Description
I am recommending the purchase of Ply Gem Industries’ (“PLYGEM”) Secured Notes ($700MM) and Subordinated Notes ($360MM), which I believe present a compelling risk / reward proposition, with total annualized return potential of >20% and >50% - respectively - over the next two years. PLYGEM is a $1.5Bln revenue building products manufacturer largely focused on vinyl siding / windows (more detailed business description below). While PLYGEM is currently facing significant housing headwinds, these two securities offer attractive current yields (13%+ and 17%+, respectively) in a very defensive / covenant-light capital structure with more-than-adequate liquidity. Several key factors should enable PLYGEM to outperform even in this difficult housing environment: (i) best-in-class management as reaffirmed via multiple channel checks and evidenced by cost savings and other acquisition synergies, (ii) limited exposure to hotbed markets (FL, CA, AZ, NV), but with potential to capture market share in these regions going forward, (iii) rational industry market structure on the siding side helps mitigate pricing erosion and (iv) highly variable cost structure helps mitigate further volume pressure. Moreover, recent channel checks have noted that PLYGEM could be on the radar of a couple international strategic companies at very big prices (especially in light of the weak USD and stressed building products universe).
While PLYGEM is subject to the vagaries of the housing cycle (which will very likely get worse before it gets better), there are four primary reasons why I think PLYGEM’s securities are timely / actionable including: (i) growing disparity between building products equities (trading at >8x) and building products credits (PLYGEM trades for less than 5.4x at market prices); bottom-line is that the PLYGEM trade can be hedged via equity shorts, (ii) PLYGEM Subordinated Notes trade at recovery values BUT the reality is that PLYGEM has a covenant-light capital structure and significant liquidity to weather the next 3-4 years w/ no covenant issues, (iii) even under draconian assumptions (for the sake or argument, assume housing starts continue to fall for the next 3-yrs at 20 – 30% YoY declines), the PLYGEM securities pay attractive 13% and 17%+ current yields that effectively reduce the buy-in price over time offer significant optionality to any bottoming of the housing cycle (if and when it comes) and (iv) the underlying business is on stable footing with attractive longer-term growth prospects.
The Secured Notes offer a coupon of 11.75% and currently trade at ~90 (leveraged from 0.0x – 4x at market price) and the Subordinated Notes offer a coupon of 9% and currently trade at ~50 (4.4x – 5.4x at market price). This compares with public peers (Owens Corning, Masco, Fortune Brands and Mohawk) who currently trade at >8x EBITDA (and ~8.5x EBITDA on 10-yr historical trading multiples). Given PLYGEM’s covenant-light capital structure and significant liquidity ($156+ million of ABL availability and cash on balance sheet), this is effectively a 3-yr cycle bet on the underlying demand drivers for residential housing. Over the next 6 – 24 months, I expect the Secured Notes and Subordinated Notes to appreciate significantly (providing ~20% 2-yr yield-to-par returns on the Secured Notes and >50% 2-yr yield-to-par returns on the Subordinated Notes).
Business Overview:
PLYGEM is comprised of two segments: (i) siding, fencing, railing and decking (“siding”) – approximately 60% of sales (~50% new construction / ~50% R&R) and (ii) windows and doors (“windows”) – approximately 40% of sales (~70% new construction / ~30% R&R). PLYGEM’s siding division is generally considered to be best-in-class from an operations perspective and is highly regarded as a price leader with established brands (including Mastic, Alcoa Home Exteriors, Variform, Napco, Georgia Pacific, Cellwood and Kroy). PLYGEM controls over 30% of the vinyl siding industry; its largest two competitors include Certainteed (owned by Saint Gobain) and Associated Materials (owned by Investcorp and Harvest Partners). In contrast, while PLYGEM’s window division has less pricing power (largely driven by the fragmented industry construct), the Company has five solid / recognizable window brands (MW Windows, Alenco, Great Lakes, CWD and Certainteed Pacific Windows– a recent strategic tuck-in acquisition helping to extend PLYGEM’s footprint into the Western US). In addition, PLYGEM has a strong distribution network (recent diligence checks also have noted the significant strategic value of this distribution network). For the LTM period ended March 31, 2008, PLYGEM generated pro forma revenue and EBITDA of $1,428 million and ~$170 million, respectively (11.9% margin).
PLYGEM was acquired by Caxton-Iseman (“Caxton”) from Nortek in 2004 for ~$560 million, or approximately 6.6x 2004 EBITDA of $85 million. Over the course of the last four years, PLYGEM has made four sizable acquisitions including: (i) MW Windows & Doors (2004 - $333MM PP), (ii) Alenco (2006 - $120MM), (iii) Alcoa Home Exteriors (2006 - $305MM), and (iv) Certainteed Pacific Windows (2007 - $35MM). In the aggregate (and inclusive of the initial purchase from Nortek), Caxton / Company have spent over $1.35 billion. I have closely followed each of these acquisitions and am impressed with management’s ability to integrate and extract cost savings. For example, following PLYGEM’s acquisition of Alcoa’s Home Exterior division in late 2006, management initially guided to cost savings of approx $22 million (implying a PP multiple of approx 7.5x), but ultimately extracted >$55 million in cost savings (implying a 3 – 3.5x EBITDA pro forma PP). Given the downturn in the residential construction market and rising material costs, the Company’s performance has declined from its peak in 2005 - 2007 (EBITDA ranged from $196-$208 million) and is expected to continue declining through 2008 and into 1H 2009. Due to the current headwinds affecting the business (and the likelihood they would breach the total leverage covenant of 6.75x in 2008E), Caxton elected to refinance the Company’s bank debt in early June 2008 with 11.75% Secured Notes to eliminate the maintenance covenants in its capital structure. During this process, Caxton ultimately contributed approx $30 million of fresh equity highlighting their confidence in the business. While this refinancing process created a great deal of volatility, I am encouraged by the end result as it effectively provides the Company with breathing room to ride-out the housing cycle (and current Subordinated Note holders continue to get paid 17%+ current yields in the interim).
Ultimately, an investment in PLYGEM is a 3-year cycle bet on the underlying demand drivers for residential housing, especially given the covenant light structure. It’s worth noting that the siding / window industries will likely go through a significant restructuring (in which I have strong reason to believe that “B” and “C” players will be culled from the industry in the next 2 – 6 quarters) which will ultimately benefit the large / liquid players such as PLYGEM and Certainteed. Given the Company’s solid liquidity profile and best-in-class operations / management, I believe PLYGEM will use the current housing downturn to take significant market share.
Capitalization:
PLYGEM’s capital structure consists of a $150 million ABL facility due 2013 ($40 million currently drawn), a $700 million Secured Notes due 2013 and a $360 million Subordinated Note due 2012 (the Subordinated Note matures inside of the Secured Notes). The Secured Notes on a book basis currently finances down to 4.4x LTM March 2008 EBITDA and 4.9x EBITDA – Capex. At the market price of approximately 90, the Secured Notes finance to ~4x EBITDA and ~4.5x EBITDA – Capex. Assuming normalized EBITDA of $240 million (bridge provided further below), the Secured Notes finance to ~3.1x EBITDA at book value (2.9x at market) and ~3.4x EBITDA-Capex at book value (3.2x at market); at normalized EBITDA of $240 million, the Subordinated Notes finance to ~4.4x at book value (~3.6x at market) and ~4.8x EBITDA-Capex at book value (~4.0x at market).
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BOOK |
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MKT |
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LTM |
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LTM |
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Face |
Price |
Market |
Mar-08 |
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Mar-08 |
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LTM Actual March 08 EBITDA |
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$170 |
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$170 |
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ABL ($150 total) |
$40 |
100% |
$40 |
0.24x |
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0.24x |
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Senior Secured Loan due June '13 |
$700 |
90% |
$630 |
4.13x |
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3.72x |
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Debt Through Senior |
$740 |
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$670 |
4.37x |
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3.95x |
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Sub Notes (9.0% Due Feb '12) |
$360 |
50% |
$180 |
2.12x |
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1.06x |
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Total Debt |
$1,100 |
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$920 |
6.49x |
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5.43x |
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Cash |
$47 |
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$47 |
0.27x |
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0.27x |
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Total Net Debt |
$1,054 |
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$874 |
6.21x |
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5.15x |
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Implied Equity |
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$503 |
1.04x |
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2.10x |
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TEV |
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$1,377 |
7.25x |
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7.25x |
With respect to liquidity, the Company has a $150 million ABL facility that is secured by the Company’s receivables and inventory, and ~$46.5 million of cash on its balance sheet. The current maximum excess liquidity is $156.5 million after factoring in the $40 million currently drawn on the ABL (which I view as more than enough to weather the current housing cycle).
Historical / Projected Financial Summary:
PLYGEM management has done an impressive job managing / executing on acquisitions over the past three years. For the last twelve months ending March 31, 2008, the Company generated sales and EBITDA of $1,428 billion and $170 million (11.9% margin), respectively, which represents less than a $38 million decline from peak EBITDA of $208 million (12.4% margin) achieved in 2005. Historical EBITDA includes pro forma add-backs related to contributions from recent acquisitions. Regarding historical performance, there are two big takeaways: (i) even in the face of a challenging housing environment, PLYGEM has maintained PF EBITDA in the $200 - $250 million range each year between 2004 – 2007 (this includes the full benefit of acquisitions and cost savings initiatives implemented during 2005 – 2007 period) and (ii) more importantly, management grew PF EBITDA margins by approximately 100 bps in 2007 even as sales dropped approximately (-12.5%) year-over-year, largely driven by accretive acquisitions and aggressive cost management.
The graph below highlights PF EBITDA in 2005, LTM March 2008, FY 2008E and normalized EBITDA inclusive of initiatives that have been / are being implemented in YTD 2008 / 2H 2008E. These PF add-backs include cost savings programs ($35+ million) + new business wins ($200+ million of top-line / conservative $20 million of EBITDA). As noted, PF 2005 EBITDA peaked at approximately $300 - $305 million and has subsequently dropped to $225 million as of LTM March 2008. I believe 2008E PF EBITDA will trough in the $180 million range (reported / actual in the $125 range) and “normalized” EBITDA (2 – 3 years out) will be in the $225 - $250 million range. Two point worth noting: (i) peak / expected trough performance is largely in-line w/ comparable building products businesses that have seen profitability erode by 30 – 50% over the past 2 – 3 years (PLYGEM has clearly benefited from its limited exposure to the “exotic” housing markets) and (ii) “normalized” EBITDA of $225 - $250 million is still 20 – 25% below peak 2005 levels (which we believe to be very realistic in 2011E – 2012E given the changed industry dynamics – i.e. less industry players holding more of the total (albeit smaller) pie).
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LTM |
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PF 2005 |
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2008 |
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2008E |
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Norm |
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PLYGEM - core biz |
$118 |
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+ Alenco Acq EBITDA |
$16 |
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+ Alenco Synergies |
$5 |
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+ Alcoa Acq EBITDA |
$39 |
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+ Alcoa Synergies |
$50 |
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+ Certainteed Acq |
$20 |
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Reported EBITDA (implemented 05-07) |
$248 |
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$170 |
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$125 |
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$183 |
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+ New Business Wins(1) |
$20 |
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$20 |
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$20 |
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$20 |
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+ Cost Savings Programs(2) |
$35 |
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$35 |
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$35 |
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$35 |
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PF EBITDA (08E implementation) |
$303 |
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$225 |
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$180 |
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$238 |
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(1) Failure of 2 - 3 small / marginal players (~10 - 15% of mkt) |
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(2) Articulated by mgmt in public call in early June 2008 |
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The Company’s LTM March 2008 Actual EBITDA of ~$169.5 million includes (-$4) million from the start-up / restructuring costs related to Certainteed Pacific Windows acquisition. Management is confident they will be profitability neutral on this Certainteed Pacific division during the Q2 – Q3 period and positive in Q4. Longer-term, management ultimately views the Certainteed Pacific Window assets (3 facilities located on the West coast) as highly attractive and should be able to generate more than $20 - $30 million of EBITDA in a normalized housing environment.
Regarding 2008E EBITDA, PLYGEM management is implementing five larger initiatives that include: (i) revenue enhancement initiatives expected to generate over $99.7 million of additional revenue in 2008 (annualized rev of $180.3 million). Given feedback I have received in recent channel checks, I believe the Company should be able to easily exceed this target, (ii) additional cost savings of (a) $19.5 million of identified savings ($12.4 million to come during Q2-Q4 2008) and (b) $14 million from personnel reductions / elimination of management incentive bonuses, employee benefit reductions, integration of Kroy into Siding division and other, (iii) working capital reductions - $17.2MM annualized - $14.2MM between Q2-Q4 2008 and (iv) capex budget reductions – expected to be no more than $20MM and (v) Denison plant sale – being finalized and should yield approximately $3 million. In addition to the co-specific initiatives noted above, it’s also worth noting that PLYGEM has effectively passed through three price increases of 7 – 10% to help mitigate some of the input cost pressure. I have done multiple channel checks that have corroborated these increases. Given the top-line / cost saving / working capital / capex initiatives noted above in addition to the price increases that are sticking in the end markets, I believe management is budgeting for approximately $130 - $140 million in EBITDA for 2008.
Valuation & Returns:
Longer-term, I value the Company on a cycle-average basis, as I do with other cyclical businesses. Our cycle-average EBITDA assumes approximately $225 - 250 million of EBITDA. The 2008E bridge includes: (i) $35 - 50 million of additional earnings from volume improvements / market share gains, (ii) $35 - $45 million from input pricing normalization (note currently up 30 – 35% in PVC YTD), (iii) $20 million of earnings power from Pacific Windows 3 west coast facilities (note management thinks this could yield up to $30 million longer-term) and (iv) $8 million of add-backs given one-time costs for profit burn / restructuring / SG&A at Pacific Window
For reference, given its strong positioning in the siding and windows industry, strong cash flow characteristics (in a normalized environment), rational industry structure on the siding business and significant strategic interest (from the PVC providers – ShinTech, Formosa, LG Chemicals), I believe that PLYGEM is worth ~7.25x EBITDA in a normalized market environment (note that this is ~1.25x discount to historical 10-yr trading multiples vis-à-vis Owens Corning, Masco, Fortune Brands and Mohawk). Assuming a 7.25x EBITDA multiple, it’s worth noting that the Subordinated Notes (trading at 50) are 100% covered as long as EBITDA is >$145 million. This compares to my 3-yr normalized EBITDA of approximately $225 - $250 million. Assuming a 7.25x multiple on $225 - $250 million of EBITDA, this implies a TEV of approximately $1.6 - $1.8 billion which provides a significant ($0.6 - $0.8 billion) equity cushion to the Subordinated Notes and >$0.9 - $1.1 billion for the Secured Notes.
Since PLYGEM refinanced their capital structure in early June, the Secured Notes have traded off into the 90 context. In talking to other funds, I believe there are a couple notable cross-currents at hand including: (i) lack of a bid – given uncertainty around all building products companies, there is a limited appetite to take building products / housing risk, (ii) technical weakness – I’ve heard some funds are shorting the Subordinated Notes and are trying to pressure the Secured Notes to trigger further downside to the Subordinated Notes. While both of these somewhat technical concerns above are worth noting, I believe the underlying business is fundamentally solid and believe the Subordinated Notes and Secured Notes are an attractive risk / reward.
Margin of Safety:
From a Subordinated Notes perspective, anything above $150 million in “normalized” 3 - 4 years out EBITDA should result in the Subordinated Notes trading back to par. Given our views that earnings power should be $225 - $250 million in 3 – 4 years, we would anticipate the Secured Notes and Subordinated Notes trading up well in advance of any improvements to housing.
Catalysts:
- Covenant-Light capital structure: This is a cycle play (2 – 3 years) in which you’re paid to wait (13%+ and 17%+, respectively)
- Q2 performance (reports August 11th): similar to building products equities, there is a tremendous amount of pent-up-negativity in credits. Any less-than-expected-disasters could result in significant short covering + marginal buyers
- Input environment: any let-up in PVC pricing would result in 200 – 300 bps of margin expansion; in addition, given the rational industry construct on siding, PLYGEM and peers should be able to raise pricing to levels that provide adequate margins
- Leverage / FCF / ample liquidity: totalLTM net leverageof~5.2x at mkt, 08E FCF neutral (given working capital source of cash), ~$156.5MM of current liquidity
- Cost cutting / best-in-class mgmt: strong operators w/ proven history of cost cutting extraction
- Sponsor / management support: management owns ~20% of the company and is highly committed to its success. Also, in a sign of strong support, Caxton recently put in an additional $30 million of equity into the Company (>$250 million total investment)
- Rational industry construct on vinyl siding: 3 players on vinyl siding control 75%+ helping mitigate pricing erosion; 3 pricing increases of 8 – 10% have been pushed through YTD (most recent 2 have stuck effectively per our channel checks); also notable that 2 – 3 of the smaller / marginal players are teetering (~10 – 15% of mkt) which should benefit the 3 large / well-capitalized players that make it through this period
- Limited "hot zone" / "toxic" exposure: helps mitigate the housing downturn / pockets of implosion; taking share w/in mkts they never were in during the downturn
- Vinyl siding cost advantage: $152 / sqr split evenly btwn material / labor is 28% less than wood (next most cost effective); having lowest cost solution is an advantage in downturns (way for contractors to help mitigate cost pressure)
- PLYGEM is the only national / pure-play vinyl siding mfter: Certainteed w/ Norandex distribution conflict and SIDE w/ in-house distribution network
Risks:
- Longer / deeper housing cycle: risk is if you view housing recovery as a 2012 – 2013 event
Mitigant: Two important items to note: (i) PLYGEM capital structure is covi-light and they have ample (156+MM of liquidity to weather the cycle) and (ii) mkt share gains will help mitigate the downside (expected to generate >$200 million of annualized new business by the end of 2008)
- Raw Material Exposure
Mitigant: PLYGEM has historically been able to substantially pass on significant PVC resin and aluminum cost increases through price increases to their customers, but there is always a time lag. To this point, while the volume environment is challenged, PLYGEM / siding competitors are being rational with passing through price increases. Most recently (and to help mitigate the PVC pricing environment), I have seen 2 price increases in the 8 – 10% range (July / August) that have stuck in the end markets which should help mitigate some of the volume degradation. In addition, over the next 12 – 24 months, I would anticipate PVC pricing falling from peak levels to a more normalized equilibrium (especially given PVC’s end market exposure is largely driven by housing construction). Further to this point, given new capacity coming on board from ShinTech, we would anticipate a more normalized PVC input environment over the longer-term.
Disclosure: I own the Secured Notes and Subordinated Notes and may buy or sell at any time, without notice. We have no obligation to inform you of any changes in our views of PLYGEM
Catalyst
1. - Covenant-Light capital structure: This is a cycle play (2 – 3 years) in which you’re paid to wait (13%+ and 17%+, respectively)
2. - Q2 performance (reports August 11th): similar to building products equities, there is a tremendous amount of pent-up-negativity in credits. Any less-than-expected-disasters could result in significant short covering + marginal buyers
3. - Input environment: any let-up in PVC pricing would result in 200 – 300 bps of margin expansion; in addition, given the rational industry construct on siding, PLYGEM and peers should be able to raise pricing to levels that provide adequate margins
4. - Leverage / FCF / ample liquidity: total LTM net leverage of ~5.2x at mkt, 08E FCF neutral (given working capital source of cash), ~$156.5MM of current liquidity
5. - Cost cutting / best-in-class mgmt: strong operators w/ proven history of cost cutting extraction
6. - Sponsor / management support: management owns ~20% of the company and is highly committed to its success. Also, in a sign of strong support, Caxton recently put in an additional $30 million of equity into the Company (>$250 million total investment)
7. - Rational industry construct on vinyl siding: 3 players on vinyl siding control 75%+ helping mitigate pricing erosion; 3 pricing increases of 8 – 10% have been pushed through YTD (most recent 2 have stuck effectively per our channel checks); also notable that 2 – 3 of the smaller / marginal players are teetering (~10 – 15% of mkt) which should benefit the 3 large / well-capitalized players that make it through this period
8. - Limited "hot zone" / "toxic" exposure: helps mitigate the housing downturn / pockets of implosion; taking share w/in mkts they never were in during the downturn
9. - Vinyl siding cost advantage: $152 / sqr split evenly btwn material / labor is 28% less than wood (next most cost effective); having lowest cost solution is an advantage in downturns (way for contractors to help mitigate cost pressure)
10. - PLYGEM is the only national / pure-play vinyl siding mfter: Certainteed w/ Norandex distribution conflict and SIDE w/ in-house distribution network