Description

GMS is the leading wallboard and ceiling material distributor in North America. It is a well-run company with a seasoned team that is capturing market share in its specialty distribution niche through rapid greenfield expansion and acquisition efforts. In creating a winning culture and entrepreneurial business environment, GMS has become a destination of choice for independent distributors when they consider the sale of their business. This continued stream of bolt on deals should drive above-market organic growth while compelling cyclical growth characteristics create the opportunity for investors to buy durable and steady growth – at a value multiple.

VARIANT PERCEPTION

We believe the market is underappreciating the long horizon growth opportunity in front of GMS as the leading consolidator of its specialty product vertical. Said differently, the stock’s valuation appears to encompass the cyclical growth characteristics of the company only, not the differentiated growth trajectory the company is delivering as the leading market consolidator.

THE BUSINESS

What it is

GMS is the leader in the ~$13B market for wallboard and ceiling materials for residential and commercial construction uses. The company started as a single branch in 1971 and has since grown to over 205 branches in 42 states through a combination of organic growth and acquisitions.

GMS aims to create a “one stop shop” for interior contractors through a high touch sales and distribution system. It has access to over 20,000 SKUs from a relatively concentrated supplier base and distributes them locally to over 20,000 commercial and interior contractors and homebuilders.

Demand drivers

GMS’ primary demand drivers are commercial new construction, commercial repair and remodeling, residential new construction, and residential repair and remodeling, with greater exposure to the “new” component of both industries. GMS’ end-market demand is tied to construction activity and typically trails housing starts by 3 to 6 months and commercial construction starts by 12 to 18 months.  

Market landscape

The North American market for wallboard, ceilings, and complementary products distribution is highly fragmented as the top four firms (GMS, FBM, ABC and BECN) control 53% of the market while another 400+ firms serve the remainder. The entire industry generated $16 billion in net sales in the 12 months ended December 31, 2016, of which $13 billion went through specialty distribution (with the remaining $3 billion going to big box retailers, lumberyards, and other channels). GMS is the single largest specialty distributor in the space and controls 14.6% of market share in wallboards and 16.7% in ceilings.

The building materials distribution industry possesses modest barriers to entry for local operators stemming from the importance of local relationships and knowledge of local markets (explaining high fragmentation at local level) but higher barriers to entry for national operators given capital costs and the high-touch nature of customer relationships. For example, GMS owns approximately 500 trucks with articulating boom loaders designed for wallboard delivery, which cost $300,000 on average, and employs approximately 600 salespeople with technical expertise and local relationships. The company’s leadership position and superior scale afford it preferred purchasing terms which means it can typically offer its customers the lowest price points available.

While fragmented, the industry is trending towards greater consolidation with GMS and Foundation Building Materials (FBM) leading the way. GMS has acquired five firms in the past calendar year, and 25 since the beginning of FY2014. FBM was founded in 2011 by a private equity company (CI Capital Partners) and has grown aggressively, completing 23 acquisitions since the start of 2014. The company came public in February 2017. We note the two companies appear to take differing approaches to deal integration. GMS has a history of allowing newly acquired entities to continue operating under their existing name, while FBM has shown a tendency to consolidate their acquisitions under the FBM banner.

Suppliers

The supplier base is concentrated in both wallboards and ceilings. The number of US wallboard suppliers has declined from 12 in the 1990s to 7 today, 4 of which control 76% of the market. The ceilings market is even more concentrated with 3 suppliers controlling 95% of the market. GMS enjoys an exclusive relationship with Armstrong Ceilings in about 60% of markets, which by itself controls just over half the entire ceiling market. Brand-specific dynamics within the ceiling sector create recurring demand for branded repair and remodeling projects, which in turn drives recurring business for GMS, both from ceiling products and from other products that the contractor might need for other parts of the job.

Customers

The customer base is quite diverse with over 20,000 customers, the top 10 of which account for about 11% of sales, and the top 100 of which account for about 30% of sales.

Commercial and residential interior contractors account for approximately 92% of sales. Contractors use GMS because it provides valued easy delivery of bulky items via a large network of distribution centers and delivery trucks. This customer base tends to comprise small, localized firms with little pricing power. Furthermore, this is the customer base best suited to the “one stop shop” approach. GMS employs approximately 600 salespeople with technical expertise and knowledge of local markets who are instrumental in servicing this customer base. As GMS grows through acquisitions and enters new markets, maintaining this entrepreneurial culture will be key to preserving and growing these relationships.

Home builders account for approximately 8% of sales. This customer set comprises regional and national homebuilders who tend to have greater pricing power and offer smaller margins.

FIELD RESEARCH

Our field research indicates the company has built an inviting and entrepreneurial culture throughout its long history. Since the company was founded with the original single branch in 1971, the company has fostered good relationships with employees and encouraged ownership across the employee base. As a result, the company has a seasoned and long-tenured work force, with senior management averaging over 25 years in the industry and over 20 years of experience at GMS. Over the years, many of these employees have accrued meaningful positions in ownership of the company, as the organization states 70 employees together now account for ~20% ownership of existing shares.

We believe this entrepreneurial culture differentiates GMS as a potentially preferred purchaser for interested sellers. Additionally, GMS tends to keep the workforces of the newly acquired companies largely uninterrupted and intends to operate them under their previously existing business names. These are noteworthy attributes for many exiting business owners who are concerned about protecting jobs and the business reputation many have spent a lifetime cultivating. While price still remains a determining factor in nearly all transactions, a winning culture positions GMS favorably for sustained success on the acquisition front.

GROWTH

The growth algorithm consists of mid-teens topline growth consisting of 3 – 6% from end market growth, 1 – 2% market share growth from new greenfields, 1 – 2% from price gains and an additional 2 – 10% from bolt on M&A. GMS targets low double digit incremental EBITDA margins, and we note the company has produced double digit EBITDA margins several times in prior up cycles (2002, 2005 – 2007). We provide a further look into the critical sales drivers below.  

End market cyclicality

There are strong cyclical tailwinds to the US construction market following massive capacity destruction in the aftermath of the 2008 housing crisis. This is particularly true for the residential market, where housing starts have not yet returned to 1980-2000 historical averages

Existing market share gains and greenfield expansion

GMS has posted mid-teens topline growth for each of the past five years and has opened 25 new greenfield sites since the beginning of 2014. We believe one reason for this above-market organic growth is GMS’ “one-stop-shop” approach including over 20,000 SKUs. Finally, GMS recently completed the roll out of its Yard Support Center, which provides centralized back office functions and inventory management assistance for its various branches and subsidiaries. This should help the company further capitalize on economies of scale as it grows.

Commodity inflation

Price inflation in the gypsum wallboard industry has historically been quite volatile and was resurgent in in the early part of this year, following a brief deflationary period in early 2016. In 4Q17 GMS indicated gross margins would contract in the upcoming quarter which subsequently declined 0.75% year-on-year. The pinch occurred as a result of supplier price increases though management is well-versed in navigating these cycles and has since indicated the upward margin trajectory has resumed. Our base case assumes price increases in the 1-2% over the longer term and continued success in passing these costs along, aided in party by the company’s relatively high inventory turns at 7-8x per year.  

M&A

Sell-side analysts are constructive with eight of nine recommending an overweight or buy. As is standard with industry practice, analysts do not model for unannounced acquisitions, despite the company’s stated intentions to continue to do six to eight deals per year. The consensus revenue estimates for FY2018, for example, implies 11.3% net sales growth, which is in line with recent organic growth, yet barely half the 21.7% CAGR that net sales have realized over the past two years. GMS uses a fiscal year ending April 30, so their Q1 FY18 earnings have already been reported, and show strong 16.7% topline year-on-year growth. Consensus forecasts are for 12.3% year-on-year growth for the quarter ending October 31 and then fall to sub-10% year-on-year topline growth for the quarters ending Jan 31 2018 and April 30 2018.

GMS added a dedicated M&A team in 2016 and has continued to stress the importance of acquisitions to its growth strategy, so there is reason to think M&A activity will continue. GMS has already completed two acquisitions in the fiscal year beginning May 1 2017. The company typically pays 4 – 7x EBITDA post synergies for deals, which compares favorably to its recent trading multiple.

VALUATION

PROSPECTIVE RETURNS

Our Base uses a 9x multiple on FY 2018 EBITDA of $252.8M and implies a $40 stock for a satisfactory return of 18%. This assumes no multiple expansion and a deceleration in M&A from the $200M in acquired sales in both FY16 and FY17.

Our Bull case assumptions merely incorporate a continuation of the status quo. We note a 10x multiple seems easily achievable given peers’ multiples and growth profiles which implies a $50 price target. 

Finally, our Bear case reflects no further M&A and continued market growth. We note a true bear case would involve a downturn in the economy, negative market growth rates and a materially worse return outlook, but we held market growth rates constant in all scenarios in an attempt to highlight the importance and relative impacts of other drivers.

Note: TEV calculation assumes a static net debt figure of $593M and target price calculations assume 42.1M shares outstanding.

RISKS

Cyclicality. End markets are pro cyclical and subject to various macro factors.

    Wallboard pricing. The entire industry is experiencing cost inflation and GMS must navigate supplier price increases in a manner that does not compress margins. Historically, steadily increasing prices have been a positive for the company as they pass these increases along to their customers.

     Future M&A. To achieve the base and upside cases, the company will need to continue to find attractive acquisitions.

     Leverage. At 2.9x LTM EBITDA proforma for recent deals, leverage now resides at more manageable levels though should be monitored, particularly in the case of macroeconomic weakness.

Catalyst

         EPS reports & continued solid execution of above market growth. We believe there are upsides to both topline sales and margins. Analyst expectations for high single digit sales growth in 3QFY18 and 4QFY18 set a low bar relative to recent company performance. Concerns of gross margin compression earlier this year was likely misplaced and is expected to normalize throughout the year.

-          M&A. We expect deal flow to remain robust (6-10 deals per year, in line with last three years).

-          Higher wallboard pricing. Wallboard pricing is currently in an inflationary period and further manufacturer price increases appear likely.

-          Storm related repair work. Texas is the largest state by sales for GMS and storm repair activity is likely to drive continued work in the near term.