Description

Business Description

Gibraltar Industries (“ROCK”) is a building products manufacturer that operates three segments: Residential, Industrial & Infrastructure, and Renewable Energy & Conservation.  Residential (42% LTM sales) manufactures mail boxes, roof ventilation, and rain dispersion products for residential new construction and R&R markets.  Industrial & Infrastructure (30% LTM sales) manufactures bar grating for industrial platforms, expanded metal barriers for commercial real estate, and expansion joints for bridges and highway construction.  Renewable Energy & Conservation (27% LTM sales), which was established through the acquisition of Rough Brothers, Inc. (“RBI”) in June 2015, manufactures solar racking solutions and commercial greenhouses. 

Set-up

ROCK is a housing/infrastructure/solar story stock that has undergone a “transformational change” since Frank Heard took the helm as CEO in January 2015.  ROCK has beaten consensus estimates every quarter since Q1 2015 and its shares are up 63% year-to-date and up 146% since Heard was promoted to CEO.  Since the leadership change took place, Heard and his executive team of ex-ITW, 80/20 Pareto, Kanban, Lean Six Sigma black belts have taken credit for expanding operating margins from 4.4% in 2014 to 11.7% in Q3 2016.  At $39.2 per share, ROCK trades at a 30x multiple on inflated earnings rife with “non-recurring,” non-GAAP adjustments—a 38% premium to building products peers.  Given the rich multiple, the street seems to believe there is further room for accelerated margin expansion despite ROCK having thus far overachieved on its five-year plan.  We believe the market is giving management too much credit and is missing the true underlying drivers of this unsustainable margin expansion story: 1) a dubious solar acquisition, RBI and 2) low earnings quality via the over reliance on non-GAAP adjusted earnings, which conveniently do not exclude non-core derivative gains.  Moreover, ROCK is a low quality, cyclical business that has not grown organically over time and is rife with red flags.

Dubious RBI Solar/Greenhouse Deal

We had our initial doubts when ROCK first acquired RBI in June 2015.  RBI was a profitable business that grew top line 43% in 2013 and 85% 2014 with 9.7% operating margins (more than twice ROCK’s 4.4% adjusted operating margin in 2014).  Yet ROCK was somehow able to acquire the business for $143M at 8.1x LTM EBIT or 7.4x LTM EBITDA ($17.6M and $19.3M, respectively as of March 31, 2015). 

We found it highly suspect that Richard Reilly, whose father Al Reilly purchased RBI in the late 1970s, would sell the profitable, fast growing family business for such low multiple.  Furthermore, Richard Reilly has the background and experience of making deals—enough at least not to get completely ripped off.  Richard started his career at Morgan Stanley in New York and even helped his father Al structure a buyout of his then partner (http://www.bizjournals.com/cincinnati/stories/2002/02/25/story7.html). 

For ROCK, the deal appears too good to be true and could have only occurred in one of four scenarios:

1.       RBI was advised by the most incompetent investment banker

2.       The Reilly family did not understand the growth and margin profile of its business

3.       ROCK CEO Frank Heard is the greatest deal-maker of all time

4.       There is something fishy going on

We are ruling out the following scenarios:

1.       Richard Reilly had worked as an investment banker, so he has a working knowledge of deal making

2.       RBI has a #2 market share position in solar racking and #1 market share position in commercial greenhouses.  It would not have built this position without a thorough understanding of the industry

3.       Based on his bio, Frank Heard has never been a CEO and was never in a deal-making role prior to ROCK

This leaves choice 4 as the only viable option.  We believe Richard Reilly was only willing to give up the business at this cheap multiple because he knew revenues and profits were peaking, driven by expiring incentive tax credits and given RBI does not play into the larger, longer-term residential solar opportunity.  RBI’s recent Q3 margin surprise, its restatement of prior period earnings, and reliance on inorganic growth via the Nexus acquisition supports our view. 

In Q3 2016, RBI reported $16.4M in adjusted operating income, a 111% year-over-year increase on flat sales.  These margins are a result of what we believe are aggressive profit recognition under percentage-of-completion accounting, which is based on very subjective assumptions of cost and project completion.  Citing the “difference between how a public company manages itself to high standards of public reporting, as required under regulatory bodies, versus a private company,” Q1 2016 operating income was magically restated from $4.3M to $8.3M and Q2 operating income from $7.7M to $10.3M.  

I fail to see how revenue and profit recognition becomes more aggressive under public company accounting.  Wouldn’t the low-quality standards of private-company accounting have resulted in previously overstated earnings and not the other way around?  How is it that ROCK, which only began using percentage-of-completion accounting post RBI, claim to have a better understanding of project completion and cost estimates compared to its founders who have been using the method for years? How can anyone trust these numbers if the margin profile of the business looks nothing like what was originally reported?

Based on these revised earnings, LTM adjusted operating income for the segment is $43.3M, which means ROCK paid 3.3x EBIT on this basis.  If everything was Kosher, I am sure RBI could have found a buyer willing to pay a much higher price. 

Misleading Increase in Guidance

I believe the underlying reason behind this aggressive change in accounting practices stems from management’s fear of missing guidance and consensus estimates, which ROCK has consistently beat since new management has taken place.  Consensus operating income for Q3 2016 stood at $28.9M and likely modeled in quarter-over-quarter operating income improvement for all three segments.  However, since results for Residential and Industrial & Infrastructure actually fell sequentially, management’s only lever was to change the accounting for the only segment it could—Renewable Energy & Conservation—which is the only segment where percentage-of-completion accounting applies.   Had revenue recognition practices remain unchanged, RBI would have earned at a maximum a low double digit operating margin (12.3% is the highest ever reported margin) it had historically reported—not the 20% adjusted operating margin ROCK reported in Q3 2016—and ROCK would have surely missed consensus expectations.

Investors seem to have bought into management’s bogus increase in guidance, as ROCK shares have rallied 13% since Q3 earnings on October 27, 2016.

Adjusted operating income guidance was revised higher $7.5M at the midpoint and adjusted EPS was revised higher $0.17 at the midpoint.  Yet the entire increase can be bridged by the $6.6M adjusted operating income and $0.13 in adjusted EPS restatement, along with any benefits from the recently acquired Nexus acquisition. 

Peak, Unsustainable Margins

Adjusted operating margins have reached unsustainable heights.  In this most recent quarter, ROCK generated adjusted operating margins of 11.7%, exceeding its five-year, 2019 margin target of 11.2% in less than two years.

While we give management credit for what it has accomplished with its 80/20 initiative, cost cutting and SKU rationalization can only grow margins so much, and it is certainly not a sustainable source of margin improvement.  While management says it is only in the middle innings of its transformation, we believe the bulk of margin expansion opportunities have already been achieved.

ROCK operates in a cyclical, relatively low margin building products industry with numerous competitors, which makes it structurally impossible to sustain outsized margins.  Moreover, manufacturers of home improvement products that rely on big box retailers like LOW, HD, WMT, etc. (ROCK’s top 10 customers account for 34% of sales, of which a large home improvement retailer accounts for 11%) find it very difficult to achieve double digit margins.  Benchmarking ROCK’s 11.2% operating margin target against other publicly traded building products peers, we find that the average operating margin the past decade has been a mere 5%—less than half of ROCK’s target.

Questionable Earnings Quality

ROCK’s margin expansion is questionable, as it has occurred amidst a meaningful decline in sales.  While it is normal to expect margins to expand when sales grow due to operating leverage, it is unusual to see such dramatic improvements in profits when sales decline.

For the year-to-date period, Residential Products sales have declined $30.4M, while adjusted operating income has increased $17.1M.  During the same period, Industrial & Infrastructure sales declined $58.2M, yet profits are up $0.3M.  Renewable Energy & Conservation earnings have been magically revised upward and cannot be fully trusted.

Lastly, management has been over reliant on non-GAAP figures to boost its profitability.  Every quarter seems to have several adjustments which inflate earnings.  In the past 7 quarters since new management has taken place, adjusted operating income has exceeds GAAP operating income by 22%. 

While non-GAAP measures are useful in excluding truly non-recurring charges, ROCK’s add-backs are not one-time in nature and are truly recurring.  The result is inflated earnings which will normalize absent these “non-recurring” add-backs.

What is missing from this margin expansion story are two significant drivers which management fails to draw attention to: 1) the significant raw material decline ROCK has benefited from due to falling commodities & 2) non-core derivative gains which are not excluded from adjusted operating income.

Falling commodity prices for ROCK’s key raw materials (aluminum, steel, and resin) have created substantial cost savings for the business, boosting gross margins.  While there is no way for investors to parse out the true savings from raw materials vs 80/20 savings, we can be sure that SKU rationalize and cost optimization alone did not drive ROCK’s margin improvement.

The second “hidden” driver of margins is derivative gains, which contributed $5.2M to operating income in 2015.  Of the $27.2M year over year operating income improvement in adjusted operating income ($65.1M in 2015 vs $37.8M in 2014) derivative gains accounted for 15% of this improvement ($5.2M in 2015 vs $1.1M in 2014).  Management finds it perfectly alright to add back acquisition, restructuring, and leadership transition related costs to juice earnings, but not non-core derivative gains.  It would not surprise us to see management adjust for derivative losses were they to occur in the future.

No Organic Growth

ROCK has not shown an ability to grow organically, with Residential and Industrial & Infrastructure segments projected to decline 10% organically in 2016 per management guidance, while Renewable Energy & Conservation (the smallest segment) is expected to only grow 3%.  The revenue decline is not a mere byproduct of some short-term lumpiness or end market weakness but points to structural weakness in revenue growth.  In fact, based on 2016 guidance the business will only have grown organically in two out of five years, relying primarily on acquisitions for growth. 

Residential continues to face headwinds from lapping a large, two-year centralized mailbox contract, which contributed $50M (10.5% of segment sales) in 2015 alone.  While its electronic package locker systems have attracted a lot of attention, it remains a very smaller percentage of the sales mix.  In fact, ROCK’s outlook for new products, which are currently 5% of total sales, aren’t expected to double until 2020.  Lastly, per ROCK’s 2015 Analyst Day, ROCK has 2/3 market share in the North American mailbox market, limiting potential share gains.

Industrial & Infrastructure continues to face weak end markets.  On the industrial side of the business, energy-related markets remain a challenge with no imminent rebound. In its most recent call, management acknowledged that its capacity here is 2x in terms of demand, which has depressed pricing.  On the infrastructure side, state budgetary pressures have constrained spending on much needed bridges and highways.  Despite the FAST Act highway bill having been passed in late 2015, CEO Frank Heard admitted on the recent earnings call that the bill “has not affected the market in any positive way yet in terms of a rising tide of order intake or shipments” and that incoming orders would be more of a late 2017 event.

Renewable Energy & Conservation, which is up 13% year-to-date through Q3 2016, is expected to decline mid-single digits in Q4 2016 per management guidance, as the federal solar tax credit, which was expected to expire late 2015, created some pull-forward demand last year.  Since the guidance includes the Nexus acquisition ($30M in annual sales), the core RBI business should be down more than mid-single digits percentage implied in Q4 2016 guidance. 

Consensus extrapolating recent results

2017 consensus assumes continued top line growth and margin expansion.  Revenues are expected to grow 5% in 2017 (highest in a decade) and with earnings growing 12%.  With two full years of 80/20 benefits (which have already exceeded long term expectations), the absence of a major postal contract, persistent weakness in energy markets, and a prolonged deferral of infrastructure spending, the Street’s estimates are far too optimistic.  

Using management’s guidance, 2016 sales will come out to ~$1.011B.  Comparing this to 2017 consensus sales of $1.066 implies 5.4% top line growth.  Assuming RBI grows 4%—consistent with its 2016 pro forma growth rate—and the Nexus acquisition contributed an incremental $30M in sales, the legacy Residential and Industrial & Infrastructure business would have to grow ~2% in 2017. We find untenable given the headwinds we cited above as well as ROCK’s general inability to grow organically.  

Without the benefit of continued add-backs, I think ROCK’s earnings are flat at best in 2017 at $1.60/share (10% below consensus).  With ROCK trading at a 40%+ premium to building products peers (22x 2017 EPS vs 15x for peers), the stock is set up to fall.

Applying a peer multiple to our view of 2017 EPS, we believe ROCK shares are worth ~$24/share, presenting 35%+ downside from its current share price.

Risk

The market has been blindly rewarding companies that have been an on acquisitive streak, regardless of whether these deals are accretive or not.  Since ROCK’s capital allocation priority remains M&A (CEO Frank Heard has interacted with 25 potential targets in Q3 alone), the market may continue to bid up ROCK’s shares in the event of another acquisition.

On the flipside, we believe there is minimal buyout risk of ROCK being acquired.  There is no strategic rationale for a competitor to acquire ROCK: it is over earning, has not exhibited an ability to grow organically, and manages three disparate segments—none of which offer any promising growth, margin improvement, or superior return on capital.   

Red Flags

·         Inflated non-GAAP, adjusted earnings

·         Persistent “non-recurring” charges

·         Restated earnings to magically restate prior earnings and boost guidance—will likely have to file a NT 10-Q

·         Exceeded five-year margin target in 2 years, leaving no room for further margin expansion

·         Ducking my calls/emails—left ~10 voicemails and emails in the past year, including right after the most recent earnings call

·         Purported #1 market share position in varying end markets based on “management’s best estimates”—not objective third party research.

Catalyst

• margin normalization
• additional accounting restatements
• multiple normalization