Description

Post-Merger Market Cap: $320MM

Post-Merger Enterprise Value: $420MM

Liquidity: NONE

Target Price - $15

Downside - $8

Note: HCAC, along with HCAC warrants, is currently very thin and will be difficult to purchase in public markets before the USI merger completes in late July. Presently, shares must be purchased accumulated via a crossing process with certain sell side institutions which should occur in late July, similar to an IPO. Liquidity should improve somewhat into the fall but HCAC will remain a thin name.

Description

HCAC is a SPAC in the process of acquiring USI, the third largest distributor and installer of insulation in the United States, behind TopBuild (BLD) and Installed Building Products (IBP). The insulation installation business is cyclical and revenue trends are highly correlated with US housing starts. USI also has a smaller business constructing home shells in Florida and Texas.

Thesis

HCAC is a SPAC buying a long held post-reorg from distressed debt holders where the public peers have appreciated substantially since the deal was signed, but HCAC remains behind due to the technicals of the SPAC process. Further, I am bullish on the peer group and I like the outright fundamental opportunity in the company being acquired. While I am typically skeptical of SPAC investments, the combination of interesting technical backdrop and my favorable opinion of USI’s peers overcame my SPAC-hesitancy.

From a technical trading perspective, HCAC is acquiring USI from a group of PE and distressed debt funds, most of whom acquired their equity via the bankruptcy process in 2009. While USI has been private for several years and the event is not as “classic” a post-reorg opportunity as some, this is still a liquidity event for a group who are not in the public equity business. The deal was negotiated in Q4/Q1 and priced at a slight discount to public peers, with the discount available due to the turbulent nature of Q1 markets (no chance of an IPO) and the requirement current USI shareholders find liquidity. While I am always hesitant to buy a post-reorg that took 6 years to return to market, it’s worth noting how long the housing recovery has taken and that USI only began to consider a public option once IBP shares had tripled following its 2014 listing. Since the DMA was signed in early April, IBP/BLD shares have rallied 20-30%. However, HCAC is underfollowed and has an effective cap at $10/share – like most SPACs, the majority of HCAC shareholders are merger arb funds with minimal interest in USI’s fundamentals. Once the merger is finalized in late July, I expect USI to close the gap versus peers, though the process may take several months to playout.

Further, I am bullish on USI’s fundamental prospects. Insulation installation/distribution is highly correlated to US housing starts, more so than most building product companies which are mainly remodel focused, and without the balance sheet risk of most homebuilders, who constantly reinvest FCF in land. Housing starts remain well below normalized levels and there should be a “catch up” from the downturn plus increased demand as millennials enter the workforce. This should drive housing start growth of at least 8% over the next 5 years, and the installers should see similar organic topline trends. Given their low incremental capex needs and incremental margins around 20% vs. current margins between 8-11% (USI at 10%), I believe the installers can grow EBITDA >15% organically. In addition, USI is an early stage roll up story, much like BLD/MAS was in the early-2000s and IBP still is.  The installation industry remains highly fragmented, providing a large runway for accretive tuck-in acquisitions, which could add another 10% to annual EBITDA and EPS growth. Despite the strong growth outlook, HCAC is pricing the acquisition at 13x 2016 EPS guidance and ~10x my 2017 EPS estimate – inline with where BLD/IBP were trading in Q1. HCAC will be ~2x levered, above IBP (1.5x) and BLD (0.7x).

Note: For a longer discussion of the housing bull case, please visit my 9/14/2011 VIC write up on US Residential Construction Equities.

Valuation

• Target Case – If USI can hit its guidance for 2016 and grow EBITDA 15% in 2017, plus ~$25MM in additional deals, HCAC/USI should earn $0.75 in 2016 and ~$1.00 in 2017. Assuming a 15x multiple, inline with BLD and a discount to IBP, despite a growth outlook more similar to IBP, yields $15.

• This corresponds with ~1.6x levered and EV/2017 EBITDA of ~9.3x

• The proxy has 2017 EBITDA guidance of $57MM vs. my $63MM estimate. The difference is acquisitions and that I believe those are conservative numbers. Hennessy put the numbers in the proxy, not USI, and USI management repeatedly has said they feel those numbers are beatable.

• Note: HCAC has ~35MM warrants for a half a share struck at $11.50, so as HCAC’s price increases, it weighs on my EPS estimates. At $15, it’s an ~13% dilution. Against that, I think IBP/BLD are buys and the USI should trade closer to IBP’s multiple given the inorganic growth story.  The warrants become a bigger issue if HCAC/USI trades closer to $18, but I’d call that a champagne problem that I’ll deal with if/when it happens.

• Downside Case – Assuming housing slows, USI misses their 2016 guidance by 10%, sees flat y/y EBITDA in 2017, and completes zero acquisitions, I reach $0.65 in EPS ($45MM in EBITDA). A 12x multiple yields $8.

• USI/HCAC would be ~2x levered and trading ~7.5x EBITDA

• My downside estimates encompass substantial slowing in housing trends and significant operational missteps

• Warrants Valuation – While thin, the 2020 warrants are currently trading ~$0.60, with an implied vol of 12 referencing a $10 HCAC price. I’m not going to speculate about what kind of implied volatility a thinly traded warrant will have in the future, but an IV of 12 is significantly cheaper than I believe is justified.

• I personally have expressed my investment via warrants.

Risks

• Housing Cycle Could Turn – HCAC/USI is highly levered to housing starts, plain and simple. If there is a serious deterioration in housing, HCAC’s operational and financial leverage would significantly weigh on its share price.

• Execution Missteps/Margin Difficulties – USI management has executed well on margins over the last three years, but topline has modestly trailed BLD/IBP organic growth. Part of this can be explained by regional differences, but some of it is likely due to PE/distressed holders pushing for higher EBITDA ahead of exiting. This could imply lower incremental margins heading forward.

• Bad Acquisitions – While management has executed well operationally, M&A is likely to be a key part of USI’s story going forward and management does not have a long history here.

• Against that, Chairman Dan Hennessy has an extensive background in M&A and invested in prior building product roll up stories (POOL, BECN)

• Low Liquidity Post Merger – HCAC stock is likely to remain thin post deal close. After the 180 day lock up for existing USI shareholders/sponsors, liquidity should improve modestly.

• Deal Falls Apart – With Trilantic now backstopping the deal, this seems unlikely. However, should the deal fall apart, HCAC would likely trade off at least 5% and the warrants off 50% or more.

Catalysts

• Deal Closing – Once the deal closes, the $10 implicit cap on HCAC goes away.

• Sellside Initiations – Unlike most SPACs, the chairman, Dan Hennessy, is well connected and has had success finding sellside coverage previously. His previous SPAC, BLBD, has four sell side analysts covering it despite a $250MM market cap. Further, BLD and IBP are both covered by several analysts who could easily pickup USI with minimal additional work.

• Continued Positive Housing Data

• Execution – Fundamentally and M&A – Put simply, if USI executes, I highly doubt shares linger at sub 10x EPS while EPS growing >20% and its direct peers trade at mid-teens or better multiples.

SPAC Process – A Background

For those unfamiliar, a SPAC raises cash, issues stocks and warrants, and searches for a deal. The appeal to an initial investor is 1) worst case you’ll get most (~99%) of your money back and 2) if there’s a deal, typically you can sell your warrants. Most initial SPAC holders are retail accounts and risk/merger arb funds who are running an IRR calculation on holding period. In the case of HCAC, getting your $10 back plus selling your warrants for $0.60 in under a year is a pretty nice IRR. The advantage for new investors post-deal is there’s a great deal of forced selling unrelated to the fundamentals of the company being acquired – in this case, I am sure many initial HCAC shareholders are thrilled to exit here. The downside is SPAC management teams get paid to do a deal, and they (very) often make lousy acquisitions and collect fees/sell their stock before the cracks show up.

HCAC/USI History

USI was formed in the late 1990s and pursued a rollup strategy of installers in the mid-2000s… right into the worst housing market in eighty years. Unshockingly, in an end-market down 80% environment, USI went through a pre-packaged bankruptcy, the old management team was kicked out, and the current management team brought in during 2011 and 2012. Unfortunately for the original distressed debt holders, the housing downturn has been prolonged and USI has remained private for the last six years with an ever shifting base of PE/distressed funds. At present, USI has 28 private owners. Given the ownership mix and the significant improvement in EBITDA in last few years, USI began exploring public options in August 2015… just in time for a down 15% stock market, making an IPO effectively impossible.

Around the same time, Dan Hennessy formed HCAC II following the success of his previous SPAC, HCAC I, which is now BLBD and has been written up on VIC several times. Dan has a private equity background and was a named partner at CHS, which ran ~$3B in PE funds over two decades. Importantly, CHS had invested in several early stage building product stories, such as BECN and POOL (and some blow ups as well), so USI was quickly brought to his attention in September 2015.

I give the timeline and background to explain why USI is an attractive deal, unlike the lousy, PE leftovers most SPACs end up buying. USI is a cyclical (but currently in a very, very strong upcycle) business with a hodge-podge of owners with different liquidity needs and investment mandates. They only began pursuing a public option once the business had rebounded enough to re-start the roll up story and the holders could get something resembling “fair value” for what USI should earn in a “normalized” environment. IBP was basically forced to go public to preserve founding family ownership… which caused the selling shareholders to miss an up 300% in two years. During the deal timeline, the markets have been volatile and the clear pubic peers have moved up and down 30% repeatedly. When the deal was finalized in Q1, 9x 2015 EBITDA didn’t look like a bad bid to hit, particularly given the inability to IPO. Dan Hennessy is also better than most SPAC creators. Whether you like or dislike BLBD, it’s not a crazy deal and the stock has generally worked since merger.

HCAC/USI Deal Process

USI/HCAC signed the deal in early April and marketed in May and June. Originally, the vote was scheduled for 6/29. However, HCAC/USI were having trouble finding new capital, as $200MM is a relatively large number to raise, not dissimilar from IPOing. Brexit didn’t help anyone. On 6/28, HCAC/USI announced that Trilantic, a PE fund, has agreed (“in principle”) to buy a majority stake in USI and backstop the deal, with the vote now scheduled for 7/21. The initial public float should be ~$75MM, which should improve once the sponsor/current USI shareholder lock up expires in late 2016.

Housing Macro

Any discussion of a cyclical industry should lead off with a detailed analysis of the relevant cycle. Having said that, I’m going to cheat. Numerous sellside and buyside publications have discussed the US housing bull case, and several years ago I posted a lengthy piece laying out my views, which I will simply reference again - https://www.valueinvestorsclub.com/idea/US_Residential_Construction_Equities/57111 . Since I posted that, housing hasn’t recovered quite as quickly as I expected – labor, credit, and psychology have all been a drag – but all that means is I am expecting a longer bull market. I think an 8% CAGR for starts over at least next few years is conservative.

USI Business Overview

USI operates two business segments, but the installation segment should be >90% of gross profit going forward so I will focus there. (The Construction Services segment is briefly discussed below.) USI is an installer and distributor of insulation. While insulation is sold into almost all new construction projects, ~70% of USI’s business is single family focused. Insulation installation is early in the housing start process – it is done between wiring/plumbing and drywall – and it is a one step process with no recurring revenues, thus USI is highly cyclical around new housing starts. Given USI’s size (~10% of industry) and that it competes against dozens competitors in a highly regional business, I do not expect market share gains/losses to materially impact sales growth.

The industry has the three large players, but most markets have many mom and pops competing. It’s a very local/customer relationship business – BLD/IBP still use the legacy branch name just to preserve loyalty. (“Nacrelli and Sons: A TruTeam Company.”) The presence of numerous competitors selling a commoditized service results in relatively thin margins. Against that, the business requires minimal capex – just a few trucks, some distribution centers – so incremental margins are strong. USI believes it can achieve ~20% incremental margins (22% on installation, 18% on distribution) going forward, which matches BLD and IBP guidance. BLD is the only national installer, while IBP and USI are more regional (but filing in the other regions via acquisition).

Unlike most building products, which are sold via a multi-step value chain, the three large insulation contractors (USI, IBP, BLD) buy directly from the OEMs. Importantly, insulation manufacturing requires high throughput to be profitable – picture a six story cotton candy machine melting glass at 3000°F. The need for bulk orders gives the large installers leverage over the OEMs in pricing discussions, and the smaller mom and pops are typically unable to go direct. The result is 1) modestly higher margins than typically seen in building product companies, 2) a more defensive market position for the larger installers, and 3) a very accretive roll up story for USI and IBP, as will be discussed below.

USI, IBP, and BLD are relatively simple, cyclical businesses that, due to the unique value chain, are modestly better than you’d at first guess. 90% of the model is getting housing starts correct.

Roll Up Story

The insulation installation industry is fragmented. While BLD, IBP and USI represent 33%, 20%, and 10% of the industry, respectively, the remaining 37% of the market is over a thousand independent contractors typically under $10MM in sales. Due to their small size, the businesses can typically be acquired between 4-6x EBITDA. Importantly, these acquisitions are highly synergistic for USI, as the newly acquired businesses immediately begin to purchase insulation at USI’s wholesale price. USI estimates it receives a 10% discount versus its typical acquisition, which results in an “overnight” ~25% boost to acquired EBITDA. Further synergies can be achieved by reducing footprint, combining branches, back office costs, etc. As USI is not yet national, they can acquire contractors in new markets that pose no risk of cannibalizing exists USI sales.

USI only re-started the roll-up strategy in Q1 2015 – the board previously would not allow it – which raises some yellow flags as to management’s ability to execute. For instance, USI “goes to market” as USI – they rebrand the acquired companies – whereas BLD/IBP leave the original name. However, the M&A story is less operationally intensive than most roll up stories. The majority of synergies come from the insulation purchasing advantage and most acquired companies are left basically intact – same employees, same location, same trucks, different sign and ownership. As long as management is diligent and doesn’t make bad initial purchases, the operational execution should be relatively simple. Further, we are not paying a “high probability roll-up story” multiple – IBP is trading 19x 2017 EPS while HCAC is trading 10x – which should leave room for minor execution hiccups.

Without acquisitions, USI should generate ~$20-$25MM of FCF in 2016 and 2017. If they can complete $25MM/year of M&A at ~5x multiple, that should add at least 10% to EBITDA growth with no additional interest cost. (USI guided to $50MM in 2016 EBITDA.)

Construction Services Segment

The Construction Services segment builds home shells for builders, primarily in Florida but also Texas. The business has some oddities – one customer is half the business and sales dropped 12% in 2015 (though EBITDA flat) due to an intensely promotional competitor. However, the CP segment is a small part of USI’s business. While 30% of sales, it is ~10% of gross profit dollars and should fall further. Importantly, the CP segment has minimal capex needs and no legacy contracts/costs that would prevent the business from scaling down if it runs into issues. The CP segment has only 80 employees and has never had an unprofitable month. Worst case scenario, the entire business drops 50% and is a 5-10% headwind for one year. I model the business flat going forward for conservatism.

Note: I am modeling acquisitions assuming 10% pre-synergy margins at acquired company, so $50MM in acquired revs yields $5MM in inorganic EBITDA growth. The underlying installation business I model growing 8% annually with 20% incremental margins.

Catalyst

• Deal Closing – Once the deal closes, the $10 implicit cap on HCAC goes away.

• Sellside Initiations – Unlike most SPACs, the chairman, Dan Hennessy, is well connected and has had success finding sellside coverage previously. His previous SPAC, BLBD, has four sell side analysts covering it despite a $250MM market cap. Further, BLD and IBP are both covered by several analysts who could easily pickup USI with minimal additional work.

• Continued Positive Housing Data

• Execution – Fundamentally and M&A – Put simply, if USI executes, I highly doubt shares linger at sub 10x EPS while EPS growing >20% and its direct peers trade at mid-teens or better multiples.