Description

There are a couple of fairly recent writeups on VIC which do a good job of describing the basics of BECN and the long thesis.  Shares sold off (again) earlier this week after BECN delivered another disappointing quarter/year (FY adj EBITDA came in @ $476 mn vs guidance of $540-610 mn at the beginning of the year), the new CEO declined to provide 2020 guidance (a departure from customary practice @ BECN), and brokers tripped over themselves to downgrade the stock.  

I believe BECN is interesting today as 1) due to poor operational performance it has massively underperformed the market/building products distributors over the past couple of years and shares have declined on an absolute basis (2) end of merger integration/a recent management change could serve as a catalyst for improved operating performance as management focuses on organic operating improvements (3) potential for higher storm activity to increase roofing demand (4) deleveraging the B/S - eventually ND to EBITDA will come down.  LTM adj EBITDA margins of 6.7% sit below Beacon’s 7.5% 16 year average (range of 5.9 to 8.5%; Beacon is 4x the size it was 16 years ago). 

I started following this company almost 2 years ago shortly after the Allied acquisition (Largest in BECN’s history) was completed. My initial impression was that this was a business that should produce relatively stable operating profit given the high level of replacement demand, that would benefit from increasing scale as it consolidated the industry (19-20% m/s, #2 behind ABC which has 24-25%) with the potential to outgrow the market by sharing scale benefits with customers (both costs but also by providing better service with online/mobile ordering which would be difficult for smaller players to offer).  While Allied acquisition looked expensive (13.5x pre-synergy; 8.8x post) but I thought that the underlying strategy was reasonable and the deal could be potentially slightly value creating were they to beat their synergy targets.  Similarly given the post deal leverage, I figured with FCF going to de-levering and that would de-lever over the next 2 years as synergies were realized and FCF was generated.  I initially purchased shares in May 2018 in the low to mid 40s when the stock fell after reporting a disappointing set of 2Q results.  As mentioned above I liked the business/industry structure and thought that this was an overreaction given that 2Q is a less meaningful quarter from a seasonal perspective.  My expectations were for a business doing $7.7-8 billion in revenue at an 8-9% EBITDA margin producing $4+ worth of FCF and de-levering to sub 3.5x EBITDA in 18-24 months.  I thought that as the business de-levered, the market would put a 15-16x FCF multiple on the stock and expected shares to sell for $60-70 (about now - according to my expectations at the time, the shares were supposed to be $60+ now).  

Investing is hard and boy was I wrong.  Today the stock sits @ $30.  Shares of Beacon have massively underperformed the market and declined on an absolute basis over the past couple of years.  The stock has been a dog for good reason:

1. Company has massively underperformed operating performance expectations since the announcement of the Allied acquisition (it’s largest ever) in January 2017.  In a presentation following the completion of Allied, management showed a PF trailing EBITDA # of $675 (inclusive of $110 million in expected synergies).  As it turns out, 2017 was above normal due to storm activity in 2016-17 (I thought this would’ve been partially mitigated by growth in new construction/ increased remodeling demand).  
2. There are multiple reasons for Beacon’s poor performance but the relative contribution of each is hard to pin down.  Reasons include: 1) less storm activity market share losses (2) negative price-cost performance in asphalt shingles (largest product category) (3) market share loss (4) operating expenses seem high.  
3. Poor operating performance has prevented the company from de-levering - Beacon levered up to facilitate the Allied transaction.  Post Allied, pro-forma BECN looked set to do $675 million in EBITDA inclusive of synergies - with ~$3 bn of net debt following the completion of the deal, company looked to be levered 4.4x and capable of getting down under 3.5x within 24 months.  However, while ND has come down $350 million or so, EBITDA has been well below expectations at $476 million last year - as such, ND/EBITDA sits north of 5x.  
4. Using tax adjusted trailing EBITDAX against total capital employed (inclusive of amortized acquisition intangibles), BECN earns poor returns on capital and doesn’t appear to be the type of business one would want to own.  

Despite this laundry list of negatives, I think the set-up for Beacon shareholders is pretty positive going forward.  While weather has been poor and execution has been lacking, I cannot identify any negative structural change in the business.  Beacon most certainly overpaid for Allied and appears to have under-deliver on synergies but 1) PE firm Clayton Dubilier (who sold them RSG and ‘helped’ them finance Allied) now has two seats on the BOD (and effectively a 19.9% stake in the business assuming conversion of convertible pref) so there should be adult supervision here and (2) the CEO was recently replaced and the company is in the midst of a search for a new CFO.   

After reporting another disappointing set of results on Monday (reasonable top line performance but weak gross margins and operating margins), shares sold off and now trade at ~10.5x trailing adjusted EBITDA.  Last year BECN earned an EBITDA margin of just 6.7%, which is below the company’s 16 year average (7.5%).  To me, this margin is unsustainably low as the company was doing just $1.4 billion in revenue 16 years ago (vs. $7.1 bn last year).  The company has not demonstrated improving returns to scale and at this stage it does not seem that the market believes there are any.  In my view, this is the nature of the opportunity - ultimately I believe that Beacon will produce sustainable operating margins at least 100 bps higher than current.  The source of scale benefits isn’t terribly complex - advantages include:

1. purchasing scale - while BECN is slightly smaller than competitor ABC (private), it is significantly larger than all other competitors (~2.5x size of next largest) and receives better buying terms.  While the shingle makers are consolidated, this isn’t dissimilar to other industries (wallboard, insulation) where distributors have produced demonstrated increasing returns to scale.  
2. operational cost efficiencies, particularly route density - more deliveries per day per truck/driver - driver and truck costs are largely fixed (except for fuel) so high local market share leads to higher operating margins
3. online/mobile ordering - While building trades have been notoriously slow to adopt technology, as younger roofers take a greater role in their companies they are more likely to demand basic online ordering tools which only a few players will be able to provide (given that the industry is fragmented and smaller roofing supply companies will be unlikely to invest in such capabilities).  This should result in a lower cost to serve which could benefit operating margins. 
4. private label product

Scale benefits are evidenced in publicly traded distributors throughout the building product supply industry.  I am very bad at formatting on the VIC so I’ll put these in the Q&A section where I am somewhat less bad at formatting.

Beyond scale benefits I think there are additional opportunities to improve results including:

1. The company has been a serial acquirer and seems to have a case of indigestion.  On the most recent earnings call, the new CEO said that the company would be focused organically going forward.  While this isn’t a surprise, serial acquirers tend to present opportunities for improved efficiencies, particularly when tackled by a new mgmt team (w/ a motivated shareholder/BOD).  
2. Branch benchmarking improvement program - on the most recent call, management said that there are significant differences in branch profitability.  Some of this is a function of local markets/ local market position and is more structural in nature (though there could be incremental opportunity for branch closures).  But some of this can be improved by sharing best practices.
3. Price optimization   

Valuation

Looking out to 2022, my base case expectation is that BECN will do an 8% EBITDA margin on $7.7 billion in revenue (3% CAGR).  This will produce just over $4 in FCF.  I think the market will put a 13-17x FCF multiple on this FCF (B/S should be ND/EBITDA of sub 3x by this time).  I see limited risk of negative structural change in this business - i.e. Amazon isn’t coming and suppliers aren’t going direct (500+ 35k sq ft branches carrying product which is has low value to weight, timely delivery is key as custs can’t hold inventory, 1800+ delivery vehicles, a customer base which is slow to embrace digital).  

Looking back over the past 16 years, Beacon has earned EBITDA margins greater than 8% a total of six times.  At its investor day in December of 2018, past mgmt targeted a 9-11% EBITDA margin.  Historically strong OPMs have correlated with favorable storm activity (hail/hurricane) and a benign asphalt pricing environment - stable to slightly increasing asphalt shingle prices tend to be best for Beacon.  Should positive storm activity occur and margins exceed 8%, I think there is a reasonable probability that investors could extrapolate this as there could be a plausible story of sustainable margin improvement which would go something like: New management has improved operating performance at the branch level, economies of scale are emerging, improved pricing strategy, digital initiatives and a re-invigorated sales force (mgmt talked vaguely about driving organic sales at the branch level on most recent call) are driving market share gains, etc.  Blah blah blah - All I’m saying is that should storm activity increase and margins exceed their LT average we won’t know if this is simply storm related or the result of operation improvements.  Human nature is such that mgmt will likely emphasize their role, investors could extrapolate this and the stock could have a bunch more upside (on $8 bn in rev/ 9% EBITDA margin, there’d be $5 share in FCF - capitalized at 16x this would be $80/share).  

Risks

-5x ND/EBITDA - though recently refinanced debt at attractive (4.5%) rates 

-Weaker storm activity

-Asphalt/shingle prices rise and there is a lag between cost/price (seems less likely with IMO 2000)

Catalyst

New mgmt drives operating improvement

Increased storm

De-leveraging