Residential Building Materials Business Conditions …...Business Conditions and 2019–2020 Market...

Residential Building Materials Business Conditions and 2019–2020 Outlook The building materials and construction industry’s most trusted source for market information and insights

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Reproduction or disclosure is strictly forbidden. © September 2019

Business Conditions and 2019–2020 Market Outlook Underlying growth in residential building materials demand is influenced primarily by the amount of repair and remodeling and new construction activity. In 2018, the 13 product categories covered within Principia’s BuilderSeries®

accounted for $97.6 billion in net manufacturer revenue with repair and remodeling accounting for two-thirds of the value and one-third in new construction. Those figures may change year over year, but only slightly based

on the product mix and role of new construction within the economic cycle. Factors that influence construction activity include the overall health and growth of the domestic economy, mortgage and borrowing rates, consumer confidence, inflation, and prices for homes and home improvement products.

New Housing Permits Activity 2016–2019YTD The years 2016 through 2018 showed successive, moderate increases in housing permits each year to the point where monthly tracking for the full year 2018 reached 1.14 million permits1 as shown in Figure 1. For July 2019YTD, monthly permits were tracking to be slightly down from 2018, reflecting a potential slowdown. In fact, Principia projects a full year-end permit rate of 1.32 million permits, nearly a 4% dip from 2018.

Figure 1: Cumulative Monthly Housing Permits, 2016–2019YTD

1 Monthly permit tracking is used for short-term trendlines such as year over year tracking and is not reflective of full year end results as not all jurisdictions report month by month. Actual annual permits for 2018 reached 1.37 million units.

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Existing Home Sales Activity 2016–2019YTD For repair and remodeling spending, there is no perfect proxy to track year over year changes. Spending is often dependent on age of homes and weather activity in the case of exterior building products like roofing, siding, and windows. Conversely, interior products like cabinets and countertops are largely a discretionary spend and more dependent on such factors as interest rates and consumer confidence. In any case, repair and remodeling spending is dependent both on the base stock of existing homes which stood at 140 million in 2018 and the rate of replacement activity which can vary dramatically each year. A 1% replacement rate, which would be the equivalent of replacing a product every 100 years, results in 1.4 million replacement projects. Therefore, it is easy to understand why R&R spending typically surpasses new construction spending since many products are replaced on a cycle between 10 and 30 years. Principia has found anecdotally that much replacement activity occurs on the sale of an existing home, based on the sellers trying to increase the sale price, or more often, the buyers sprucing up their new dwelling by updating worn or tired areas of the home. Looking at existing home sales month-by-month for the past three years in Figure 2, you can see that 2017 and 2018 both ended at just about 5.2 million units sold. For 2019 through June existing home sales were running 6% behind 2018 which would put the year end results at 4.9 million units if no ground is gained in the second half.

Figure 2: Cumulative Existing Home Sales, 2016–2019YTD

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Spending Activity by Region Principia uses permits and existing home sales to evaluate the likely spending levels by Census region which can be very helpful for building product suppliers and distributors for product and market planning. Figure 3 shows new permits and existing home sales as percentages of regional population in 2018. New home permits were largely driven by the sun belt regions of the Southeast, Southwest, and West which are all above the overall average. For existing home sales, again a proxy for remodeling activity, the greatest activity was in the Southeast and Midwest, above the average on the horizontal axis. Accordingly, sales and marketing strategies in each region can be guided by this mix.

Figure 3: New Permit and Existing Home Sales vs. Population, 2018

Labor Shortages Continue Drag on Industry Labor shortage is a recurring theme across all building products, affecting manufacturing, distribution as well as contractor channels. The reasons cited are simple. Young people in the current workforce do not want to do manual labor in dated facilities and offices and many do not believe trade schools can lead to high paying jobs. Specifically, a recent study performed by BigRentz concluded that only 11% of Americans between 18-24 years of age believe they can achieve a high paying job through a trade school. Further, 54% of the 3,000 people surveyed believe that workers with a trade school certification make an average of $18,000 less than an individual with a bachelor’s degree. However, the accurate variance is closer to $12,000. Also, of note is that many of the smaller companies in the distribution channel are relatively low-tech, continuing “business as usual” practices. Further, as ownership of these companies continues to age,younger family members do not want to take over the business. At the manufacturer level, automation is alleviating the need for a large workforce to a degree, but talent remains in short supply. The goal is increasingly to hire key people with competitive compensation in hopes of retention while allowing automation to take over the more mundane tasks.

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Overall, this shortage of labor is hurting the top and bottom lines of companies across the supply chain as manufacturers are not operating at their full capacity, which in turn is hurting their economies of scale and ultimately their operating margins. At the distribution level, receiving sufficient product on time to fill orders is becoming increasingly difficult. These delays are furthered by freight issues as recent legislation restricts the number of hours a truck driver can be on the road per day safely. This in turn, has a negative impact on the contractor channel as jobs are delayed while waiting on material to arrive. It has, however, had a positive impact on pricing as the channel is becoming more “brand loyal” and ordering from one supplier that can source material more efficiently versus a price conscious buying behavior that may result in waiting for material from multiple suppliers. At the contractor level, as many contractors sub-contract, the quality of work is diminishing with labor in short supply. As labor continues to be a persistent issue, the National Association of Home Builders has developed the Home Builders Institute as a development program for education, career development, training, and ultimately job placement. Separately, a movement called Generation T, comprised of approximately 60 large companies, is dedicated to efficiently training and placing tradespeople across their manufacturing facilities and distribution centers. Therma-Tru, Pella, Lowe’s, and The Home Depot are among these 60 companies. Further, The Home Depot announced that it has committed $50 million toward training 20,000 tradespeople over the next ten years. Pella has cited the labor shortage on its website and stated that the skills gap manifests itself in two ways in its business: getting qualified craftsmen to work in factories and getting qualified contractors and builders who can install products efficiently. The company is attempting to bring attention to the issue with Fine Homebuilding’s #KeepCraftAlive initiative, developed to create awareness of skills training and scholarship opportunities for aspiring tradespeople. The company hopes to close the skills gap and elevate the overall trade industry with this initiative. Overall, these movements should help to try and ease the overall shortage of labor across the supply chain and improve manufacturing, distribution, and contractor efficiency.

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Mortgage Rate Decreases Are a Mixed Bag In 2019, average 30-year fixed mortgage rates are expected to fall to 3.7%, down from 4.8% according to the Mortgage Bankers’ Association (MBA)2. According to the MBA, “the most significant development over the past month (July-August 2019 time frame) has been the precipitous drop in US Treasury yields and mortgage rates. Widespread investor concern over slowing economic growth in the US and in other major global economies, along with an escalating US-China trade have been two major contributors to this market angst.” Further, in the same forecast, the MBA states that “Since hitting a recent high of over 5 percent in November 2018, the 30 year fixed mortgage rate has fallen more than a percentage point, and homeowners have responded strongly to the drop in rates, as more borrowers are now “in the money” and have a rate incentive to refinance. In the second quarter alone, refinance applications increased 30 percent from the first quarter and in the first two weeks of August, refinance applications surged another 50 percent, which will lead to higher than anticipated origination volume for the third and fourth quarters of 2019.” These two conflicting statements present the double-edged sword of current economic and trade policy. Consumer confidence and spending as well as business spending are driven by both the cost of money as well as the predictability of personal and business income to a certain extent. Low mortgage rates can stimulate new home buying and enable remodeling projects easier to finance. However, increased tariffs on consumer goods as well as any imported raw materials or building products can cause swings in prices, tempering consumer optimism and dampening spending. In the case of the MBA, the forecast for 2019 is basically flat for both new home mortgages and existing home sales.

2 MBA Mortgage Finance Forecast, August 15, 2019

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Principia Building Materials Outlook is Moderate The net result of these overall business conditions is a forecast increase in building materials factory gate revenue of 2.9% in 2019 over 2018 (prices held constant). For next year, our 2020 preliminary forecast calls for an increase of 3.7% in factory gate revenue as shown in Figure 4. Overall spending is projected to increase to $100 billion in 2019 and to $104 billion in 2020. The increase is largely driven in both cases by R&R spending which comprises the larger portion of overall spend and is faster growing. This is based on several factors including continued aging of existing housing stock, low mortgage refinancing rates driving R&R project funding, and in some cases changes in product mix from originally installed products to newer, more modern and higher priced replacement materials. Principia tracks 13 product categories3 within this index and the mix by new and R&R, regional spending and product choice may vary considerably within each category. Our analyst team can provide more detail on any of the categories of interest to specific companies or investors.

Figure 4: Construction Outlook and Building Product Revenue Metrics

3Principia’s current tracking includes structural lumber, sheathing, cabinets, countertops, decking, doors, insulation, railing, roofing, siding, trim, windows, and weather resistant barriers

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BuilderSeries® Geographic Regions In Principia's BuilderSeries®, demand and supply are broken out according to the following U.S. Census Bureau regions and divisions. The South region is proportionately larger than other regions, so Principia further segments the South region by Census division into Southeast and Southwest regions.

Regions Divisions States/Provinces Northeast New England CT, MA, ME, NH, RI, VT

Middle Atlantic NJ, NY, PA Midwest East North Central WI, MI, IL, IN, OH

West North Central ND, SD, NE, KS, MN, IA, MO Southeast South Atlantic DE, MD, DC, VA, WV, NC, SC, GA, FL

East South Central TN, MS, AL, KY Southwest West South Central OK, AR, TX, LA West Mountain ID, WY, NV, UT, CO, AZ, NM, MT

Pacific CA, OR, WA, AK, HI Canada East Canada NL, PE, NB, NS, QC, ON

West Canada MB, SK, AB, BC

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Residential Building Materials Business Conditions …...Business Conditions and 2019–2020 Market...

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