Description
Quick Thesis: Beacon Roofing (Nasdaq:BECN) is the highest multiple building products distribution company I can find. The high PE multiple is even more concerning in light of a temporary blow-out in operating margins, (almost twice their historic average), which have been buoyed by inventory carry gains (Katrina price hikes, higher oil pass thru) and one time accounting adjustments for manufacturer’s volume rebates. Not to mention a national housing boom.
Beacon runs 5 to 100k sq ft distribution centers (mostly 40-60k) specializing in roofing products, sold mainly to mom & pop roofing/reroofing contractors. The industry is consolidating, but activity is accelerating, which is a typical sign of a top for a mature 3% long-term growth industry. This high operating leverage industry will also be facing headwinds on key demand drivers such as slowing housing starts and housing turnover. Competitively, they face threats from more traditional distributors ‘reshelving’ away from new construction oriented products (lumber, doors, windows, prefab wood panels, etc) to the more ‘stable’ roofing/remodeling products, as the demands from the hot new construction customers (builders) cease absorbing so much time and warehouse space. And while I’m at it why not throw in the potential weakening consumer and (insert perma-bear dark prophecy here) disasters awaiting the US economy & housing (if you believe in that stuff).
Oh yeah and the stock is up 210% from its $13 IPO 18 months ago, and 50% from the massive $27.50 secondary that basically cashed-out every insider 4 months ago.
Overview: Beacon distributes roofing, siding and some windows to mom & pop contractors primarily engaged in renovations and reroofing activity (75% of revenues), and of course some new construction (25% new build). For property type the end-customer is 70/30 residential/commercial. BECN has been pursuing the basic corporate strategy of ‘rolling-up’ the industry, as they’ve taken location count from a few branches in the 80s to 145 branches across 30 states and 3 Canadian provinces today. Beacon was acquired by a mgmt led buyout in 1985, then sold to Hennesy in 1996 and then to the public markets in late ’04. Throughout this history it has been growing mainly through acquisitions of smaller operators as well as a small amount of ‘organic’ new branch openings.
(Warning Proselytizing Ahead):
I’m not biased against roll-ups, but I think it’s useful for me to share a few observations of what make a good vs poor roll up-play. In my experience, good roll-up opportunities tend to include most (but not necessarily all) of the following:
Industry:
1) The industry is fragmented, and there are plenty of sellers competing to sell to a few acquirers. Industry multiples are cheap, stable, and easy to calculate (EV/S, P/B).
2) Dispersion of performance across regions allows for the roll-up to benefit from geographic diversification.
3) Moderate to strong barriers to entry (other than capital), with competitors tending to favor profitability over market-share and growth at any cost. (mom and pops and tightly held small scale chains).
4) Suppliers are not as fragmented, and there is a meaningful opportunity to: leverage consolidated purchasing power, benefit from vendor financing/loyalty programs…
5) The acquirer is reasonably ‘sized’ relative to the acquisition opportunities so that the pipeline will represent a meaningful future part of the business.
Business Strategy:
1) The roll-up entity can benefit from company wide investments that boost productivity, more so than just ‘consolidating HR and Finance.’ The investments are usually intangible such as best practices sales force training, quality control, working capital efficiency.
2) The roll-up is run by a competent management team who clearly understand the assets they are buying and looks to buy them at bargain prices, particularly during industry downturns. Moreover, ‘the understanding of the assets’ includes management’s ability to implement standard operating procedures that work across different markets, and doesn’t rely heavily on previous management’s local market knowledge. (The ‘blue print’ scales well.)
3) Management talks about capital management in terms of ROIC (has a high hurdle rate) and benchmarks acquisitions against other opportunities such as buying back stock and paying dividends.
Valuation:
1) Lastly, and most importantly, buy these types of businesses when they are trading below a reasonable market multiple with respect to the long term growth prospects of the underlying industry (equity financing is expensive). AND when management has an abundant and cheap source of non-equity capital to put to work. Valuation = boring multiple x normalized trailing earnings + value of acquisitions opportunities/pipeline.
2) Acquisitions multiples allow for very high marginal returns on invested capital, and therefore, one could say that the targets are trading below a risk adjusted multiple on normalized earnings.
When the above indicators overall start changing from ‘green’ to ‘red’, you should probably sell. Moreover, when the market is giving a high multiple to a rollup that is facing rising industry-acquisition multiples with steep competition for assets at top-tick margins, its time to short.
Ok, now that I’m off my soap-box, lets take a look at how Beacon stacks up. The market appears to be abstracting BECN into a story stock by comparing it to a roll-up that has worked in the past (SCP Pool, who rolled up super-distribution centers as well as retailers in the pool equipment supply vertical). I don’t think that BECN fits the mold of POOL and here’s why:
POOL was rolling up a HIGHLY specialized, 2-step industry. Manufacturers tended to ship to ‘super-distributors’ who then ship to retailers (with all the types of pools out there each geography must stock a massive 90k+ SKUs). How many different types of shingles and vinyl siding is there really? (BECN carries about 9K SKUs). Also, fewer homes have pools than roofs (a truth that will never change), and as such geographic monopolies are easier to create in the pool biz. POOL also uses direct to consumer marketing to forward these very valuable leads to contractors, further strengthening their value added for a particular market. In addition, POOL’s had some wonderful secular trends to their back: growing number of homes installing pools, rising disposable incomes, a secular trend toward ‘investing’ in one’s home, strong new home construction: all of which contributed to impressive same center sales growth. Whereas shingles, are well, shingles.
‘Reshelving’ risk: BECN on the other hand competes in a less than ‘niche’ market. While they specialize in roofing products (85% of sales), other distributors who tend to focus on new home construction, as well as DIY outlets such as HD and LOW can also participate. I argue, that the willingness of these competitors to participate in roofing sales depends on how strong their core markets are. Analysts and mgmt talk about the wonderful stability of the roofing products biz, as 75% of sales are for ‘reroofing’ work as opposed to new build. In addition, the 70/30 split btw residential and commercial also stabilizes demand. This theory however, ignores the fact that there is ‘swing’ shelf space that will come into play during a housing slowdown. How do I know this?
Just like cement and wallboard, there is a bit of a shortage of roofing shingles. As a result, big distributors of roofing shingles like Beacon get their allocations, and small distributors have trouble. Whenever there is a shortage of a commodity product, it seems like every one in the supply chain magically makes more money. But don’t let that lead you to believe that a simple distribution business has better economics that it really does during normal times. With barely enough product in the channel, shelf-space expansion is being held down. Also, remodeling sales is always the ‘fall-back’ position for building products distributors in general. For example, if you manage a building products distribution center with a diversified product line (lumber, windows & doors, wood panels, wallboard, siding, roofing shingles/tiles), as your key homebuilding customers’ orders slow, your inventories draw down, and you start looking for ways to put that newly released sq footage back into play. If you see that roofing shingles/tiles are running a 25% GM and companies like BECN have 7%+ EBIT margins on 8x inventory turns, you might start to look at going after some of their customers.
So with new build slowing down, the supply chain will eventually moving back into equilibrium over the next year or two and I expect distribution margins to come back to a more pedestrian level. An example would be ABC Supply (private company), which is the largest roofing distributor ($1 bil+ for quite some time) who used to file annual reports with the SEC. During the 90’s they saw EBIT margins around 3-5% (See spread sheet financials at http://geocities.com/doobadoo1/BECNRelativeValue.xls ).
‘True’ Re-roofing Work only 20% of Demand (its less stable than the market thinks): From Beacon’s10-K: “While major replacements account for about 20% of residential re-roofing spending, repairs, additions and alterations represent the majority of this market.” These demand drivers are clearly related to housing turnover and the availability of cash-out refinancing and affordable home equity loans. I can’t predict where interest rates are going, but the mortgage numbers are weakening: slowdown of originations, default rates rising to 3 year highs (Fannie Mae), and with central banks every where tightening, liquidity should eventually dry up. And just to beat the dead horse here, a slowdown of demand will pressure margins and relieve the supply constraits.
High Fixed Costs: Approximately 70-80% of BECN’s SG&A costs are fixed, and gross margins run around ~24%. I figure the new housing construction market makes up at least 25% of total revenues. It is not crazy to say that housing starts could drop 25% or more in the next year or two from the obscene 2.3 mil/year run rate. This could take same branch sales down by 5% or more, and with 70-80% of SG&A costs fixed, a 25% drop in new home construction slowdown alone could reduce Ebit margins by 1% or more. Naturally, high fixed costs cut both ways.
Inventory Carry Gains: Roofing shingle’s prices have been appreciating 6-8%/year for the last 2 years (driven by higher energy, crude as a significant feedstock, and manufacturing capacity shortages). I believe the inventory carry gains could have added as much as 50-100bps to recent results. BECN recently beat earnings for the Dec ’05 quarter due to a variety of seemingly one-time issues:
1) An inventory build at the tail end of the Sep’05 quarter, followed by manufacturer’s ‘Katrina Special’ price hike in October, followed by an inventory draw down in the Dec ’05 quarter.
2) Underestimating manufacturers rebates over the first 3 quarters of the year, which was reversed in q4
3) A record warm winter in New England keeping roofing work abnormally strong.
4) Price insensitivity for Gulf-Coast orders, filled by branches that typically don’t deliver to that region.
The market nonetheless, has no issue with capitalizing these gains at 30x.
Rising Acquisition Multiples. Historically, BECN buys additional branches at 0.4 - 0.55x Sales or 7-10x EBITDA before operating margin improvements. Because BECN is in a secular low growth business, a 30x ’06 multiple can only be supported by strong earnings growth from acquisitions. Unfortunately, acquisition multiples are rising dramatically. The most recent acquisitions should make investors quite concerned. BECN recently purchased a California distributor ($53 mil annual sales) and two Gulf Cost distributors ($73 mil sales in ’05) and paid a staggering $104 mil or 0.8x sales, which is 50% higher than the top end of their historic range. Clearly these Gulf Coast branches will be experiencing strong margins for the next year or so (mgmt indicated OM 4-500bps above company wide 7% margins). However, using even a 7% normalized margins, this deal represents over 11x Ebit. Sure it will be highly accretive in ’06, but to me, it looks like management is just buying these businesses for the short-term earnings pop.
Sell-side Industry Analysis Seems Overly Optimistic: A sell side analyst maintains that Beacon is the ‘sole’ acquirer in this industry, which is simply not true. Case in point: Out of the direct competitors ABC Supply, Allied, Bradco have all increased branch count materially in the last 2 years. In 2004, Bradco purchased 20 branches taking branch count from ~120 to 143. Even Beacon’s own acquisition of Shelter in mid-05, was preceded by Shelter buying a smaller competitor (1/3 Shelter’s pre-acquisition size) for 0.4x sales only 7-months earlier!!! Clearly, Shelter didn’t pay enough for the business ‘the first time’ b/c Beacon paid .6x sales who the whole shebang. *Oddly*, the sellers of Shelter took the whole $180 mil price tag in cash. Beacon financed the deal with a ~$50 mil follow-on (2 mil shares), which was sold 15% ‘in the hole’ from the deals original announcement (along with another 6.5 mil insider shares). I think this is instructive as the sellers to Shelter didn’t mind taking some Shelter equity in the first deal. However, they clearly wouldn’t take 25% of the Shelter sale in BECN stock, which would naturally allow for a capital gains tax deferral, and an avoidance of underwriting fees.
The sweet spot in the acquisition market was typically for branches or small chains with less than $100 mil of sales, which once upon a time you could buy for 7x ebit. With a run rate of $1.4 bil, how helpful can a few $50mil/year acquisitions at 10x ebit really be? In addition, BECN’s annual report estimates the US roofing products distribution market to be only about $10 bil/year. That means the above-mentioned conglomerates (ABC, Bradco, Allied, Beacon) have already rolled-up over 50% of the market, leaving a handful of fragmented targets, with plenty of buyers (Hence the rising acquisition multiples).
Even Still a New Entrant Paying up:
Earlier in the year, Wolesey’s (NYSE: WOS) Stock Building Supply purchased Universal Supply Co. (chain of roofing distribution branches in NJ, smack in the middle of Beacons historic market). Although details of the acquisition have not been disclosed, a little massaging of WOS’s recent filings leads me to believe that they paid about 0.6x ’05 sales. Around the same time, Beacon’s acquisitions in Cali and Gulf Coast were 0.8x sales. These multiples are a far cry from how BECN used to build shareholder value, and from here on out its clear that they will have to ‘keep their pencil sharp’ on future deals. In addition, HD is beefing up its contractor services business, and is advertising roofing work from an approved list of contractors in its stores.
Shareholders are mainly vanilla, and the general behavior of mutual fund stockholders is to buy a stock b/c of a thesis & sell when the thesis changes. The thesis may rely on the industry analysis of the aforementioned sell-siders. Incorrect industry assumptions by analysts are always good to see in a short. Not to mention it’s always easier to sell a stock that is up 50% from where most of these shareholders bought their position ($27.50 secondary only 4 mos ago).
Industry insiders bailing: Code Hennesy printed their remaining position at $27.50 on that secondary as well as a large chunk from the Chairman Andrew Logie (who led mgmt buyout in the 90s). Andrew also had a 10b-5 for almost 100k shares/month going into that deal.
Catalyst
Operating Margin Contraction, Housing Slowdown, Failure to meet expectations on acquisition plan, competitors coming public