James Hardie Industries - Q2 2020

Transcript

Jack Truong (CEO)

Good morning, everyone, and thank you for joining us for the Q2 Fiscal Year 2020 Earnings Conference Call. I will start with key business and operational highlights on our second quarter performance. Jason Miele, our Head of Investor Relations, will then cover the financial details for the quarter. Afterwards, I will come back to update you on where we are relative to the execution of our three-year global strategic plan. As our Interim CFO, Anne Lloyd, has only been in role for about eight weeks, I have asked Jason to present with me today based on his extensive experience in finance and investor relations at James Hardie. Regarding the CFO position, I will make a few comments now, and will not be taking questions on this topic during Q&A.

As you are aware, Anne Lloyd is currently functioning as our Interim CFO, and she will continue in role until we find a permanent CFO. She had served previously as the CFO of Martin Marietta. She also served currently as a member of James Hardie's Board of Directors. Anne has done an excellent job running and jumping right in and is adding value to our executive team, as well as to the global finance organization. I'm pleased at how this transition is progressing, and we're actively recruiting, and I would anticipate we'll hire a permanent CFO in early next year. Now, let's talk about our results. The global James Hardie team executed well and delivered a very strong operational performance this past quarter. We delivered positive growth in both net sales and EBIT in all three regions that we operate in: North America, Asia Pacific, and Europe.

I would like to put our second quarter results in the context of our three-year global strategic plan. We are an organic growth company. We're built to drive growth above market, which is PDG, in all regions of the world that we operate in, and with strong returns. In North America, this means that we're on a commercial transformation journey to be a more customer-focused company by continuing to invest significantly in demand creation with our end users, the builders, the installers, the R&R contractors, while building a more robust account management capability to serve our customers much better, the dealers, the lumber yards, the distributors, and the retailers. This is aimed at driving a sustainable growth above market of PDG in the 6% range for the long term, sustainably.

We also drive lean manufacturing across all of our plants in North America to take advantage of our scale, to reduce variability, and to improve productivity. We target to generate $100 million in cumulative savings over the three years due to lean. In Asia Pacific, our goal is to make a good business better, and hence, to continue to deliver growth of our market, even in a contracting market that we currently have in Australia, and as strong returns. In Europe, it's all about accelerating fiber cement growth based on a growing fiber gypsum business while improving our EBIT margin. Now, let's turn to page 7 on the group results. We deliver volume growth above markets in all three regions. Our net sales and local currency grew in all three regions. North America grew 6% in the quarter and 5% in the first half.

Europe grew 5% in the quarter and 6% in the first half. APAC grew 2% for the quarter and 1% in the first half. Our Adjusted Net Operating Profit for the group grew 22% in the quarter, driven by strong operational performance in all three regions. We're pleased with this continued positive momentum in executing our global strategic plan. Now, let's turn to page 8 on North American results. Our exterior volume grew 6% in the quarter and 5% in the first half. We estimated that the blended market growth in the first half of our fiscal year was essentially flat. Our interior volume grew at the same level as the previous quarter a year ago, which is flat, and it is, however, a continuous improvement versus the prior two years.

With increased volume through our factory and with lean savings, we deliver an EBIT increase of 25%, despite continued raw materials inflation, particularly pulp, in the quarter. Our EBIT margin in the quarter was 27.1%. In the first half, it was 26.1%, exceeded the top end of our long-term target range. Both commercial transformation and lean manufacturing continue to gain traction and are now delivering improved financial results. Now, let's turn over to page nine for European results. Our EU team continued to execute well to deliver good fiber cement growth, along with solid execution on fiber gypsum business. Housing market in Western Europe has been softening this year, particularly in Germany and the U.K. Fiber cement net sales grew 23% in the quarter, and 30% in the first half in local currency.

Fiber gypsum net sales grew in local currency 3% for both the quarter and the first half. EBIT margin was 10.3% in the first half, which is in line with our internal targets, and we're on track to deliver full year EBIT margin accretion. Now, let's turn over to page 10 for APAC results. Our APAC business delivered a solid quarter, driven primarily by very strong operational performance coming from our Australian and Philippines businesses. As you're well aware, the Australian housing market continued to contract. Our addressable housing market in Australia declined 8%-10% in the first half. Despite the headwind, our APAC team delivered net sales growth of 2% in local currency with flat volume. EBIT grew 5% in the quarter, and EBIT margin is at 24%, which is at the top end of our long-term target range.

The EBIT team, the APAC team continued to execute well with price mix, and lean manufacturing is gaining momentum across our APAC plants. Finally, on page 11, following our updated key assumption for Fiscal Year 2020, that we see modest growth in the U.S. housing markets, was roughly about 1%. The first half was quite challenging for the new construction home starts in North America, but what we see right now is improving. U.S. residential housing start forecast is still between 1.2 and 1.3 million units. And we're raising our exterior volume growth from 3%-5% to 4%-6% PDG for the whole year of fiscal year 2020.

We also raised our EBIT margin for fiscal year 2020 from the top end of 20-25% to 25-27% in North America. In Europe, the housing market is down slightly across addressable market, particularly in Germany and the U.K. The key for us in Europe will continue to introduce new fiber cement products that developed and made for the European markets, and continue to replicate the lean manufacturing processes and systems from North America to Europe, so that we will deliver the EBIT margin accretion for the whole fiscal year of 2020. For Asia Pacific, the addressable housing markets in Australia is contracting to the tune of about 8-10% in our assumption for the year. APAC volume will deliver a 3-5% growth above markets.

Our EBIT margin in Asia Pacific will be in the top half of our stated range of 20%-25%. With the continued improvement in our results, we are raising our full year adjusted net operating profit to be between $340 million and $370 million. With that, I would like to have Jason to come up and share with you in more detail the financial results of our quarter. Jason?

Jason Miele (Head of Investor Relations)

Thank you, Jack, and good morning, everyone. We will start with the group results on slide 13. You can see a strong financial performance for the quarter and the half year, for the group. The top line, straight down through to the profit metrics. We'll start with the top line. Net sales were up 2%, for the quarter, as well as for the half year, compared to the prior corresponding periods. That was really driven by two things, growth above market and volume for all three of our segments, so North America, Asia Pac, and Europe, delivering growth above their markets, as well as a higher net price in all three regions as well in local currency.

Moving down to the profit metrics, gross profit was up 16% for the quarter and up 11% for the half year. Adjusted EBIT of $134.2 million was up 26% for the quarter, and it was up 21% for the half year. Finally, adjusted net operating profit of $98.6 million for the quarter. That's a record high for any quarter in James Hardie. For the group, that was up 22% for the second quarter compared to the same period last year, and a solid result for the half-year as well, up 17%. Finally, operating cash flows up 37% at $251.8 million. Pretty simple story there, driven by the strong performance of all three segments, and the operating cash they're generating.

Moving on to North America, as Jack said, a strong top-line result. Sales volume up 5% for the quarter and up 4% for the six months, driven by strong exterior volumes. PDG is on track. Exteriors volume +6% for the quarter and +5% for the first half. And as Jack mentioned, that's on a underlying market for our first six months of relatively flat. With that, we raised our PDG target for the fiscal year 2020 from 3% to 5%, and now to 4% to 6% for the full year. Also gaining momentum is our interiors business. Flat volumes on the quarter, as well as -2% for the first half. A marked improvement versus the last two fiscal years.

Price is up 1% for both periods compared to the same periods last year, favorably impacted, obviously, by our strategic price increase on the first of April 2019, partially offset by mix. That's a combination of customer mix as well as product mix. Moving down to EBIT, excluding, another record for James Hardie, $124.7 million in the quarter, is our highest quarter to date. That was up 25% compared to the same period last year, and $238.2 million for the half year, up 15%. Jack talked about margins, 27.1% for the quarter and 26.1% for the half year. Again, both above our long-term value creation range.

And as Jack mentioned, we raised our guidance on EBIT margin as well, and added some more specificity to a range of 25%-27% for the fiscal year. The EBIT results were really driven by the top line. The top line result, volume and sales... or sorry, volume and price, improved plant performance driven by lean, as well as lower freight in both periods. This is a chart most of you will be familiar with. We plot EBIT dollars on the left axis and EBIT margins on the right axis. The gray bars represent the EBIT dollars, and the green line is the EBIT margins by quarter, with the red range there being our long-term value creation range of 20%-25%.

As we've previously mentioned, 26.1% for the half year. Input costs. This slide is starting to look a little nicer than it has over the past few years. We'll start with pulp. Pulp was down 15%, for the three months ended 13 September, compared to the same period last year. I want to remind everyone, these are market prices that we show on this slide. The sources are down there on the right-hand corner. That's important with pulp. As you're aware, the market prices we see with pulp lag by about one quarter into our P&L. And so for the quarter and the half year, as Jack mentioned, pulp was still a headwind for us. We'd expect to start seeing that favorability in the third quarter. Freight, similarly down 16%.

A different dynamic for us. Market price kind of flows through the P&L immediately, so we've been seeing the favorable impact in our P&L in the quarter as well as the first half. Something to note on freight, the first half of FY 2019, the freight market in the U.S. was quite high and elevated, and so we're seeing that favorability now, but certainly in the back half of this fiscal year, we'd expect that to narrow substantially. Cement up 3%, very similar to the first quarter result. Gas prices flat is an improvement compared to what we reported three months ago, and electric prices down 7% is consistent with the first quarter. Moving on to Asia Pacific. As Jack mentioned, a very strong result considering the Australian housing market.

Sales volumes were flat for the quarter and only down slightly 1% for the half year. Really driven by growth above market in both Australia and the Philippines, as well as a growing market, underlying market in the Philippines. Net sales plus 2% at AUD 164.2 million. There's an impact on currency translation there, where that number comes through in US dollars at a lower rate. But good price as well. Price was up 3% in both periods compared to the prior year. In Australian dollars, a EBIT margin result of 39.5 million was up 5% on the quarter on flat volume.

A good result by the team there, and AUD 74.9 million for the six months was flat year on year. EBIT margin of 24% for the quarter and 23.5% for the half year. Those are both in the top half of our long-term range of 20%-25%, which is what we guided to for the full year, and we're on track to hit that target. You see the U.S. dollar EBIT result there, being down year on year. That's just impacted. That's the impact of the foreign exchange translation. Europe continued strong. Net sales results for Europe up 5% for the quarter and up 6% for the half year.

Fiber cement for the half year was up 30%, and fiber gypsum in EUR increased 3%, consistent with Q1. At the EBIT level, EBIT excluding 7.8 million EUR is up 7% for the quarter, and 17 million for the half year is up 1%. The EBIT increases are being driven by the gross margin performance and partially offset by higher SG&A, as we've stood up the corporate function there and exit the TSAs. Last thing is on EBIT margin, excluding 9.9% for the quarter. It was up 20 basis points, and 10.3% for the half year is down slightly from the six months of the same period last year.

But that's on track with our internal targets, and we're still on track to deliver EBIT margin accretion for the full year FY 2020 versus FY 2019. Lastly, I've spent about EUR 4.7 million of integration costs through the six months, and approximately EUR 3 million left to spend in euros over the last two quarters of FY 2020 as we wrap up the integration. Moving to the remaining segments. Other business segments, you'll recall we exited our Windows business last fiscal year. The majority of those charges were taken in the second quarter. So you're seeing the large $17.6 million charge there in the prior year.

In the current year, all operations ceased in the first quarter, and we're winding up the rest of that business, and there's small charges or gains or losses as we sell the remaining assets. So we'd expect very minimal activity the last two quarters within that segment. Research and development, we continue to be committed to R&D investment, as Jack has talked about in our September investor tour as well as today. That'll be an area of focus and a very area of investment for us going forward. You'll see the numbers there are down slightly for the quarter and for the half year, but we'd expect R&D activity to increase over time.

Lastly, with general corporate costs in line with our expectations, are up a bit for the quarter and for the half year at $15.9 million and $31.9 million, respectively. But that's driven by the higher stock compensation expenses, which is being driven primarily by the increasing share price. Moving on to income tax. Our current estimate for our adjusted effective tax rate for the full year FY 2020 is 17.9%. That is very much in line with what we would have reported three months ago at Q1, when we reported 18.2%. There's no real change in anything around our income tax, and we'd expect our full-year H-ETR to be 17.9%. Moving on to the balance sheet. Our financial management framework remains unchanged. Reminders around capital allocation.

Our first priority is our organic growth and investing in R&D and capacity expansion to drive that. Second is to maintain the ordinary dividend, and lastly, remain flexibility for cyclical market volatility, creative inorganic and strategic inorganic opportunities, as well as further shareholder returns. You'll note in our media release this morning, we announced a 10 cent first half dividend of $0.10 per security. Moving on to cash flow. Discussed this a little bit on the first slide. For the group, for the six months, operating cash flow is up significantly, 37%, at $251.8 million. Again, primarily driven by the strong performance of all three business units. In the cash used for investing and financing, you'll see some large changes year-over-year.

That's just driven by the fact we acquired Fermacell in the first half of last year, first quarter of last year, and the large transactions associated with that in the prior period are driving that fluctuation. On to our liquidity profile as of 30 September 2019. Really no significant change from 30 June. The same debt instruments remain in place, $800 million of U.S. dollar notes, EUR 400 million euro notes, and a $500 million U.S. dollar revolving credit facility. Those are all remain in place. We remain on track to get back within our one to two times leverage range. Last quarter, we would have said we're four quarters away, and we're still on track with that.

We're currently at 2.3x, and our long-term range we want to operate in is one to two times. Moving on to capital expenditures. $123.4 million for the six months, down from the prior year, down $16 million. We would have talked the last few quarters about an estimate of $200 million for fiscal year 2020. We're right on track with that. We expect to end up right around that number for the full year. In the first half, we completed the start-up of our Tacoma 2 greenfield expansion. We continue construction in Alabama on our Prattville facility and remain in a position to open that in the first half of FY 2021, and we continue our brownfield expansion at Carole Park.

Lastly, you've seen this slide already. Jack went through it once. I'm just gonna touch on the changes that we've made from last quarter to this quarter in our key assumptions and market outlook and guidance. Starting with North America, we've changed our PDG assumption around exteriors for fiscal year 2020, increasing that from 3%-5% to 4%-6% PDG for fiscal year 2020. Similarly, with EBIT margin, at last quarter, we've had an assumption around the top end of our long-term range of 20%-25%. We've narrowed that and added some more specificity to 25%-27% EBIT margin for fiscal year 2020. I want to point out that does not change the long-term value creation range of 20%-25%.

In Europe, one change, as Jack had mentioned earlier, three months ago, we were expecting a slight increase in our underlying housing market. And today, as we look across all the countries we operate in, the segments, commercial, new construction, R&R, we see a slightly decreasing addressable market. It's not a massive change, but certainly something that has changed in our outlook for the fiscal year. No changes to our assumptions around Asia Pac for the fiscal year 2020. And finally, Adjusted Net Operating Profit. Our guidance, at this point last quarter, we provided was $325 million-$365 million. We have raised that to $340 million-$370 million. With that, I'll turn it back over to Jack for our strategy update.

Jack Truong (CEO)

So now I'd just like to give you a quick update on where we are relative to our three-year strategic plan that we shared with you back about nine months ago. Just through to remind you that we for this-- here are the key metrics for our long-term value creation. For North America, it's about having the 35/90 goal with strong returns, and that's roughly 6% PDG and an EBITDA return of 20-25%. And in Europe, it's really about creating the €1 billion euro business with 20+% EBITDA margin in about ten years. And for APAC, it deliver growth above market with strong returns, which is a 20-25% EBITDA margin.

Here are the key strategic priorities that we set out as a goal for our organization of global teams around the world. How about in North America, it's really accelerate the exterior growth. What that means is that we are develop, market, and sell the full Hardie solution for exteriors. I mean, HardiePlank, HardiePanel, HardieSoffit, HardieTrim, and all HardieShingle, everything about fiber cement that provide the total exterior wrap for home construction, as well as R&R.

And second is about leverage on the fact that we are the world's largest fiber cement producer, and also in North America, we have a very large scale, and this is now about having all of our 10 plants running the same Hardie Manufacturing Operating System to really take advantage of our scale and then to, and capability. And third is really about make interior business a growth business again. And so these, these are the three strategic priorities that drive a lot of the the key planning and then the execution for our business in North America.

Europe is really all about gaining market traction for fiber cement, and that means that we are leveraging on the R&D capability and new product commercialization capability within the company to develop relevant new products in for the European market based on European demands. So that we can really start to grow our fiber cement business in Europe in a very meaningful way. While we're doing that, it's also important that we continue to drive fiber gypsum growth. To drive market penetration, this is also a profitable business for us that also differentiated that we will continue to invest to grow in Europe.

And, really leveraging on the lean manufacturing system that we have in Asia Pacific and North America to really unlock the manufacturing capacity in Europe to help drive EBITDA margin growth for our business in Europe for the short and long term. Asia Pacific is really all about continuing to drive growth above market, and that means that in Australia, it's really about gaining share against brick. In New Zealand, it's really about fiber cement gaining share against timber. And in the Philippines, it's really about fiber cement gaining share against plywood. And to continue to drive lean manufacturing across all of our four plants in Asia Pacific to really drive the strong returns as we grow.

So just a quick give you a quick update on where we are in the commercial transformation in North America. This is where we essentially move from being a pull approach to push-pull. James Hardie in North America, we have always been very, very strong of creating demand of our products with the builders and contractors. So as we convert homes and jobs into fiber cement, those conversion must then be converted with at our customer for sales. And, but we have not paid a lot of attention in the past about how to manage our customer, which is really the distributors, dealers, retailers.

And really, a big focus for us during this year and going forward is really about number one, is that we will continue to invest significantly more and more in the pull side in terms of driving the demand creation. This is what we know how to do best. But as we create a lot more demand, we have to make sure that we also manage our customers, which are the distributors, dealers, and retailers in the way that as they sell more of the James Hardie products, that they make more money and improve their working capital. And that means that for James Hardie is that we have to build the capability with our customers to be.

Really based on the analytics of how do we integrate our supply chain capability in with our customers to deliver the right product to the right the end user, which are the builders and the contractors. This is where we also invest in our systems to ensure that we are a lot more easy to do business with. And it's all about having the win-win approach with our customers. So far, we have some early traction in this area. The shift from pull to push-pull is really proceeding well. And we're on track now to deliver 4-6% PDG for the fiscal year 2020.

And it is an area that as we continue to gain more profit growth in our business, that we will allocate more of those cash to invest in our market creation, as well as the account management to ensure that we can deliver the long-term value creation toward the 39. And another key part for our long-term success to the 35/90 is that we will come out with more of a, what we call the market-driven innovation. The inner innovation that really matter most to the market, as opposed to being technology push.

And that is really one of the key transformation within our company. It is more about understand what are the key trends in the marketplace, the hyper trends in the marketplace, which is labor shortage, the affordable housing, and then the move to cities. And based on our trends, and then that we will be working closely to our customers and end users to have really the right insights in terms of what are those unmet needs. And based on those insights, and we turn those into action for our R&D team to really develop the right products and commercialize it quicker to the marketplace and make a big difference. It is one of the key four pillars for our global strategy going forward.

Not only to help North American business march into the 35/90 objective, but also a key driver for us to grow to the EUR 1 billion business in Europe, as well as in Asia Pacific. But having those key strategies is nice, but if we don't have the right team, the right skills, the right culture, and the people to execute, then we won't. We won't get there. And this is really a key area that really is moving quite well within our company as we move from being a big, small company to now a small, big company going forward. And that's really about moving from being managed and top down to really drive a lot more empowerment and accountability deeper within the organization.

This is one of the key drivers of success for our lean transformation in our plants, where we make the operator be in the center of our operations, as opposed to being driven from the top. In the past, we were working primarily in different teams and different functions, and it's really not connected. This now, we really move from being working in silos to working a lot more cross-functionally with very clear alignments toward delivering result for the total company, the total business, as opposed to just sub-optimizing for functions. And we're now, with the acquisition of Fermacell, creating a new business within Europe.

We're truly now a global building material company with significant operations in North America, in Asia Pacific and Europe. It is an area that we're really take advantage of that value, as that is taking the best that we have in our businesses around each region of the world and replicate where applicable. For example, we took the preliminary, the early lean manufacturing approach in Asia Pacific, and then to replicate that to North America, improve on it, and then we took that, and we replicate to Europe, and then now some of those key advancement now replicate back to Asia Pacific.

Another example is that our interior business for our European business is very a lot more advanced than what we have in North America, and so there's a lot more of the interactions and know-how been transferred from Europe back to North America. In terms of we're moving from being reactive to a problem to more now about having a clear plan going forward and know where the opportunities are, and know where the pitfalls are, and then really plan it correctly so that we can drive toward the results with not having a lot of big barriers in front of us.

And so this is a cultural transformation in our company today that is really, really important as we continue to grow, that our people, our teams, our employees around the world are really getting more and more energized to execute the plan to deliver. So with that, that concludes our presentations, and Jason and I will be happy to address questions. Sophie? Oh, Peter.

Peter Steyn (Analyst)

Thanks, Jack. Peter Steyn from Macquarie. Jack, just keen to get a bit of an understanding of what happened in the North American, particularly the plant performance and essentially your input cost, delta there, 270 basis points of improvement. Could you give us a sense of what freight contributed to that relative to plant performance? Just want to try and get an understanding of what's cyclical and what's potentially structural.

Jack Truong (CEO)

If you look at our operational performance, we have lean savings, we have freight savings, and those were offset with the raw material headwinds in the quarter. We take all three together. I would say about 50% of that is due to lean, and about 40% is due to freight, and then the rest are materials. I'm sorry, 50%, 30%, 20%.

Peter Steyn (Analyst)

Perfect. Thanks. And then, perhaps just a shout out on Asia Pac, a really strong performance, particularly from a volume perspective. You've pointed to Philippines doing reasonably well, but, you know, what, from an underlying point of view, is driving the very strong performance from an execution perspective in volume, and particularly in that business?

Jack Truong (CEO)

It's really driven primarily with the... Yes, we have very, very good volume performance in the Philippines, and we also have very good growth of our markets in Australia. And, you know, despite the contraction in the Australian business of 8%-10%, our business in Australia has performed a lot better than that. And then, given now that with the focus of Hardie Manufacturing Operating System, that replicate back into Asia Pacific, that's also enhanced the performance, the financial performance of our plants in the Asia Pacific. So a combination of volume growth and also improved, much improved, operational performance in the plants.

Peter Steyn (Analyst)

I guess it just sort of strikes me that they're potentially doing better than the 3-5% PDG guidance you've given for the full year at this point in time. So, sorry, one last one from me. Just on cash performance, working capital unlock, particularly strong. There's been a couple of movements there, but really trying to understand whether there's something fundamentally improving your inventory position. You know, it's only up 7%, and if you think about price movements and cost movements and underlying market growth, it seems like that's a pretty decent performance. Is that some of the restructuring you've done from a supply chain point of view over the last twelve months coming to bear there?

Jack Truong (CEO)

Oh, absolutely. You know, it's really, we discussed this back in February, is that lean with the Hardie Manufacturing Operating System, is really about driving a lot more of the predictability of our output, as well as reduction in variability of our output. And at the same time, we would be able to produce more volume per hours within our plants. So by now, as we continue to improve with lean, that we have, of course, we can be more predictable with our output, and then that would allow us to manage our inventory better than it has been. And of course, there is just continuous improvements.

Peter Steyn (Analyst)

Thanks, Jack. I'll leave it there.

Sophie Spartalis (Analyst)

Good morning, Jack and Jason. Just, two questions from me. First of all, you know, exceptional performance in Q2.

Jack Truong (CEO)

Thank you.

Sophie Spartalis (Analyst)

You've hesitated from changing any long-term targets. I guess, can you just explain why the hesitation today, when, you know, things are continuing to improve from where we sit today, given all the internal initiatives that you're driving, why you're sticking to the 25% or 20%-25% EBIT margin?

Jack Truong (CEO)

Okay, so, Sophie, that's a good question. I say, I think it's three factors. One is that, you know, the housing market is still quite variable. And then two is that we also need to make sure that we invest back into our business, particularly in innovation, particularly in terms of how we are going to continue to do a better job, much better job of managing our key accounts, our customers. And so that means there's going to be more investment in systems and so on. So it's very, very important for us to make sure that we have the right investment in place for tomorrow, and be able to continue with this type of sustainable performance.

And I think the third, which is very, very important, is that we want to make sure that we establish a good track record of delivering sustainably and consistently to be able for us to make some decision on what that guidance, if we need to change that guidance or not.

Sophie Spartalis (Analyst)

Okay, thanks. And then just in terms of North America, prices are up 1%. Your key competitor was talking around rebates. Can you just maybe update them, update us in terms of why that pricing increase was probably a little bit lower than expectations? And have you had to pull the rebate levers?

Jack Truong (CEO)

Well, you know, if you remember the first half of last year, our price was relatively large. I think we were about 4 or 5% price the same time period last year. So we're confident against a higher number. No, it's we don't really have to focus too much on price on how we approach the market. And it's really now more about what's growing into more a what we call a the mix of customers and products.

With the lean manufacturing approach now that allow us to have better operational performance, that we now can afford to move into a new expand into segments like multi-family, which tend to be a lower margin than the new construction for single family, for example. So it's now, it's really about allow us to to grow into new segments. So we're very about the price mix. So yes, we did have an increase in the invoice price, but then that's offset by the mix of customers and products.

Operator (participant)

Thank you. Pete Wilson, Credit Suisse.

Peter Wilson (Analyst)

Just following that up on that, kind of, you know, the relative performance. So you've printed strong volume growth above market today. LP also printed very strong growth above market today. Do you think? Is there any sense that maybe the market was stronger than you think? Or are you both just ripping share from vinyl?

Jack Truong (CEO)

I think first of all, there's one thing I'd just like to, I mean, to reinforce, is that for James Hardie, we are focusing on driving demand. So our sales are really based on our product getting on the wall. And then as they get on the wall, that will flow back to our dealers for replenishment sales for our business. So our business really relates back to the actual demand in the marketplace. Whereas LP will be more what I would call on the push side. So it tends to be more sales to distribution and then but not so much on the pull side.

So that's why you have the, so it's when you compare the two. It can be quite different.

Peter Wilson (Analyst)

Again, on that, that push side, you know, there's sales growth through distributors. Are they- who are they winning distributors off or volume off? Are they winning off you or, or someone else?

Jack Truong (CEO)

No, it's a push is really. I mean, it's don't really for us, is that we don't really get sales until they actually been used in, on the wall with the builders. Because that's why we're correlating more with, with the, with the housing starts and R, R&R. Because that's, that is really more about how we build our business. It's about demand creation when our product get on the wall.

Peter Wilson (Analyst)

Okay. And then in Interior, so improving momentum. Has that... I'm trying to sketch out, I guess, the path. Has that business actually turned the corner? You know, have you actually had some tangible, you know, improvement in product placement, for example, that explains that performance? And should we expect that momentum to continue?

Jack Truong (CEO)

Yeah, I think, Peter, that is a very good question. Really comes down to what we discussed in New York Investors Day. Therefore, Interior business for the short term is that we have to get better placement, which we began, our team began to get some of that, and we'll continue to improve. Second, is that we gotta have better promotion. So better promotion here is our product have to be better positioned on the retail shelf, to be able to tell the end users, contractors out there, that this is James HardieBacker, here's our key benefits, and so on and so forth. And third, is really about new products.

The positioning, the promotions are starting to improve, and that will continue to improve. Then we just launched the HydroDefense, the first waterproof backer board in the marketplace. And so that should continue to gain traction in the marketplace. But it's just more about gaining our position, holding our position. Growth will really come when we start to improve our new products introduction, start to bring new product to the category that really give us that true sustainable growth for the long term.

Peter Wilson (Analyst)

Okay, and then North America margins, you've attributed ninety basis points to the gross margin increase to lower start-up costs. Would we be right to assume that that benefit continues for the rest of the financial year, but then next year, as Prattville comes online, for it to actually reverse and, you know, maybe even double? It's actually a negative effect into next year.

Jack Truong (CEO)

You know, it's. I think it's. Well, that's. You know that this year, we. Don't forget that we also have a start up with Tacoma, too. And, so it's, so Tacoma 2 start up commission and is really, is also big in the numbers. So for us, it's all about, you know, we have a long history of being, you know, invest into capacity for growth. And our business is quite, is in terms of cost structure, very, is highly variable. So we say, as we move on to commission the Prattville facility, that's, that would be just a normal course of how we would manage our business.

Peter Wilson (Analyst)

Lee Power, CLSA. Jack, just on plant performance, you haven't increased the lean target. Is it coming through quicker than you expected?

Jack Truong (CEO)

Lee, good question. Yeah, I think we are ahead of our plan to date. It's really the key. Yes, it's better than expected, because a key foundation for our Hardie Manufacturing Operating System is really about driving the employee and operator engagement. And then we have thought that that probably take a little bit longer time to get traction, but that's really gained significant traction. And that's how we're able to help us get better results to date.

Lee Power (Analyst)

Okay. And then in terms of the amount that you're reinvesting into growth, I mean, we heard Pete's questions around LP printing some pretty big numbers. Did you put more down to the bottom line or than you expected, or was it same as you went into the quarter when you delivered earlier than you expected? I mean, did you deliver the same proportion back into growth, or did you say, "We've delivered more early, and we'll flow that to the bottom line?

Jack Truong (CEO)

Yeah, you know, it's to invest in innovation and then all the capability for account management, for example, is really take time to make sure that we develop the plan correctly before we put money behind it, so most of our investment will, which will begin in the second half, so most of the lean savings that we had in the first half really dropped to the bottom line.

Lee Power (Analyst)

Okay. And then can you talk to that FY 2020 target? What - how much higher you think that'll be, lean being delivered earlier?

Jack Truong (CEO)

Well, Lee, I think once you know that, I, I'd like to know that, too.

Lee Power (Analyst)

I do. Fair enough. And then just on interiors, you talked about know-how coming across from Europe. Can you give some examples of that? Is that on new product development, merchandising? Like, where have they actually-

Jack Truong (CEO)

Yeah, I think the first and foremost is really about merchandising. Make sure that we have the right brand placement, make sure that we make that into our category or become a destination category. That is, make it easy for contractors to find, make it easy for new contractors who don't know about our value proposition, to be able to see the product in retail and know why they need to pay higher price for our products. So those are the basic retail blocking and tackling that we have to do, which is really an area that we didn't have the expertise here in North America. So that's an area that we had beef up recently.

I think at the last earnings call, I shared with you that we just hire a vice president of interior sales for the North American business who this is a leader that used to run the Home Depot accounts for 3M Company. So he know how to deal with the big box retailers at different levels and how to drive the push-pull effects through the big box. So that's will help. That'll be the first step toward that direction.

Lee Power (Analyst)

Okay. All right, thanks.

Jack Truong (CEO)

We can take questions from the phone.

Operator (participant)

Multiple questions on our phone. The first question is from Simon Thackray from Jefferies. Please ask your question, Simon.

Simon Thackray (Analyst)

Thanks very much. Good day, Jack. Good day, Jason. Just a couple of really quick ones. Some of them might have already been answered, but just want to go to Europe for a second. Jack, I'm trying to understand how fiber cement can grow 30% plus, and the fiber gypsum only goes 3%, and the margins go backwards year-on-year, when fiber cement was always meant to be a higher margin product. Now, maybe I'm missing something, but can you step me through how margins go backwards in Europe on that kind of mix?

Jack Truong (CEO)

Yes. Simon, I think... It's Simon, right? Yeah. Simon, this is, it's just, it's just the normal variations in the business, and it's just a timing of some investments. And, but, you know, as the year goes on, we should see that smoothen out. And then, and we still expect that for our EBITDA margin for the year to be accretive, and, and that's, and that was our expectation for Europe as we set out in the plan.

Simon Thackray (Analyst)

So is it just that the fiber cement is growing off such a small base that the number looks impressive, but it didn't really make much difference to the overall result? Is that the better way to think about it, or am I-

Jack Truong (CEO)

No, it's just an investment that we've put into the business to drive growth.

Simon Thackray (Analyst)

Would that investment continue in this current path, or is it likely to slow down that rate of investment? I'm just trying to understand how the margin, when the margin goes back to reflecting what should be growing margins, pretty aggressively growing margins on that kind of volume growth, when

Jack Truong (CEO)

So the way to think about it, Simon, is that our four factories, fiber gypsum factory in Europe, as is, is now gaining more momentum in terms of running the factory more efficiently, and we now open up more and more capacity. So as we get a volume of fiber gypsum growing back to where the plan is, and that's where we will get the force multiplier effects for margin accretion, as well as the EBIT growth. And then we still expect that as we grow more fiber cement sales, and that fiber cement has a higher margin fiber gypsum, so that will also be more accretive.

Simon Thackray (Analyst)

Okay. That's helpful. A small one. Jack, when do you sort of weave your magic in New Zealand? You've called out plant performance yet again in New Zealand. It seems to be a perennial issue with New Zealand. What's the plan for New Zealand?

Jack Truong (CEO)

Oh, yes, the New Zealand plant performance during, actually during, the past two months is. It has a step change in improvements. And then we should expect that to continue to improve going forward. You know, this is a case of the new culture within our company now, is in terms of how we become more have a global mindset and really sharing best practices as well as resources.

So as we now implement the lean manufacturing in North America and have really good success there, and what we did is that we took the number two leader in our Waxahachie plant and now made him the plant manager for our plant in New Zealand and effective this month. So we would expect that an improvement in our New Zealand plant will continue to improve, if not continue to have a step change improvement.

Simon Thackray (Analyst)

When you were in charge of international and that was under your remit, and, you know, you obviously demonstrated great success with Carroll Park. Was it just a question that New Zealand just didn't get on the bus, didn't get on the journey when you were driving change through the region? Is that the right way to understand it? And now you're fixing that with the Waxahachie manager going there?

Operator (participant)

He's asking why Penrose lagged the other three plants in AsiaPac.

Jack Truong (CEO)

Oh, right. It is a, it's also, Simon, that's a good question because it is also part of the priority. And because Carroll Park was, you know, it is our biggest plant in Asia Pacific. And then the second one is Rosehill, third one is Cabuyao in the Philippines, and Penrose is our smallest plant. And it's just in terms of how we prioritize our resources to focus on the biggest opportunities, and which we did. And then now to all three plants, Cabuyao, Carroll Park, and Rosehill are performing at the exceptional level, which kind of contribute to the good performance that you see in Asia Pacific this past quarter.

So now we can then reallocate the resources to really take Penrose to that next level.

Simon Thackray (Analyst)

Stuff. Good stuff. All right. Thanks, Jack. Thanks, Jason.

Operator (participant)

Question is from Brook Campbell, from JPMorgan. Please ask your question.

Brook Campbell (Analyst)

Yeah, morning, Jack and Jason. Thanks for taking my question. Just one on the SG&A line in North America. It looks like, I guess, the first half, that SG&A expense lines up sort of 2%-3%. So your comments earlier on about costs picking up in the second half, was that just relating to R&D, or should we see SG&A expense increase in the second half? And if you could help us understand what sort of magnitude of increase we should be looking for.

Jason Miele (Head of Investor Relations)

Yeah, Brook, thanks for that question. We talked about three areas of spend or investment going forward. Demand creation, which is certainly would be, most of that would be in the SG&A space, customer management capabilities, as well as customer-led or customer-driven innovation. So how that impacts our P&L will be in a variety of places. So within the segments, it may show up in SG&A, depending on the program, it could show up in cost of goods sold. And certainly in our R&D segments, as well as our general corporate costs, are all kind of the places it could show up. We're not at a position today where we're gonna provide guidance on the increase in spend, but certainly investment is a focus going forward.

Jack Truong (CEO)

Hey, Brook, the way to think about that, too, is, for example, with innovation. Yes, we are gonna need the additional funding to develop new products, but then as we develop those new innovative products, sometime we need to have a new certain new manufacturing process to put in to make them in the lower cost environment and so on and so forth. So to think about is for innovation, it cut across several different P&L lines.

Brook Campbell (Analyst)

That's really helpful. Thanks, Jack. One more for you. While you're there, just interested to understand if the hiring in the senior management team is now done. Are there any sort of open roles, I guess, apart from the CFO position, which we're not talking about today, that you're looking to fill at the moment or restructure going forward?

Jack Truong (CEO)

Yeah, I think yes, we're looking to have a new CFO, as well as we are looking for a new head of manufacturing for North America.

Brook Campbell (Analyst)

Okay, thanks. And just one more for Jason. Yeah, just on mix in North America. Talked about this already, but you've mentioned it's due to both customer and product mix. Just wondering if you can sort of dig into that a bit deeper, maybe provide some examples for us just to help to understand really that mix drag in the period.

Jason Miele (Head of Investor Relations)

Yeah. I don't know that I'd describe it as a drag. Obviously, in the numbers, it comes through as a drag. We executed our price increase, and that went into the market successfully, so the team did a good job with that. And then as you're aware, we sell across a variety of segments, as well as to a variety of customers and a variety of products. So in any given year, one may be growing faster than the other. I think the key is we're doing a good job across all of our segments and across all of our products, and the fact that that's coming out with a negative mix impact is not something we're concerned with. We're trying to grow across all those spaces, and we're effectively doing that.

Some examples that you guys would be familiar with for any period. I'm not gonna be specific to this period, but if you sold more multifamily than, say, new construction, that would have an impact on mix. More prime product than a ColorPlus product, that has a product impact on mix. So it's all those types of dynamics that could impact that mix equation.

Jack Truong (CEO)

But, you know, the bottom line is that we're managing our business holistically now. It's really key is that the keys that we focus on driving our growth of our markets at the target that we have, and also we are driving our EBIT to the target that we have. So anything in between is what we do to manage our business to deliver those two outcomes that really drive the value creation.... Okay, understood. Thanks.

Operator (participant)

And our next question is from Daniel Kang from Citigroup. Please ask your question, Daniel.

Daniel Kang (Analyst)

Good morning, everyone. Just, firstly, on, can you just provide some color on underlying markets that you're seeing? I think I heard you say, Jason, that the addressable market was relatively flat in the period. Can you talk about the underlying drivers there, and what you're seeing in particular in the R&R market? I think you also mentioned that you're expecting that to be a drag for the year. That's my first question.

Jason Miele (Head of Investor Relations)

Yeah, we wouldn't have R&R as a drag for the year. So, underlying housing market in North America, Daniel, you know, we assume, or we are assuming that the data we see would be R&R up 3% for the full year, and we see that consistently through the full year. So, our first half, we'd be looking at our assumption is a 3% R&R increase in the underlying market. New construction is the space where it's a bit more, a case of two halves. You can look at various sources externally, including U.S. Census data, and through the six months ended 13 June, you know, the market would've been down 4%, 5%, 6%, looking at depending on which data source you look at.

And I use 13 June because that kind of activity lags by about one quarter into our PDG calculation. If you look at those same data sources, you're now seeing a 3 or 4 or 5% increase in, for the three months ended September. And so we'll see that kind of housing market underlying for new construction kind of impact us in our third quarter. And so, you know, Jack talked about it earlier when he went through the assumptions page. We're still assuming, which is what we were assuming last quarter, slight underlying housing market increase, and that's when you blend the 3% R&R increase along with something, you know, below zero, maybe negative two, negative three.

For new construction, you blend those two together, and you end up at something right around, you know, Jack talked about a +1% for our underlying market, for FY 2020, is kind of where we're seeing it.

Daniel Kang (Analyst)

That's great. Thank you for that. And just on margins, you know, 27% margins in North America, clearly a strong performance. But the lower pulp cost, we didn't really see much impact from that. So should we expect that Q3, given the favorable impact of that, Q3 margins should actually be higher than 27%? Or is there other factors that I should be taking into account?

Jason Miele (Head of Investor Relations)

So, we certainly are confident in EBIT margin. That's why we raised the guidance to 25%-27%. I think your question is, what are the puts and takes going into the back half of the year? As I flagged earlier, certainly the favorability we've been getting on freight in the first half of the year, we don't see that repeating, 'cause the freight market started correcting in the back half of last fiscal year. So that comparison will tighten. Certainly, pulp will be a tailwind for us in Q3. But then you gotta remember, we've talked about investment quite a bit today. So investment would be the other thing. It sounds like you're not considering, as you talk about margin going forward. Outputs will be more continuous improvements.

Daniel Kang (Analyst)

Jack, in terms of, you've spoken in the past in terms of base customer erosion that you're looking to narrow. Can you update us on the progress there? Has base business begun to stabilize?

Jason Miele (Head of Investor Relations)

He's asking about base erosion.

Jack Truong (CEO)

Oh, yeah, it's really as we continue to focus more and more, expand our focus more into our customers, we'll begin to gain more trust and credibility with our customers. And also as we also bring the demand to our customers, and so we see that our customers tend to substitute less and less. So I think that's an improvement, and that's why you see some of the result that you see here is really due in part to that.

Daniel Kang (Analyst)

Great. Thank you. I'll leave it there.

Operator (participant)

Our next follow-up and question is from Grant Slade, from Morningstar. Please ask your question, Grant.

Grant Slade (Analyst)

Hi, Jack and Jason. Look, thanks for taking the question. Just one from me on the Lean program in North America. I just wondered if you did have any sense as yet as to how much latent capacity in the North American manufacturing network will be ultimately unlocked by the Lean program? Thanks.

Jack Truong (CEO)

Yeah, we would estimate that that probably would be the equivalent of about one additional sheet machine within the next 12 months capacity that we don't have to build.

Grant Slade (Analyst)

Right. And how much is that in terms of million sq ft?

Jack Truong (CEO)

Roughly 200-250 million square feet.

Grant Slade (Analyst)

Right. Okay. And that's, that's the total that you think. That's the total amount of latent capacity you think you'll unlock?

Right. Thanks.

Jack Truong (CEO)

Okay, is there any more questions on the phone?

Operator (participant)

We have another question from Paul Quinn, from RBC Capital. Please ask your question.

Paul Quinn (Analyst)

Yeah, thanks very much. Morning, guys, and congratulations on the results. Looks like you have a pretty good strong tailwinds here. Just trying to understand the longer term picture and the 35/90. We saw LP put up, you know, almost 7.5% growth year-over-year. You guys were 5% on volumes. Does, to be able to get to your 35/90, does LP's growth have to slow, or do they have to shrink?

Jack Truong (CEO)

Yeah, I think, Paul, I think the, well, this is why I mentioned earlier, our growth is really coming from the demand on the marketplace, where our fiber cement boards are actually on the wall. And that's and that could be driven by the creation of our sales. Whereas, our the competitor is more in terms of selling into the channel with not a lot of the pull through. So it's a two different type of. So when you look at those numbers, you have to you can't really compare them from period to period.

You gotta look on a long-term view to make sure that you see that as being the flow through to the market, because in our case, it's really more about the flow through to the market and being on the wall.

Paul Quinn (Analyst)

You know, I completely understand the difference in methodologies, but when LP posts a number of years, and, you know, we can go back five years, and you can still see the same type of growth, the question still remains. If they're growing at this stage, does that put in jeopardy the 35/90 goal? That's all.

Jack Truong (CEO)

No, I think, you know, it is for us is that we are the key for us to continuing to drive our game plan, and that is about driving from pull to push-pull, and really drive the lean transformation that would allow us to expand into new markets and create a lot more demand. And then the key to 35/90 for long term for us is innovations. And also, all of that have to deliver a strong profit growth and strong margin. So that's our game plan. That's our long-term value creation, of which we are on the path, and that's what we're delivering.

It's really about driving that growth of our markets with strong returns, and consistently and sustainably, and that's our game plan.

Paul Quinn (Analyst)

Fair enough. Congratulations. Good results, and good luck going forward.

Operator (participant)

There's no further questions at this time. I'd like to hand the call back to the speakers for any closing remarks. Please go ahead.

Jack Truong (CEO)

Thank you all very much for your questions and your interest. I think we are James Hardie, a global team. We're happy with the results that we had just delivered in Q2, and this is about all three of our regions deliver positive growth in sales and EBIT. And that which allows us then to raise our PDG target for fiscal year 2020 from 3%-5% to 4%-6% in North America. We also raised our EBIT margin in North America from the top of 20%-25% range to 25%-27% range. And also with strong performance, too, in Asia Pacific, and good performance in Europe, now allow us to also raise our full-year guidance, and now to adjust the net operating profits to between $340 and $370 million. Thank you.