage of labor in the construction industry. It's not great for us because of course, we're a lot better than bricks and some other things that take a lot of labor per unit to install. But we take more than vinyl and wood. A lot more than vinyl, a little bit more than wood. So it's not great for us, but it's not a crisis type situation. I think the builders talk about it a lot because it really delays their closings, so it's cash flow, very important for them in the business. I think starts are more important than closings for a business like ours.

So if an order for, you know, subdivision gets delayed, you know, forty-five days or thirty days because of labor, tight labor market, you know, it really doesn't affect us that much. So, I do think, you know, the housing starts, you know, we're getting into a regular occurrence of forecast housing starts being higher than actual housing starts, and, I think that's partly driven by the labor situation, and it wouldn't surprise me if that existed again next year, where the forecast weren't reached in actuality.

Keith Chau (Executive Director of Equities Research)

Good morning, Louis and Matt. Keith Chau from JPMorgan. A couple of quick questions from us. First one is just around your targeted PDG. I think you spoke to PDG running below target. Just firstly, to clarify, what you mean by target PDG. I think a couple of quarters ago-

Louis Gries (CEO)

Yeah.

Keith Chau (Executive Director of Equities Research)

We were talking about 10%, 6%. So I just want to get a bit more color on that and, in relation to that, just around the time frame. I mean, is this an FY 2017 or back end of FY 2017 story before we see some meaningful PDG?

Louis Gries (CEO)

Yeah. Yeah, just to kind of get everyone up to the same page, coming out of the downturn, you know, several years ago, we kind of set a six to eight PDG target, and we were hitting it. And, we're in a market that we really liked and that the market wasn't really spiking at all. It was a slow, steady increase. So it really, really felt like, you know, this was gonna be an extended recovery because it's not overheating at all, and that we ought to put more money in the growth side and try and get the PDG up to the eight to 10 level. Obviously, without trading off the financial returns in the business.

So, our timing on that was bad because I think we declared that about last year, and now we're sitting pretty flat this year, so not the greatest forecast there on our part. But. So I think, you know, if you look at it, how are we gonna step into it? Of course, we see everything, you know, by market. You don't see things by market. So by market, it's really important to us, you know, to tell how the different programs are running in different markets, because your positioning is a little bit here and there, a little bit different here and there. But if I get, you know, back to five, and then kind of push on the ten, the ten is still...

That eight to ten is still the right target, but I think it's pretty hard to go from, you know, flat to eight to ten. I think we got to look for that step in between that we were at, you know, which was more the six to eight, five to seven. So I'd say short term, five to seven, maybe second year, back to the eight to ten target. Keith brings up a good point. You know, this thing has settled down over four or five quarters. It's not like our - I mean, when you guys read our results, you probably think it happened in the last couple of quarters.

But again, we track the business a little bit differently, and we not only look at our sales, we look at vinyl sales, we look at LP sales. You can actually see vinyl decline starting to slow about five quarters ago, and you can see our PDG start to slow at about the same time. So, it only becomes, you know, clear, I think, to the market when you get four quarter rolling, and it's like we are now four quarter rolling. I think we're somewhere around 4% or 5%, four quarter rolling. In order to get that momentum back, it's gonna take some time. You can't do it one quarter.

You can't post a twenty in one quarter and have that four-quarter rolling all like, all of a sudden come back up to, you know, seven or eight. So my guess, well, we got a tough comp coming up. Matt talked about an easy comp in the first quarter on the EBIT side. We got a tough comp coming up on the fourth quarter on the volume side, because we're not going with a price increase in March this year like we did last year. So there'll be no pull-forward volume, which you normally get when an increase. Now, it's not a huge amount, but it does make it harder to comp with the price increase not being there.

Again, it doesn't matter that much to us because we look at PDG on a four-quarter rolling basis. But we think we're probably fiscal year 2017 before we can realistically expect to be back at the five to seven, and probably fiscal year 2018, we can try and hit that higher target that we had said last year.

Keith Chau (Executive Director of Equities Research)

Thanks, Louis. And just a follow-up one on mix. I think Backer has been reasonably flat until now, just how that's tracking, and also interiors versus exteriors. I think first quarter, interiors was pretty strong.

Louis Gries (CEO)

Yeah, interiors was strong first half, so it continued in the second quarter. So we like, you know, we had concerns about interiors now, probably not quite two years ago, maybe a half, a year and a half ago. We kinda did a similar assessment to what we've just done on exteriors, and I think we've got interiors the way it should be. I think we're gonna see potentially some acceleration in our momentum in interiors, which so we expect that to continue. So exteriors is really, you know, the where the gap is on the volume side, it's not interiors. Any questions on the phone?

Operator (participant)

Your first question comes to the line of Emily Smith from Deutsche Bank. Your line is open. Please go ahead.

Emily Smith (Director of General Industrials)

Good morning, Louis. Good morning, Matt. Just a couple of questions from me. I'm just wondering, is it only the PDG side of things that's changed between the last result and today, as a result that's changed your overall guidance expectations? Also, just wondering if you can give us a sense for how the December quarter is looking sort of at the moment. And, obviously, the price up 1% this quarter, you've outlined that it relates predominantly to mix. Do you expect at some stage that that mix change might turn around, and you might start to get a positive benefit from mix again? And what are you looking for for that to happen? Thank you.

Louis Gries (CEO)

You asked three questions. I forgot your middle one, so I'm gonna give that one to Matt. The change has really been our volume forecast. So, the guidance already had a tax rate that we seem to be, you know, tracking to. And the FX, you know, isn't far off of what was in our forecast. So the reduction in our guidance is the reduction in the volume that we think we'll sell this year in the US. Now, again, we hadn't decided not to take the price increase in March until just recently, so that would have let some more volume slip out of the year. So that played a small part in it. As far as the price, 1%, better on a good roll.

Not sure if we'll take a price increase next year, but we normally take it in the spring, so if we get through the spring without an increase, I'd say the probability of an increase that would affect our numbers very much next year is fairly low. I would think price would be flat, it could even if, if Backer went on a real tear, you know, it could even be flat to minus one, something like that. But I'd call it flat. We're not looking for big price improvement over the next five quarters, six quarters, actually. Oh, I know, I remember your middle question now. What do we look like right now this year, this quarter?

We look very much like we have, the last couple of quarters. So the business is tracking in that same range it's been tracking, I think, for, four quarters now. So we think we're growing at, probably just a little bit above the market index. Plants are running well, input costs are staying, staying favorable relative to last year. So yeah, everything, everything kinda... This quarter is gonna, in my mind, you know, track a lot like the, previous three or four quarters.

Emily Smith (Director of General Industrials)

The 1.7-point benefit you got from lower production costs, how much of that would be manufacturing efficiencies versus input cost savings?

Louis Gries (CEO)

Yeah, I don't know if you heard Matt's earlier response, but you know, just a rough estimate is two-thirds, you know, due to plant performance and one-third due to input costs. But he kinda gave a little warning there that our plants started running well in August and well, about September last year. So the comps in the winter on that performance in plants is gonna be a tougher comp than what we've had so far. So we won't get the same benefit just 'cause we're against a better running system this time last year.

Emily Smith (Director of General Industrials)

And-

Louis Gries (CEO)

Having said that, sorry, Emily. Having said that, I think that's one of the things we wanna keep, keep in the front of your mind. We actually think we're on a long-term improvement trend line with our manufacturing plants. We got the Carole Park blip here, but we think in both regions, we're pretty optimistic we're gonna be able to continue to drive efficiencies, greater efficiencies in our operating plants. So that'd be one of the areas we're pretty, pretty pleased with as far as what we think we can deliver over the next couple of years.

Emily Smith (Director of General Industrials)

Great. And sorry, just finally, what was the reasoning behind not proceeding with a price increase in March?

Louis Gries (CEO)

Hmm.

Matt Marsh (CFO)

Let's try.

Louis Gries (CEO)

What's that?

Matt Marsh (CFO)

We want to keep the field focused on executing. I mean, a lot of what we're trying to change is, as Lou said, internal execution, and we're trying to take the distractions away from the sales team. So we just felt like we were happy with where price has been over the last couple of years. And you know, the benefit of taking a modest price increase next year versus the work that would require of the team over the next couple of months to get that in place, just weren't as great as keeping everybody focused on getting growth back to where we wanna get it to, and getting PDG back to where we need it to be.

John Hein (Analyst)

Okay, thanks.

Operator (participant)

Your next question comes from the line of John Hein from Merrill Lynch. Your line is open. Please go ahead.

John Hein (Analyst)

Oh, good morning, gents. I'm just wondering how you expect to grow PDG in this slower environment without really having to reduce prices to some degree? Obviously, flat pricing coming up is a little bit of a flag for me. And also with some of the problems, is it that the West with PDG, is it the West that's new market share sort of at its limit, and some of the easy wood gains have already been made? And, I mean, how much stickier is vinyl than you previously thought?

Louis Gries (CEO)

Yeah. Well, I'll kind of start where you finished. So I think the vinyl equation is the same as it's always been. So first thing we wanna do is address the price problem. This isn't a situation where you can increase PDG by lowering price, 'cause PDG stands for Primary Demand Growth, meaning you're growing from others outside of your category. So again, it's not market share growth within your category, it's growth outside of your category. So less vinyl, more Hardie, and that's the equation we're dealing with. So because we sell at about twice the premium from an installed cost to a builder, about maybe 50% or 60% for a re-sider or homeowner, the price of the product doesn't play a big part, okay?

Because, if, say, vinyl were to drop their price 10%, the premium to put on Hardie would go from, like, $4,500 to $4,680. Okay, so there are large premiums that a builder actually has to deal with when he's deciding to go away from vinyl and come to Hardie. So pricing is not it at all. If it was a, you know, competition within a category, then pricing becomes important, but that's not what we're talking about here. You can see, as I said, five quarters ago, the rate of decline in vinyl market share started to slow down, and you can see in about the last, looks like three or four months, so it's too early to call.

You can see it start accelerating again. Now, it's not anywhere near what, where it was five quarters ago, but it has started to come down a little bit again. I think, you know, selling against vinyl is market development. We're the company that does market development, so if we don't do it, it doesn't get done. And I think the reality is, we haven't been doing as well as we should do, and vinyl's had a temporary benefit from that. But I don't see the positioning of vinyl in the market has changed one bit. It's been in decline for a lot of years. It's still in decline. It's just at a, in decline at a slower rate than it has been. And we think that rate will pick back up.

John Hein (Analyst)

Thank you, and, I mean, obviously, clearly, a few issues with margins, even margins outside the U.S., which you've, which you have addressed. I'm just wondering, obviously, Windows has had a negative impact on EBIT. Given the impact, is it appropriate for you to provide a little bit more detail around revenue and potential run rates for the business yet?

Louis Gries (CEO)

Is the Windows business?

John Hein (Analyst)

Yeah.

Louis Gries (CEO)

Yeah. No, I mean, number one, I get. You know, I mean, because we look at the margins so closely in the U.S. business, and when I say we, I talk external. You know, it gets a lot of attention, but it's not at all material to the corporation. It is a market development initiative. It's meant to cost money. It's what we talk about when we talk about balancing growth with returns. This just happens to be outside of fiber cement. So, normally, when we talk about growth and returns, we're talking about market initiatives within fiber cement, but this is a market initiative outside of fiber cement. It's a very, very small business.

You guys are gonna quickly be able to figure out how many dollars I'm talking about and estimate how many are foreign exchange, and then you can come up with your guess on Windows. And it's not insignificant, but it's not gonna break the bank. And we do expect this year's loss will be the highest of that initiative. We'll move into a lower loss position next year, and that'd be the kind of. We think in about two and a half years, if the initiative runs the way we expect it to, before we make a further investment decision in Windows, we'd be at a neutral position on EBIT, so it wouldn't be pulling down the EBIT line for the US.

We haven't gone through that gate yet, so you know we've got a relatively small investment in this initiative. We haven't gone through the reinvestment gate, which would be a significant decision by the company, and of course when we get there we'll lay everything out. If we reinvest and decide to try and grow Windows, fiberglass Windows into a large business, we'll lay that out for you guys on why and how we're gonna do it, but at this point we haven't made that decision.

John Hein (Analyst)

... Okay, thank you very much.

Operator (participant)

Your next question comes from the line of Andrew Peros from Credit Suisse. Please go ahead.

Andrew Peros (Equities Analyst)

Thank you. Sorry, Lou, just to clarify your last comment on the Windows business. Can you confirm whether that's now included in the U.S. and Europe Fiber Cement division, or whether that's still being carried elsewhere in the business?

Louis Gries (CEO)

Yeah, no, it's in the numbers you see for US and Europe, but the numbers haven't been big enough until this year for you to care about it, so last year, the EBIT loss, 'cause we're just starting up the business, would have been smaller than we're dealing with now.

Andrew Peros (Equities Analyst)

Yeah. So, so I guess my question is, why, why would you put it into that divisional contribution if you're not sure if you're gonna continue with it longer term?

Louis Gries (CEO)

Well, again, if I have a market initiative that has a three-year stage gate process, and say I don't go ahead with the business the next three years from now, it comes out, it looks a lot like a lot of initiatives we run in the US business. Again, it just doesn't happen to be fiber cement, it's fiberglass. So we have debated that, but you know, and if you know, if we reinvest in the business and we think there's good reason from a shareholder perspective to pull it out of the fiber cement numbers, we'll do it at that time. But you know, again, our investment is small and the losses relative to the US business are small as well.

Andrew Peros (Equities Analyst)

Okay. And just a question for Matt, around the balance sheet, capital management. You obviously haven't been very active with the buyback for the past quarter. And, I think, Matt, you made the comment that you're pulling back on distributions above ordinary dividends. Does that mean that, you know, you won't be paying any special dividends if you don't execute that 5% on-market buyback?

Matt Marsh (CFO)

Yeah, and we've. I think we started saying, probably last February, and then certainly in the May result, that our focus on distributions would be on the ordinary first, and then anything above the ordinary, we'd move away from specials. And I think at that time, I said it was because I felt like there was confusion around some guesswork. I felt like everybody was guessing what the special dividend would be, and there was really no need for that. And some of the specials that we've done over the last couple of years, I think the circumstances, you know, aren't the same as they will be kind of going forward.

So now that we've got the balance sheet where we want it, if we do distributions above and beyond the ordinary, it would be in the form of share buyback. But our focus going forward is really around maintaining the ordinary in that 50%-70% range. Obviously, we've got the buyback. We haven't been active with that since the summer. And so we'll continue to operate with that, with the buyback open. But our focus is on maintaining the ordinary in the 50%-70% range, and you shouldn't expect kind of a special dividend in the second half of the year. Any additional amounts would be done through share buybacks.

Andrew Peros (Equities Analyst)

Okay. And so that was a deliberate effort to pull back on the buyback. Is that right? Or was it because there weren't any trading Windows, I think, which was kind of an issue that you had in the past?

Matt Marsh (CFO)

Yeah, no, the trading window restrictions are definitely greater in the summer than they are in the fall. And, you know, and so that was obviously a conscious decision that we were making as we were going through the last couple of months.

Andrew Peros (Equities Analyst)

Okay, thanks for your help.

Operator (participant)

Your next question comes from the line of Matthew McNee from Goldman Sachs. Please go ahead.

Matthew McNee (Equities Analyst and Managing Director)

Thanks, guys. Just a little bit more expanding on some of the pricing and margin impacts. So, Louis, I think 7 or 8% of your volumes are in Canada and Europe. Now, both those currencies are down sort of circa 15%, which, you know, simple count would have taken about 1% off your average price, and something a little bit less than that, obviously, off your margin. Have you thought about or have you announced any price recovery in those markets or thought about pushing prices up in those markets, just given all your costs or a lot of your costs are obviously in US dollars?

Louis Gries (CEO)

Yeah. No, Matt, we market price, you know, in all our markets, so we don't pass cost on, and we don't, you know, we don't drop prices when costs go down. So, at this point, we haven't had any discussion about adjusting Canadian prices beyond the normal little bit of tweaking we did up there recently, which had nothing to do with the exchange rate. And then in Europe, same thing. So no, we wouldn't try and, you know, recapture the cost and price. We wanna be price positioned right for what we're trying to do with volume and market. So, that's that.

Matthew McNee (Equities Analyst and Managing Director)

Yeah, but obviously you've got some pretty big, you know, costs you've been through with the currency. Louis, just to allow us to do that calc you mentioned before a little bit better on the Windows loss. When you said the U.S. business on its own was doing 26% plus margins, is it low 26 to high 26?

Louis Gries (CEO)

Let's call it mid. How's that?

Matthew McNee (Equities Analyst and Managing Director)

Okay. Okay, so maybe a $3 million loss-ish, something like that, out of Windows?

Louis Gries (CEO)

How much?

Matthew McNee (Equities Analyst and Managing Director)

Two or three.

Louis Gries (CEO)

Hmm. You're gonna have to do your own work. Yeah.

Matthew McNee (Equities Analyst and Managing Director)

All right.

Louis Gries (CEO)

But it's not hard to figure out. You guys can figure it out.

Matthew McNee (Equities Analyst and Managing Director)

And sorry, just Louis, just, you know, going back to the PDG thing. As you said, LP is probably down 10%, you know, year to date to you guys, to your year. And the vinyl guys are sort of flat at best in a growing market. Where, even though that might only be a few percent, where do you think that, you know, PDG growth is going? It's obviously not bricks. We can sort of see that in Boral, but is stucco picking up, or is it really? And can you give us a little bit more color on your regional mix? Is it one region doing a lot worse than others?

I know you mentioned the Northeast and the North, but, you know, your sort of heartland in the South and the West, are they still growing, or they flattened out? Just a bit more color on that'll be good.

Louis Gries (CEO)

Yeah, the first part, we did go through that exercise of, hey, if we're not getting it, vinyl's not getting it, LP's not getting it, who's getting it? And I'll be honest with you, we didn't find it. So, it is just a couple%. The... Of course, with our numbers, with our volumes, we know exactly what they are. With vinyl, we use, you know, published numbers, but you can't be certain how accurate they are. With LP, we use their results, which are hard for us to interpret at times. And we don't track the bricks much. And then you get a, you hear all the, you know, delayed closings and stuff like that, so we just stopped. Okay?

And the reason we stopped is 'cause we went back to that. By the way, you said we were, like, 10 points ahead of LP so far this year, but we only look at things four-quarter rolling. And four-quarter rolling, they're kind of flat. They're zero, and I think we're six or seven. So we're pretty sure it's not LP. Now, LP being flat the last year, that's another thing you gotta keep in mind. We don't know how much their capacity has played into that, and how much is some of the other stuff they've done, like pricing or, you know, if the market's just seeing that chipboard probably isn't the answer for a cheaper alternative to fiber cement. So we can't interpret that till they're back in free supply.

It doesn't look like they've sold their capacity over the last year, but maybe they have, and we're just not aware of it. But the compelling chart, if you plot vinyl over that five-quarter period, you're gonna see their rate of decline slow, and you're gonna see, during that same five-quarter period, you're gonna see our rate of PDG slow down as well. So theoretically, their rate of decline during that period is slow, so there's less, you know, coming our way. And again, a market sits on a standard unless there's a compelling reason to move, okay? And we started against vinyl when they were something like 36% of the market, and the compelling reason to move was fiber cement. Okay?

It was a big premium, but it had value to target customers greater than the premium to move to Hardie. You know, we've done a lot of good things in the U.S. business over the last two, three years, but I think we're just not as good market development against vinyl as we had been two or three years ago, and as we need to be to keep driving toward that thirty-five. So the whole game is us against vinyl, keeping an eye on LP, who's trying to sell themselves as a cheap alternative to fiber cement. So that's the market model on the exterior side.

Matthew McNee (Equities Analyst and Managing Director)

Just your observations by region, is there any markets?

Louis Gries (CEO)

Sorry, you want me to answer both questions?

Matthew McNee (Equities Analyst and Managing Director)

Yes.

Louis Gries (CEO)

It's vinyl. I guess, I guess that's the reason I didn't answer it. You know, the Midwest, Northeast, Canada, Carolinas, it's all the same. Those are the big vinyl regions, and one of them is not doing significantly better than the others. They're just... We're just not doing as well against vinyl as we were two or three years ago.

Matthew McNee (Equities Analyst and Managing Director)

Yeah, no worries. Thank you.

Louis Gries (CEO)

By the way, I'll give you a bonus answer, too, because I forgot that one. Segment-wise, we see it the same thing. It's not one segment, new construction or R&R. It's both segments. We're just not doing as well as we need to do.

Operator (participant)

Your next question comes from the line of Simon Thackray from Citi. Please go ahead.

Simon Thackray (Director and Senior Industrial Analyst)

Thanks very much. Lou, you made a point earlier about interiors had made a strong contribution in the mix, and that was obviously affecting price to a certain degree, and eighteen months ago, you were a bit worried about that, and you wanted to deal with it. You obviously dealt with it, and it's accelerated. Can you talk to that strategy and then talk to your strategy around PDG? Because, I mean, you guys sound pretty somber, I've got to say, in terms of where PDG's ended up. You were like this about interiors eighteen months ago, and now it's a strong contributor. So can you just really help us nail down?

I know you're gonna say we'll wait for September for strategy, but talk to exactly what we should be expecting from in terms of initiatives over the next, you know, four quarters.

Louis Gries (CEO)

Yeah, I think I don't think you should expect any new initiatives in the next four quarters.

Simon Thackray (Director and Senior Industrial Analyst)

All right.

Louis Gries (CEO)

Our focus, Ryan's focus, Matt, you know, with the new structure, they've spent a fair amount of time doing a current state assessment on the business and working out the game plan, both short term, medium term. Short-term game plan is execute what we do better. So we like our 9-box, we use in new construction. We like our R&R program in vinyl markets. We know what to do with the channel now. We've gotten better with the channel. We just need more attention on the growth side of the business. Now, Simon brings up the point that we did have a problem, which I agree with 100% on, on HardieBacker market share, maybe eighteen months ago, maybe a little bit longer, and the organization has responded quite well.

Now, the problem is, you know, we've also, you know, you can remember two, three years ago, we were operating for, I think two years in a row, just below our twenty, twenty base on our EBIT margin range, and we took care of that. We had tactical pricing problems, which was a big part of taking care of that. We took care of it. I think the story for our organization internally has been, hey, we can't do it one at a time. We gotta do the interior things right, and then we gotta run our exterior strategy. We gotta have our tactical pricing, the plants have to go.

So I think Hardie coming out of a downturn, you know, now five, six years ago, whatever it's been, has become a much better company, but we're still not a company—we're not that juggler that can keep six balls in the air. It seems like we're always finding a way to, you know, drop one of them. And I think the one we dropped now is growth against vinyl, and we gotta get that back in the air without dropping one of the other ones. So that's what you just should expect out of Hardie, is a lot more intensity around how well we're executing, and the fact that we're executing all segments, all product line strategies at the same time. Which will be... It'll be a challenge.

So, I'm very confident we can get it done. That's what drove the organizational structure change. But, you know, you're gonna have to see how the results come out.

Simon Thackray (Director and Senior Industrial Analyst)

Yeah, and I guess that's the following question, which you've just answered really, is that the management structure that you've now put in place supports that strategy to be able to juggle all those six balls at one time?

Louis Gries (CEO)

Yeah. Yeah, I covered it earlier, Simon. You know, the structure, you know, there's a lot of reasons we went with the structure we went to, but it was triggered by our inability to grow, or, or take market share at the rate we're intending to take market share. So, that's, that's what started the process of, you know, evaluation, and, and we ended up with the structure change, we ended up with execution as being our main thing we need to change over the next four or five quarters to get back on track, PDG-wise. There's a lot of game plan, game plan enhancement, value proposition bumps that we're gonna do over the next five years, but that's not, that's not what we're focused on right now.

We got some people working on that, but the majority of the organization is committing to a higher level of execution on, on existing game plans.

Simon Thackray (Director and Senior Industrial Analyst)

So Lou, just one final question, if I can. I mean, housing starts, certainly from October, were pretty lackluster, just a bit above a million. So that's sort of okay. I mean, with the trajectory is certainly a lot slower than people would expect. Now, we used to think that that was a benefit for you guys, both in terms of PDG and manufacturing cadence. What's your expectation now that an acceleration would be much better for the business? Or that it's irrelevant, you just need to be executing a lot better?

Louis Gries (CEO)

Yeah, we like the market. I mean, I know, you know, if the market was larger now, market demand were more, just because of more housing, we'd make more money. But we like the market. You know, I'm not an economist, I tell you guys that all the time. I think X number of houses are gonna be built in this recovery, and you can either build them in five years or you can build them in nine years. And it looks to me like if it doesn't just take off, it's gonna be a longer recovery. And a longer recovery for a market share company is good, 'cause you got more years to, you know, kind of build on the momentum of the previous year. So we like the market, no complaints about the market.

Simon Thackray (Director and Senior Industrial Analyst)

Okay. Thanks so much, gentlemen.

Operator (participant)

Your next question comes from the line of James Rutledge from Morgan Stanley. Please go ahead.

James Rutledge (Executive Director)

Thank you. Good morning. Just wanted to clarify, how we should be thinking about price increases going forward, given, I guess it seems, at least on the face of it, that no price increase this year seems to be because of how PDG growth is tracking. If, as you say, hopefully these initiatives work, and you see PDG growth return to that 5%-7% over the next 12-18 months, should we be expecting a 2%-3% price increase, in 18 months' time?

Louis Gries (CEO)

Yeah, I mean, I think if you go with the history of the business, we review price every spring. Most years we take two to three. We're careful not to be greedy on price. We don't wanna kill potential, you know. We don't wanna lower the terminal share for fiber cement by creating a perception that we need more price, you know, every time you turn around. So we've been very disciplined on pricing. Every once in a while, we skip a price increase, and looks like this year, at least this spring, we're gonna skip the price increase. I think Matt summed it up well. I actually didn't know how to answer that question, but he did answer it well.

Our focus on the exterior side of the business is volume, and we just didn't want a lot of the distractions for the people that are trying to execute on our strategies. So we took a pass on pricing. And I wouldn't expect that would be a regular occurrence. I would think that would be more of a one-time occurrence.

James Rutledge (Executive Director)

Okay, thanks. And just to... I'm not sure if I missed this earlier, but can you clarify what the exterior versus interior growth was for the half or the quarter? I think you indicated that interior was stronger.

Louis Gries (CEO)

Interior was a bit better than exterior, and so if you look at our overall growth, and go a little bit higher on interior, a little bit lower on exterior, you're probably pretty close.

James Rutledge (Executive Director)

Okay, thanks a lot.

Operator (participant)

It appears as though that we have no further questions. I'd now like to hand back for any additional closing remarks.

Louis Gries (CEO)

Okay. We appreciate everyone's interest in the company. Thank you very much.