I am advocating NCI Building Systems (“NCS” or the “Company”) as a long investment for patient investors.  At over 15x LTM EBITDA and more than 19x FY 2014 EPS, this does not screen as “value” but my thesis is predicated on the Company’s strong strategic positioning and operating leverage to capitalize on the likelihood of a recovery in the non-residential construction sector. 

As a cyclical company operating within an industry near a 50-year low, one should not be surprised that the current multiple is high.  It would be more precarious to invest in a company at a low multiple when the industry is at its peak and on the cusp of a decline.  I believe the industry is near an inflection point in the cycle towards improving, albeit slowly, and NCS is well-positioned to capitalize at a higher margin, on a lower cyclical industry peak, based on management’s restructuring of operations.  During the past four fiscal years in what management has described as the “perfect storm”, EBITDA margin averaged only 4.2%.  In the previous ten fiscal years, notably an overall better industry environment, the Company’s margin averaged almost 12% (ranging from 9.3%-15.6%, a median of 11.3%).  In only one (2010) of the past fourteen fiscal years did NCS generate negative operating income. 

Based on management’s forecasted EBITDA of $200M to be generated during a more “normalized” level of non-residential construction activity at 1B sf, NCS is currently trading at ~5.5x 2016E EBITDA.  Since the business is not capital intensive (capex averaged 2% of revenue since 1999 and maintenance capital is $11-12M), the implied FCF yield is also attractive if the $200M level of EBITDA is achieved.  In thinking about potential upside for the stock in a couple of years, I assume ~$100M of FCF is generated through mid-2015 and apply a 7x multiple to management’s forecasted 2016 EBITDA to arrive at a $17.35 target.  As a cyclical investment play, I anticipate there will be volatility to Company results and the stock price that could provide opportunities for “trading around” the position.              

To the extent the non-residential construction sector moderately improves from what is currently more than a 50-year low, NCS should be a substantial beneficiary.  In exploring potential derivatives that might benefit from the nation’s recent housing rebound, I found the historical 12-18 month lag for improvements in non-residential construction derived from improvements in residential construction to be compelling.  I believe NCS is an attractive investment to capitalize on the likelihood of improving non-residential construction trends.  Since there is a large equity overhang (over 72%) held by a private equity investor, described in more detail below, I believe a secondary offering looms as highly likely and therefore I intend to size the position gradually.  However, I am currently invested and am advocating the investment now as I envision that Q3 and Q4 results will be strong and provide the market with further validation that NCS is well-positioned to capitalize upon an improving level of non-residential construction activity.

Management has spent much of the past five years streamlining infrastructure and driving efficiency improvements that boosts the likelihood for achieving $200M of EBITDA when non-residential construction starts improve to 1B square feet, a level of activity that is more than 25% below the industry average for 1967-2008 but ~33% higher than the depressed activity in 2012.  In addition to being substantially less than the trend line average (~1.3B square feet), the domestic non-residential construction put into place last year (~750K square feet) was well-below cyclical lows in the past fifty years.  The most recent cycle highs of ~1.875B sf and 1.69B sf were generated in 2000 and 2007, respectively.

The improvement to the Company’s operating leverage is primarily as a result of management’s aggressive cost reductions that began in 2009.  Right-sizing and retooling implemented by management over the past several years has generated approximately $700M in costs being reduced, partially through rationalizing headcount by 40% and from consolidating manufacturing plants.  Management took ~$120M in fixed costs out of the business ($88M from the engineered building segment) and another ~$560M in variable.  Management recently communicated in its annual letter that “our operating leverage has been greatly improved by our ability to keep the $121M in fixed costs that we cut in 2008 and 2009 from seeping back into our cost structure.  This means that any modest incremental increases in volume should have a solid positive impact on our operating results in the near term.”  In that same letter, management reinforces its confidence to achieve, largely based on initiatives to improve its margin, an “intermediate objective of producing $200M in adjusted EBITDA in a nonresidential market of 1B sf.  The last time we reached that level of profitability was in a market of 1.4B sf of new construction, which gives you a good idea of the magnitude of our improved operating leverage.”

Also adding to the likelihood for better results under a moderate improvement to non-residential building starts, the metal buildings industry should benefit from a more rational pricing environment as the top three industry players control ~80% of the market.  Furthermore, the industry downturn from 2008-2010 drove a reduction to industry-wide engineered building capacity by ~25%, a majority of which will not likely return.

NCI Building Systems, founded in 1984, is one of North America’s largest integrated manufacturers of pre-engineered metal building (“PEMB”) systems.  The Company currently operates thirty-seven manufacturing facilities located throughout North America operated in an efficient “hub-and-spoke” network.  An affiliated builder network and architectural relationships provide substantial and extended channels to market. 

PEMB systems have garnered favor in the past several years because of shorter construction times (most work done in the fabrication facility), more efficient materials utilization, lower construction costs (less skilled labor required on-site), and lower maintenance costs.  Engineered steel construction is the norm in today’s domestic low-rise non-residential construction market.  Almost every school, hotel, retail, strip center, big box retailer, car dealership, gas station, fast food restaurant, self-storage, and low-rise R&D or office building that is erected today has an engineered building system at its core. 

The Company operates across three integrated business segments and each segment maintains a market position as either first or second.  Based on management estimates, the Company’s Engineered Building Systems is the largest producer of metal building systems with ~28% share, its Metal Components segment is the largest producer with is ~12%, and the third segment Metal Coil Coating is the second largest coil coater company in North America with ~40% in heavy gauge hot rolled steel and ~11% in light gauge coil.  A summary description of each segment follows below (note segment EBITDA mix excludes corporate costs of ~$47M):

Engineered Building Systems (54% of FY’12 Revenue, 42% of FY’12 EBITDA)

The engineered building systems segment provides its customers with custom designed, engineered, ready-for-assembly primary structural framing, secondary structural members (purlins and girts) as well as metal roofs and walls.  The segment’s focus is on low rise markets such as self-storage mini-warehouses.  NCS’ engineered building systems segment operates through numerous brands including A&S Building Systems, Metallic, Heritage Building Systems, Steel Systems, MESCO, All American Systems, Garco, Robertson, and Ceco Building Systems.  NCS markets its building systems through an in-house sales force to an authorized builder network of over 3,400 builders/dealers.  Many of the Company’s builder relationships approximate thirty years.  While some of its relationships are not exclusive, NCS garners over 90% of what its network spends on engineered buildings.  The building systems are also sold to general contractors and directly to end users.  NCS is able to support its extensive builder network with competitive pricing because of its hub-and-spoke delivery system.   

The Company’s share in this segment is ~28% and they primarily compete with BlueScope Buildings and Nucor Building Systems; management estimates the market share for each competitor is 25%.  BlueScope acquired Butler in 2004, and Nucor acquired American Buildings (Magnatrax) in 2007.  At the end of Q2, NCS’ building systems utilization was ~55%.  Summary financial performance for the Engineered Building Systems segment is shown below:

($M)                ’03       ’04       ’05       ’06       ‘07       ’08       ’09       ’10       ’11       ’12      

Rev                  297      414      452      782      980      1066    523      477      530      626                 

EBITDA         24        40        54        83        130      122      29        1          28        52

Margin %        8.1       9.8       11.9     10.7     13.3     11.4     5.6       0.1       5.2       8.3

Metal Components (39% of FY’12 Revenue, 37% of FY’12 EBITDA)

The metal components segment provides its customers with roof and wall systems with specialized product lines such as insulated metal panels and standing seam roof panels for architectural and commercial/industrial applications.  Products include secondary structural members, roll-up doors, and interior partition systems. 

NCS’ metal components segment operates through numerous brands including Metal Depots, DBCI, ABC, and Metl-Span which the Company acquired in mid-2012.  The $145M acquisition of Metl-Span catapulted NCS into the insulated metal wall and roof panel business, a capability growing in importance as energy costs rise. 

The Company’s share in the metal components segment is ~12%.  This industry segment is relatively fragmented with market share across the competition ranging 4-7% from Metal Sales, Centria, McElroy, Kingspan, Fabral, and Firestone; other industry players comprise the remaining 56% share. 

Summary financial performance for the Metal Components segment is shown below.  Note that internal volume comprised 19% of FY’12 tonnage but external revenue is shown below.  During FY’12, as a percent of the Company’s tonnage volume, external commercial/industrial comprised 61%, external agriculture comprised 18%, and external retail comprised 2%.

($M)                ’03       ’04       ’05       ’06       ‘07       ’08       ’09       ’10       ’11       ’12      

Rev                  473      548      567      671      562      600      389      328      354      447                 

EBITDA         55        83        86        102      60        92        46        37        30        46

Margin %        11.6     15.1     15.2     15.2     10.7     15.4     11.8     11.2     8.4       10.3

Metal Coil Coating (7% of FY’12 Revenue, 21% of FY’12 EBITDA)

The metal coil coating segment cleans, treats, and paints flat rolled metal coil substrates.  NCS’ other two segments—engineered building and metal components--use over 50% of this segment’s production.  During FY’12, as a percent of the Company’s tonnage volume, external construction comprised 31%.  The remainder (~18%) was used by other manufacturers of metal components and painted metal goods, such as the appliance industry, for light fixtures, walk-in coolers, and HVAC systems.  NCS’ metal coil coating segment operates through brands Metal Coaters and Metal Prep.  The Company’s share in this segment is ~40% in heavy gauge hot rolled steel coating and ~11% in light gauge coil coating.  In heavy gauge hot rolled steel, NCS leads the industry segment; the competition includes Hanna Steel with 24% share, Midwest Metal Coaters with 17% share and SDI with 12% share.  In light gauge coil coating, NCS is second, well-behind 45% market share leader Precoat Metals at 45% share.  Other competitors include SDI with 9% share and Steelscape with 8% share.  NCS is the only metal coil company that can provide localized service to every major manufacturing region of the United States. 

Summary financial performance for the Metal Coil Coating segment is shown below:

($M)                ’03       ’04       ’05       ’06       ‘07       ’08       ’09       ’10       ’11       ’12      

Rev                  127      123      111      118      84        97        53        65        75        81                   

EBITDA         26        31        25        30        32        39        13        21        23        26

Margin %        20.5     25.5     22.9     25.9     37.9     39.9     24.3     32.8     30.0     31.7

A summary of the Company’s financial results since 1999 follows below:

                                                            EBITDA                                 EBIT                           CapEx %

            Revenue          EBITDA         Margin             EBIT               Margin             CapEx of Rev

1999    $937M             $146M             15.6%              $120M             12.8%              $33M   3.6%

2000    $1,018M          $154M             15.1%              $125M             12.3%              $29M   2.8%

2001    $955M             $105M             11.0%              $80M               8.4%                $15M   1.6%

2002    $953M             $100M             10.5%              $71M               7.5%                $9M     1.0%

2003    $898M             $84M               9.3%                $57M               6.3%                $18M   2.0%

2004    $1,085M          $128M             11.8%              $97M               8.9%                $9M     0.9%

2005    $1,130M          $138M             12.2%              $104M             9.2%                $20M   1.7%

2006    $1,571M          $176M             11.2%              $138M             8.8%                $27M   1.7%

2007    $1,625M          $176M             10.8%              $132M             8.1%                $42M   2.6%

2008    $1,763M          $201M             11.4%              $159M             9.0%                $25M   1.4%

2009    $965M             $45M               4.7%                $5M                 0.5%                $22M   2.3%

2010    $871M             $16M               1.9%                ($20)M            (2.3)%             $14M   1.6%

2011    $960M             $36M               3.7%                $2M                 0.2%                $21M   2.2%

2012    $1,154M          $77M               6.6%                $35M               3.1%                $28M   2.4%                           

Like many industries and numerous good companies, the metal construction industry and NCS in particular confronted severe challenges in 2009.  As the economy slowed precipitously during the second half of 2008 and early 2009, the Company saw building orders decline by 60%.  During 2010, the industry saw just 635M sf of non-residential construction.  To put that in perspective, in the prior 12 of 14 years, there was ~1.4B sf of new construction.  Moreover, through every recession in the previous 41 years until 2009, the U.S. economy supported ~1B sf in new construction. 

In addition to industry challenges, NCS had debt that was maturing in November 2009.  To address its liquidity challenges during a period of economic turmoil, the Company signed an agreement with Clayton, Dubilier & Rice (“CDR”) in August 2009.  CDR invested $250M in exchange for a 12% PIK convertible preferred stock that resulted in an as-converted ownership interest of ~68.5%. 

The highly-dilutive deal with CDR, which was completed on October 20, 2009, was essentially a pre-packaged bankruptcy that refinanced the looming term loan and modified the terms and maturity of the remaining $150M of debt.  Effective May 14, 2013, the CDR preferred was converted into 54.1M common shares (~72% of current outstanding shares).  CDR’s $250M investment has compounded at over 25% and it is highly likely that after four years, CDR will be seeking some liquidity through a secondary.  Although that overhang might provide a challenge to the stock’s near-term appreciation, I believe the increased float will improve the stock in the medium term.  It should be noted that the conversion created a technical sell-off at the end of May when NCS no longer met requirements for inclusion in the S&P Small Cap 600 Index because the Company’s public float fell below the 50% requirement threshold.  From the date of the index change announcement on May 22^nd to the end of May, trading volume was ~5x the prior daily average.  At some point when CDR’s interest is back below the 50% threshold, one could infer the benefit of a technical buying catalyst for index inclusion.    

NCS is well-positioned to benefit from modestly better business conditions

Based on restructuring and investments in automation and systems, the Company’s operating leverage is much improved and therefore NCS will greatly benefit from modestly better business conditions.  NCS management has modified headcount and rationalized facilities without compromising the Company’s emphasis on customer service.  In short, management has learned to do more with less.  Management believes it will generate a higher level of EBITDA when the non-residential sector generates 1B sf of activity than when the industry was at 1.3B sf several years ago.    

To improve operating leverage in Building Systems, manufacturing facilities were reduced from 15 to 8 and headcount was reduced by over 40%.  Management reduced cycle time and costs through centralization and standardization of manufacturing, engineering and drafting across all its building brands.  The current engineered building facilities are significantly more automated than they were five years ago.  Before the operational restructuring, all twelve of NCS’ engineered building brands had their own individual drafting software and CAD/CAM system.  When the industry and therefore NCS order activity was strong, engineering and drafting were often bottlenecks.  Management believes those issues are now solved based on all brands currently being on a common system, and in the past several years, engineering and drafting costs are down 35% per ton. 

To improve operating leverage in the Components Group, manufacturing facilities were reduced from 22 to 18 and headcount was reduced by over 35%.  The Company expanded its insulated-panel capabilities and product offerings through the retooling of its manufacturing facilities located in Mattoon, IL and Richmond, VA. 

In metal coiling, a significant contribution is envisioned from the refurbishment of the plant in Middletown, Ohio.  During 2010, the Company opportunistically acquired the Middletown plant, which was shut down since 2007, and converted it into a state-of-the-art light gauge coatings facility.  By extending its footprint to this new geography, the Company is now able to capture new business while concurrently freeing up capacity in other facilities.  This should enable NCS to increase its light gauge coil coating share from 11%.

Initial production began in Middletown in late December 2012 and has ramped throughout 2013 but is not anticipated to contribute to NCS’ bottom line until Q4 of 2013.  Management believes an incremental $35M of annual revenue will be generated from the Middletown plant which NCS acquired for $5M and modernized for another ~$8M.  Management estimates that replacement value for the 170,000 sf facility is $60M.

The operating leverage from current utilization levels is meaningful as demonstrated by management’s comment regarding the less-than-expected revenue generated in Q2.  Management said an additional $4.3M of operating income would have been generated in Q2 on $17M of additional revenue that was expected.  That $17M of revenue did not materialize in Q2 as a result of a slower release of work from the Company’s backlog which management ascribed to bad weather preventing site preparation. 

Likelihood of a recovery in the non-residential construction sector

At just 753M square feet, 2012 marked the fourth consecutive year of depressed non-residential markets, during which, new construction starts measured less than 800M square feet, more than 20% below any recession in the past four decades.  It was ~45% below the average new construction starts of the previous cycle of 2004-2007.  But non-residential construction appears to be recovering, albeit slowly, from what many have characterized as a “depression”. 

The industry average for 1967-2008 was a pace of 1.35B square feet.  The American Institute of Architects (“AIA”) forecasts growth of 2.3% in 2013, moderating from almost 6% in 2012, but then accelerating growth of 7.6% in 2014.  Current forecasts from McGraw-Hill Construction are growth of 2.1% in 2013 followed by growth of 8.5% in 2014.  IHS-Global Insight is forecasting growth of 1.6% in 2013 followed by growth of 9.7% in 2014. 

Through midyear, the AIA’s Architecture Billings Index (“ABI”) had shown growth in design activity for 10 of the past 11 months, with strong growth in inquiries for new project activity over the past several months.  Since design activity typically leads construction activity by an average of 9-12 months, the recent growth in design billings points to healthy gains in future construction levels. 

According to the AIA, billings at commercial/industrial firms have begun to accelerate after a soft spot in late winter.  Billings at institutional firms have increased every month for the past eleven months, an encouraging sign for construction in these categories.  Non-residential vacancy rates have recently been declining to levels that support demand in new construction.  The Dodge Momentum Index posted significant increases in expected commercial building activity and is at its highest level since 2008.  However, the path to growth will not be linear and one element of certainty is there is no guarantee that the sector will in fact grow.  Nevertheless, based on historical correlation and trends, the likelihood for growth is positive.

The July 2013 Federal Reserve Senior Loan Officer Survey showed banks easing their lending policies for commercial/industrial and commercial real estate loans as well as experiencing stronger demand for such loans over the past three months.  Note that correlation of real non-residential (structures) investment to the Fed Survey is 0.73 since June 1990 (source:  MKM Partners) so the favorable survey is likely positive for the outlook in the non-residential construction industry and therefore to NCS as well. 

Based on increased quoting activity, higher backlog, and current shipping schedules, management has articulated an optimistic outlook regarding a non-residential construction recovery, albeit slowly in the shorter-term.  At the end of the second quarter, NCS’ backlog was up 10% in volume and 6% in value compared to prior year second quarter.  The backlog provides at least six months of “good visibility”.  Management said it envisioned adding shifts to meet increased demand in the building systems segment so one can infer utilization is improving substantially from the ~55% at the end of Q2.

Signs of improvement at NCS despite lackluster industry environment

Given the more than 50-year low in non-residential construction activity, NCS’ operating and financial metrics are far below historical levels but the Company has generated substantial improvements derived from management’s investments in manufacturing, engineering, and supply-chain operations.  Although 2012 was the fourth consecutive year of a depressed non-residential construction market, at NCS, volume increased 15% and revenue increased 20% from 2011 levels.  As evidence of the substantial operating leverage in the business, gross margin increased by 130 basis points while EBITDA more than doubled to ~$77M.  During the first quarterly call in 2013, management stated an expectation in additional year-over-year gross margin improvement of 100-200 basis points in both the third and fourth quarters of this fiscal year.  NCS reports in the upcoming week and results will provide visibility if the trajectory of recent and envision improvements is on track.

Management team is aligned to drive shareholder value

In 2012, the management team’s incentive structure became almost entirely weighted to share price appreciation.  This was a modification from a restricted stock incentive program.  The revised incentive program vests in June of 2015.  Management gave up their restricted stock for 2012, 2013, and 2014.  The new program is based on the market price of the stock.  For example, at a price of $17, management would achieve parity with what they gave up in 2012, 2013, and 2014 restricted shares.  At $20, management would garner the benefit of over 1M shares and at $30, the benefit would exceed 3M shares.  At $10, the management team receives nothing from the incentive program.  The top five executives own ~2.1M shares in total; the CEO owns ~925,000 shares.  Three directors purchased a total of ~$150,000 in stock in June/July at ~$14.80, on average.

Selected Risk Considerations

Although there is a historical trend of non-residential construction recovering pursuant to a recovery in residential construction, as already witnessed, it is possible that the persistency or magnitude of the trend will not follow the most recent residential construction recovery.  One key structural difference from prior years is that a more technologically-driven economy (e.g., more e-commerce) might marginalize the need for some non-residential construction that would have been constructed in the past without the growth in e-commerce.  Furthermore, construction activity is highly correlated, at ~0.85, to GDP so a strengthening economy is most likely a necessary tailwind as well.  I believe this issue is somewhat mitigated by the substantial operational restructuring that management implemented.

One area of ongoing challenge within non-residential construction is education facilities.  With fiscal problems continuing to confront state and local governments, and relatively weak demographic growth in the student population, spending on education facilities was flat in 2012 and conditions are not expected to improve in 2013.  AIA forecasts that growth across education facilities will improve in 2014 to almost 5%, below their overall 2014 forecasted growth of 7.6%.

The Company’s largest cost is steel.  Since steel represents ~70% of cost of goods sold, market price fluctuations can create volatility in profitability and working capital.  While cost increases can be passed through relatively easily in the components and coiling operations (being short cycle), the price relief typically lags in the engineered building systems by one to two quarters.  During fiscal year 2008, steel prices increased by over 80% and then plunged by almost 60% by June 2009.  This volatility in steel is partially the reason that FCF as a percentage of EBITDA was 8% at NCS in FY2008 and then 163% in FY2009.

Of course the surge in U.S. bond yields is another consideration as witnessed by the decline across the homebuilding stocks recently.  However, I think this risk is somewhat mitigated by the ~50-year industry low and the historical trend for non-residential activity to follow residential by 12-18 months. 

Also as described above is the CDR overhang risk.  It should be expected that a secondary looms.  I expect Q3 results will be strong, the stock should appreciate on such followed by two investment conferences that management is attending which will reinforce many of the points I highlight for being bullish.  I assume a secondary will be announced soon afterwards but that should provide for the next leg of appreciation as results exhibit a healthy trajectory pursuant to Q4 results.  I of course have noted that much of this thesis is predicated on the improvement to the non-residential activity and if that does not materialize as envisioned to 1B sf, then my thesis will be marginalized.