Description

Recommendation: Initiate a long position in BECN at today’s price

Summary

Beacon shares are down 45% since the start of 2018 on poor weather and investor concern around the housing cycle. Both fears are misguided, however, as Beacon offers a highly stable business model with very capable management oversight. Today the market gives long-term investors the opportunity to buy a cycle-resilient, high ROIC compounder at 10x FCF. I see 75% upside from today’s price.

Business Overview/Background

Beacon Roofing Supply is a $2.5B market cap distributor of roofing materials and other complementary building products. The company buys roofing products (e.g. shingles) from OEMs, and distributes those products to local roofing contractors and homebuilders through its network of 550 branches. Through a combination of organic growth and acquisitions, Beacon has grown EPS at a 14% CAGR since its 2004 IPO. BECN is the second largest distributor of roofing materials with approximately 20% market share amidst a fragmented market. Most of Beacon’s 46 acquisitions have been small regional mom & pop competitors, but BECN has recently done two larger deals, acquiring RSG for $1.2B from PE sponsor CD&R in 2015, and acquiring Allied Building Products for $2.6B from CRH in 2017.

Investment Thesis

1. Roofing distribution is an excellent business at scale

2. Beacon has been unfairly dragged down by the rest of the housing sector

3. Fact pattern and track record of BECN insiders gives a high degree of confidence in execution

1. Roofing distribution is an excellent business at scale

Investors might be surprised to learn that distributing roofing products is a great business. The uninitiated may assume the business lacks barriers to entry, earns low ROICs, and is highly exposed to the housing cycle. In fact the BECN business model provides consistently high ROICs, profitable growth, and stable end-market demand.

High ROIC

• Price insenstive customers: Most of BECN’s customer base is relatively unsophisticated mom & pop roofing contractors. For these roofers, gross margins on any given job are quite high at 35%, but operating profit varies widely (0% - 25%) with the industry average at just 6%. The name of the game is volume. I estimate the average roofer can increase EBIT by 28% with just a 7% increase in jobs.

As a result of this cost structure, it’s highly impractical to waste time negotiating price with distributors. Raw materials are a small cost relative to labor and are typically passed through to the homeowner.

Bulk buying is infeasible because each job has different requirements and storage is impractical. Spending 1 hour per job calling distributors to get the best deal would take 150 hours per year (about 6 jobs

worth of time). Most importantly, wasting time on raw materials reduces labor efficiency (which is the biggest piece of the cost structure), so using a trusted supplier is crucial. All these factors have allowed the

roofing industry to take an average of 2% pricing each year.

• Fragmented competitive landscape: Beacon’s scale allows it significant operating advantages in procurement and logistics over its mom & pop peers. According to management, BECN’s margins are about 20% higher than independent operators. Since 50% of the industry’s sales come from mom & pop shops or retail-oriented home improvement stores (Home Depot/Lowes), the marginal competitor in most markets is a non-scaled player. This allows BECN to use its advantaged cost structure to earn economic rents.

Simple, Profitable Acquisition Strategy

• Proven rollup model: Beacon has completed 46 acquisitions since its IPO in 2004, and has plenty of runway to continue consolidating the space. BECN’s acquisitions have allowed the company to grow EPS at an impressive 14% CAGR since 2004 (despite the housing crisis). The rollup model is simple: BECN can acquire small roofing suppliers for ~8x EBITDA and extract synergies taking the post-synergy cost to ~6x EBITDA. Beacon shares have typically traded ~10x EBITDA, thus creating significant shareholder value.

Cycle-Resistant Demand for Roofing

• See below

2. BECN shares have been unfairly dragged down by the rest of the housing sector

Anything even tangentially related to the housing sector de-rated substantially in 2018. Home builders and building products suppliers are down 20-50+% since 2018, and BECN has suffered more than most, down 50%. Most of the housing data (housing starts, permits, etc.) has come in below expectations, and rising rates and higher construction costs have caused some analysts to call the top of the cycle. Roofing supply though, is an incredibly stable, cycle-resilient business, and does not deserve to be grouped in with its more cyclical peers.

• Stable through-the-cycle demand: Roofs typically last for about 20 years, creating predictable demand for re-roofing. Over the past 20 years, just 18% of roofing demand has come from new construction, with the remaining 80+% coming from repairs and remodels. Even during the greatest economic/housing market crash we’ll ever see (the GFC), the roofing industry continued to do well. This is because most demand cannot be substantially deferred in a downturn. Major storm damage (7% of volume) is typically covered by homeowners insurance, and thus is consistent throughout the cycle. Early re-roofing due to weather (21%) can’t be deferred because unrepaired leaks will cause much worse damage. Of the normal cycle remodeling demand, a significant portion is commercial demand (20%), which is also stable during downturns.

• Beacon powered through the global financial crisis almost unscathed: Examining the performance of housing-related names during the GFC makes it clear why most housing stocks currently trade at <10x FCF. Homebuilder and building products names saw revenue slashed by 80%, and EBITDA margins fall sharply negative. BECN stands in great contrast, though. Organic revenue only fell 14% from top to bottom, and EBITDA margin saw just a 2 percentage point decline, remaining positive throughout. The one name below that hung in almost as well, MHK, trades at a higher 12x FCF. Note that any downturn is also a chance for BECN to pursue opportunistic M&A.

• Rampant private equity activity supports view of stability: While there is some concern over BECN’s debt load (4.3x 2019E net debt/EBITDA), private equity sponsors seem to agree that this industry is attractive, and stable enough to handle LBO-sized debt loads. There has been consistent PE activity in the space, as the investment model has been proven effective time and time again. The space has been seen highly reputable investors including Leonard Green, CD&R, Berkshire Partners, Oaktree, and Platinum Equity. SRS and RSG, which are direct comps for BECN, have been owned by 5 separate PE owners alone. SRS is private, but according to credit filings, Leonard Green purchased SRS in April 2018 using ~7.5x debt/EBITDA.

• Not clear that the cycle is peaking: An investment in BECN can work out regardless of one’s views on the housing cycle, however it’s not clear that the cycle is peaking today. Single family housing starts and overall housing starts are still significantly below long-term averages. Recall that roofs last ~20 years, so the housing mega boom of 15 years ago may start to trickle into roofing demand soon.

3. Fact pattern of insider buying gives a high degree of confidence in execution

Beacon shares are down more than the rest of the housing industry due to poor execution. Management has lowered guidance multiple times as storm activity was less than expected and higher asphalt prices were a temporary drag on gross margin. This is a temporary dislocation, though, and insiders have backed up their words with their wallets.

• Massive insider buying led by CD&R: Private equity firm Clayton, Dubilier & Rice (CD&R) has recently made substantial equity investments in BECN, signaling confidence in the state of the business. CD&R is intimately familiar with the roofing space as well as BECN’s specific assets. The firm previously owned RSG from 2012-2015 before selling to Beacon in a cash + equity deal (earning a 33% IRR in the process). As part of the 2015 sale to BECN, CD&R appointed 2 members to BECN’s board of directors, one of whom remained with BECN even after CD&R sold its shares. Knowing the value of M&A in this space, CD&R came back in 2017 to provide convertible preferred equity for BECN’s acquisition of Allied. Even more, CD&R has subsequently made large (~7.5% of market cap) open market purchases in August 2018 at ~$39 and March 2019 at ~$33 taking their total ownership to 20%. It is extremely compelling that a private equity firm with incredible insight into this business (via owning it and having two board representatives) was willing to go out of its comfort zone for a public equity, open market purchase. On top of this, the CEO, CFO, and 9 of 12 board members have made $2.7M worth of open market purchases over the past year.

Valuation

I come to a 20% IRR over 3 years by projecting the business out until 2022 and applying a multiple (P/E, EV/EBITDA, P/FCF).  

• P/E and P/FCF: I exit 2022 at 14x P/E and P/FCF, which is 3 turns below historical average. A 14x P/FCF translates into a 7.1% FCF yield, and layering in 2% organic growth (significantly slower than 5% historical average) gives a market return (9.1%) upon exit.

• EV/EBITDA: I use 10x EV/EBITDA, roughly in-line with historical average despite BECN being a full beneficiary of tax reform. PE firm Leonard Green purchased BECN competitor SRS for ~13x EV/EBITDA in April 2018.

Catalyst

Positive earnings surprises

Better housing data points

Further open market purchases from CD&R