Description

THESIS SUMMARY

Quanex Building Products (NYSE: NX or the “Company”) presents an attractive short opportunity with multiple near-term fundamental and technical catalysts leading to a +40% return over the coming quarters. The Company is a manufacturer and supplier of components to residential window, door and cabinet OEMs facing accelerating end-market challenges that are almost certainly going to be compounded by the recently closed acquisition of peer Tyman PLC (formerly LSE: TYMN). The Company paid a full valuation for a business nearly its same size, provided ambitious synergy guidance and is now levered nearly 3x. Quanex management has never done a deal of this scale (only one small acquisition in ten years) nor managed leverage at this level. Such large homebuilding products deals have often fallen short of expectations and can lead to hiccups that take years to rectify. We believe there is a high probability this merger follows that course. NX’s current valuation does not reflect these challenges and risks. The Company has limited institutional following and cursory sell-side coverage from only one analyst. Upwards of 23% of the proforma shares outstanding (distributed to legacy European Tyman holders on 8/2 concurrent with the LSE-listed TYMN shares being cancelled) are at risk of near-term forced sale. NX is currently GC (3% SI % of float).

CATALYSTS

1. Potential imminent forced selling by legacy European TYMN shareholders following the 8/2 stock conversion.
2. Ongoing fundamental deterioration in the business. Pricing pressure combined with worse than expected volumes implies a high probability of earnings miss. Note TYMN has not reported earnings since 2023. Next earnings report for the combined business will be the week 9/2.
3. Investor awareness of the actual earnings and leverage levels of the business.
4. Falling short of cost savings guidance and possible dis-synergies (customer losses, performance shortfalls, etc.).
5. Potential dividend cut. NX continues to pay out its dividend ($10M/ year).

SHORT THESIS

Merger Overview & Setup

On 8/1/24, Quanex closed its acquisition of Tyman PLC (LSE: TYMN). The Company paid approximately 9x EBITDA and 14x P/E. Post-close, the Company’s share count increased 43% (14.1M new shares issued) and is now levered 2.5-3.0x. Tyman sells different components within the same product categories to the same customers as NX with a comparable end-market exposure profile. Tyman has a declining growth profile as well and is nearly the same size as Quanex. The combined entity’s products are all largely commoditized components with limited pricing power. The end applications of which are 65% R&R/ 35% new construction with geographic exposure being 73% North America/ 27% W. Europe. The pro forma product breakdown is approximately 90% window and door components (hardware, spacers, seals, hinges) and 10% cabinet parts.

1. Forced Share Selling: Potentially as much as 23% of the current NX shares are at risk of being forced sold (equating to 34 days of trading volume). On 8/1, the LSE-listed Tyman shares were cancelled and the following day, the newly issued shares became effective on the NYSE. Most European mutual funds and ETFs are precluded from owning securities that are not listed on the LSE or another European exchange. On a pro forma basis, approximately 30% of the NX shares are now held by legacy Tyman holders (data as of 7/27 based on daily Form 8.3 filing requirements) with no lockups in place. Below are the legacy Tyman top holders that just received NX shares and pro forma shares outstanding breakdown. The largest of which being European hedge fund Teleios Capital with a 9.8% position. As part of the transaction, Teleios received board observer rights. There are not any restrictions on their ability to sell but if they do dispose of greater than 30% of their shares, they will forfeit their observer rights. Teleios also elected all-stock in the transaction so presumably they intend to remain holders. Excluding Teleios, the legacy TYMN shareholders account for 20% of the shares outstanding. It is likely that many of these new passive holders and mutual funds will be forced to dispose of their shares over the coming sessions (some probably some have not even realized they own NX shares yet).       

2. Ambitious Synergy Guidance: This management team has only made one small acquisition over the last ten years. Curiously, as part of their compensation plan, management has a financial incentive to reach $2B in revenue. This motivating factor, rather than shareholder value creation, was likely the driving force behind the merger. The proposed synergies are aggressive. Of which 40% or $12M, are to come from product consolidation even though there is very limited actual product overlap and thus potential facility closures or manufacturing scale benefits. Management has been unable to substantiate this math and noted the estimates were produced by an external consultant. The plan also assumes a 100% reduction in Tyman overhead ($9M). The aggregate proposed cost savings equate to 3.7% of Tyman revenue which is at the higher end of precedent larger homebuilding products acquisitions. Below are cost saving guidance at deal announcement for four peers. Three of those deals ended up falling short of expectations and taking longer to realize; two of which resulted in several quarters of significant disruption (customer losses and performance shortfalls). It will also be harder and more costly to realize cost synergies in Europe given labor laws.  

3. Elevated Pro Forma Leverage: At close, the combined business will be levered 2.5-3.0x ($636M net debt at close, based on LTM results as of 6/30 for NX and FY2023, the most recently reported period for Tyman). Management’s acquisition presentation cites a 2.1x leverage ratio based on 2023 EBITDA (which is overstated given earnings for both are declining), assumes a full realization of the cost savings but curiously does not adjust for the $35M of costs that will be required to achieve these synergies. The $35M upfront costs and leverage would increase the financial impact if the proposed synergies were delayed or fell short. Once again, management has never integrated a merger of this scale. The calculation of FCF supporting the deal in the proxy is a bit of alchemy. It uses Adj. EBITDA, credits for all synergies, excludes tax expenses, assumes declining capex and working capital while excluding restructuring costs.

Over-Earning & Pricing Pressure

Revenue for both Quanex and Tyman has been declining at an increasing rate. Quanex had been temporarily overearning due to price-cost lags which are now reversing. Meanwhile its customers have been pressuring suppliers on price with further consolidation among these OEMs, Owens Corning (OC)-Masonite (DOOR), and JELD-WEN (JELD), likely making things even more challenging for NX. The merger synergy guidance for the OC-DOOR deal (closed 6/3) is focused on cost reduction, primarily sourcing. “Owens Corning expects to deliver significant synergies in sourcing and supply chain immediately after the acquisition, with other synergies to follow as they leverage the scale of the company to increase efficiency.” Masonite is a top three customer for both Quanex and Tyman. The Company’s cabinet component customer base is highly concentrated with its top three accounting for 85% of sales. OEMs have historically produced most of the parts the Company sells but over the last decade have outsourced the supply bases for these lower value-added components. NX’s customers could certainly bring manufacturing back in-house or at the very least use it as a leverage point when negotiating pricing.

End-Market Headwinds

The residential R&R activity in which the Company participates have been deteriorating at an accelerating rate. Recent Census BTOS survey data signals future home improvement demand is slowing materially--near-term demand -13.2% Y/Y on a four-week moving average on 6/30 slowing from -6.8% Y/Y in the prior month. Per the most recent LIRA estimates, MRO spending is forecasted to continue to decline through the rest of 2024. This has been particularly pronounced in the large expenditure categories in which the Company’s products are sold. High cost/ big ticket home improvement is the most challenged area of the residential building materials category. Lower and mid-market consumers (NX’s price point) are increasingly unable to afford upgrades as window and door prices have risen 40-50% since 2020 (note). Further over the last two quarters, 41% of the existing homes that came to market were reported to have outdated windows.

Peer and customer performance presents a bleak picture as well. American Woodmark is one of the largest domestic manufacturers of wood cabinets and NX’s largest customer in the category. AMWD’s recent earnings have been weak, noting deteriorating demand. JELD-WEN (JELD) and Masonite (now Owens Corning) are experiencing mid-teens demand declines (JELD Europe and US sales volumes declined 13% in Q2, citing trade down in R&R). On the 8/7 earnings call, the CEO noted, “R&R is expected to contract mid-to-high single digits as consumers continue to delay bigger ticket projects.” Meanwhile, door shipments are still 25% ahead of mid-cycle levels thus shipments of doors are likely to remain tepid over the coming quarters as elevated mortgage rates with limited access to HELOC and other factors lead retailers and consumers to take a more cautious approach to inventories and home improvement projects. Home Depot (HD) and Lowes (LOW) have reported particular softness in the larger ticket MRO category. Pool Corp (POOL) has also been cutting guidance (different product but comparable ticket size as window replacement). The shift in spending to smaller ticket, less discretionary items, will likely continue to weigh on large spend items like windows and doors.

Europe accounts for 27% of the pro forma business. The European residential market is in particularly bad shape. Demand has been softening as consumer confidence has been waning (citing energy cost pressures, high borrow rates and election year uncertainty). It has been harder to furlough labor or cut overhead over there, which has compounded the impact of sales volume declines.

FINANCIAL PROFILE & VALUATION

NX and Tyman manufacture lower value-add parts and components that go into residential doors, windows and cabinets. It appears likely sales will continue to decline HSD/ LDD in-line with that of JELD and DOOR. The Company has demonstrated limited pricing power and historically generated 10-11% EBITDA margins. Margins expanded and peaked at 14% last year as NX held onto price increases and as input costs moderated. Now pricing mechanisms are reversing and OEM customers are pressuring them aggressively on pricing in the face of declining sales, particularly on the windows side of the business. Lower revenue, volumes and margins will likely have a compounding impact on earnings.

On a pro forma basis, NX is currently trading at 13.4x P/E (based on the most recently disclosed earnings and capital structure in the June proxy statement) and at a higher multiple on a forward basis given the declining earnings profile. There are not any perfect comparable companies but the closest residential products manufacturers in terms of product set and end-market profile, American Woodmark (AMWD) and JELD-WEN (JELD), trade at 8-10x EPS. Those multiples imply $17-20 per share for NX, 40-30% below its current stock price. The downside to the equity is even larger if the integration experiences challenges and/ or if the forward earnings deteriorate further. The most recently reported Tyman results are from 2023 and stale. The YTD 2024 performance will be published on 9/6 and should serve as a catalyst as all indication are earnings will be materially lower.  

RISKS  

• Cost savings could exceed expectations. Pro forma market share in certain sub-categories will increase to >50% and potentially afford greater pricing power.
• Raw material input costs (~50% of total cost) have been moderating. The Company cycling through legacy higher cost materials and only began to realize the benefits in late 2023 so could be a margin tailwind in 2024. Customers are acutely aware of this dynamic and pushing back on price. This is also being offset by commensurate reversals in surcharges.
• The Company is levered to R&R activity so a rebound in MRO could lead to outperformance.
• Additional sell-side coverage following the transaction could be supportive of the stock. 

Catalyst

1. Potential imminent forced selling by legacy European TYMN shareholders following the 8/2 stock conversion.
2. Ongoing fundamental deterioration in the business. Pricing pressure combined with worse than expected volumes implies a high probability of earnings miss. Note TYMN has not reported earnings since 2023. Next earnings report for the combined business will be the week 9/2.
3. Investor awareness of the actual earnings and leverage levels of the business.
4. Falling short of cost savings guidance and possible dis-synergies (customer losses, performance shortfalls, etc.).
5. Potential dividend cut. NX continues to pay out its dividend ($10M/ year).