Description

BMC Stock Holdings

We are long shares of BMC Stock Holdings (BMCH), the second largest distributor of residential building materials in the United States.  We believe the normalization of the residential housing market in the US over the next several years will allow BMCH to increase its EBITDA 50-70%, creating a situation with 30-40% upside (on a present value basis) for long-term investors.  To be clear, despite subpar economic growth and a strong likelihood of a rising interest rate environment, we are bullish on the prospects for single family residential housing in the US given nearly a decade of underbuilding.  Further, we believe that distribution industry consolidation coupled with labor shortages at builders (creating product opportunities in pre-fab, construction services, and Ready Frame, a proprietary software enabled solution for framing).

Background

Stock Holding came public in 2013 (see a very good write-up by Mrmgr from Sept 2013 for background info).  Following the acquisition of ProBuild by market leader Builders Firstsource (BLDR) in early 2015, Stock merged with the larger BMC Holdings a couple of months later creating BMCH which is now the number 2 player in residential building materials distribution industry. 

BMC has a strong regional presence in Texas and the West.  BMC (was public under the ticker BLG) was built through a series of debt-fueled acquisitions in the go-go housing market of the 2000s.  While there was industrial logic for many of these transactions, the implosion of the housing market forced the company into bankruptcy in 2009.  Like the former Stock Building Supply, the implosion of the housing market forced the old BMC through a dramatic cost reduction whereby it dramatically reduced headcount, the number of branches it operated, reduced the number of IT systems, integrated and improved procurement.  Many of these improvements were overdue rationalizations given the large number of acquisitions the company had done during the boom years (and never properly integrated given then-management’s focus on the next deal as well as using operational resources to meet strong customer demand rather than integrate acquired companies). 

BMC had higher EBITDA margins than Stock in the years leading up to the merger (BMC had done a 5.8% EBITDA margin in the 12 months to 3/31/15 vs. 3.1% for Stock).  The extent to which this is due to management versus product/geographic mix is unclear though it is worth noting that upon merging the two businesses, BMC management took a somewhat larger role in running the combined entity with BMC CEO leading the combined company (CFO & COO from Stock, Chief Integration Officer from BMC).  BMCH initially targeted $30-40 million in synergies but has increased the target to $40-50 million.  This represents 1.3-1.7% of revenue and is somewhat lower than 1.7-2.0% targeted by Builders Firstsource following the acquisition of ProBuild though BMC-Stock had less geographic overlap.  On today’s 3Q results conference call management reiterated its synergy targets.  55-65% of synergies are coming from sourcing/supply chain with the remainder coming from SG&A (SG&A is includes of branch & distribution savings) by 4Q17. 

BMCH primarily caters to single family residential homebuilders (sales to single family homebuilders represent 77% of revenue, 12% is repair/remodel, 11% is multifamily/commercial) and counts most of the large publicly traded homebuilders as customers (though no customer represents greater than 5% of revenue).  With ~$3 billion in revenue, BMCH benefits from both scale and scope as it is able to offer its customers a broad product offering (claims to supply products representing approximately 50% of the construction cost of a new home).  Scale benefits the company in terms of lower procurement costs as well as fixed cost leverage – particularly at the local market level whereby sales/distribution efficiency is increased through density.  

Forecast & Valuation

Here is our simple valuation framework for BMCH:

The most important assumption here is that we assume housing starts (and completions) revert to their long term (50 year average – see page 15 of investor presentation) by 2020.  This drives our volume growth assumption for single family home revenue to which we add 200 bps reflective of pricing (have seen deflation past couple of years though this reversed in 2016) as well as market share gains.  We assume 3-5% revenue growth in the commercial and remodel space.  EBITDA assumes an incremental $10 million in synergies from 2017 and assumes incremental EBITDA margins of 10% (at low end of management’s 10-12% guidance). 

Our 7.5x operating profit multiple equates to roughly 12x normalized FCF. 

Why BMCH instead of BLDR (Builders Firstsource)?

In short – it has a lower risk profile.  To be sure, I own shares of both though I have greatly reduced my ownership of BLDR while increasing my holding of BMCH.  The case for BLDR was laid out 14 months ago on VIC by Ringo962.  Since that time BLDR has underperformed Ringo’s estimates, my estimates and BMCH.  While BMCH has also underperformed my estimates (by a lower magnitude than BLDR), it has a much stronger balance sheet than BLDR with ND/EBITDA of less than 2x my 2017 estimates vs. ~5x at BLDR (though to be fair BLDR has termed out its debt to 2022-2024 I believe; BMCH recently refinanced the bulk of its debt at 5.5% coming due in 2024 replacing 9% debt due in 2018).  Additionally, management depth at BLDR seems a bit thin (CEO is nearly 80), which is of greater importance while integrating a large acquisition with a highly leveraged balance sheet.  That said, the upside for BLDR is clearly higher assuming it works things out (shares could be worth $20-25 so +100-150% upside in PV terms).  

Risks

-        Housing market does not come back to ‘normality’.  Clearly a large increase in residential single-family housing is needed to make this idea work.  There are 2-3 common counter-arguments to this: the first is that millennials are more inclined to live in urban areas (and be dwellers in multi-family housing to which BMCH is less exposed – 77% of revenue comes from single family new build) rendering historical figures less relevant in determining normalized single family housing completions.  Secondly there is an assertion that millennials are more comfortable renting having seen the downturn in housing during the Great Financial Crisis (as well as tougher borrowing standards) and in part linked to their inclination to live in urban areas (where single family housing is less available/affordable).  Lastly there is concern that millennials (record for usage of millennials in a single paragraph on VIC?) are entitled little brats and will perpetually live in the basements of their adoring parents.  We contend that while current trends support the aforementioned ideas, as ‘life happens’ millennials age, leave the basement, marry, and procreate (not necessarily in that order) they will eventually seek the relative comfort of suburban living.  I am not a millennial but have experienced and observed this phenomenon amongst my cohort of former die-hard city slickers who now find themselves in the suburbs. 

-        There are various constraints (labor shortages, lack of suitable building plots) negatively impacting the residential developers.  I view these as transitory in nature.  Similarly, labor shortages offer opportunity for companies like BMCH which can create pre-fab solutions that reduce jobsite labor intensity. 

-        Interest rates will probably go up over the next 5 years I said boldly.  Higher mortgage rates could reduce the attractiveness of own vs. rent (depending of course on rents, tax policy, magnitude of interest rate hikes, etc). 

-        Texas – BMCH has Texas-sized Texas exposure, representing 34% of 2015 proforma sales (probably ~33% of 2016 revenue given relative underperformance vs. rest of the business). Texas is clearly a near term risk given oil price weakness.  That said, while Texas was down YoY in the third quarter, it is up slightly for the first 9 mos despite a very tough oil patch environment.  We like Texas long term given strong population growth partially driven by favorable tax positioning.   

Catalyst

- Housings starts show signs of life