Description

We believe BLDR is a long because the combination of its transformative merger with its #2 competitor, substantial firepower available for highly accretive capital deployment, and a favorable housing cycle creates the opportunity for 100-150% upside over the next 18-24 months. From the highest level, we believe BLDR’s business quality is inflecting from okay to good due to an improving competitive picture (recent merger with BMCH removed its #2 competitor) and financial picture (higher margins from synergies and scale) that should have positive implications for BLDR’s trading multiple. Competitively, BLDR+BMCH is now 3x larger than its next closest competitor and will achieve meaningful scale advantages that our research suggests will enable the company to offer unmatched service capabilities to homebuilders, which should result in revenue synergies and share gains. Financially, the merger creates significant cost takeout opportunities from synergy capture, and will also accelerate existing initiatives to automate and digitize manual processes across the business that will drive additional EBITDA benefits on top of synergies. We believe BLDR can grow EPS off 2020’s base by ~25% by 2023 through cost takeout alone. Further, BLDR has a war chest of firepower available to further roll up a fragmented industry – the company has 50% of its market cap available to deploy into M&A and possibly buybacks over the next 2-3 years at their historical leverage range of 2-3x that should be highly accretive (BLDR can buy smaller distributors at 4-7x synergized EBITDA and we believe BLDR should trade at 8-10x EBITDA). 

In addition to the positive view we have on BLDR’s fundamentals, we believe the housing cycle is at an attractive point in the cycle to invest in. BLDR has cyclical exposure to new single family home construction that is currently undergoing an upturn, supported by several tailwinds that we believe should persist for at least the next few years: 1) Demographic tailwinds from Millennials aging into the prime home buying age, 2) lasting lifestyle tailwinds from hybrid Work From Home policies that structurally enables people to live further away from city centers than ever before, 3) favorable home affordability levels driven by low mortgage rates and high personal income, and 4) an all-time low supply of existing homes for sale that is funneling more housing demand into new single-family homes. 

There is currently tension in the industry because we are seeing a slowdown in new home orders, down from 10-year highs earlier this year, which has caused the sector to trade poorly over the last several months. We believe the cause of the slowdown is supply driven due to significant increases in commodity prices such as lumber, which is causing home builders to limit their pace of sales to avoid margin compression and to catch up on their largest order backlogs they’ve had since the prior upcycle in 2004-2007. We are only at midcycle levels today for new SF starts, as we just recovered to historical average levels after a significant industry underbuild since the GFC, but current SF starts are still 30% below prior peak levels seen in 2004-2006, presenting a long runway for growth relative to historical precedents. In our model, we underwrite relatively modest starts growth, and don’t need to assume much growth because BLDR’s idiosyncratic growth initiatives from share gains, capital deployment, and margin expansion can drive strong earnings. We think the opportunity for BLDR is to experience strong earnings beats and multiple expansion over the next several years as the market shifts its perspective from being concerned about peak cycle to comfortable that current demand is mid-cycle and sustainable and BLDR’s business quality and competitive position have materially improved. Using a P/E multiple of 13x on our 2023 EPS of $6.85, we forecast an $89 stock by 12/31/22 for 100% upside and a 60% IRR. On 2025 EPS of $9, we forecast a $117 stock, for 160% upside. The primary risks to the thesis are housing market cyclicality and rising interest rates, which we discuss in more detail below. 

Company Background:

BLDR is the #1 player in the U.S. building materials distribution industry with 7% share, and just acquired the #2 player, BMCH that had 3% share, giving the company 10% share pro forma, now 3x the size of the next largest player. The $120bn building materials industry is highly fragmented and BLDR itself is a rollup of more than 45 acquisitions dating back to 1998. BLDR sells lumber, windows, doors, manufactured products such as pre-fabricated home frames and panels, and other materials such as siding (they don’t do much in roofing or insulation) from over 500 store locations to homebuilders across the U.S. (no customer is >4% of rev). BLDR is exposed to cyclical end markets – 73% of pro forma sales comes from new single-family construction and 7% from multifamily construction, with the remaining 20% derived from the steadier repair & remodels market. From 2008-2012, significant declines in new home construction following the GFC caused negative organic growth and margins. Since then, BLDR’s organic growth has been positive every quarter except for 2Q20 due to shutdowns from COVID as housing starts have recovered, which is better than several “best in class” distributors’ performance in other markets over this period. 

While we dislike the inevitable cyclicality of BLDR’s business from being tied to new construction, it has several attractive qualities and competitive advantages that attract us to the business. Tangible ROICs are 20-25% approaching 30% on our estimates, having larger scale post-BMCH enables BLDR to provide better service capabilities to homebuilders, which enables share gains, and BLDR is expanding its portfolio of proprietary “Value-Added” products to capture more economics in the value chain that are margin accretive (these products represent 40% of sales today and earn several points of gross margin above the corporate average).

Importantly, we have a favorable view of the management team. The CEO of BMCH, David Flitman, came over in the merger and is now the CEO of BLDR. He is viewed as a good operator and had a successful track record of beating numbers, achieving cost takeout, and pursuing M&A in his 2.5-year tenure at BMCH, and previously, he built a career running distribution and industrial businesses at PFGC, UNVR, ECL, and DD. 

Housing Industry Primer and Investment Thesis:

An investment in BLDR requires a view on the housing market. What follows is a brief intro on the key drivers of the industry and concepts to understand, a historical overview for context, and our view on the outlook for housing. 

Demand for incremental housing units (new and existing homes and apartments) is the sum of household formations, demolitions, and growth in vacation home ownership. A household is formed when a person newly identifies as head of household, and can be a renter or owner (e.g. a dependent or roommate moving into their own place creates one new HH, but a family moving from an existing home to a new home does not create a HH). From 1980-2020, HH formations averaged 1.2mm, demolitions averaged 200k, and new vacation homes owned averaged 150k, which totaled 1.6mm of demand for incremental housing units per year, on average. The split of this demand that goes toward owning vs. renting, single-family homes vs. multifamily apartments, and new vs. existing homes/apartments is a function of the relative affordability and availability of each type, and population demographics (size and age). The percentage of the population that owns versus rents generally increases with age, so as the population grows and ages into cohorts that have higher homeownership rates, this generally drives demand out of rented multifamily apartments toward owned single-family homes, and since the availability of existing SF homes usually relatively fixed, this generally drives demand for new SF starts (new SF homes started for construction). 

The period from 2008-2017 is known as the “lost decade” in the homebuilding industry. The GFC caused a massive amount of personal savings and equity to be lost, which reduced the number of people who could afford a home and also reduced the ability for parents to shield their children from taking on student loans. This drove a shift toward renting away from owning across all age groups and also resulted in an accumulated deficit of HH formations than what otherwise would have formed. For the 25-44 year old population cohort in particular, this group, which today is the Millennial generation, has tended to live with their parents for longer than previous generations, in part due to affordability limitations from student loans, and in part due to lifestyle differences where Millennials have tended to get married and have children later in life than previous generations. This was clearly evidenced by the 24-44 YO cohort showing the largest decline in homeownership rate of any age cohort from 2008-2017. Further, demographically, there was a decline in the number of people aged 35-44 from 2000-2016, the key home buying cohort that traditionally drives growth in new SF starts. These trends all combined to cause weak demand for new SF homes. New SF starts languished at subdued levels from 2008-2017 at 450-850k per year vs. the 1980-2020 avg. of 1.0mm (for context, average MF starts are 400k which sums to a 1.4mm 40-yr average for total starts).

However, beginning in 2017/2018, several trends turned positive and by 4Q19/1Q20 pre-COVID, the housing market was swinging into an upcycle. Homeownership rates among 25-44 YOs inflected positively after years of decline, suggesting Millennials were beginning to demonstrate similar marital and child bearing trends as prior generations, just later in life, the number of people in the 35-44 YO cohort turned positive, driving incremental demand for new housing units, and personal balance sheets across age cohorts reached increasingly healthy levels driven by the economic expansion post the GFC. 

Looking forward, we believe a variety of demographic, lifestyle, economic, and supply trends are combining to create one of the most favorable periods for new SF home demand over the last several decades. We believe new SF starts will experience an upcycle in demand over the next 3-5+ years driven by the following trends:

1. Demographic headwinds flipping to tailwinds will create an outsized level of demand for homes.

1. Population growth in the key home buying cohort to drive higher baseline demand. The number of people in the 35-44 YO cohort will flip from a decline from 2000-2015 to growth through 2030. At the current level of HH formation rates among age cohorts, this population growth is expected to create 6.4mm HHs through 2025, translating to a baseline of 1.3mm per year (vs. the 40-yr avg. of 1.2mm and 2008-2017 avg. of 0.9mm). To contextualize, the baby boomer generation drove strong housing market demand in the 80s and 90s; their kids, the Millennials, are now reaching the prime home buying age. 

2. Normalization in homeownership rates release pent up demand to drive upside to baseline demand. As discussed above, there was an accumulated deficit of HHs created from 2008-2017 from people living at home for longer due to economic and demographic conditions, evidenced by the decline in homeownership rates over this period, particularly in younger age cohorts. Compared to HH formation rates in 2003, there is a 4mm deficit of HHs today. If HH formation trends move only halfway back to 2003 levels over the next five years as Millennials age, marry, bear children, etc., this would create demand for 400k HHs per year. We are confident this thesis is beginning to play out as evidenced by the uptick in homeownership rates beginning in 2017 and by mortgage purchase data that shows growth is being driven solely by Millennials. Said differently, we think the air pocket in home demand from 2008-2017 will result in pent up demand unwinding over the next 5-10 years. The baseline 1.3mm HH formations from population growth plus our estimate of 400k HH formations from pent up demand unwinding could drive ~1.7mm annual HH formations over the next 5 years. 

2. WFH is here to stay, which will create structurally higher demand for SF homes. We’ve tracked announcements from a number of large corporations who are moving to “work from anywhere” models where employees can choose to be fully office based, fully remote, or flex where they come into the office 1-3 days per week, with the majority of employees expected to choose the flex option. Prior to COVID, 7% of U.S. HHs worked from home. We think it’s reasonable to believe at least 15-20% of the working population will now have the ability to live further from the office than ever before with flex WFH policies. Generally speaking, the willingness to undergo a 60-minute commute for the lifestyle benefits of living in a suburb increases significantly if you only have to do the commute 1-3x per week vs. 5x previously. Additionally, WFH increases the importance of having a home office space that’s in a separate room from your family, and outdoor space to entertain your kids. Thus, we believe HHs’ willingness to pay for SF homes to adjust for the new working world reality is high, their ability to pay is high as they move out of higher priced cities to generally lower cost suburbs, and their ability to live further from city centers is now structurally higher, all of which directly benefit new SF homes which are generally built at the edges of cities / suburbs. The chart below illustrates how the shift away from owning to renting from 2008-2017 began unwinding in 2018-2019 due to the demographic tailwinds discussed above, and in 2020, shows how home ownership rates exploded at the expense of renting. We expect these trends to continue for the next several years.

3. New and existing SF home affordability is near multi-decade bests.

1. Mortgage rates are around all-time lows at 3.3% today. A 100bps increase to 4.3% would put them in-line with the 2010-2019 average and still 100bps below the 2000-2009 average. 

2. Household balance sheets are at record strong levels, increasing HHs’ ability to pay. The greatest barrier to homeownership has traditionally been a lack of funds for down payment, but thanks to forced savings during the pandemic, this is directionally less of a barrier today. 

3. This is resulting in high affordability for new SF homes. If mortgage rates rise 100bps to 4.3% and home prices rise by 10%, affordability would still be within 20-yr averages. 

4. The economic decision to own versus rent is also at 15-year bests. 

4. Record low supply and price appreciation of existing homes will channel most of incremental SF home demand to new SF home starts from here.

1. The supply of existing homes available for sale is at all-time lows. 

2. Low supply coupled with strong demand is causing the price of existing homes to skyrocket. 

3. This is causing the price of new homes to be at the cheapest relative premium to existing homes in the last two decades, increasing the relative attractiveness of and funneling demand toward new homes. 

5. In conclusion, we believe these trends discussed above can drive an upcycle in new SF starts over the next 3-5 years. New single family starts have just reached historical midcycle levels and demand is far outpacing supply.

1. The current supply of new SF homes is being limited by labor and materials shortages, which is limiting growth in new SF starts and completions but could help prolong the demand upcycle. 

2. The supply of new homes available for sale was already low entering 2020. The homebuilding industry was rational in the “lost decade” period and significantly underbuilt versus new HH formations, creating a cumulative underbuild of 4.8mm units (480k/yr) since 2010 relative to total HHs formed. The gap between demand and supply created was filled by HHs shifting to MF rentals from SF ownership.

3. Our rough industry supply and demand model suggests an upcycle in new SF starts can be sustained by the trends we discussed. Walking through the math, we think 1.3mm HHs will be formed per year from population growth, 400k per year from pent up demand from Millennials unwinding, 200k from demolitions, and 150k from vacation homes, plus a difficult to quantify benefit from WFH (possibly 300-600k equal to 0.25-0.5% of U.S. HH’s moving into a house due to WFH?) that we think solidly puts demand for housing units at >2mm for the next several years. At the same time, demand is shifting from MF rentals to SF owned homes, and there is no incremental supply of existing homes, so the majority of this >2mm demand should go to new SF homes. We model 1.1-1.2mm SF starts in 2021-2023, significantly lower than demand. We think there is potential for starts to surprise to the upside in 2021 and 2022 vs. what we are modeling but are also wary to underwrite too aggressive of an upcycle. 

BLDR Investment Thesis:

1. Transformative merger with BMCH materially improves competitive position and creates revenue synergy and share gain opportunities. The merger removes the #2 competitor in most of BLDR’s markets, turning them into the dominant player in the majority of markets where they compete, and in some cases, the only player that can serve larger homebuilders. BLDR now has 10% national share vs. the next player at 3% and the #2-5 players totaling 10% share, however, competition is localized and BLDR has 20-30%+ share in some markets. Achieving scale multiples the size of other competitors creates a significant competitive advantage in this industry that manifests in a variety of ways – better purchasing power to acquire materials at lower costs, a broader store network to offer a wider range of inventory with greater availability, faster and more reliable delivery times – all key selection criteria for homebuilders, and more capital to invest in differentiated products and pursue operational efficiency initiatives to further drive a cost advantage. At the same time, homebuilders benefit by concentrating procurement on fewer vendors because they receive volume discounts. Our channel work suggests pro forma BLDR will have unmatched service capabilities that will enable it to offer a better value proposition at lower costs, which will result in revenue synergies through cross selling BLDR and BMCH’s customer base and product catalogs, and the ability to price to value in less competitive markets, benefiting margins. 

2. Significant runway for margin improvement through synergy capture and digitizing the business. Management is targeting $130-150mm of synergies by 2023 from procurement, distribution network, and SG&A savings, which we believe are achievable and will drive 18% EPS growth off of 2020’s base. Additionally, management believes they have a multiyear runway to achieve additional cost takeout that is incremental to synergies through automating and digitizing the business. Both BLDR and BMCH have historically been highly analog / manual businesses, and for the last two years the management teams of both companies have pursued a variety of work streams dubbed “Operational Excellence” initiatives that are driving tangible EBITDA benefits. These include setting up an online consumer portal to automate the order entry and billing process, back office automation to streamline accounts payable / receivable processes, pricing and margin optimization tools for the salesforce, delivery and logistics projects to improve efficiency and customer service, using CAD and automated machinery in facilities to reduce labor, etc. Greater resources scale from the merger will accelerate these initiatives. Combined, we estimate synergy capture plus operational excellence initiatives will drive ~25% growth to EPS by 2023.

3. Substantial amount of firepower available for highly accretive capital deployment. After levering up to 6x in 2015 to acquire ProBuild, a close competitor at the time, BLDR paused M&A and largely spent the last five years delevering. Management hasn’t discussed new leverage targets following the all-stock BMCH merger but their historical target was 2.5-3x, yet BLDR has now delevered significantly to 1.2x that will fall to neutral by year end if no additional cash is spent. BLDR now has an immense amount of firepower available – we estimate BLDR will generate ~35% of its current market cap in FCF in 2021-2023. If BLDR re-levers to 2x, they will have 50% of the current market cap available ($4.5bn) over the next two years to deploy, and over 80% over the next three years if they lever to 3.0x ($8bn). Management’s capital allocation priorities are investing organically followed by M&A followed by buybacks. Organically, management noted they can earn 20-25% ROICs on new manufacturing facilities and are building in multiple markets that are capacity constrained today. Inorganically, BLDR’s new CEO had a successful M&A track record at BMCH and is focused on systematizing the M&A process to roll up the industry and make inorganic growth a key pillar of the BLDR growth algorithm. He can now use BLDR’s underlevered balance sheet as a weapon to consolidate a fragmented industry. This is beginning to be evidenced by BLDR building out a robust M&A team and recently indicating a full pipeline of inbound and outbound opportunities. Rollups of competitors are highly accretive (can acquire at 5-9x EBITDA, or 3-7x including synergies vs. BLDR trading at 8-10x). BLDR has already announced $850mm in M&A of two companies so far this year. Lastly, we believe BLDR will use buybacks to supplement capital deployment if they can’t deploy enough cash to organic and inorganic investments. 

4. Highly favorable demand environment for new SF homes and constrained supply to support robust organic growth over the next 3 years. The support for SF starts growth is discussed above. Regarding BLDR’s organic growth, the current environment should be conducive to BLDR outperforming starts growth driven by its Value-Added products (40% of sales) disintermediating traditional, on-site construction practices. BLDR uses automation to build pre-fabricated home frames, trusses, walls, etc. in their own manufacturing facilities, then delivers these components to the job site for just-in-time installation. This reduces homebuilder labor costs, materials waste, and improves inventory cycle times, all value propositions that are very important in today's environment. Our research suggests BLDR will see increased penetration of Value-Added products over the next several years as homebuilders increasingly look for production efficiencies. These products are margin accretive for BLDR and also help differentiate BLDR from smaller distributor peers as not all competitors have manufacturing capabilities.

    

5. Call option from higher market share and margins that should drive a rerating in the multiple over time. There is a strong relationship between market share and valuation among distributors. As BLDR pursues more M&A, the company believes their market share can approach 15-20% over the next 5 years. Also, moving from a 6-8% margin business to an 8-10%+ margin business, and having a less risky financial profile

Risk/reward: 

BLDR historically traded as low as 5-6x P/E at market troughs and as high as 15-16x, with a five-year average of 11x. BMCH historically traded as low as 7-8x at troughs and as high as 18-20x, with a five-year average of 14x (pre-M&A announcement). Due to BLDR’s higher leverage profile historically, we think BMCH’s multiple is more representative for assessing historical trading ranges for the combined company. Looking forward, on the one hand, we could argue we should use a below historical average multiple as SF starts push into upcycle territory due concerns of peak cycle. On the other hand, we could argue for a higher than average multiple to account for an improved competitive position / larger market share, higher margins, and higher prospective growth from capital deployment outlays. Higher margin, more consolidated distributor peers such as BECN and IBP trade at 15-18x despite similar end market exposures. We think underwriting 13x on 2023 and 2025 EPS is reasonable given the improved business quality characteristics discussed (implies 9x EBITDA). Applying 13x to our 2023 EPS of $6.85 leads to an $89 stock at 12/31/22 for 100% upside and a 60% IRR. If we assume BLDR does no capital allocation and leverage falls to 1x net cash in 2023, we would have EPS of $5.50. Importantly, our estimates assume “normalized” lumber prices of $400, though there is an argument that lumber will be higher over the next several years due to a lack of capacity investment in the industry, which would be a tailwind to BLDR. 

In our bad case, we assume new SF starts slow in 2022 and show signs of falling in 2023 due to a combination of unaffordability from higher mortgage rates and home prices, and assume very minimal capital deployment. Applying 8x to “peak” 2022 EPS of $4.25 implies a $34 stock by year end for 25% downside. To be permanently wrong, we would have to believe we are heading into a multiyear downcycle for new SF starts, as another real downturn in housing is the biggest risk to the stock. Per the multiyear demographic tailwinds discussed, we believe this should support a higher baseline level of demand over the next five years even if affordability becomes a temporary issue, limiting the chance of this risk materializing.  

Key Risks: 

1. Highly cyclical end market exposure creates outsized downside risk if economy / housing cycle weakens. BLDR’s stock has had three drawdowns of 50% over the last 5 years when the market grew fearful the economy / housing cycle would turn negative (1Q16, 2018, 1Q20). BLDR’s stock should be more resilient going forward given its lower leverage profile than previous drawdowns, larger size / liquidity, higher margins, and cost synergy + capital deployment levers to support earnings growth irrespective of the cycle. We are also investing in a favorable point in the cycle where the economy is recovering from a recession and intense fiscal and monetary stimulus is supporting consumer balance sheets, which de-risks the story to some degree in our view.

2. High sensitivity to rising interest rates creates trading and fundamental risk. Unlike high multiple stocks where rising rates mostly just impact the multiples, if rates rise by too much too fast, housing demand can be negatively impacted. The conversation today is that mortgage rates are near all-time lows driving strong housing demand; the conversation in 6-9 months could be that mortgage rates have moved up to a level that is on the cusp of hurting demand. Additionally, commodity inflation is causing the price of new homes to increase by low double digits, which is impacting affordability. We ran a sensitivity that indicates mortgage rates can increase 100bps from 3.3% to 4.3% and new home prices can increase by 10% yet affordability will still remain in-line with historical averages, which could give us some margin of safety in demand sustaining (see table below). That said, the absolute level of interest rates and housing affordability ironically aren’t that correlated to housing demand over multiyear periods (affordability was in the 30-35% range in the early 2000s upcycle; mortgage rates were at 5-10%+ in the 80s and 90s upcycle) – it’s more the speed of increase / decrease that can cause a buyers’ strike / rush of demand based on sequential changes in affordability. If mortgage rates rise materially from here and we see continued strong appreciation in home prices, this could cause the softness in new home orders to continue through the end of the year into 2022 and spark fears of a decline in new SF starts in 2022/2023. 

3. Elevated lumber prices are benefiting BLDR’s EBITDA and are a headwind as they fall. 33% of sales are of sheet lumber where BLDR passes through commodity prices and earns a markup for distribution. Another 7% of sales are prefabricated Value-Added products that contain lumber where BLDR’s prices are more negotiated. Lumber prices (LB1 comdy) are at all-time highs, up 100%+ yoy. This has slightly compressed BLDR’s gross margins as selling prices haven’t risen as fast as purchasing costs, but the higher gross profit dollars flowing through the system leverages over SG&A. We estimate lumber inflation contributed 22% growth to PF 2020 EBITDA and is benefiting 2021 EBITDA significantly. We model lumber prices normalizing to $400 by by 4Q21 (consistent with what management incorporated in their 2021 guidance), thus, are not capitalizing any lumber inflation in our estimates. We furthermore believe street estimates incorporate normalized (~$400) lumber in 2022 so are not at risk of negative revisions if lumber prices full normalize over the next 12 months. 

Catalyst

Earnings beats and upward revisions to consensus estimates in 2021/2022 due to share gains/organic growth exceeding market growth

Capital allocation (potential buyback announcement in addition to regular way M&A)

Consensus shifting to an adjusted EPS metric that adds back intangible deal-related amortization of ~$1.25/share (better aligning with FCF)