Description

I recommend buying GMS (GMS Equity). Originally known as Gypsum Management & Supply, GMS is the largest wallboard and ceiling distributor in the US. Benefiting from the wallboard pricing cycle and industry consolidation, EPS could grow from $3 in FY 2021 to $5 in FY 2024, which at 10x earnings would result in a $50 stock (+18% IRR from $30/share today).

Thesis

1. Wallboard pricing cycle

• The wallboard market has recently tightened due to housing strength. With housing starts increasing to 1.5mm, wallboard capacity utilization has improved from 75% to 90%.

• Wallboard prices have recently spiked. The industry’s October price increase was accepted (November wallboard PPI up +4% YoY, the first increase in two years). The industry recently announced a January price increase.

• GMS benefits from higher wallboard pricing. Sensitivity: each +10% increase in wallboard prices results in +14% EBITDA and +25% EPS growth. 

• Following the wallboard price increases, we estimate GMS’s EPS grows from $3 today to $4 in FY April 2022 (+25% above consensus $3.29) and $5 in FY 2024.

2. Industry consolidation
   

• The wallboard industry is consolidating from 4 large companies into 3. Foundation Building Materials (FBM Equity), the #2 wallboard distributor, was acquired by American Securities, a private equity firm, on November 15 for 8.5x EBITDA. One month later, on December 21, American Securities acquired Beacon's Allied interior business, the #4 wallboard distributor, for 11.5x EBITDA. GMS, the industry leader, currently trades for ~7x EBITDA.

• The FBM merger proxy, released on December 4, shows that 6 companies tried to buy FBM, including GMS. GMS could be acquired by one of the losing private equity bidders, or potentially merge with FBM after the Beacon Allied integration. The status quo is GMS continues rolling up mom & pop distributors, which has attractive returns.

• Coliseum Capital filed a 13-D in GMS on November 9. They could help accelerate industry consolidation. 

GMS is a small ($1.3bn market cap, $10mm ADV), under-followed company (1 Buy, 7 Holds, 0 Sells). With few publicly traded wallboard stocks since the acquisitions of USG and Continental Building Products, we believe the wallboard pricing cycle has been overlooked by the market.

GMS background

GMS is the largest US distributor of building interior products such as wallboard and ceilings.

• $1.3bn market cap, $2.2bn enterprise value, ~$10mm ADV.

• The company was founded in 1971 with one branch. After going public in 2016 with 160 branches, GMS currently has 262 branches with $3.2bn revenue and $300mm EBITDA.

• GMS distributes wallboard (40% of sales), ceilings (15%), steel framing (15%) and other products (30%, mostly insulation, lumber and ready-mix compounds).

• GMS is 45% residential / 55% non-residential. Wallboard is 75% residential; ceilings and steel framing are largely non-residential. 

Building interiors distribution is a fragmented market.

• GMS is the largest wallboard distributor with 15% market share (= 4bn sqft in a 28bn sqft industry). 

• The next largest distributors are $2bn revenue Foundation Building Materials (acquired by private equity in November 2020), ~$1.5bn revenue L&W Supply (acquired by ABC Supply from USG in 2016) and ~$1bn revenue Allied Building Products (acquired by Beacon Roofing Supply in 2018). 

• After the 4 national players are a long tail of 400+ small mom & pops that make up ~50% of the industry. They are slowly being consolidated by GMS, FBM and L&W Supply. 

GMS has been rolling up the industry.

• GMS has made 60+ small acquisitions. The acquired companies are locally run but benefit from GMS’s purchasing rebates. Like many distribution industries we follow (such as electrical equipment, roofing and insulation), the industrial logic for consolidation has increased in recent years due to supplier consolidation.

• Since the 2016 IPO, GMS has made ~30 small acquisitions for 56 branches and $600mm revenue. We calculate they paid $273mm for these deals, which represents 0.4x sales and 5x EBITDA (at GMS’s 9% EBITDA margins), well below GMS trading multiples of 0.6x sales and 7-8x EBITDA. These are attractive acquisitions.

• Their biggest deal was the $627mm acquisition of WSB Titan in 2018 for 9x EBITDA. Titan is the largest Canadian interiors distributor, but Canada’s housing market immediately rolled over. GMS recognized a $63mm impairment in the quarter ending April 2020. We like the acquisition, and even the price paid, but not the timing. 

• GMS also opens ~5 greenfield branches per year (+2% annual branch growth), expanding their geographical coverage outside of their Southeast origins. 

GMS has an attractive financial profile – it is a surprisingly good business! 

• EBITDA margins of 9%, above competitors 7% due to scale and efficiencies. EBITDA margin has increased by +200bps since IPO due to accretive acquisitions (Titan had 15% EBITDA margins, which added +110bps to company margins) and organic growth (10-15% incremental EBITDA margins). This is the business model every branch-based distributor shares: run more volume through the box!

• Gross margins of 32.5%. GMs have increased +60bps since IPO, the only distributor we follow where gross margins have been flat-to-increasing in an age of price transparency. 

• Inventory turns a consistent 7x per year (~50 inventory days) – these are fast turns of commodity products with little obsolescence risk. Tangible assets turn 2.5x per year, leading to good returns on capital. 

• FCF generation targeted at 40-50% of EBITDA, with 56% average since IPO (helped by 93% conversion in FY April 2020, which will be followed by ~40% conversion in FY April 2021 as they rebuild inventories). The company has ~110% EPS-to-FCF conversion – this business is very cash generative. 

• ROIC of 12%, up from 7% at IPO. Excluding the benefit of tax reform, we estimate incremental ROIC has been 16%, with an incremental ROE of 19% after 2x net debt / EBITDA leverage. Since they spend all their capital on acquisitions (minimal capex, no dividends or buybacks), this roughly ties to their acquisition returns (= 5x EBITDA after 22% tax rate = 6.1x EBITDA after tax => 1 / 6.1x = 16% ROIC). 

• EPS has grown +20% per year since the IPO. The stock has only returned +7% per year, as the P/E multiple de-rated from 14x to 9x, but over the long run the stock should compound at the rate of EPS growth / incremental returns on capital. With a large fragmented market, GMS has decades of acquisitive growth ahead of it. 

Wallboard cycle

Like most building products, wallboard was oversupplied from 2007-2020 – that’s a long time! 

• Wallboard (often called gypsum board or drywall) is used in residential new construction (40% of demand), residential R&R (25%), multifamily (10%), commercial new construction (5%) and commercial R&R (20%). Wallboard demand typically follows housing starts, see chart below.

• The industry was tight during the early 2000s housing bubble, which led to a wave of supply: capacity expanded from 30bn sqft to 40bn sqft, just in time for a -50% demand shock (from a peak of 36bn sqft in 2005 to a trough of 17bn sqft by 2010). Capacity utilization fell from 97% to 50%, and wallboard prices collapsed.

• The wallboard industry has been rationalized over the last decade: the number of companies fell from 8 to 6, plants from 76 to 63 and plant capacity from 40bn sqft to 34bn sqft (-15% capacity reduction).

• There were two pricing cycles in 2012 and 2017 as the industry bounced off the bottom. But with housing weakness in 2018, wallboard prices fell again in 2019, see PPI chart below.

The wallboard market has recently tightened due to housing strength.

• We estimate that wallboard demand has grown from 25bn sqft in 2019 (at 1.3mm housing starts) to ~30bn sqft run-rate today (at 1.5mm housing starts), which has tightened capacity utilization from 75% to 90%, typically the threshold for pricing power in a capital intensive industry. 

• Wallboard, along with fiberglass insulation, will be one of the main bottlenecks to the US housing market growing beyond 1.5mm starts. Without capacity increases, we calculate the wallboard industry will run at 100% utilization at 1.7mm housing starts. 

• The industry responded with price increases. The October price increase stuck, with November PPI showing prices up +4% YoY, the first increase in two years. The industry followed with +20% list price increases for January, of which we estimate +5-7% should stick as net price increases. 

• Wallboard being a cyclical commodity industry, the industry also responded with capacity additions. In October, Georgia Pacific announced it was tripling the capacity of a Texas plant – the plant would add +650mm sqft (+2% industry capacity expansion). But with two-year lead times, the plant will only “start production in late 2022”, which likely means 2023 after delays and ramp-up. Wallboard prices should stay high for years. 

Investors are overlooking the wallboard cycle because there are few publicly traded companies in this industry.

• Wallboard is a 6-player market: Knauf (private), CertainTeed (owned by St. Gobain, public European conglomerate), National Gypsum (private), Georgia Pacific (owned by Koch Industries, private), Eagle Materials (public US conglomerate) and PABCO (private). 

• With Knauf’s acquisition of USG in 2019 and Saint Gobain’s acquisition of Continental Building Products in 2020, there are no manufacturing pure plays left for investors to follow. 

• GMS and FBM benefit from wallboard pricing, but are under-followed companies due to their small size (GMS has $10mm ADV, FBM $5mm). With FBM now private, GMS has scarcity value as the only remaining wallboard pure play (unless you include Eagle Materials (EXP Equity) which is a cement / wallboard conglomerate, but has promised to spin off its wallboard business due to activist pressure). 

GMS benefits from higher wallboard pricing.

• With higher pricing, GMS can earn the same gross margin on higher revenue, leading to higher gross profit spread across a fixed SG&A base – this leads to margin expansion. 

• We estimate a +10% wallboard price increase would lead to +4% revenue growth (= wallboard is 40% of sales), +4% gross profit dollar growth (= flat gross profit margin), +14% EBITDA dollar growth (= fixed SG&A base) as EBITDA margins expand +100bps from 9% to 10%, and +25% EPS growth (= financial leverage). 

• GMS has benefited from prior wallboard pricing cycles. In FY 2014-2015, wallboard prices were up +21% and EBITDA margins expanded by +170bps; from FY 2018-2019, wallboard prices were up +6% and EBITDA margins expanded by +150bps (we estimate +40bps excluding the Titan acquisition). 

Wallboard Shipments vs. Housing Starts

Wallboard Capacity Utilization

Source: Gypsum Association

Gypsum PPI

Valuation

GMS trades at very low multiples.

• On consensus estimates for FY April 2021 (= current fiscal year, two quarters in), GMS trades at 9x earnings, 7x EBITDA, 11% FCF yield. We believe these are trough earnings: FY ending April 2021 includes the covid impacted FQ1 May-July 2020 quarter. The funky fiscal year might confuse people looking at their Bloomberg screens. 

• On our above-consensus FY 2022 earnings, GMS trades at 7x earnings, 5.5x EBITDA, 15% FCF yield, 12% unlevered FCF yield. We don’t see many double-digit FCF yield companies that are industry leaders, growing and gaining share in good end markets. 

• GMS has de-rated since its IPO. P/E multiple has fallen from 15x to 9x, average 10x. EBITDA multiple has fallen from 8x to 7x, average 7.5x. The group tends to trade on EBITDA multiples. 

• Wallboard distributors (GMS 7x EBITDA, FBM 8.5x) trade at discounts to roofing distributors (BECN 10x) and insulation distributors (IBP 11x, BLD 12x). Even though GMS has superior financial performance to BECN on almost every conceivable metric, we believe investors reward distributors within consolidated industries (the roofing market is twice as concentrated as wallboard, led by ABC Supply with 25% market share, BECN with 20% share; wallboard has GMS at 15%, FBM at 12%). 
  
  

Our FY 2022 earnings estimates are +25% above consensus. 

• We model +6% organic revenue growth (+5% wallboard volumes, -2% ceiling volumes; +6% wallboard price, +2% ceiling price), above consensus +3% growth. 

• With +100bp margin expansion (-10bp gross margins, +110bp SG&A margins) and +5pts M&A revenue ($100mm acquisitions at 0.7x EV / sales, which sell-side analysts never forecast), EBITDA grows +25% and EPS grows +35%. 

• Over the next 3 years, we forecast EPS grows from $3 in FY 2021 to $5 in FY 2024 (+20% annual EPS growth).

Our 3-year target price skew is compelling.

• Base case: $50 (+18% IRR), $5 x 10x. After the cyclical recovery in FY 2022, earnings grow +12% per year through FY 2024. +3% organic growth, +5pt M&A contribution, flat gross margins, +30bp SG&A margin expansion. P/E multiple returns to its 5-year average. (But we’d prefer $40/share in cash today, thank you). 

• Bull case: $72 (+34% IRR), $6 x 12x. The non-res cycle is better than feared, P/E multiple expands towards the high end of its historical range due to industry consolidation.

• Bear case: $27 (-4% IRR), $3 x 9x. Earnings don’t grow due to non-res headwinds and multiple doesn’t change – dead stock for 3 years. The present value of a dead stock for 3 years is ~$20/share today (-25% downside). 

EV / NTM EBITDA multiples

White = GMS; Orange = FBM

NTM P/E multiples

White = GMS; Orange = FBM

Risk factors

• Non-residential construction weakness. Non-residential construction has peaked and will decline for several years. GMS is 55% non-residential.

• Mitigant: We agree about non-residential volumes, but believe there is upside to non-residential product prices. Similar to the wallboard economics described above, GMS is seeing price inflation in steel framing (HRC steel is up from $500/t to $900/t), lumber (lumber futures are up from $400/ft to $800/ft), insulation (+8% price increase in January) and ceilings (GMS primarily distributes Armstrong ceiling products, which have +2% price increases every year). 

• Mitigant: If you are bearish non-res construction, you can hedge out this exposure directly by shorting Armstrong World Industries (AWI Equity), their ceiling supplier, which is a non-res pure-play trading at 20x earnings.

• Declining market share? Over the last 3 years (CY 2017-2019), GMS has grown organic volumes -100bps slower than the industry (+0.7% vs. +1.7% per year). They are a share loser. 

• Mitigant: GMS outgrew the industry by +200bps in CY 2014-2016 (+8.3% vs. +6.4% per year), and targets +200bps outgrowth going forward.

• Mitigant: ABC Supply’s acquisition of L&W Supply in 2016 was disruptive to the interiors distribution industry. L&W had been USG’s captive supplier – under third party ownership, L&W started carrying other manufacturers. Rather than fight for market share, GMS kept margins high and conceded share during 2017-2019. In 2020, GMS appears to have returned to market outgrowth, and management believes the ABC Supply disruption is behind them. 

• Wallboard manufacturer consolidation. Wallboard has consolidated from 8 to 6 suppliers over the last two years, with Knauf’s acquisition of USG and St. Gobain’s acquisition of Continental Building Products. Manufacturers will squeeze distributor margins. 

• Mitigant: Manufacturer consolidation is bad for small distributors, but could be positive for large distributors because it encourages distributor consolidation: mom & pop distributors are forced sellers when they can’t get best price out of USG and CertainTeed anymore. 

• Mitigant: Ceilings are a 3-player industry, yet GMS makes similar margins as wallboard distribution. Roofing and insulation are 4-5 player industries, but their distributors still have good economics: Beacon Roofing has 7% EBITDA margins in roofing, Installed Building Products has 13% EBITDA margins in insulation. 

• FBM sold for a low multiple. FBM sold for 8.5x EBITDA, far below historical wallboard distributor transactions (ABC Supply paid 13x EBITDA for L&W Supply in 2016, Beacon Roofing Products paid 14x EBITDA for Allied Building Products in 2018). FBM is 47% owned by Lone Star – they are selling at a “low” price because there is a bad outlook for the industry. 

• Mitigant: L&W Supply and Allied Building Products were acquired by roofing distributors who expected large cost synergies: BECN promoted the Allied acquisition as 8.7x EBITDA after synergies. FBM’s 8.5x EBITDA may be slightly low relative to historical transactions after synergies, but it is not like multiples have derated by -40% (from 14x to 8x). 

• Mitigant: Lone Star acquired FBM in 2015 for $0.6bn, brought it pubic in 2017 and is now selling in 2020 for $1.4bn – they got a good return. They may have been a forced seller as their fund expired, but we are concerned that none of the 4 private equity bidders were willing to pay higher than 8x EBITDA. 

• Mitigant: GMS is a better business than FBM, with higher margins and better organic growth, and has historically traded at a ~0.5-1x premium to FBM. At FBM’s 8.5x multiple, GMS is worth $38/share (+25% upside from $30/share today).

Catalyst

• Wallboard cycle. Does the January price increase stick?
• Earnings. Our FY 2022 estimates (year ending April) estimates are +25% above consensus, with beats every quarter, predicated on higher wallboard prices. 
• Industry consolidation. Does GMS benefit from FBM-Beacon disruption? Does industry structure benefit going from 4 to 3 (albeit with a long tail of mom & pops)? What do the losing private equity bidders for FBM do? 
• Activism. What does Coliseum do?