PGTI Background

PGT, Inc. is a leading manufacturer and supplier of residential hurricane impact-resistant windows and doors in Florida.  PGT was founded in 1980, and essentially pioneered the impact-resistant window in Florida after Hurricane Andrew devastated Dade-county in 1992.  Its impact-resistant products are marketed under the WinGuard, PremierVue and PGT Architectural Systems brand.  PGT offers the broadest line of impact-resistant windows/doors in the market, is a leader in the impact-resistant market (~60% share), and is over 5x the size of the next largest regional competitor.  In Florida, the WinGuard brand is to impact-resistant windows as Kleenex is to tissue.  Impact-resistant windows and doors (“passive” form) satisfy stringent building codes in hurricane-prone coastal states and provide an attractive alternative to shutters and other "active" forms of hurricane protection.  We estimate over 60% of Florida households live in “code-mandated” areas in Florida.  PGTI participates in both repair-and-remodel (70% of revenues) and new construction market (30% of revenues) in FL

Code Legislation Background

Since Hurricane Andrew devastated Miami in the early 90s, FL began to implement building codes which require window/door protection along hurricane-prone zones.  .  Residential homeowners are required by law to have protection, albeit “protection” can vary from “passive” impact resistant windows (i.e., WinGuard) to “active” protection (shutters / plywood boards which are installed/removed before/after a storm).  While theoretically 100% of building code areas should have “protection”, it is estimated that passive windows (i.e., WinGuard) have a 27% penetration of the coded addressable market (estimate over $1bn – and growing).  While building codes have existed since the late 90s, enforcement had been limited; conversations with local industry experts suggest enforcement became meaningfully more rigorous post significant hurricane activity in the Gulf during 2005 (Katrina, etc).  The latest code “2010 Florida Building Code” was implemented in 2012 (i.e., this is a really nascent industry)

Investment Thesis

1. PGTI is the best way to play a cyclical housing recovery – given significant exposure to Florida (87% of sales), high-end housing, and increasing building code enforcement.  FL housing market is in the early stages of a prolonged recovery as home starts are -80% below 2005 levels and expected to grow by +35-40% CAGR over the next 4 years.  Since 1990, single-family permits per 1,000 population has averaged approx. 6.0x, peaking at ~12x in 2005 and trough at 1.4x in 2009.  We estimate 35%++ CAGR over the next several years to return to the historical 20-year average.  Given household formation in FL over the past 5 years, and under-building, one could argue for a sustained 40-45% CAGR in starts for several years
   1. Currently new construction revenues represent approximately 30% of PGTI’s revenues, compared to 67% of in 2005.  New construction revenues are highly correlated to building permits on a 3-quarter lag (80% R-squared), and FL permits have been growing at a 45% growth rate over the past 6-months
   2. New construction revenues peaked at $223M in 2005, nearly 5x 2012 new construction revenues of $50M --- after 25 quarters of declines, PGTI’s new construction revenues inflected in 2Q’12 and has grown an average +54% over the past 4 quarters
      1.                                                    i.      Conversations with local distributors suggest passive windows are gaining significant share with penetration rates of up to 70-75% of new high-end construction in code-mandated areas (vs. current 27% penetration).  Case in point, PulteGroup will have WinGuard in 100% of their new communities in code mandated ares (new PGTI/PHM partnership from Spring 2013)

                                    ii.    We expect new construction revenues to grow ~40% for the next 3 years and eventually surpass prior peaks by 2017

1.   2.       Increased addressable market:  while cyclical recovery is easily identifiable by the street on the new construction side, we believe PGTI is a secular grower (street underestimates potential for repair-and-remodel (R/R)), given increased addressable market and significantly improved value proposition to consumers (better economics)
   1. Detailed county-by-county analysis suggests new 2010 Florida building (implemented in 2012) has increased required code addressable market by 12-15% --- Hendry, Glades, Charlotte, DeSoto, Okeechobee counties were all added to code requirement
   2. Improved Economic Benefit:  New energy efficiency codes implemented over the past 3 years have increased desirability for WinGuard products (more energy efficient) and narrowed the economic trade-off between passive / active (shutters/board) protection
      1.                                                    i.      According to local distributors, standard, a single-pane non-energy efficient window costs $150 vs. $225 for an energy efficient window (new 2012 code-requirement) and $500 for Winguard -- plus a typical shutter costs $125.  Winguard used to be ~80% more expensive than non-energy efficient window (w/ shutter) and this has dropped in half to ~40% given energy requirements.  Further, when one includes labor cost to install the window (and shutter), the total price gap has dropped from 25% more expensive for Winguard to only 8%

                                    ii.   In 2015 new set of codes are expected to further increase energy efficiency requirements and further narrow the economic trade-off (U-value from 0.60 to 0.40-0.45)

1.                           iii.      Additionally, insurance companies in code restricted areas provide up to 50% annual premium discounts  for homes with passive protection – in-fact creating an economic advantage for WinGuard products

                                    iv.    Our due-diligence with local distributors highlight industry participants now understand this value proposition and economic trade-off, and is now a regular part of distributors sales pitch today (but not 5-yrs ago)

1. 3.       Street misunderstands secular market share growth story.  Impact resistant windows penetration increased from just 11% in 2003 to 26% in 2007, but has stalled since.  This has coincided with a lack of hurricane landfalls in FL during this time period.  Thus, the street has hypothesized that market share flattening out is due to the lack of hurricane landfall and thus lower awareness.  However, conversations with numerous distributors, consultants and local industry participants suggest that this is more coincidental rather than cause-and-effect.  While nobody will argue that a hurricane landfall in Florida would be beneficial for increased awareness and cause  a sense of urgency, experts believe market share has flattened out given housing downturn, home prices and underwater situation in FL – thus homeowners unwillingness to invest in their homes
   1. Distributors / builders indicate this is now changing with home price appreciation, as impact windows is a investment with a very tangible return profile (insurance, energy, safety, etc)
   2. We believe home price recovery in high-end market in FL is a bigger drive of R/R activity than Hurricane landfalls.  Awareness of building codes and passive protection is materially higher today than pre-2007 and lack of increased penetration was due to the cost of impact-resistant windows
   3. Given improved economic trade-off, new building codes, new energy efficiency codes, increased awareness and increased enforcement, we believe impact-resistant windows will resume market share increases similar to between 2003-2007.  This thesis is evident in PGTI’s recent R/R results which have an averaged +27% growth over the past 4 quarters (and accelerating to +40% in 3Q’13) coinciding with home price appreciation, despite 2013 being one of the mildest hurricane seasons in over 50-yrs (no major hurricane registered near FL)

       i.    Conversation with local distributors suggest impact resistant windows is one of the most highly sought after “investments” given significant paybacks with insurance discounts and energy efficient codes

1. 4.       Secular penetration gains and cyclical recovery should drive +25%++ topline CAGR for the next 4 years – best in class among building product companies
   1. a.       Exists further opportunity in expanded business partnerships as PGTI is just now starting to work with Menards/PulteGroup on potential bundled projects – Pulte to feature PGT products in all of its communities in South Florida
   2. In 2013, PGTI started (for the first time ever) creating a sales force to focus on commercial projects – PGTI currently has 0% market share in commercial, but their products can be seamlessly adapted for commercial use and we estimate the commercial market for impact-resistant window to be over $1bn in code-restricted areas – opportunities include retail, hotel, office and condo markets
   3. Opportunity to expand geographically along eastern US coastline, Gulf of Mexico and potentially Caribbean over time
2. 5.       PGTI is a best-in-class building product company – excellent management team, significant topline growth, leading margin profile, strong inventory turns driving best-in-class ROIC
   1. Management team pioneered the industry (founder is still CEO), sit on numerous code boards, and help create impact-resistant standards
   2. b.       Gross margins in the mid-30s range (we estimate going to high-30s after new plant facility, see below) vs. low-to-mid 20s for building product peers
   3. c.        EBITDA margins high-teens going to low 20s vs. peer group struggling to hit double digits – vertical integration (fixed costs) driven high incremental margins
   4. d.       PGTI, being vertically integrated, has best-in-class lead times (2-3-weeks, a competitive advantage) which leads to essentially just-in-time inventory turns of 12x / year
      

e.     Financial profile above yields mid-20s tangible ROIC and high incremental margins – nearly unheard of in building products sector

1. 6.       Despite lack of patents, PGTI has significant moats / barriers which protect aforementioned excellent financial profile
   1. a.       Lack of patents, but leading brand (WinGuard synonymous with impact-resistant, i.e., Kleenex), verticalization (and best in class lead-times),  in-house glass cutting/tempering (low cost), broadest product platform facilitates distributors relationship with builders (all products are custom made), extensive and loyal distribution network (1,300 customers), aluminum and vynil capacity in impact, best-in-class warranty, and scale (5x size of next largest impact player) create a substantial moat around PGTI’s business
      1.                                                    i.      More than 3M installed units – zero reported impact failures
      2.                                                  ii.      Time consuming and extensive process for code-approval create incremental barriers (PGTI management team sits on board and helps create FL building codes / standards)
   2. b.       Conversations with local distributors highlight significant competitive advantage, solid customer relationships which are unmatched in the industry.  Barriers, was our single biggest concern when we first started diligence on PGTI, after numerous conversations with local experts in FL, we gained a significant appreciation for the “soft / intangible” barriers in this niche business
   3. c.        Large national players (Pella, Andersen, PlyGem) lack aluminum capacity, local distributor network for impact and building code access.  We believe these players will look to enter this attractive market, but most likely through an acquisition of PGTI

Valuation / Price Target

1. 1.       We believe PGTI is worth $16-18 per share, +75-100% premium from today’s price.  We use a triangulation approach with a variety of valuation metrics to arrive at fair value for PGTI, namely DCF, EV/EBITDA vs. peers, FCF Yield, normalized multiple on mid-cycle earnings, earnings power analysis, takeout/M&A analysis

1. $16-18 implies 9.5x to 10.5x our 2015 EBITDA, or 16-18x our 2015 EPS (fully taxed), or 6% levered FCF yield
2. We estimate 2014 EBITDA of $61M and EPS $0.61 vs. street $51M and EPS $0.48.  Our 2015 EBITDA of $88.5M compares to street $66.5M and EPS of $0.98 vs. street $0.66
3. c.        Under our base case, we estimate PGTI can grow sales 25% CAGR ’16-’12 to reach $435M in sales, high 30s gross margin and $110M in EBITDA and $1.30 in EPS
4. d.       Our EPS power case where FL housing starts return to 150K (vs. 205K peak in 2005) and PGTI enters commercial market,  we arrive at $2.00 EPS power with sales approaching $500M and EBIT margins in the mid 20s
   1.                                                    i.      This assumes new construction revenues return to prior peak of ~$220M and R/R benefits from increased market share of impact resistant windows to 40% of mkt (vs. 2012 27% share)
5. e.        Our 15 year DCF analysis yields stock price of $17.85 assuming 12% WACC, 6.5x terminal EBITDA multiple
   1.                                                    i.      Excluding 2013/14 new plant capex (growth capex), PGTI has one of the highest FCF yields of peer group – at $9.32, we estimate 2015 levered FCF yield of 10%
   2.                                                  ii.      NOL balance pushes out cash taxes for couple years
   3. 2.       Growth algorithm:  25% topline CAGR, 25-30% incremental margins drive 30% EBITDA CAGR all else equal

              a. Given best-in-class growth, margin, ROIC profile AND potential takeout candidate – believe PGTI should trade at high-end of peer group valuation

Recent Results

1. PGTI reported 3Q results on 10/30/13 – sales grew +45% vs. street +28% driven by +40% R/R sales growth and +57% new construction revenue growth.  PGTI guided 4Q revenues to grow ~+30% vs. the street estimate for +19%
2. While sales results were outstanding, PGTI is encountering some growing pains due to unprecedented acceleration in topline growth.  New hires and plant inefficiencies drove gross margins down -180bp y/y which was lower than street estimated (down slightly)
1. “Growing pain inefficiencies” (labor/scrap/glass capacity) hurt gross margins by -480bp (one-time items), implying core GM would’ve been up +330bp. This is a sequential improvement vs. 2Q where inefficiencies hurt GM by -450bp and total shrunk by -200bp – meaning core margins actually expanded by +250bp
2. Given capacity constraint (due to surge in demand), PGTI purchased significant amount of land next to their glass plant to expand production capacity in a new facility on 2H’14.  PGTI mgmt. expects this initiative alone to help GM by +200bp (offsetting glass bottleneck), and labor efficiencies should be resolved with time
3. We believe topline will remain in the 30%++ range and GM issues will improve sequentially in 4Q and start gorwing y/y in 2014 (with significant growth in 2H14)

Risks / Concerns

1. Gross margin declines offset topline recovery, pressuring EPS:  We believe the worst of GM pressure is behind us as new hires become more efficient and we estimate “glass” pressure will moderate from 180bp past 2 quarters to 130bp in 4Q and <100bp in 1H’14.  New hires generally take 6 months to become efficient which will help 1H’14 GM and new plant capacity to drive GM expansion in 2H’14.  PGTI recently implemented a 3% price increase (first since 2006), which should help GM by ~190bp (all else equal)
2. JLL stake overhang:  JLL is a private equity fund which made an investment in PGTI in 2004.  Their 10-yr investment anniversaries in January 2014.  We believe JLL is likely to exit its stake in the near future which is causing significant over-hang in the stock (7.7M shares of 16% of float).  On September 2013 JLL distributed 5M shares to its partners which caused a temporary dislocation in PGTI shares as those partners liquidated.  We believe investors are hesitating to step into PGTI given this overhang
1. We believe this concern is misplaced given that the next JLL sale will be a “clean-up” and once this event is behind us, PGTI stock should recover the recent dislocation immediately.  Given the lack of liquidity in PGTI and JLL overhang being “the only concern” we believe there is no incentive to “wait for distribution” at the current price
3. Increased competition:  We believe PGTI has significant intangible competitive advantages that protects its leadership in this niche market.  However, we recognize this is one of the most attractive sub-sectors of building products and large national competitors should look to enter once the recovery slows.  We believe the most likely avenue to enter this niche market is through an acquisition of PGTI and believe management would be open to an offer
4. Housing Recovery -- tapering / interest rate increases could cause a slowdown in housing recovery.  While we acknowledge the macro risk, we believe PGTI is the best idea within the building products complex given nearly 90% exposure to FL housing, high-end nature of customer base and code driven demand drivers

1. Significant near-term catalyst would be JLL clean-up, which we expect before January 2014 -- more specifically, we believe JLL blackout window would start in mid-December, so a potential clean-up should come before then
1. Given stock liquidity, and how well known JLL overhang is among investor community, we believe there will be a sharp and sudden “snap-back” once JLL distribution is disclosed.  Investors are unlikely to be able to participate in this snap-back given liquidity – as such, at current prices (and given 8-100% upside) we believe it is prudent to initiate position now given clean-up will likely happen in the next 2 months
2. PGTI will be at DB small conference in FL the week of November 18^th which should be a positive for the stock given little knowledge of story on the street
3. 4Q’13 earnings results to be reported early February should prove a positive catalyst as we believe sales will remain robust and GM should improve sequentially and be better than management guidance