James Hardie Industries plc (JHX) Q2 2018 Earnings Report, Transcript and Summary

Good morning, everyone in Australia and everyone on the phone, thanks for joining. Normally we have the same agenda, in fact, since I started at Hardie in 1991. Today's the first day we're going to announce-- we announced it yesterday, actually, a relatively large acquisition. So we've slotted that on the agenda. It will be up front. When we get to Q&A I think we should do the Fermacell questions first, just to make sure we get them all in in case the normal business questions kind of run on. And as far as the business itself, I'll cover as I always do, kind of overview of the operations. Matt will take care of the financials. And then we'll move to Q&A. Okay, so Fermacell, I guess first it's a business we've known them for a lot of years. It's very much set up like Hardie. They started investing in the technology about the same time Hardie started investing in fiber cement technology. So it's been almost 40 years. This is more the financial overview of the transaction, which when we get to questions, Matt might fill in a few blanks if you need them filled in. But the headline numbers are here EUR 473 million. It's roughly 9x. It will debt financed. And we'll own it sometime in the fourth quarter. So a binding offer was signed yesterday by both parties. Get to the next slide which talks about it a little bit. Like I said, it's very much set up like Hardie, category leader. It's a differentiated business sitting on top of a commodity industry basically, in their case gypsum, in our case we normally sit on top of either basic cement boards and things like cardboard, OSB and vinyl; which are all basic commodities. The business has a strong brand and they developed their brand the same way Hardie did, and that's through pull-through selling, so try to get to the decision makers with your decision rather than push your product through the channel. So they use more technical sales approach than we do, and you'll see in a slide coming they participate more in non-res than we do. So the technical sales is pretty critical for a couple of the segments they participate in. They have a good track record. Like I say, over that period of time they didn't grow to the same scale as Hardie did with fiber cement. But certainly when you look around the world, they're the company that did the job growing the category for fiber gypsum. And they do have a strong management team, which was critical for us. Because as most of you know, our capabilities our either North America or Asia Pac as far as management. So it was important to get a strong management team that goes with the business. And again, those of you that follow the company know that we anticipated launching an international growth strategy and started to rebuild the GMT that in mind. So Jack Truong who joined us in April on the senior team does have a lot of experience in international, and obviously he'll be responsible for the business. Now on its own, it's a good business, well set up. It has organic growth opportunities, not to the same upside as Hardie would have in the U.S., but more similar to what we have in Australia. There's still market share gains for the Fermacell business available. The second part of the equation for Hardie investors is we've been in Europe for 10-plus years trying to grow organic fiber cement business and we just haven't gotten there. We're roughly EUR 30 million to EUR 40 million without much cash flow that goes along with at. It's a different market than what we participate in either in Asia Pac or in the U.S. But it is a market that we see a lot of potential. It has a lot of the macro drivers that we look for that we think are important in value creation for fiber cement. We just never got to scale to have much influence in the market. So we sell basically U.S. products that are exported from U.S. plants. And it becomes very niche-y and very kind of scattered geographically. So what we think Fermacell does is it gives us that regional capability and regional perspective and regional influence that I think will be important to launch a much higher growth fiber cement strategy in Europe. So that's the second part of the equation. Obviously those regular cash flows out of Europe, I think, are important to us because we do need product development and market development and a regional plan in fiber cement. And our current business doesn't yield any real cash flow in Europe and that was always kind of an obstacle for us to make the big bet in Europe. We didn't think our capability was right and we didn't have any kind of regional cash flows to work with. So going forward, we just feel like we've solved that problem. Now there's a lot of work to be done. In the short term, our focus would be on bringing Fermacell into the corporation and making sure we don't go backwards with their business, in other words do a good job with the integration. And then sometime in the next 12 months or so, we'll start thinking about resetting fiber cement strategy. So right now we've got to close the business. Once we close the business, we'll start the integration process. And I would say sometime in the next, like I say, 12 months, we'll really get serious about what the fiber cement strategy for Europe looks like, gen-2 basically. Next slide, the bullet points on the left there kind of are a bit of a repeat, so the category, scale, European capability and perspective, the strong management team. On right where we list out the countries, it's interesting. The U.K. is not up there. And that's kind of fine with us. The U.K. is actually the geography we have the strongest position with our current fiber cement. And it is a target market for them. But they haven't gotten good traction in that U.K. market. So the fact that U.K. is not there is probably fine with us. They're biased toward Germany. Frame construction is growing in Germany. Modular construction is growing in Germany. So Germany is a target market, even for our current product line in fiber cement. So that works well for us. Like I said, they're split commercial, residential and repair and remodel. It looks to be pretty even. I didn't even actually look at the exact numbers. And I think what you're going to see in the fiber cement business in Europe is going to be very similar. It won't be like the U.S. where we're mainly an exterior company, 80% exterior. It will be more like Australia where we're 50/50 by half our business down here is interior and half is exterior. This gives you some of the details on this slide. So EUR 270 million and this is basically they're on a calendar year. So EUR 270 million is where they expect to end up. They have about 800 employees, 6 manufacturing plants. There are a lot of similarities between their manufacturing plants and our manufacturing plants. So I think that's going to work well for us. One area they're out ahead and hopefully maybe we can accelerate our progress is they're basically zero process waste leaving the site. So those of you that follow the company would have heard we have kind of an objective in Hardie to be at zero to the landfill. And this business has already gotten there and I think we'll get some good transfer there. They've got a salesforce spread across Western Europe, headquartered in Germany. This is kind of our summary slide. So this is why Hardie wants this business. Obviously there were other bidders for the business. A lot of companies recognize it as a good business. We were more interested in and have been actually for several years, because of what we think it can do for us with fiber cement. So this kind of just ticks off the main points. When we get to routes to market, channel and customer; it's really a way more about end customers and specifiers than it is channel. Now there will be some channel benefit. But the main benefit will be on customer and specifier. Strong brand, so we haven't obviously taken over the business. So we haven't worked out our branding strategy. But we will not be moving away from their Fermacell brand. And we may even use the Fermacell brand on some of our fiber cement products. The middle column basically says you don't get there because you bought Fermacell. Fermacell is a gate that we go through and it kind of enables it. But we need product development, market development specific for Europe, and we need regional supply in Europe. So those will all be future investments. I think product development and market development will start earlier, product development almost immediately, market development when we start seeing that we have some products to bring to market that have a different value proposition than our current products. And then regional capacity is probably something like 3 to 5 years. It's not something we'll be announcing real quick. And then the other thing is these technologies do sit side by side. They're very close technologies. There's some significant differences and significant similarities. So we do expect some crossover. We expect some of what we do to kind of push their capability forward a bit and vice versa some of what they do will help us in fiber cement. And that's hard to clearly identify right now. But I think intuitively you know it's there. Because what we're trying to do is so similar. Okay, we're going to the U.S. business, like I said you'll have the chance to ask plenty of questions on Fermacell. But first slide on the U.S. is the group overview. You see a lot of red arrows pointing down. Basically that's all driven by the North American business. So when we get into that, we'll show you where we're basically-- we're tracking the way we set out, the way thought we would for the year. And we're resolving so many issues that were triggered when we ran out of capacity or the capacity planning in fiscal year '16 wasn't right. And we ran out of capacity in fiscal year '17. So I guess there's a couple bullet points here about manufacturing. International is running well. And obviously we declared a dividend. Go to the next slide, which will be on the U.S. business, basically revenue is up on flat volumes. So the price is strong but the volume is flat, below the market index, obviously, so a little bit of negative market share there. The volume in the second quarter, which it's unusual because it's negative, I understand, a bit of surprise. The last two times we've done results I've told you the order file has been soft. It was soft in May and it was soft again in August. There's a few things that probably drove that to be flat, I mean drove that to be negative rather than flat last quarter, or at least help drive it. And that was -- I think talked in September about a product line we exited in the interiors business which is [4x] G2 product, which is an interior product. And then we had the two storms and the temporary disruption in the markets kind of affected the order file for a period of time with both storms. So we think the half year is about 25 million feet short for those two reasons. But believe me, that's not the main story. The main story we're still coming out of a period of allocation where we lost traction in the market. We've got to get that traction back in order to start growing above the market index. So I guess the bullet points on the right, we're below the market index. It's basically still coming out of that period where we were short board and customers were forced to go to other products. Price is good. Manufacturing is tracking the way we thought it would. I think we told you in February it was going to get better every quarter. And it's been on that trend line. And the EBIT in the first half, obviously not what we'd expect for our business. But we'll talk about it a little bit further. Next slide does cover the unit costs and manufacturing. You can see we're still above some kind of low lows we had in the early part of '17. We've obviously taken-- we've got more headwind on price this year than we've had in most years. So our input costs will quite a bit higher than that period in '17. But our performance isn't quite back either. So it's not all price that's left. We've got some performance opportunities that are still there. And I believe we'll get more out in this quarter and then again next quarter as well. Next slide is our EBIT margin slide, which everyone knows was at the wrong end of the range for 3 quarters in a row. Actually that number in second quarter still below what I'd expect for a second quarter in a good market. So it's not fully back. The efficiency in the business model is not fully back to where it needs to be. But obviously we've made a lot of progress. Mostly that progress we have price helping us this year. But that was helping us in the first quarter as well. So the big difference between last quarter and this quarter is just the manufacturing and some organizational efficiencies that we've been able to start realizing. Next slide shows the price. Price has been tracking as planned. So that's been zero issue this year. You go to the next slide on the right, top line growth, we've talked about it. We're not growing above the index the way we want. So till we start doing that that slide really doesn't become a positive story, even though the market has gotten incrementally better every year. International fiber cement, or Asia Pac for the most part; has been a really positive story first half of the year, largely driven by Australia. But New Zealand is running fine and Philippines business is in a bit of a win-back from a position they lost short-term against imports. And that's what's really driving the 2 red arrows there is relatively more volume from the Philippines and reset pricing in a segment in the Philippines. So the story that you'll see at the next page, the story on Asia Pac business is pretty much good across the board, everything pointing up and A and Zed. Philippines, you got that one -- you got that EBIT slightly off, but going in the direction that we want. So we're very happy, actually, with the Asia Pac business. We think they're doing a good job running the business. The growth rate in Australia is very good in a market that's coming off. So it's all good. All right, I'll hand it over to Matt.

Okay. Good morning everybody in Sydney, and thanks to everybody on the phone for joining us. I'm on slide 21. I'll go through the financials. For the second quarter we reported net sales of $525 million, which was up 6% for the group with EBIT of $97 million in the quarter up 10%, and net operating profit of $66 million up 16%. The net sales increase of 6% was driven by price, as Louis talked about already in the North America segment, and good volume performance in the international segment. Gross profit increased 3%, gross margin rate is down 110 basis points year-over-year. I'll step though that a bit more later. SG&A expenses are up 9%. We're continuing to invest in organizational capability and you're seeing that reflected in the SG&A. And then adjusted net operating profit was down 1% for the most part on the heels of the North America business. For the half, we had reported sales -- I'm going to do the rest of the presentation as Darth Vader. For the first half, we had reported sales of $1.034 billion, which was up 6%, a similar story to the quarter. Gross profits of $356 million and EBIT dollars of $181 million, down 12%; and net operating profit of $123.8 million, down 14%. With very similar drivers, you can see noted on the right for the business performance, so price performance in North America drove top line with volume being favorable. And then international SG&A expenses increased 5% for the first half compared to the same period a year ago. And net operating profit down 4%, for the most part driven by the North America segment EBIT down 8% for the half, while international fiber cement EBITs were up 15% for the half. Foreign exchange, as you can see, this is a chart we've used now for some time. It didn't really have a material impact on the quarter on the reported comps. You can see really no change on net sales gross profit or adjusted EBIT, and only a point on adjusted and operating profit, excluding the impact of translation. Louis mentioned earlier that input costs have been a headwind for the year, and they continue to be so. You can see pulp, cement, freight, gas are all up, so all important inputs for us. Pulp continues to climb in the market. It's up 11% compared to the same 6 months a year ago. And we're continuing to see that market move up. Cement is up 5%. That's pretty consistent with where we've seen it the last several times we've talked and in prior years. But the cement market kind of continues to be strong. One change since we've talked in August and then in May, freight market prices are up about 16%. We're continuing to see driver shortages and truck shortages, as well as market and fuel increases. That's on top of our own inefficiencies that we're still working out from the capacity constraint. But nonetheless, the actual market prices are up quite a bit. And then you can see gas up 13%, electricity down 5%. But input costs for the year are certainly a headwind on the North America results. This slide looks at our second quarter versus our first quarter. And you can see that quarter-over-quarter our gross margins in the segment improved about 270 basis points. And that's almost entirely all the production cost increase. You get a little bit of price favorability quarter-to-quarter, getting a full quarter of the price increase and some mix. And startups are a little bit lower as we're coming out of some of the startups and we've got Plant City more or less fully started up now and the Summerville startup is stabilizing. And so the performance of manufacturing each quarter is starting to demonstrate an impact on gross margins, and therefore EBIT margins. So EBIT margins in the segment in the second quarter were up about 420 basis points to 24.5% in comparison to where they were in the first quarter of the fiscal year. I'll zip through the segment results. You can see North America EBIT was flat in the quarter and down 8% in the first half. And that's a combination of in comparison to a year ago, production costs were higher in the first of this fiscal year than they were in the first half of last fiscal year. Keep in mind that the cost of the capacity constraint and the stress on the network wasn't really felt until the second half of last fiscal year. So we've got a bit of a comp this year, a tougher comp, if you will. And then obviously we're continuing to invest in SG&A. So both of those are negative dynamics on the EBIT for the North America segment. Internationally the market index is about flat. We've got dwellings in Australia that's, call it, down high single digits. The R&R market is down 2-3%. And then you get non-residential that's up. So we're up on a market index that's flat and volume comps that are obviously above that. The team has done a good job on category share and a focus and a drive this year on executing certain strategies to drive category share gains. And that's what you're seeing come through in the strong volume performance. That combined in Australia with the stabilization of the Philippines, sales strategy and the performance of that business has helped the international business report a second quarter EBIT increase of 20%, a first half EBIT increase of 15%. Our other segment is continuing to perform more or less where we thought it would perform for the year. You'll see that EBITs are going to be a little bit more of a loss this year. We're continue to invest in product and manufacturing capabilities in the windows business. We like kind of what that team is doing. So we're investing a comparatively small amount of money into the business in order to enable them to deliver on their strategy. You can see the R&D, no real significant change in R&D spend from quarter to quarter-to-quarter or half-to-half. So that continues on a pretty consistent trajectory. General corporate costs for the half, they obviously look flat and that's what they are on a reported basis. Keep in mind that the first half also includes the gain on sale that we took when we sold a building next to our Fontana manufacturing plant. We reported that in the first quarter. That was about $3.4 million. So general and corporate costs are up $3-4 million in total. And that for the most part is on organizational capability and some discretionary spending. Income tax, we're estimating a 23.8% estimated adjusted effective tax rate for the year. Our adjusted income tax expense decreased due to where our earnings moved from period to period, and a lower adjusted operating profit before income taxes. Income taxes are paid and payable in Ireland, the U.S., Canada, and New Zealand and the Philippines. And I think as many of you know, income taxes are not paid or payable in Europe or Australia, due to the tax losses in Australia that's primarily because of our contributions to the fund. On 29, cash flow, we reported cash flow from operations for the first half of $98 million, down 25% from $131 million that we reported in the first half of the prior corresponding period. We're rebuilding inventory levels, so working capital is a use for the first half and will likely be in the second half, as we get inventory levels back to where we want them. There was also an increase in the payment to AICF this year in comparison to a year ago, as many of you that are familiar with how that payment works, it tends to fluctuate year-to-year. And this year it was higher. We're continuing to invest in capacity-related projects. I'll go through those in a moment. So we had higher investing activities. And those were the main drivers of our cash flow for the first half. We spent through the first 6 months of the year, $83.6 million on CapEx. And that's an increase of $48 million compared to a year ago. During the quarter we completed the commissioning of the fourth line in Plant City. So PC4 has been fully commissioned and we're continuing to start up the Summerville facility. That startup is where we thought it would be at this stage from the last time that we talked. We're continuing the construction of our Tacoma, our second plant that's adjacent to our current plant in Tacoma. And that's scheduled to commission and open in the first quarter of next fiscal year, so next spring. And we're continuing to do planning on our Prattville, Alabama facility. We expect that to commission in the first half of fiscal '20. I'd expect at the February result that we'll take you through some numbers on Alabama. And then we're continuing to expand capacity at our Philippines facility. That project was announced quite a while ago. And we expect that to be complete during the second half of this fiscal year. On financial management and capital management, so strong margins and operating cash flows, governance and transparency, and overall an approach on our balance sheet as though we're an investment grade financial management approach. Our capital allocation remains the same. So our first interest is to fund the fiber cement business and ensure that we've got the necessary tools in place and teams in place to support organic growth in that business. We remain committed to the ordinary dividend. You saw that today with the announcement of a first half dividend. And then as we've said, we always want to have the flexibility both for changes in the market and fluctuations that are out of our control as well as to be strategic. And certainly the Fermacell acquisition presented an opportunity for us to do that. We are going to maintain our leveraging target between 1 to 2x adjusted EBITDA. You will see that for a short period of time we will be above that range. I'd expect us to come back within the range over a 1-to-2-year period. As of September, we had $500 million of unsecured credit facilities. We had the existing $400 million unsecured-- senior unsecured note. You can see the average maturity there of 3 years, 3.2 years. And from a liquidity standpoint, we shape up pretty well. A bit more on the balance sheet, you can see the debt profile on the left, overall a very strong balance sheet, $79 million of cash, $602 million of net debt and 42% liquidity. You see the debt structure. Our net debt leverage at the end September was just shy of 1.4x, and as I said, we remain committed to the 1 to 2, despite the Fermacell acquisition that will for some time will put us up above 2. In terms of guidance, we've narrowed the range $245 million to $275 million. So we think that that's a good representation of the likely outcomes for the year. Obviously that's still subject to how the housing market in the U.S. finishes out for the year, as well as our own performance, as well as some factors that are outside of our control, like foreign exchange and the like. So with that, I'll open it up to questions. As Louis said at the top of the call, we're going to start with Fermacell-rated and acquisition-related questions. And then we'll come back to the core business.

It's Emily Smith from Deutsche Bank [indiscernible]. Just I guess firstly on the Fermacell, I guess just trying to understand if this is part of a strategy where you're going to grow [indiscernible] I guess through further acquisitions that we should think about. It's been a long time since you've made an acquisition, as you said, Louis. So I guess trying to understand what this means, if there are further acquisitions in the pipeline, and if you intend to continue to grow through acquisitions. I think secondly, just wondering, I think if you look at the numbers we have, I think the EBITDA margin comes in at around [9-10.5%]. I'm just wondering if you guys see some upside to that as you [indiscernible].

Okay, the first question on our buy [indiscernible] growth, so that really changed. We've kind of built ourselves to be an organic growth strategy, organic growth company. And we'll continue to be that, I think, in the foreseeable future. We don't have any work going on in Europe for further acquisitions. We've had a scan in the U.S. for several years now. But we expect anything we do in the U.S. to be more about the technology than the market position. So we don't expect a big acquisition or an acquisition this size in the U.S. So we are an organic growth company. We feel like it's obviously harder to grow organically. But we think it's way more valuable revenue growth. The acquisition of Fermacell was really partly because it is a big business, but if we weren't interested in fiber cement growth strategy in Europe, we wouldn't have bought Fermacell. So it is there to kind of provide that gate or that enabler for where we think we need to be in order to fully commit to Europe as a fiber cement for Hardie. As far as the EBIT margin, this is a good business. It returns much better than most building materials businesses, especially through a cycle. And we do see opportunity for further improvement in both on the top line and the bottom line. Our main focus, like I said early on, would be this is a well-run business. So as we bring in it into Hardie, we want to make sure we don't knock it off in any way. So we're not really looking to change the EBITDA margin or the basic growth rate they've been tracking on the last 3 to 5 years. We're hoping to maintain that and bring this into our company in a very kind of-- in a way that gives us that platform we're looking for, rather than have to try to fix things up. So it's not broken, so we're hoping not to break it.

It's Peter Steyn from Macquarie. Just in terms of the channel, could you give us a sense of how Fermacell are going to the market at this point in time? And then the sense is that this is largely an interiors business as it stands. You're trying to bring exteriors to that. Is there a very clear commonality in the channel opportunity? Do you see a relatively easy sell into those existing channels?

Okay, good question. We're not near as much about the channel as we are the market position. So we think the end users and the specifiers involved are key enablers for Hardie fiber cement. And I think to channel, basically both companies feel the same. Okay, we're pull-through companies. We create demand for products in a market with the decision makers. And then once you create that demand, normally the channel will support you. So both companies starts with that view. And certainly we'd have that view at Hardie in Europe. So it will help that they're fairly big with DIY in Germany and they have dealers established mainly for interior products. But some of those dealers do have both exterior and interior. That will be a small help, but that's not the big enabler. The big enabler is kind of that European capability and customer specifier. And I don't know if I'm been thinking wrong all these years or not. But I think having regular cash flows in the region will encourage us to really make the investments in product development and market development and capacity that we needed to. We just can't get this thing going the way we've been investing in the market to date. So we think this-- obviously we haven't invested to a greater degree because we weren't very certain of our returns. And we feel way more certain with Fermacell as part of the company.

Andrew from Morgan Stanley. Can you just talk a little bit about what you see as the addressable market? You referenced wood frame construction in Germany growing. I think that's from a pretty low base. Historically that's been something you've said you thought was key for Hardie's platform. What do you view as the addressable market and what does it require from a product perspective?

Yes, that's a good question. I want to go back. As over years I have talked about what we think the macro drivers are for our current fiber cement business model. And that's we like being in regions where there's no asbestos. So we don't want, quote, "cheap" cement boards in a market. We like frame construction. Our value proposition on our current product line, especially in the U.S. is basically high durability, low maintenance and it looks like wood. We like high GDP per capita, not because we want to sell to the most wealthy people in the country, but we want a big middle class. And big middle class seems to be highly correlated with high GDP per capita. We want a large population because basically we're a fiber cement company that has technology that allows much higher throughput and lower unit cost than a machine. And then we want an open business system. So we don't want to have to have a JV to be successful on a market. JVs, besides splitting the profits, you take a risk on technology and IP that we've never been comfortable with. So when you look at Europe, they have all but the frame construction. They're in a long-term trend of kind of moving toward frame construction. Currently -- let's see here -- currently the U.K. is about 25 coming off of 20 in 2004. They're forecasted to be 31 in the next 9 or 10 years. Germany is currently 16 coming off of 13, forecasted to be 20. And then France 10 coming off a 5, forecast would be 13. So as Andrew says, we have our eyes open. Okay, we're going into a masonary construction market. Now that trend line on frame construction will help our current product lines, which are built for frame construction. But we have to come out with product lines that have a value proposition on masonary construction markets. Because that's the standard in the market, and it's anticipated to be a standard for a long time. So that's why I was talking about commitment to product development. And once we get that product, get that value proposition clearly described, then we'll start the market development, depending on if it's commercial or a residential product line.

And what does mean? Does that mean more panel, less plank?

Yes, certainly panels are used in masonary construction, especially high density. Yes, definitely less plank. Planks a frame construction market. So you won't see a product mix in Europe reflecting our product mix in the U.S. And remember, our product mix in the U.S. is very different than our product mix in Australia, Australia and New Zealand. So you will definitely see a different product line in Europe.

And then the last one from me, this might be more for Matt. But can you just talk to us about what that revenue trajectory and maybe the share positions look like over the last few years for Fermacell's core business?

Yes, they've got a very good market share position in their core markets. They're very strong in Germany and German-speaking countries. As Louis said, we like that they're underpenetrated in countries like the U.K. and France where we've got a strong position in France and in the U.K. as far as [indiscernible]. So they've been on a good trajectory over the last several years, 4 or 5 years, and growing each year. But where they've been focused, that's where they've been growing. They've not been focused on a broader Scandinavia or the U.K. or France. And that's where we see good market opportunity to grow [indiscernible].

Andrew Johnston, CLSA. A question around the interior [indiscernible] in Europe. So if you look at the interiors, it would seem that these would see [indiscernible] to use their existing channel in interiors through that back board. But then if you look at their range of products, they seem to have -- and I'd be interested to know what percentage of their sales is essentially [indiscernible]. So how do you get your board into interior design [indiscernible]?

They do have a small cement board. One of their plants is actually a cement board plant. They make two product lines. One would be very similar to what I think most of you would be familiar with, a Durock, a Permabase; Aquapanel in Europe actually. The difference is they put a very smooth face on it. Because it's a board that sometimes finished. It doesn't always have tile over it. So it's not exclusively a backer board. But it is a cement board for wet areas. And then the other half of that business is for kind of niche applications. It's a super high performing fire board for tunnel lining and stuff like that. So that's one of their facilities. It's a relatively small part of their revenue and profitability. But it's not something that we'd walk away from. We think they're in pretty good positions in the market that we could continue to grow. Our backer board product is more designed to be a high volume product. Now Europe hasn't gotten to high volume use of backer boards. But the trend line has been okay. And it's better in the U.K. than it is Continental Europe. But I mean now that we own both, I mean basically we're going to go to the customer with the technology that gives them the best value proposition. So I can't tell how much we would be cannibalizing. But EUR 270 million we talked about, revenue, isn't much at risk through Hardie product substitution. That's not really in our-- especially since their product is produced locally and ours is produced in the U.S. There's not much motivation in our mind to get there.

Does that mean Hardie's strategy at this stage is to put your backer board through that channel?

Yes, well if they can carry our backer board to market better than we do, we'll certainly want them to do that.

And on the exteriors, to what extent does the whole insulation, exterior insulation that they're retrofitting to buildings in Europe to what extent does that represent a significant opportunity for you?

When you think about a significant, in the region, yes for Hardie, would be one of our product lines. But I don't think it will be our biggest product line, even if you look 10 years down the road. It kind of relates to the earlier Andrew question, which was what about panels. And panels, the insulation systems have -- they're competing with stucco. The panels are competing with stucco over insulation on reskinning a building in Europe. So we think it's a good market. We need to do product development for that. So it's a higher density color through standard right now, which currently Hardie doesn't have. So we'd have to do that product development to participate.

And just finally on the price differential between fiber cement in the U.S. and Europe; what's driving that? Is there significant extra marketing expense, or is there something that process or something that's not obvious that why there should be [differentiation] in price?

Did you pick this up through research that probably fiber cement sells at a higher price in Europe? I just want to make sure I answer your question right?

Yes.

Yes, it's ability to pay, to be quite honest with you. So U.S. is a very way more competitive market than Europe, so a lot more competition on price. The value proposition for the products are probably pretty much the same. But Europe's ability to pay for building material seems to be higher than the willingness to pay in the U.S. So we do sell at higher prices in Europe. It's not based on our cost. It's based on market pricing.

Surely that's not [indiscernible].

No, no. Everyone likes our prices.

Keith Chau from Evans & Partners. Just a couple of quick questions. The first one is just based on the historical ownership of the Fermacell business. Are you comfortable that you've acquired a business with the right capital structure and capital and assets employed? Or is part of the integration costs associated with putting a little bit more meat behind the management and operational bone to run the business?

Yes, we're certainly very pleased with the management team. It's a very good team, and we're optimistic that that entire team will come over and join us. So that was certainly one critical component to us proceeding with the acquisition. On the asset side, I mean they've got good manufacturing facilities today. They're in good condition. They've been run well. The facility that Louis and I visited was operating well and the team was very knowledgeable. So that gave us some good reassurance. We've included in our business assumptions capacity expansion CapEx over the next several years, as we continue to grow the business. And certainly our objective is to continue to take the current market share growth that they've enjoyed over the last several years and expand on that, which will obviously drive the incremental volume, which will result in capacity above what it is today. So we've assumed some level of both capacity CapEx as well as a recognition that we're likely to invest in the facilities at a slightly higher rate than probably where they've been invested at the last several years. So we've got both of those assumptions included in our business case and business model.

And Matt, are you able to give us a bit of us a bit of a steer on what those CapEx requirements will be beyond FY18 or in the next 6 to 12 months?

Yes, I'll be happy to do that, Keith. But we'll have to wait till we close. They've been privately held now for more than about 10 years. And so just out of respect out of our confidentiality agreement, we're going to be a little limited today with kind of detailed information that we're able to share. But we'll certainly provide more once we close on it. And we'll give you some projections on what we expect CapEx to look like over the next couple of years.

Okay, and then in terms of the return hurdles for the acquisition? Are you able to give us a steer on what those return hurdles are when you may or when you consider those return hurdles achievable at the EBIT level?

Yes, you know we've tried to be pretty transparent in the way that we disclosed the acquisition and set the expectation. It's not going to be accretive in the first year. We know we're going to-- or we're at least planning on putting some cost into the business above what its current rate is today to ensure that it's got the right organizational capability, operating and capital cost structures in the business. That combined with some integration costs and the transaction costs will prevent it most likely from being EPS accretive in the first year. When you exclude those, it's EPS accretive in the first year. But that seems a bit unfair to talk about it that way. That's not what our shareholders get to enjoy. In the second year, it looks like, based on our assumptions, it will be EPS accretive. From an EBIT rate and EBITDA rate, we're not going to provide specific numbers on that today. They're good. They're very good in comparison to other building materials peers. They're not going to be quite as good as our EBIT margins that we enjoy in most of our segments. But they'll be quite healthy and we would expect once we get the [technical difficulty]. You see the EBIT margin rates that are a bit below what our [indiscernible].

It's Brook JP Morgan. Just a question on Europe again [indiscernible] on what cement is it. Is it more of just adding a shift towards frame construction or it going to be about taking share from products that might be already in those countries?

Yes, frame construction is the easier part of the equation. But it's also a much smaller part of the equation. So like I said earlier, I think as we grow fiber cement in Europe over the years, you'll see us offering value propositions for builders that are building in a masonary standard. So the frame construction trend is helpful. But it's not the main game.

And then the products that you're going to be making and shipping over to Europe, I mean which plants in the network in the U.S. are you thinking about? Could you [indiscernible]?

It could move around a bit. You have to get them certified, so you don't move them regularly. But I think Peru and Pulaski are the current plants now, and will probably continue to be the plants. Again, within 5 years, we expect to have capacity in Europe. So that's been a long bridge. The 10-plus years we've been importing product and part of our commitment to Europe is we need to move down that track and as soon as we get our product lines figured out, commit to capacity in Europe. Okay, if there's no more -- we got a mic that works? We're going to start putting you guys to work, Keith. You have to pass your own baton.

Peter Steyn from Macquarie again. Just very quickly if you could give us a sense of any concerns you may have around conditions precedent being fulfilled, and then perhaps a perspective on the funding costs, both bridging and in your long-term plans, and will that be funded in Europe?

Yes, both good questions, I'll take those. In terms of the closing conditions, I mean obviously the transaction is subject to the normal customary closing conditions. We're obviously not anticipating that we have any issues as we progress through that. But nonetheless, we'll be diligent and rigorous in our approach and make sure that can get an on-time closure. So we're not anticipating have any difficulties with that. But as I think many of you know, most of the problems that come in closing aren't anticipated. So on the funding, we did announce it as a debt-financed transaction. Certainly the debt markets are very favorable at the moment and are projected to be so for the next several months. We are considering a permanent replacement of the bridge financing that we've already got in place with a bond in Europe. We'll continue to evaluate that. The financing cost and the current bond market make it very attractive to fund the transaction long term at a relatively low cost of capital.

Okay, any Fermacell questions on the phone? Sorry. I guess we have a few more in the room. You shouldn't have passed that mic over so fast.

Emily Smith from Deutsche, just one more question from me. I'm just wondering if you can help me in terms of like how would guys define success in Europe. What are you-- over the sort of medium term, what are your plans and aspirations there?

Yes, I think I'd kind of frame it up a bit, you're probably looking for a revenue number 10 years out, which I'm not going to give you. We'll be working on our kind of organic strategy for fiber cement in Europe very seriously over the next year or 2. But I've already given you product development and market development and regional capacity. So you know we're willing to invest quite significantly. And we wouldn't do that unless we saw a pretty good upside scale of the business outside of fiber gypsum that is really material for the company. So some of you I've talked to over the years and you know we've been kind of dissatisfied with just sitting there with a toe in the water in Europe. And we really had to make a decision whether we're going to kind of invest in that geography or not or we're going to pull back from it. We obviously went ahead with the investment route and a lot of our emphasis as we kind of built up the capability on the GMT was around growth outside of the U.S. So we feel like this is a decision we made about a year ago and we were fortunate to have Fermacell come onto the market. It came on pretty quickly after Jack joined. So it was a little hard to get our arms around it right away. But it took about 6 months to get to the binding offer, which I think was good for us. We know a lot about this business. We knew a lot about it when it was on the market as part of Xella back in 2008. We looked at it. We weren't interested in anything other than Fermacell at the time, and the sellers weren't interested in breaking it up. So we didn't get a chance at it then. But so our knowledge going in was pretty good. But we also had the 5-plus months with a full-time team working on this. So we definitely know what we got and we're definitely comfortable with the commitment we're making to Europe.

Lou, you mentioned in the release, I think fiber gypsum or gypsum fiber has 70% category share. Can you give us a sense of what proportion of the interiors lining market or the addressable interior linings market gypsum fiber has at this point in time and how that's developed over time, and what the goal is for the future?

Yes, that's a good test for me, which I think I'm going to fail. So just generally it's -- if you look at the broad market, Western Europe, it's probably in the 6% to 8% and then in some markets it can be higher than that. Germany and Switzerland it would be higher. But it's not a substitute for gypsum board. It's a value add alternative to gypsum board. When you're really looking for high performance either around sound, mainly around sound, fire or strength; when you're looking for that high performance, you want to move away from gypsum board. So it's in no way a substitute for gypsum board.

Matt, just a question whether you're willing to disclose what the total cost of the transaction will be. So if we add in the initial cost plus the year-one costs, transaction costs, integration costs, et cetera; are you willing to give us a guide on where you think that number is going to come out?

We will on closing, but I'd be hesitant to do that just yet. For one, we haven't obviously incurred some of the closing costs and the integration costs just yet. We've obviously got estimates, but I'd be a bit more comfortable once we move through the next several months and we get the transaction closed.

Okay, and then Lou, just a question around potential market opportunities. You said you're expecting the European business to look more 50/50, so 50 interiors and 50 exteriors. So I assume 50 interiors is really just your backer board product or are there other opportunities in Europe?

You can use backer boards behind stucco systems. But currently we don't market that in the U.S. or Europe. So what I meant to say is it won't look like the U.S. Australia is 50/50. In the U.S. we're 80/20 exterior, and I expect Europe will be a much more balanced kind of product line, meaning we have almost no sales in commercial in the U.S., so I would expect commercial is a target market in Europe. I'd expect exteriors obviously be the target market. But I also think we'll do more interiors business with fiber cement in Europe than we do in the U.S. But it's way too early to call. I would just kind of frame that up. Don't think we're taking a U.S. business model to Europe. Because we're not. It's not frame construction. It's a different value proposition for most decision makers in Europe. Hey, I know you're going to want to have a few questions on the business, so let me just check real quick. Are there any Fermacell questions on the phone?

[Operator Instructions] Your first question comes from Simon Thackray from Citi.

Just a quick one or a quick couple of questions, Lou and Matt. You made the point that the business came to you fairly quickly after Jack came on board. It's been into a lot of private equity hands. Can you explain how it came to you? Obviously Lone Star bought off PAI and Goldman Sachs in December 2016. Did they approach Hardie? How come they're bringing the-- why are they willing to exit this business?

We knew the people at Fermacell. So we did get a call from Fermacell. But I think the bank that was working for Lone Star used a pretty normal process in marketing the business. But we just happened to know the people from Fermacell. So we did get a call from them.

Right, and so just when I look at that business and I think you made the point they've been in business, marketing this gypsum, fiber gypsum for about 40 years. But the revenues are EUR 270 million. And you're saying it's got 70%-plus category share. So the category itself is only what? About EUR 375 million?

Yes, whatever those numbers divide out to, that's right. And it would be smaller than that in the U.S. and Asia. I think it may be a little bit bigger in U.S. So it's not that different than Hardie. Obviously they haven't gotten to the same scale. But when we were investing in fiber cement in the early '90s when Keith Barton was running the company, certainly we were counterintuitive with our investments. Most people saw fiber cement at the time as a declining industry rather than a growth industry. And we were able to invest in the technology and push it into some other places, get it to a cost point that enabled certain market positions. And we've grown it, and we've grown it to whatever it is, 2 billion or something. So they've got to EUR 270 million. But I'll tell you, it's a very similar story. They're more niche-y than we are. We hit some volume markets in the U.S. and they wouldn't have volume markets like we have in siding in the U.S. But they have a lot of specific value propositions for certain niches, whether you're in commercial or frame construction, residential, or you're either looking for strength, fire or sound. And they have a very strong value proposition to those buyers. Whether that can be expanded over time, I'm not sure. I don't know enough about the business itself and the technology itself. But I know their incremental growth rate is fairly good. And as Matt mentioned, in Germany they're way ahead of other parts of Western Europe. So we think there's opportunities to maybe not pull that market share up to where it is in Germany, but we do feel we can pull it up in countries like the U.K. and France and Scandinavia.

Got it, so what has been just as reference point, what has been the sort of the rate of growth? I mean I know you're guiding EUR 270 million to calendar year '17. But what sort of growth rate has that been seeing for the last 3 years?

As Matt said, I mean we're not going disclose information till we own the business. But we will give investors a good update. Here's what we have. Here's how we look at it. Here's what we're going to do with it.

But it's grown above its index is the point you're making?

Yes, it is. It definitely is.

Okay, so if I just divide -- and I know there'll be more detail -- if I just do this math very simply and so based on the transaction multiple, it's about EUR 52 million of EBITDA and you're going to -- you said you're going to put incremental CapEx into the business. Has the business been somewhat -- I'm going to use the word rather carelessly -- starved of CapEx under PE. Is there an opportunity to grow the core business with incremental CapEx or is the CapEx you're referring to really more about growing your capability for fiber cement?

Yeah, those are all good questions. So the first, I guess everybody in the room's between the lines you're saying, hey, you bought it from a PE firm. Did they starve the business of capital? And the answer to that is no. We like how the business has been run during the period of time that Lone Star owned it or still owns it, I guess. But these plants are a little bit older than Hardie plants. But they're well-kept. They're well-maintained plants. But I mean they haven't -- as we talked about their scale of the business wasn't growing at the rate like it was fiber cement where we were building a plant every 2-3 years for a period of time. And we're kind of getting back in that window of building capacity regularly. So what that means is most of your capacity is relatively new rather than relatively older. They have a new plant in Spain that is relatively new, and won't need much CapEx, normal maintenance type CapEx that Matt and I are referring to. But some of their older plants have a few sections that need some maintenance CapEx, which we will address.

So in summary then, if I can try and conclude this properly, the existing business will grow at the rate that it has been growing that it hasn't been starved that it's actually a good business. There's nothing incremental you bring to the existing business. Is that my understanding more you will learn more about the market for fiber cement, how you're going to put your product portfolio together for Europe, but the existing management will stay and drive the existing business? Is that right?

Yes, that's right. It's a good way to term that. Basically what they're bringing to us is the story, not what we're bringing to them. Okay? So it's a very similar continuous process, plants to what we have. So we're not going to get in a room with them and kind of lose each other on how we think about how you run these plants. And they're not going to have any trouble figuring out our plants. Because they are very similar processes. Now, the forming section is different and a few other things are different. But it's similarity. It's not like we just brought in an assembly plant and we're going to have to learn how to do assembly. So we're not going to have any problem in that respect. But the opportunity is what they bring to us. They bring the European capability. They bring the European access to customers, and that's what's going to help us in fiber cement. Now I kind of indicated and I think it was the last slide I had, there's going to be cross-over on the technology. We're going to learn from them and they're going to learn from us. I don't know how to quantify that. I don't know exactly where those areas would be right now. But I'll guarantee you it will happen in the next 5 to 7 years. There's just absolutely too many similarities to not learn from each other. Okay, Simon, I'm going to have to cut you off. I know there's a few questions on the business and we're two minutes from quit time. So we'll extend our quit time to 11:30 and take care of business questions.

Andrew Johnston, CLSA. Just a question around volumes in the U.S. Can you talk about what the trajectory is like for recovering lost customers? Because it sort of feels like it might have got a bit worse this quarter.

Yes, it did. And that's the first thing. I agree with you. There's no question the negative number is hard to swallow. So it feels like it got worse. But it didn't get worse. When we were sitting here in August and even in May, [indiscernible] and we have a soft order file. Believe me, I'd like to have a better order file than we have now. But I don't consider it soft, based on where we're living. So I think we're starting that win-back process. It's starting to show up in our order file. I think the third quarter will be better than the second. And I think the fourth quarter will be better than the third. So I think we have momentum on the market side. It's a slow go. I think it was maybe in August I said, hey, I thought the year would kind of end up at market index. And if you just take out your adjustments, we exited a product line and if that storm kind of doesn't -- if the storm demand doesn't swing the other way, there's a little bit there, but not enough to worry about. I think there was a possibility we could end up flat to market index. But I think right now it's more likely we'll be a couple points below market index.

Okay, and on the technical pricing, 6% is pretty impressive for the quarter. But how should we think about the overall pricing for the rest of the year? Does that tactical pricing, is it such that we should be seeing 6% in the subsequent quarters? Or was it just like a sort of one-off?

Yes, we commented on the price increase we took effective April 1 plus the tactical pricing kind of tune-up we did. And that product line we exited would have helped our overall pricing as well. So there's stuff like that that's going on. But I think we're now back to normal on pricing. We skipped a year and we didn't have much the year before. So when you look at our chart, it's flat, flat and then it's up quite a bit this year. We're back to regular reviews. We've got a pricing framework we're going to work with this year, and we'll be announcing a price increase probably right around the first of the calendar year for April 1 implementation. And it won't be a super aggressive price increase like some of the others' commodity businesses are taking right now, because of the demand due to storm and stuff like that. But it will be normal Hardie increase that fits well with our 35-90 growth objectives and return objectives. So I didn't answer your specific question. I think Q3 and Q4 will look very much like Q1 and Q2 on pricing. But then you'll have a new price coming in starting next year.

Lou, just in the context of what you've seen from a price point of view, if that continues, it does suggest that your guidance range certainly as your margin performance stands right now, at the very least outcomes could be fairly high at the top end of that range. How do you sort of think about the progression? What concerns have you built in to how you think about the outcomes for the full year?

I mean our guidance is our guidance for a reason. We think there's things that could pull us up and things that could pull us down. But we think we'll be in the range. We don't know if we're likely to be in the top end of the range or bottom end of the range. I mean I don't have any guidance on our guidance. Our guidance is our guidance is my guidance. Any other questions on the business? Yes?

Lou, just on the cost side, I think in the first quarter result you mentioned that manufacturing or unit manufacturing costs had fallen 5 of the last 6 months. That's certainly come to fruition. How are they tracking now?

Yes, it's tracking well. I think like I said, early in the year we said we think it gets better every quarter through the year and we still feel the same way.

Emily Smith, just on the -- I know everyone is sort of talking about the margin. So you talked about Q3 volumes are going to be better than Q2, Q4 better than Q3.

Relative to the comps from last year, yes.

Yes, relative to the pcp. I think in previous results you've also talked you kind of expected to exit the year at close to the top end of your EBIT margin guidance range, the 20 to 25. And you've done that earlier than perhaps some many would have expected. So I mean is there upside from here going into the end of the year as these manufacturing costs continue to come down, or how should we be thinking about the margin aspect?

It would be the same question as Andrew's just phrased differently. Yes, there is upside, but it's certainly not guaranteed. So we've got to see what we can deliver. There's potential upside. We got a good trend line in manufacturing. We're very early on the market win-back. So it's really hard to call that right now. But if we got both volume and manufacturing and yes, I mean we're a manufacturing business. We got prices set. If we get volume and manufacturing we're going to end up pretty strong. But that's not what we're forecasting. We're forecasting kind of how we did. I mean we haven't change at all. We just gave checked the box for you rather than changed our thinking about the business. Our thinking is still the same. We're working out of the funk we got in because we ran out of capacity. It showed up first in manufacturing cost and now it's showing up in growth above the index. And we think we have game plans in place to fix both, and when we fix both you're going to like our results a lot better than you do today.

And so just looking at the manufacturing cost that you called out in terms of how much it's impacted margin, I think in the Q1 it was close to 900 points. And this quarter it was maybe -- I don't have the numbers in front of me -- but 4.7 or 4.9 points. I mean how long is it going to take in your view for us not to be talking about that anymore and to be back to normal?

I mean normal with some variance, probably not more than a couple quarters. There's variance in a business and we got a little bit outside of our normal variance. When we ran out of capacity we kind of shocked the business model a bit and got outside of our normal variance. And we expect to be back in that certainly first quarter fiscal year '19. Any questions on the phone?

Your next question comes from George Clapham from Arnhem Investment Management.

Okay, it looks like George might have moved on. Is there any question beyond his?

Hello?

Oh, yes. Sorry.

Sorry? Hello?

Yes, George. This is Louis. Can -- have we got a telephone problem, he can't hear us?

Can you hear me? Hello?

Yes, we can hear you.

Yes, Louis, a couple of developments in the U.S. home builder market. Lennar and CalAtlantic getting together. Do you guys have much exposure to those builders? I understand they're going to be about the second-largest home builder by volume. Is that an opportunity? And just you mentioned the market index. I'm not too sure what the market index is growing at in terms your benchmark for this year. So if you could just let me know what you're expecting the market index to grow at.

Yes, on Lennar CalAtlantic, they are merging. I think they're going to be about the same size as Horton. We already have their business, both builders. So we're very confident we'll have the combined company's or combined builder's company business as well. So probably not much of an opportunity, but not much of a risk for us either. On the market index, I think we're tracking somewhere approaching 5, somewhere between a 4 and 5, approaching 5 on our market index calculation.

Your next question is a follow-up question from Simon Thackray from Citi.

Just one on the volume again, and I'm sorry if it's been answered. It's been very hard to hear on the line here. The cash flows in the first quarter showed an $11 million sort of drag from a buildup in inventory. The second quarter, which shows $16 million drag so for a total of $27 million. I thought the whole point about building the inventory was so that you could meet the market for customers who were on allocation. And you made some comments obviously from Dallas that you had been winning back some of those larger customers. How does volume end up being flat quarter-on-quarter in those circumstances when you had inventory to meet demand?

Yes, we have the material. We don't have the demand. So that's how it ends up being flat in the quarter. If we had more orders, obviously we had the ability to ship it. So yes, I mean it's just market traction. Now I think the question -- I think that was the question. But I think I should comment on why we're building inventory. Basically this year is going to be much more of a level-load approach to our manufacturing plants. So we normally build inventory in the winter months. This year we started to build it earlier because we had been working hard on getting our throughputs up in the plant. When the order file was coming in softer than forecast, so we didn't want to pull the plants back. We wanted to continue on with the manufacturing. And that's kind of how we're looking at the year as well. So we'll distribute inventory closer to the customer this year than we ever have in the past. It's kind of a new program that we're evaluating whether it should be a long-term program for the business. So we'll build inventory more this winter than previous winters. Partly because we think we have kind of a supply chain game plan that might be beneficial for both us and for our customers, but also because we want to continue on with our manufacturing kind of initiative to increase throughputs per hour in the plant or net hours per week. Having said that, we have pulled some of the plants back. So we're not running all plants 24/7. We have 2 plants running at about half the time, so 2 shifts rather than 4. And then we have a few other plants where we've taken some shifts off some of their lines, but not all their lines.

Right, I think I'm a bit confused. September when we were there in Dallas, there was commentary about sort of stratifying the different types of customers and the big builders [indiscernible] volume. Because you're contracted to them. And then there was a series of sort of mid-sized builders that some had been on allocation. But you were getting those back. I'm trying to understand did that not happen or did you lose--

No, no. We're getting back. I mean I don't know specifically what your interpretation at a presentation was. But I think we've talked about -- we're talking about not all customers but some customers that have had to go onto different products when we were short product have not come back. And that's a win-back type game plan, which the guys have in place. But we're certainly not through it yet. So we've won-- you said the September tour. We definitely won more customers back since September. But we haven't won all of those customers back.

Right, but that means you're getting positive traction on volume, yes?

Yes, we're like I said, I think Q3 will be better than Q2, and Q4 will be better than Q3, indicating I think we have some traction or momentum, whatever you want to call it. But we're nowhere near where we want to be on our growth against the market index. We still got a lot of work to do.

There are no further questions at this time. I'll now hand back for closing remarks.

All right, thank you very much. I appreciate everyone's interest in the company.