Summary Thesis:

Continental Building Products (CBPX) is something of a busted IPO of a niche manufacturer of a key building material product (gypsum). The Company announced a 20% price increase Jan 1 that isn’t reflected in reported financials which has created a misperception around the valuation which is much less expensive than it would appear on a headline basis. These price increases flow through to EBITDA on a near 100% incremental margin, plus the Company will benefit from the tailwind of rebounding housing. Additionally, the wallboard industry is a consolidated space that has removed excess capacity since the last cycle and changed the structure of pricing contracts to disincentivize pricing based competition which should lead to greater ability to sustain pricing increases. 

Company Background:

• CBPX is a manufacturer of gypsum wallboard, mostly concentrated in the eastern US. Wallboard is a relatively consolidated industry with top 6 manufacturers controlling +95% of the market. CBPX has 10% share of the national market, but 17% share of the US east of the Mississippi and a substantially higher share in the key metro areas within 300 miles of their three facilities (including NY tri-state area, Florida, Georgia, Ohio, Michigan and Kentucky)
• Only wallboard manufacturer in US to use all synthetic gypsum which enhances product quality and consistency and reduces production costs.
  • Use of synthetic gypsum has increased from ~5% of wallboard production in ’95 to ~50% today.
  • The company has among the lowest cost structures in the industry due to their reliance on synthetic gypsum and substantial capex incurred to build/renovate their plants in past 10 years ($500MM in capex over past 10 years to update facilities).  Go-forward maint capex needs should be ~1% of revenue because of this investment.
• Company went public Feb 4-was expected to price $16-18 but ended up coming out at $14 in a volatile market environment.
• Incremental margins on pricing +90% and on volume ~35% so meaningful operating leverage to upside.

Valuation:

Variant Perception:

• Market just seems asleep at the switch on this one. Company increased pricing 20% on Jan 1 and those numbers have not begun to flow through to reported financials and aren’t being reflected in valuation.
• Very high incremental margin and minimal ongoing maintenance capex needs mean continuing strength in gypsum wallboard pricing will lead to rapid delvering and multiple compression.
• The wallboard industry structure has changed and will allow greater ability to extract pricing increases.

Key issues:

• Will wallboard price increases stick?
• What are reasonable assumptions for wallboard demand?

Initial evidence on Key issues:

• Wallboard pricing appears likely to stick (at least for the most part)
• 5 of the 7 US wallboard manufacturers (with combined market share ~55%) have announced price increases of 20% effective Jan 1. The remaining two companies do not typically issue formal increase letters so this effectively represents full participation in a price increase.
• USG (largest manufacturer of gypsum wallboard in US and one of the above peers that doesn’t issue price letters) notes on Q4 call that they expect pricing for ’14 to be up 15+%.
• The industry as a whole only achieved profitability in late ’12 so even with these price increases, they are not earning super-normal returns.
• The industry has consolidated dramatically. In 1997 there were 13 gypsum wallboard producers v 7 in ’13. This has created a more rational pricing environment.
  • Additionally, in 2012 wallboard manufacturers transitioned from a structure where they provided quotes for specific jobs to individual customers to a model that set annual pricing levels to the distributor and the distributor, in turn, did the individual job negotiating. This disincentivizes wallboard producers from competing for volume by lowering prices mid-year (a dynamic which had existed prior to this change). Since most wallboard is sold through distributors, it also allows distributors to better manage and plan their inventory needs.
  • There may be some backsliding from the 20% headline price increase figure, but mid teens pricing increase should be readily achievable.
    • Wallboard demand has been cyclically depressed and has meaningful upside, but aggressive assumptions for starts aren’t required for the stock to work.
      • Demand driven by housing starts and R&R.
      • US housing market continues a gradual recovery. Over the past 55 years, housing starts have averaged ~1.5MM/year v ~900K currently.  
        • Note CBPX’s specific local markets are among the most attractive nationally and over the past 12 months, building permits rose 39% YoY which is well above the 16.4% reported in the rest of the US.
        • USG expects industry demand for wallboard to be up 14% in ’14 which would imply housing starts ~1.05MM in ’14.

Reward/Risk:

Upside:  ~$37 @ 6x ’16 EV/EBITDA of $278MM (we return to mid cycle starts by ’15, pricing increases track change in starts)

Downside: ~$13 @ 5x ’16 EV/EBITDA of $143MM (Housing starts stagnate and we top out <1.1MM units. Pricing discipline is lost and only increases 5%/year for next 3 years.

Pre-mortem:

• Industry loses pricing discipline and begins competing for volume.
  • This is mitigated by the fact that the industry has proven remarkably disciplined in pricing. The change in industry structure over the past 10 years and the shift to annual pricing means the players should behave more rationally. 
• Housing starts stagnate
  • By most measures, the housing market seems to remain underbuilt. Housing starts are still below average cyclical lows for previous cycles over the past 50 years (despite the fact that we are ostensibly in a housing recovery). Even just getting back to average mid-cycle starts would imply a ~20+% in annual starts (to say nothing of any future cyclical peaks).