Value Investors Club / PGT (PGTI)

Description

Thesis:

PGT manufacturers and distributes both impact-resistant and traditional windows with sales concentrated in Florida, but steadily moving up the East and Gulf coasts. The company is characterized by high operating margins (22.3% in most recent quarter), a commanding market share (67% of impact-resistant windows in Florida, 50% nationally) and rapid growth (51% sales CAGR since 1999 for the flagship WinGuard product) We believe the growth is not necessarily linked to new home construction in Florida (see table below). It is a product replacement story similar to getting rid of the 8-track player in your classic 1975 Pontiac vs. buying a new car. We also don’t think people will stop moving to FL or buying new houses—only that prices will drop. Many homebuilders, such as Lennar, are actively lowering prices to maintain volumes. PGTI has large brand recognition (100% among building professionals in Florida). Sure Anderson Windows or others could aggressively enter the market—but they could also buy PGTI. There are no unions, manageable debt, and the company has a spectacular inventory turn rate—23 days vs. an average of around 70 days for other large-cap building products companies.

There are three main products: WinGuard (impact-resistant branded product), non-WinGuard (mainly aluminum non-impact resistant product) and Multi-story (impact resistant windows for taller apartment buildings). The sales mix in 2Q was 66% WinGuard, 28% non-impact and 6% multi-story. We expect WinGuard and Multi-story to increase to 77% and 8%, respectively by 4Q07.

WinGuard sales were up 77% y/y in 2Q06 and 71% in ’05 (verses -28% and +2%, respectively for new home sales in Florida) and have had a CAGR of 51% since ‘99. In our model, we have sales of these windows going up only 30% in ‘07 – this seems to be very conservative considering 42% of sales were remodel (vs new home construction) in 2Q. Remember, since new home construction has been booming in Florida for the past couple of years, there is a backlog of remodel projects (especially with all the hurricane damage) as people have put these off these projects due to unavailability of labor, materials, etc because of the new construction boom. The percentage of remodel in 2Q is up from 39% in 2005, but has historically run at 45%.

Impact Resistant Market Consistently Outgrows Housing Starts:

Active impact-resistance (shutters) still represents 80% of the impact-resistant market nationally with impact-resistant windows (passive) representing the other 20%. In Florida, PGT controls 67% of the passive market meaning they have 13% of the total impact-resistant market. We believe the windows share of total will continue to go up as the windows are more aesthetically pleasing, easier to maintain (shutters have to be opened and shut for every hurricane – very difficult if it is your vacation home), and cost approximately the same.

In Florida, insurance companies will only give discounts for shutters or impact-resistant windows and these discounts can be up to 62% off of your premium – a compelling incentive to install new windows on your existing home or use impact-resistant ones on your new home. By January 1, 2009, you will not even have a choice whether or not to install impact-resistant windows or shutters – the code will dictate that all homes in certain wind zones (most of Florida) must have either impact-resistant windows or shutters.

WinGuard sales increased to 66% of total sales in 2Q06 from 56% in 2005. This is important because 1) WinGuard is much higher growth and 2) WinGuard windows have a gross margin of 45-50% versus mid-20s for the regular aluminum windows. We project the non-WinGuard sales to decline 20% next year.

An unrecognized part of the story is multi-story windows, which had sales improve to $11.6M in 1H06 from $2.6M in 1H05. These windows have a low 40s gross margin. PGT estimates the market for these windows is $350M annually and they believe PGT will only do about $25M this year. Currently, they can only manufacture windows for buildings up to 10 stories, but are introducing a product line in 4Q that can be used for buildings taller than that. It appears analysts are ignoring the benefit of multi-story as they don’t even break out the revenue line in their models (lumped in w/ non-WinGuard windows, which are expected to decline).

One last application of the windows is for security and noise prevention. PGT currently markets these windows to homes that are near airports because they are much more effective at muffling noise than regular windows. In addition, these windows can be used for security reasons. In one case, a customer of PGT wrote a letter to the company saying how burglars had tried to throw cinder blocks through the sliding glass PGT door and finally gave up and ran off because they could not penetrate the glass.

Risks:

The bear case is that 88% of sales come from Florida and housing starts have declined close to 50% in Florida. While the concentration is a risk, it is also an opportunity as we believe a lot of the company’s growth will come from outside of Florida. The adoption of more strict building code up the East Coast is a tremendous opportunity. Florida is obviously the forerunner in adopting strict building code, but other states are slowly following suit (while the Caribbean and Mexico have obvious insurance savings-related drivers). PGT helped write the actual code in Florida and they are sending representatives to other states such as Louisiana, Mississippi, Georgia and the Carolinas to help those states accelerate the adoption of relevant building codes. (Something called the International Residential Building Code sets the standards which all states usually adopt in 3-4 years; the most current edict is similar to the FL code). In January 2007 GA will adopt the above code and it has also been adopted in the costal areas of the Carolinas and Long Island. PGT began an advertising campaign that stretches all the way up the East Coast to Long Island in July and this should start to become a bigger contributor to sales going forward. The only negative to the code changes is panhandle FL (separate governing body) elected to retain less stringent standards than peninsula FL.

Quarterly update:

June was PGTI’s first quarter as public company. Not only did it blow away the estimates on all lines, it beat the estimates for Q4 2007.

We believe this quarter should also be better than estimates given our channel checks and conversations with several sell side analysts. We are hearing that sales are better from both the traditional and WinGuard channels. The company is also saying that penetration into LA and Mississippi is going faster than expected (diversifies the FL exposure.)

The price of aluminum is also falling – 60% of COGS is materials, with aluminum making up the majority of the cost. When the company did the IPO, the price of Aluminum per ton was $2,600 (and estimates have $2,450 embedded) and the company was hedged at approximately $1,900. Today, aluminum is $2,300 which adds 50bps to margins and $0.06 to our 2007 EPS.

We’re also hearing that a large national homebuilder is close to securing a sizable contract directly with PGTI (despite national homebuilders representing 15% of total revenue, nearly all sales are now done through suppliers).

Valuation @ 10/6/06 $12.91 close:

7.8x our ’07 EPS estimate = $1.66

8.5x ’07 consensus EPS = $1.52

8.8x our ’06 EPS estimate = $1.46

10.3 ’06 consensus EPS = $1.25 ($0.24 in 1Q & $0.47 in 2Q implies $0.54 2H06)

EV = 5.4x our ’06 EBITDA estimate = $97M

EV = 4.5x our ’07 EBITDA estimate = $116M

Our Price Target is $25 or 15x our 2007 estimate of $1.66, which we believe is conservative. There is no reason why PGTI should not trade at the high end of peers.