BECN fits this profile. It was also written up a couple of years ago, so refer to that for good background information. I think it is still just as good short today as it was then because it can quickly become a distressed situation.

 

BECN is still expensive and all the more so because it has yet to really feel the brunt of the recession and the consensus expectations call for continued top line growth through 2010, which seems irrational.   Results have been relatively good lately as a result of continued benefit from acquisitions, pricing, and the commercial market holding up. It is trading at 15.7x F’09 EPS, but I think there is considerable downside to this estimate. Judging by the results of the homebuilders and parsing economic data, it is reasonable to expect a 20% decline in revenue during this recession.   There is a lot of operating leverage in their business model, which will compound the effect on margins in the downturn.   If one models moderate revenue declines with some margin degradation it does not take much to push this company to an operating loss, which of course makes it much more expensive, but also leaves it struggling to cover its borrowing costs.

  

Shares	44.8
Price	$13.95
MCAP	625.0
Cash	26
Debt	377.5
EVAL	976.5

 

F1Q'07	F2Q'07	F3Q'07	F4Q'07	F1Q'08	F2Q'08	F3Q'08	F4Q'08
Dec-06	Mar-07	Jun-07	Sep-07	Dec-07	Mar-08	Jun-08	Sep-08	F07	F08
Revenue	380.2	286.9	484.9	493.8	398.4	304.3	514.6	567.2	1,645.8	1784.5
COGS	288.5	220.8	377.0	385.6	306.7	235.9	394.5	427.4	1,271.9	1364.5
GP	91.7	66.2	107.8	108.2	91.7	68.4	120.2	139.7	373.9	420.0
Opx	70.7	70.4	81.2	81.9	75.9	75.3	83.2	90.9	304.2	325.3
Op Inc	21.0	-4.2	26.6	26.3	15.8	-6.9	37.0	48.8	69.7	94.7
D&A	6.8	7.1	9.4	9.5	8.9	8.6	8.3	8.4	32.8	34.2
EBITDA	27.8	2.9	36.0	35.8	24.7	1.7	45.3	57.2	102.5	128.9

 

It is somewhat shocking that last quarter BECN reported its best quarterly EBITDA margins ever at 10.1% and its highest LTM EBITDA of $128.9 million. This seems unsustainable. Despite generating $128.9 million of EBITDA, BECN only generated CFFO of $49.6 million. The cash conversion cycle is also worth watching at 57.2 for F’08, up from 47.3 and 51.9 in F’06 and F’07. This is mainly the result of DSO rising from 41.3 to 53 to 56.5 and inventory days on hand rising from 40.3 to 47.4 to 50.3 from F’06 through F’08. While not egregious, this is certainly going the wrong direction considering the environment we are currently in.

 

The bull case for the past few years has been that even if new residential construction slows, the commercial market and the replacement market will hold up.   I think most people would agree at this point that this argument does not hold water, as credit has become scarce, particularly in home equity, and transaction volumes have fallen precipitously.  The bull case also maintained that this was a high return on capital business and the returns on its acquisitions were strong. It seems clear to me that this a very little value add distributor that was just benefitting from an unprecedented building boom and that over the long term returns will be significantly lower.  

 

BECN is also a roll up. It overpaid for acquisitions at peak profitability during the boom period of the cycle and that worked for a while, but as they say when the tide goes out, you can see who is swimming naked. In this case the building boom is over and the acquisition spree that juiced growth rates is also over since financing is no longer available, so I expect it to become very clear that this capital allocation strategy was very flawed. Furthermore, the amount of debt that they were piling on to the balance sheet did not seem onerous at the time to most, but I think that soon it will become a serious problem. Because of the debt fueled rolling up of the industry the balance sheet will not be able to withstand a serious recession. The main covenant BECN has to contend with is the maximum consolidated leverage ratio, which has to be below 4x. In F4Q’08 (Sept) this ratio was a seemingly manageable 2.62x, but the end of the summer is the strongest time of year seasonally. The previous quarter, F3Q (June) was 3.58x. I think as the economy slows further there is a good chance that BECN will trip this covenant.

 

 

F07	F08	avg
Maximum consolidated leverage ratio				4
Current leverage		2.62
BV	323.9	366.7	345.3
GW	355.2	354.3	354.8
TBV	-31.3	12.4	-9.45
TA	1006.7	1067.8	1037.3
Goodwill % of assets		35%	33%	34%

 

I also think that very little value will accrue to equity shareholders in this scenario. After the acquisition streak, average tangible book value for F’08 was -$9.4 million and goodwill as a percent of average total assets was 34%, which does not leave much cushion for the equity.   I also expect these metrics to deteriorate with the economy.