Description

Executive Summary:

Nearly a year after Doobadoo802 posted a well-timed short recommendation on BMHC, we are recommending the purchase of Builders FirstSource (BLDR) - a company often confused as a direct comp to BMHC.  Based in Dallas, BLDR is a leading distributor/supplier and fast-growing manufacturer of structural and related building products for the residential new construction market in the US (primarily east of the Mississippi but also includes Texas).  BLDR operates in 11 states (with greatest exposure to SC, NC, FL and TX respectively) through 63 distribution facilities and 52 manufacturing sites.  Over the past several months, BLDR has traded down from $26 to $15.99  (08/02/06).  Based on 2006E EBITDA of $200MM (conservatively $8MM - $15MM below consensus estimates), BLDR is trading in-line with the homebuilders (4.3x 2006E EBITDA; 4.9x EBITDA less capex).  While BLDR faces headwinds (housing cycle and timber prices most notably), the market has unfairly lumped the business alongside its customers (the homebuilders).  We believe that BLDR deserves to trade at a premium to the homebuilders given its (i) lighter asset model (PP&E + WC / Sales is roughly 17% for BLDR vs. 63%+ for the large homebuilders), (ii) low capex requirements and (iii) high return on capital (40%).  Even in the face of a difficult housing environment, BLDR has done an impressive job of growing its top-line through market share gains and improving margins through product mix improvements and expense reductions.  Moreover, BLDR stacks up favorably versus its peer building distributors; goss profit and EBITDA margins are in-line with comps and leverage is reasonable (1.5x for BLDR vs.4.7x for BXC and 3.2x for BECN), yet BLDR trades at a significant discount. 

 

As a quick aside, investors often confuse BMHC as being a direct comp to BLDR.  As the business model and geographic mix are completely different, we believe the comparison is misleading.  BMHC generates 50% of its revenues from construction / installation services (versus virtually none at BLDR).  As Doobadoo802 highlighted in his write-up, the construction services personnel are basically sub-contractors who handle some of the lower value aspects of homebuilding (including job site management, installation and framing). This business is arguably the most exposed to the housing cycle as sub-contractors have witnessed meaningful pressure from the homebuilders.  In addition, BMHC operates almost exclusively in the western region of the US (including AZ, NV and CA) versus BLDR’s south / southeastern exposure (NC, SC, FL and TX).  As homebuilders have been minting money in these regions, these areas will likely be the center of attention in a downturn that should spell trouble for BMHC.        

 

Over the next 6-12 months, we believe investors will recognize the differences between BLDR (distribution/low-cost manufacturing model) and it customers (the homebuilders).  As the Company continues to prove out is strategy of gaining market share and improving the business mix toward higher-value pre-fabricated products, investors will pay a premium to BLDR over the homebuilders.  It’s also worth noting that at these depressed levels, we believe there is high likelihood that M&A activity will occur over the next 6 – 12 months (BLDR to acquire or be acquired).  The heavy activity of potential deals discussed in the market by Home Depot, Stock Lumber (part of UK producer Wolseley), BMHC and Lanoga creates potential upside[1].  Assuming 7x 2006E EBITDA (which is still conservatively below any prior M&A transaction), the market will pay more than $30/share implying a potential double from here.

 

Company History:

BLDR has been a portfolio company of JLL Partners (a mid-size buyout firm) since 1997 and is the product of 20 acquisitions made between 1998 and 2001 (including the former distribution business of homebuilder Pulte Homes).  When JLL acquired the business, BLDR was simply a distributor of lumber, windows and doors primarily to residential homebuilders and generated ebitda margins of 3.7% on revenue of less than $1 billion.  The Company generated the overwhelming majority of its profitability (70%+) by purchasing lumber, windows and doors and delivering product to construction sites (not a wildly exciting business model we’re open to admit).  In 2001, JLL brought in a new management team led by Floyd Sherman as Chairman and CEO.   Sherman demonstrated his skills while at Triangle Pacific/Armstrong Flooring and was credited with transforming the business from its commodity focus into a higher-end flooring business.  In addition to Sherman, several other executives were tasked with integrating prior acquisitions (prior management had failed in this regard and the Company was essentially being run as 20 separate businesses) and growing the businesses. 

 

Upon joining the firm, Sherman recognized that BLDR could “value-up” the business by providing manufacturing services for its customers.  Specifically, BLDR was the first distributor to enter the manufacturing side of the business.  BLDR’s focus was to produce pre-fabricated structural and related building products (roof and floor trusses, wall panels, stairs, etc.) that could be delivered in finished state to a construction site along with lumber and other commodity products.  This initiative was very well received by the homebuilders and led many major competitors to follow suit.  The benefit of this to the homebuilder was (i) reduced manufacturing cost (factory-produced products could be made at far lower cost through automation than those made at a worksite by people), (ii) reduced shrinkage (lumber at a worksite tends to disappear during the construction process) and (ii) increased inventory turns (BLDR is able to deliver product just-in-time).  As a result of this shift in business focus, BLDR has shifted its mix away from lower value distributed wood products to higher margin manufactured products (50%+). 

 

Company Overview:

The description of the business below is purposely brief since there is ample background information on the Company’s website (www.buildersfirstsource.com) and in its public filings.  BLDR manufacturers and distributes a mix of products under five main product categories: (i) prefabricated/millwork components – 31% of sales (but much higher in terms of share of company profitability), (ii) windows and doors – 19%, (iii) lumber and sheet goods – 36%, % and (iv) other building products and services – 15%.  BLDR is currently undergoing a significant mix shift away from commodity lumber products toward more value added items.  The prefabricated components segment includes both floors and roof trusses, along with pre-built partition walls.  We estimate that the gross margin in the prefabricated division typically runs in the 30% range versus sub-20% for the remaining businesses.

 

BLDR is the largest manufacturer/distributor in the US and serves the Mid-Atlantic, South and Southeast.  The Company has developed deep relationships with the large homebuilders and acts as more or less a logistics arm for the builders (delivering the right product at the right time to construction sites).  BLDR is usually in the top two of suppliers to single-family residential new construction in 75% of its chosen markets.  BLDR’s primary customers are both production and custom homebuilders, with a smaller percentage to the remodeling community.  Over 90% of its business is to the new residential market.  The top 10 customers represent approximately 26% of sales with no one customer representing more than 5% of sales.

 

Financial Performance:

The table below highlights BLDR’s financial results for the past six years.  In 2001, operating performance was negatively impacted by falling lumber prices.  As a result, top-line remained flat between 2000 and 2002 and EBITDA margins were squeezed by roughly 200 bps.  It’s worth noting that BLDR’s lumber sales to the homebuilders is based on a percentage margin rather than by a margin per unit.  As a result, when lumber prices rise, BLDR makes more money and vice versa.  As much as this has frustrated investors, BLDR continues to utilize this pricing construct.  To its credit, however, BLDR locks in 90-day pricing on its lumber purchases that is a significant short-term hedge versus the exposure its peers (notably BMHC) take.  On a side note, we believe the greatest reasonable downside exposure to lumber pricing (conservatively assuming a 10% decline on $850MM of revenue and 20% flow through) is only ~$15MM - note that this would bring us back to 1990 lumber pricing, which we believe highly unlikely.  Upon Sherman’s arrival in 2001, BLDR started shedding unprofitable/undesirable business lines (6% effect on sales in 2002 versus 2001).  In addition, Sherman began constructing facilities to begin BLDR’s foray into the manufacturing business.  Since 2003, the results below highlight BLDR’s core business performance and this is when the investment story starts to get interesting.   

 

FINANCIAL RESULTS
	FYE December 31,
	2000	2001	2002	2003	2004	2005	LTM
Revenues…	$1,513	$1,514	$1,500	$1,675	$2,058	$2,338	$2,441
EBIT	$62	$40	$37	$48	$108	$161	$182
EBITDA	$84	$64	$59	$70	$127	$181	$203
Capital Expenditures	22	25	15	16	21	30	31
EBITDA-CapEx	$62	$39	$44	$54	$106	$151	$172
EBIT Margin	4%	3%	2%	3%	5%	7%	7%
EBITDA Margin	6%	4%	4%	4%	6%	8%	8%
EBITDA less Capex Margin	4%	3%	3%	3%	5%	6%	7%

 

 

A likely initial suspicion is that BLDR grew revenue from $1.5Bln in 2002 to $2.3Bln in 2005 because they rode the housing wave.  Let’s expand on this a bit.  The graph below highlights BLDR’s market share gains versus its competition between 2003 – Q2 2006.  If you trust the analysis (we do as the CFO - Charles Horn - is amongst the most straight-shooting CFO’s we know), this would imply that the Company’s sales increase between 2002 and 2005 was comprised of approximately $350 million from market share increases (assuming 4% of sales per year). 

 

Increase in Sales from Market Share Gains
2003		n/a
2004		3.1%
Q1 2005		n/a
Q2 2005		n/a
Q3 2005		6.0%
Q4 2005		2.0%
Q1 2006		10.1%
Q2 2006		11.5%

 

 

Digging deeper into the numbers, BLDR’s manufacturing business grew from $257 million in 2002 to $517 million today.  Some was naturally due to housing growth but a large percentage was from opening up new facilities to serve pre-existing demand; so we have assumed a 75% / 25% split between organic and market growth.  In addition, BLDR acquired two small businesses during this period (let’s assume BLDR only gets $25MM in incremental revenue as data is unavailable).  This would leave us with a revenue bridge that looks like the table below. 

 

2002 - LTM Revenue Bridge
2002 Revenue			$1,500
Market Share Gains			425	assumes 5%; management expects 10% going forward
Manufacturing Expansion			195	assumes 75% of manufacturing business growth is organic
Lumber Prices			50	lumber up 22%; est. 12% change in lumber equals 1% per mgmt.
Effect of Acquisitions			25
Implied LTM Revenue			$2,195
LTM Revenue			2,441
Revenue in excess of 2002			$246
Effect of May 2006 Acq			40	per press release
Revenue in excess of 2002			$206

 

 

Unless you believe we are going back to 2002 levels, BLDR should be able to grow as a function of its size and breadth of product offering.  As a point of reference, BLDR’s 2Q results reaffirmed its ability to gain market share from its smaller competitors even in the face of a difficult housing environment.  The graph below highlights selected statistics from BLDR’s markets during the 2Q.  While many investors have taken the position that more bad things are yet to come and BLDR will be challenged, we are of the view that they have already begun and BLDR has found ways to grow through it. 

 

YOY Change in Key Statistics in BLDR's Specific Markets in Q2
Starts			(8.2%)
Orders			(24.1%)
Backlog			(10.3%)
BLDR's markets represent 27% of the US.

 

 

With the above data points regarding BLDR’s end markets in mind, one would have expected BLDR to implode (or at the very least show some signs of strain).  The table below highlights the BLDR’s actual Q2 results. 

 

Key Q2 Statistics
			Q2 Results
Revenue Growth			4%
Revenue Growth (excluding impact of lumber price decline)			7%
EBITDA Growth			14%
YOY EBITDA Margin Improvement			140bps
Pre-Tax Return on Net Tangible Invested Capital			40%

 

 

With Q3 shaping up to be similar to slightly below Q3’05 (from housing starts and order perspective) this gives us conviction that BLDR can at least maintain it’s current profitability levels and generate nearly 40% ROIC (frankly we see them being up YoY) in the worst housing environment we have seen in 14 years.  Trading at less than 4x 2006E ebitda and 5x ebitda less capex, we are comfortable owning this for the long haul.

 

Investment Merits:

Okay, so this is probably getting a bit long-winded but with so many naysayers out there we had to get the facts on paper before making our case.  The reasons for the investment are:

 

Cheap – It’s Not a Homebuilder.  We know everyone of us owns cheap stocks but we doubt there are many that trade at 4.3x ebitda/4.9x EBITDA less capex and generate 40% pre-tax return on invested capital, is not leveraged and can grow through this period (see capitalization table below).  This company has traded like a homebuilder but the only thing that’s the same is the company’s name.  BLDR has superior return characteristics and consolidation opportunities and is not yet fully penetrated in the manufacturing side of its business.  It went public at 7+x ebitda in June 2005 ($16 per share) and deserves to trade like a value-added distributor not a homebuilder.

 

Capital Structure and Valuation
Stock Price			$15.99
Shares			36
Market Value			$575
Net Debt			293
Enterprise Value			$869
2006E EBITDA			$200
Free Cash Flow Analysis:
EBITDA			$200
Less: Capex			(30)
Less: Interest			(30)
Less: Taxes			(40)
Free Cash Flow			$100
EBITDA Multiple			4.3x
FCF Yield			17.4%

 

 

JLL Didn’t’ Sell and Warburg Bought.  In February of this year, JLL was offered a chance to sell the business to Warburg Pincus.  After 9 years and with the opportunity to take $450 million off the table (a very large payday for JLL), JLL was only willing to sell half ($225 million) of its position to Warburg (at approximately $25 per share).  What this tells us is that a very smart potential seller and buyer have validated their conviction in this business at a time (February 2006) when the market was predicting a 7% decline in homebuilding in the current year.  Perhaps Warburg and JLL  know something more than the market and are willing to wait it out for the payday.

 

Consolidator in Fragmented Industry.  BLDR is the domestic leader and holds only 9% of the market.  Competitors who are merely distributors are taking it on the chin right now (small volume declines kill small players) and are looking to sell at low prices. 

 

Potential for Home Run Take-Out.  Home Depot has repeatedly stated its goal of getting closer to the professional builder.  In the past year, HD purchased Hughes (admittedly plumbing not building supplies) for 11x and Cox (a direct but much smaller competitor to BLDR) for an undisclosed multiple.  We believe that Cox was an example of HD dipping their toe in the water as they want to own this channel.  And if that is the case, they will want to own BLDR.  We have heard through media sources that discussions have been had in the past.  If HD doesn’t take the Company out, the sponsors would probably do it themselves just to spare the costs of being underappreciated as a public company.

 

Consolidation/Integration Continues.  The Company is still engaged in bringing together the businesses under one SAP system in order to reduce cost and manage the business tighter.  There is still upside to fixing their own house. 

 

Did We Say It’s Cheap?  We all own a handful of cheap stocks that we’re content with holding for 2 – 3 years

 

Investment Risks:

So what are the risks?  All the usual suspects is the brief answer: (i) homebuilding falls off a cliff/more than 20% (your call on this one); (ii) lumber prices fall to levels not seen since 1990 (we doubt it); (iii) pricing pressure from the homebuilders (as if they’re not already exerting it as a matter of good business practice); (iv) homebuilders begin factory manufacturing their own structural products (some have tried but its hard to get the scale when BLDR can put up a factory and serve 10 builders in a region versus a builder only serving internal needs in the region); and (v) it never de-couples from the builders (possible but unlikely after what we saw in the Q2 results).

 

Over the past three months, a lot has come out from the homebuilders reporting massively negative numbers.  As we evaluate the relative positioning of BLDR in key geographic markets, we found an interesting dynamic that appears to be prevalent in BLDR’s key markets.  Specifically, BLDR is exposed to North Carolina, South Carolina, Florida, Texas, Georgia and certain other southeastern states (FL represents approximately 20% of revenue).  As NC, SC, GA, TX and TN were generally much less exposed to the rapid housing price increases, these markets continue to report decent results (July pulse was also neutral / positive YoY). The graph below highlights national permit growth in Q1 – Q4 2006E for national vs. southeastern regions. 

 

Permit Growth
	2006
	Q1	Q2	Q3E	Q4E
National	0.2%	-13.0%	-13.0%	-14.0%
SE Mkts	4.7%	-6.0%	-9.5%	-10.5%

 

Based on the work we have done, we believe the Company should trade for 7+x ebitda / 8+x ebit in any non-chicken little-the-sky-is-falling on the housing market.  The following graph highlights the implied stock price of BLDR at various ebitda levels and multiples.

 

BLDR Stock Price at Varying EBITDA and Valuation Multiples
	EBITDA
15.99	$180	$190	$200	$210	$220	$230
5.0x	17	18	20	21	22	24
6.0x	22	24	25	27	29	30
7.0x	27	29	31	33	35	37
8.0x	32	34	36	39	41	43
9.0x	37	39	42	44	47	49
Note: EBITDA less Capex is approximately 1x greater than EBITDA

 

In summary, we know that sentiment is terrible for builders and we know that running downhill is easier than running uphill.  However, when the prize at the top of the hill is great and everyone’s running to the one at the bottom you have to consider putting on the hiking boots.  This story makes so much sense to us.  In full disclosure, we own a little of BLDR and would like to own more so appreciate your candid thoughts (which we know no one on this site is loathe to provide). For those investors that are cautious of a long only trade, we would suggest looking at shorting BXC / buying BLDR.  Due to the limited borrow and lack of float, this trade may be difficult to execute, but worth a shot for smaller investors.

 

Catalyst

- Financial performance and eventual de-linking from homebuilders
- Further M&A activity within the space (HD is salivating and thinks long-term)
- Continued acquisitions by BLDR
- Potential that JLL and Warburg take the business private