S&P Predicts Tough Year For LBM

Because the decline in housing starts in 2OOl was sharper and quicker than expected, Standard & Poor's Ratings Services sees the U.S. building material industry as in the midst of the most difficult market conditions in more than a decade.

With a further decline in starts expected this year, how the industry manages any potential moderation in the commercial, remodeling or infrastructure markets will be critical in determining credit quality within the sector over the next year.

S&P economists recently examined the top trends that could affect credit ratings for LBM companies:

A recession of unknown depth and length in the U.S.

S&P places the industry at the beginning of a mild recession and believes it will become more difficult for companies to continue cost-cutting measures, disciplined production, higher productivity, and solid pricing that kept profits and cash flow at acceptable levels for most companies in 2O07, despite lower volumes. Market conditions were relatively stable for LBM companies with diverse end markets or concentrations in commercial and infrastructure sectors. while companies with a significant presence in new residential construction experienced steeper drops.

While new residential construction will likely remain depressed, a general recession could also lower demand in the commercial and repair-and-remodeling sectors.

. The housing slump could spread to repair, remodeling and commercial

S&P's baseline expectation is for more than a 30Vo drop in annualized housing starts in 2008, to approximately 930000 units. Factors include a reduced level of permits, tighter mortgage lending standards, and the prospect of further foreclosures.

As a result. S&P does not see a meaningful recovery in LBM pricing in the near future. Meaningful production cuts to align with demand should provide a pricing floor, and prices should rise modestly as the spring building season ramps up. In addition, many companies benefit from largely variable cost structures that help them adjust to lower volumes. Still, at fewer than 1 million housins units. even companies with low fixed costs may have difficulty covering overhead.

S&P's believes housing will not begin to rebound before 2009. While companies are either slowing down output or temporarily closing facilities, they have not, for the most part, been permanently reducing overcapacity, because the long-term fundamentals for housing remain positive and the companies want to be positioned to participate in the eventual upturn.

The conventional wisdom has been that, as new home sales decline and the prospect of trading up diminishes, homeowners take greater interest in remodeling and repairing existing homes. However, behaviors could be altered, as consumers become concerned about job security, the inability to tap home equity sources due to the drop in home values, and increased worries about the extent of recession. Building products that can be repaired, such as air conditioners. should benefit, while more discretionary products, including kitchen cabinets and spas, will experience wider swings in sales.

Although 2008 should see stillhealthy commercial activity, after year-over-year growth of l27o in 2001 and 8.47o in 2006, there are isolated

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the best outdoor projects start with the best materials signs that are cause for concern, causing S&P's to forecast flat nonresidential construction activity for 2008.

The most prevalent cause of concern is the prospect that the current tight credit markets will result in the shelving of planned projects as financing and refinancing become less available and more expensive for commercial owners and developers. In addition. credit availability to small and medium-size businesses, often the sponsors of individual projects, has clearly tightened in recent months. Higher borrowing rates, more collateral, and smaller loan amounts are apt to reduce activity in this sector and further crimp revenues and profits for building material suppliers.

A second concern is the lag effbct of sharply lower housing starts 0n commercial construction. After new communities are built out. big-box retailers, malls, offices, restaurants and other services and amenities folIow. With the buildout of large communities unlikely in Arizona, Nevada, California and Florida, for example, a ripple effect could delay or shelve commercial projects in these regions. While this may not be as much of an issue during 2008, given the current backlog of commercial projects, the state of this market will come more into focus as 2009 approaches.

Still-voletile raw material and energy prices

Price volatility of raw materials continues to be a risk for the sector. While prices for steel, copper, aluminum and resins have declined somewhat in the past few quarters, they continue to be volatile and near historical highs. Over the past few years, many LBM companies largely offset raw material price escalation by raising product prices, reducing costs, and improving productivity. In fact, in periods of strongest demand, price increases outpaced higher raw material costs. However. with volume now retreating, companies will find it more difficult to raise prices to offset the expected clirnb of material costs.

Energy can also be a cost factor, particulally for companies with energy-intensive manufircturing processes. Such costs include natural gas for wallboard producers. asphalt fbr roofing-shingle makers, and resin for siding manufacturers. The cornbination of lower volumes and continued high energy prices are likely to constrain

operatlng margtns.

, Tighter credit

With many banks and other lenders experiencing large losses, the climate for companies with housing exposure has become less amenable to negotiation of amendments and waivers. The result is deepened concern about liquidity as lines of credit become limir ed or unavailable. Comoanies at the lower end ol' the speculative-grade scale will face the most Dressure as rel'inlncing options become limitecl.

Because many smaller players will find it harder to compete, S&P fbresees larger LBM companies pursuing acquisitions and attempting to broaden product, manufacturing. geographic and end-market diversity. However, the extenl to which trensactions are funded with debt will be a key rating determinant for potential acquirers, particularly given expected lower levels of internally generated cash flow compared to 2OO1

With little optimism for the housing market in 2008, S&P foresees LBM companies conlinuing to scramble to bolster other areas of their business, husband their resources. and artfully manage their credit needs.