Description

2015.09.20 Continental Building Products (Ticker CBPX; $21.03; 9-20-2015) Writeup

I believe Continental Building Products (ticker CBPX) is an attractive long today.  Bdad’s writeup and thread from June 2014 provides some excellent background, and bdad recommended exiting early this year at a stock price virtually identical to where it is today.  While at a high level the story today is not terribly different, a number of things have changed since the initial recommendation, some of them materially.

The quick thesis is that CBPX is a simple, FCF-driven story that is far too cheap given a US new housing market whose volumes should continue to enjoy very significant upside from current levels.  So long as new home construction continues to increase and wallboard pricing doesn’t break, I believe there is tremendous upside to CBPX.

The current housing upturn has been somewhat atypical in that home pricing rebounded quickly and significantly off the bottom, while volume growth rates have generally surprised to the downside.  Given current housing prices and volumes, along with where mortgage rates are today, I am far more comfortable assuming that volumes several years out should be materially higher.  While I don’t expect home prices to fall, I think that home price growth should be significantly more muted than volumes and also subject to greater risk (particularly in the event that we see 10 year UST yields and thus mortgage rates at materially higher levels in the future).

I think CBPX is a great way to get exposure to this thought process.  Unlike homebuilders who generally exhibit poor FCF characteristics and who are far more dependent on home price gains to be in excess of expectations embedded into land prices to drive significant profitability growth, CBPX has exceptionally strong FCF and the strong growth I project in profitability is driven far more by steady volume increases than by large incremental pricing gains.

High incremental margins imply that moderate volume growth driven by housing starts will drive much higher EBITDA going forward.  Total housing starts in 2015 are projected to come in ~1.1mm, which approximates prior trough levels, despite what will be 8+ years of significant underbuilding relative to core demand for shelter in this country.  Meanwhile, MF starts have grown well in excess of SF starts so far in this upturn.  With MF starts expected to essentially plateau going forward, the bulk of the growth in total starts from here should be driven by SF starts.  This is notable because Single Family starts use several times the wallboard per unit that Multi Family starts use.

Starts need to increase roughly 40% from today’s levels before we return to normalized volumes.  Given the magnitude of underbuilding during the downturn, a strong case can be made for an extended upturn and even a potentially large over-shoot.  While the housing recovery is not “news” to anyone anymore, I believe the persistence of the recovery will surprise to the upside.  In the same way that even homebuyer tax credits and a litany of government sponsored programs couldn’t get the housing market to sustainably recover until after the massive excesses had cleared, I think that it will be very difficult for housing volumes to sustainably decline from today’s levels for a long time to come.  Admittedly, we could see starts fall in a particular year or two, especially in the event of an exogenous macro shock or recession.  However, I would expect any such decline to be shallower and shorter than typical, and then usher in a continued significant upturn.  Given how far into the recovery we are from the credit crisis, it is hard to find many industries with as much cyclical upside still remaining.  This is especially true if we exclude those cyclical industries that are still in the midst of their own downturns.  I also believe that US housing benefits from a number of macro trends we’re seeing, including declining commodity and energy prices, strength in the USD, low interest rates, etc.

CBPX’s plants are new, low cost, and of significant scale.  As you can see in the following table, on average, they are the largest in the industry, averaging ~1.1 BSF per plant versus an industry average of under 0.5 BSF per plant.  

Lafarge invested heavily into them before the sale to Lone Star, and thus capex for the foreseeable future is projected to remain ~$10mm or below.

Management at CBPX is competent and strikes me as highly unlikely to do anything stupid.  They’ve generally admitted there isn’t much money to spend organically on the business as high return projects consume only minimal capex.  While the focus for FCF from the time of the Lone Star LBO until Q2 was on debt paydown, I don’t foresee incremental debt paydown from here.  No principal payments are due until August 2020 and the cash interest rate is only 4% (L+300 bps with a 1% LIBOR floor).  CEO Jay Bachmann is an accountant, former investor relations director at Lafarge, and CFO at CBPX.  He has always struck me as straightforward, competent, and prudent.  I can’t imagine CBPX trying to buy a competitor and they’ve said they won’t make an acquisition into a separate business line.  With their target leverage ratio of 2.0x closely within reach (especially as EBITDA continues to grow), I have a high degree of confidence that CBPX will simply continue to return its significant FCF to shareholders.

Given the simplicity of the business and the investment thesis, it is worth asking why the opportunity exists.  I believe there are several reasons.  Initially, there was extreme disbelief that CBPX could possibly be worth so much more than the price Lafarge had sold it for on August 30, 2013 to Lone Star.  Lone Star took out nearly half their initial equity in a levered recap pre-IPO just 94 days after the ink dried on the purchase contract.  Even with the IPO pricing well below the initial range, the IPO price still represented over 3x Lone Star’s adjusted basis and roughly double their unadjusted basis despite less than 6 months passing!  After the IPO, Lone Star’s continuing majority ownership stake represented an overhang and left CBPX with limited float.  In the past year, Lone Star has executed four different secondary equity offerings in pretty rapid succession.  With a remaining stake of 6.0mm shares or 14%, Lone Star is basically one offering away from a complete exit.  (See the following table for additional details).

Additionally, CBPX screens expensive on EPS because of several factors, the largest being that D&A is far in excess of capex.  That delta alone represents roughly $1 per share.  There are also the LTIP payments entirely funded by Lone Star that nevertheless have been running through the GAAP income statement further depressing EPS.  Even with the bulk of Lone Star’s shares having now been transferred to the public, CBPX remains a small cap and illiquid name (<$900mm market cap) relative to many of its public peers in the building products space.  On a fundamental level, I believe the single biggest reason that the opportunity exists today is due to fears around wallboard pricing going forward.  After several years of explosive double digit price realization, pricing has decelerated to roughly flat.

I think that is a good segue into a bit more detail on what I believe has changed since bdad’s initial writeup in June of last year.  Most noticeably, the pricing gains that were being extrapolated at that time on the back of several years of explosive gains have made way for significantly lowered expectations.  As noted above, the increases in housing starts have also disappointed consensus expectations during this period.  Not surprisingly, fy18 consensus is now below the fy16 projections in that initial writeup.  Often it is a mistake to venture into a cyclical name when projections are falling, and often once they begin falling, that process can last a long time.  While that remains the most acute risk in my mind to this investment, I believe that lowered expectations today pave the way for upside surprises in the future, in particular as housing volumes re-accelerate.  Said another way, while the recent trend has disappointed, I think that today there is far more room for upside surprises in the future.

Another significant change since the initial writeup revolves around the balance sheet and the use of FCF.  From a leverage ratio of 4.1x at 3/31/14, I project CBPX will be at or below 2.4x at 9/30/15 and 2.2x at 12/31/15 using LTM Adjusted EBITDA.  Also, share repurchases began in Q2’15 and continued in Q3’15, totaling ~4% of outstanding shares so far at the same time that the leverage ratio has decreased.  The current share price is obviously higher than at the time of the initial writeup, but to the extent the cycle continues to unfold, that look into the rearview mirror should prove counterproductive.

Historically, the wallboard industry experienced explosive pricing at utilization levels of ~85%+.  Given the current trajectory, we’re roughly two years from that point.  While I’m not assuming such gains given today’s prices are already healthy, price spikes in the out years could represent an incremental source of upside, and I would note that my base case fy18 pricing assumption is still well below prior peak.

In addition, I would expect that management should be coming out with a more detailed and explicit plan around capital return in the not too distant future given current leverage levels.

Risks

I think the most fundamental risk to investing in CBPX is would be that housing starts fall.  As noted above, I can’t foresee this happening outside of an exogenous shock or recession and believe this risk is mitigated in part by the magnitude of under-building and low current rate of new housing volumes.

The potentially most dangerous risk to a CBPX investment would be a breakdown in industry pricing.  While the industry has consolidated and demonstrated exceptional pricing discipline to date in this cycle, this risk can never be ignored, especially as the depths of the last downturn recede further into prior memory.  That said, it would be a break from historical precedent to see pricing decline at a time when volumes are increasing.  Specific to CBPX, the company’s low cost plants and low market share renders it better positioned than the industry as a whole in the event that pricing discipline is lost.  After all, CBPX would have less to lose (and potentially more to gain in market share relative to the larger players) if pricing discipline were to be abandoned.

Lawsuits alleging industry collusion are another risk.  Suffice it to say that I believe this risk fades into the background as volumes and utilization levels continue to increase.

Finally, from time to time investors express concerns around CBPX’s synthetic gypsum supply to its Buchanan plant.  Specifically, 1/3 of the plant is supplied by NRG power plants currently scheduled to deactivate in May 2018.  I think several items are notable here.  First, the deactivation timeline has already been pushed out and may well be pushed out further.  Second, this is a take-or-pay contract under which the risk and cost of supply lies with NRG, not CBPX, and I believe the parent company NRG is the entity on the hook for this contract as opposed to just the individual power plants that may be shut down in the future.  Per CBPX’s filings, its synthetic gypsum supply contracts don’t mature for another 10-35 years.

Catalysts

Housing starts continue to ramp, especially Single Family

Pricing realization comes in ahead of lowered expectations

More explicit and detailed capital return program gets articulated

Lone Star completes exit after one more offering

Pricing reaccelerates sharply after utilization hits tipping point of tightness (i.e. ~85%)

Potential takeout.  Not banking on it, but clearly management would entertain it very seriously if an offer were to arise

Base case model excerpts

Bull case model excerpts

Bear case model excerpts

Catalyst

Housing starts continue to ramp, especially Single Family

Pricing realization comes in ahead of lowered expectations

More explicit and detailed capital return program gets articulated

Lone Star completes exit after one more offering

Pricing reaccelerates sharply after utilization hits tipping point of tightness (i.e. ~85%)

Potential takeout.  Not banking on it, but clearly management would entertain it very seriously if an offer were to arise