Description

Summary:

SIG plc is a high-quality mid-cap UK specialist distributor of technical insulation and roofing, trading at a cyclically cheap level, with strong prospects of a turnaround of a traditionally high ROIC business in a stable industry. Further, SIG is backed by an operationally-oriented private equity firm Clayton Dubilier & Rice (CD&R) with a real prospect of a near-term catalyst via take-private. In our base case, we do not underwrite the take-private option but still see a clear path to ~£0.60 per share by FY 2023, ~2x upside from today’s £0.30 share price and a 40%+ IRR. Importantly, our risk-adjusted downside case of 18% IRR does not require any success in the turnaround project, comes with a clean balance sheet, incentivized quality management with good shareholder communication, and a strong margin of safety from the low price of ~5x 2019 EBITDA.

The business:

Founded in 1957, SIG plc is a specialist distributor focusing on interior insulation (68%) and roofing (32%), operating 418 branches across UK (44%), France (25%), Germany (18%), Poland (7%) and Benelux (5%), with an equal (50%) distribution across the new build and RMI end markets. It recorded 2019A sales of £2,085m, EBITDA of £56m (2.7% margin), and EBIT of £35m (1.7% margin). At SIG’s peak, pre-2008, it was the clear no.1 in UK insulation and roofing distribution with 2x share of the aggregate of its 3 largest competitors, achieving >6% EBIT margins.

However, a series of poor leadership under 3 different CEOs across 2013-2020 saw the company begin a run of ‘self-inflicted wounds’, characterized by strategic and operating missteps, and poor capital allocation that have led to continued underperformance. As a result, the company’s share price significantly underperformed in 2019, issued a profit warning in January 2020, and ousted the management team. The share price tanked in Jan by 70% to 80p from a 2019 high of 139.5p, and later fell even lower to 15p in the Covid-March lows. 

What happened?

1. First, the company focused on i) reducing distribution costs and ii) driving aggressive purchasing gains. These led to cost actions (branch rationalization, de-manning) which impaired customer service and satisfaction, alienated suppliers, and allowed competitors to gain equivalent levels of rebates which they chose to reinvest in market share gains.
2. Second, commercial functions were centralized (without the necessary IT Capex infrastructure) and P&L responsibility was removed from the local level, creating the wrong incentives and undermining the autonomy and ownership mentality of branch and sales managers – ultimately leading to low employee motivation and a series of front-end staff departures.
3. Third, more recently, the resulting pressure led to a number of poorly thought-through commercial decisions which accelerated share loss (lower margin customers were publicly discontinued – thus discouraging “profitable” ones, low margin but sales-leading products were discontinued or discouraged, a general price increase, etc). A new “operating model” was also introduced, divorcing the various branch-based functions and centralizing decision-making further.
4. Fourth, the company was plagued by poor capital allocation: 18 businesses were acquired 2015-2016 under then-CEO Stuart Mitchell, then 19 businesses were closed/divested by the 2017-2020 CEO.
5. Importantly, however, these problems are only limited to UK (39% revenue) and Germany (18%), the remaining ~47% of the business is stable and cash generative.

The risk of tripping financial covenants leading to a default saw the company raise £83m from CD&R (~25% equity) as part of a £165m equity rights issue, which extended debt maturities by 2 years, waived financial covenants, and introduced new debt which we think reflects an attractive SIG outlook (elaborated below). Post capital raise, the company is net cash at £29m pre-IFRS 16.

The market reacted well to the June capital raise and the share price rebounded to 30-33p almost immediately, appreciating by ~22% to CD&R’s blended entry price of £0.26p from Jun-Sep. However, the share price declined again to May lows (~23-24p) driven by the triple whammy of 1) macro-related reasons, mainly elections and Brexit, 2) September’s European Covid rebound causing temporary share price depression, and 3) poor but better than guided 1H results announced in Sep (as to be expected, given Q2 saw Europe stricken by Covid), before appreciating again on the back of vaccine news to ~£0.33-0.35p, due to fears of a third strain originating in the UK and the third UK lockdown, the price has declined to about £0.30p today. There will be near-term volatility, but we believe the long-term fundamentals of the business are intact. 

Thesis:

1. SIG is a good business in a good industry. Evidence: SIG has no.1 positions in all the market segments it operates, especially in UK, Germany, and France. We think the best evidence for this is its very stable gross margins of 25% in the last 10 years, which in fact have expanded by ~150bps in the insulation segment in the last 5 years reflecting a stronger competitive advantage in this product segment. In addition, longer-term ROIC (EBIT/net FA + WC) is ~15%, before its self-inflicted wounds. In a normalized environment, the business is also highly cash generative, with low Capex requirements (1% of sales, little reinvestment requirements) and working capital requirements (8% sales) leading to high FCF conversion (>90%)
   1. SIG has strong competitive advantages.
      1. The company is well-positioned in the attractive specialist distribution industry: customers trust SIG as a market leader for product quality and technical support. There is a reason why this business exists, which is why the company is immune to channel shifts and e-commerce disruption. When you look to build a roofed house with sound, heat, and fire insulation, you want expert technical advice (so your home is quiet, warm, and safe) and honest advice (so you don’t get ripped off), advice that is also bespoke wrt technical attributes of your house. You’d also want a wide selection, which another SIG’s moat from leadership in this product ecosystem, by way of end-to-end sales, marketing and distribution. This is why SIG’s niche expertise is a strong brand moat; their true edge lies in stronger local/regional execution than the pan-European scale, and its strengths are reflected in the fact that there has been no channel shift away from specialist distributors to general distributors and direct suppliers.
      2. SIG also has durable economics from scale and distribution, as the no.1 distributor in a highly fragmented customer and supplier base: no individual customer or supplier constitutes >3%, and top 10 of customer and supplier are only 7-9% of the business. What is particularly key to note is that 80% of their customer base are repeat specialist contractors, revenue that is highly recurring.
   2. The investment case is also underpinned by attractive industry dynamics at a cyclical trough.
      1. Our primary field research shows that orders are up in end markets: we are tracking a large increase in delivery of inventory and construction starts in UK and Germany, with is supported by the company stating in its H1 2020 press release that “near-term order books” are encouraging.=
      2. In addition, the specialty building materials market is a large and growing >€20bn market in relevant countries and product segments. It tends to grow organically around GDP levels, but SIG’s strengths in insulation mean it has and is likely to grow faster than overall building products (historically 3-4% organic CAGR in real terms). Although construction markets are currently at a trough / disrupted by Covid-19, and as you would expect a highly cyclical business (in GFC sales were down 10%), judging from the US experience (UK is generally a lagging indicator), demand for building materials should rebound, helped by low mortgage rates, the backlog of construction projects, and increased consumer interest in suburban homes. Furthermore, there are strong industry dynamics: Homes are ultimately a basic necessity, and exposure to renovation and residential limits downside going forward. In addition, UK policy regulation encouraging homeownership and negative UK rates provide additional support. The real covid impact is also limited, with the company’s performance being ahead of expectations, largely a result of France reopening with pent-up demand (trading at 150% of pre-Covid-19 levels in May), the UK, and Germany fully caught up (100%).
2. The issues are easy fixes and are underway. We elaborated on the problems above; building products distribution is fundamentally a relationship business, and you need local branches and sales executives incentivized by local PnLs for customer-centric service.
   1. Reinstating branches (payback <1 year), reemploying quality sales staff is underway (most of them are either laid off in L2Y and unemployed, or recently furloughed).
   2. We are also seeing (a return of) quality management. What was convincing for me was the strong leadership to lead the turnaround. New CEO Stephen Francis is a prolific turnaround CEO, having turned around numerous UK mid-cap companies such as Tulip, Danwood, Vion Food Group (UK mid-cap companies), and has built his entire career and credibility around his ability to turnaround declining businesses. We spoke with him and went away reasonably impressed with his thoughtfulness, meticulousness, and track record. He recognizes that the building products industry is ultimately a relationship business, and was very detail-oriented in terms of the key performance targets to reach our base case. Another key driver for the UK business unit is also the re-hire of Philip Johns, a highly respected industry leader who was the UK MD for SIG over a decade during its peak years (2006-2015), when he oversaw stellar capital allocation (ROIC of ~18% during his tenure; he left because of the dispute with Chairman Leslie Van de Walle (2011-2017) who oversaw the installation of the 3 CEOs that were inimical to the business.) Philip Johns has spent his entire career in this specific industry, and his rehire is a strong indication that the turnaround is on track. For the German business unit specializing in technical insulation, SIG is due to announce a new German MD in H2. Based on my diligence, the person is likely to be Alfons Horn, who was the MD for Germany (2014-2017) and also spent 17 years at SIG in various management roles.
3. Valuation: Company’s price is temporarily depressed by fears of a Covid resurgence in Europe, recent UK elections, and residual Brexit issues. Another reason why SIG has recently traded lower is that SIG is an underfollowed UK midcap name <200m market cap, little research coverage, and is mistaken for a secularly declining business from eCommerce disruptors like Wayfair.
   1. On an absolute basis, at current EV, SIG is trading at 2019A ~18% earnings yield (determined by EBIT/EV), ~15% FCF yield levels (FCF/EV), when historically trades more at a 6-8% FCF yield levels. This is too cheap. In other words, the market is fully pricing in the negative EBITDA H1 results, and not even pricing in recovery to 2019 levels, thus you are essentially buying a business under asset value, and getting the significant, stable cash flow for free.
   2. On a relative basis, SIG currently trades at ~5x EBITDA, vs. 8x to its European building materials distributor peer set. Peers like Travis Perkins trade higher despite muted growth (higher concentration in roofing segment) and similarly afflicted by covid worries. For the last 5 years, EBITDA, SIG has traded at 8.7x while peers trade at 9.5x, and M&A precedents are generally 10-12x EBITDA, which are mostly sponsor deals. We believe SIG can generate at least ~60m EBITDA in 2021, which means that SIG is trading below 3x EBITDA, significantly below the low end of the range.
4. Now is a fantastic time for a CD&R catalyst: We spoke with the CEO to better understand the dynamics of the capital raise and queried (a) why CD&R did not press for a convertible preferred structure (which We think makes more sense for CD&R in this situation given their bargaining power, and as CD&R have frequently done in the past, e.g. see recent Covetrus deal), or (b) opt for distressed for control by buying the debt (CD&R has a little known, Apollo/Centerbridge-like debt investment fund called “Arawak”, and they have done loan-to-own deals in the past (NCI Building Systems during GFC). The CEO response was that their long-term shareholders (mainly IKO Sales) and management ‘preferred’ an equity rights issue to focus their attention on the operational turnaround and not be burdened by an onerous balance sheet from an LBO or change of control.
   1. Open market purchases: Notwithstanding this gentlemen's agreement, there is nothing that stands in CD&R’s way from building up its equity position in the open market, especially given the depressed valuation a mere 3 months from the recapitalization. We believe CD&R will do so, as they have regularly done in the past (e.g. Beacon Roofing Supply). In addition, CD&R has just raised its latest $13b fund ($12b raised as of Sep 2020) and will be eager to deploy at a price below their capital raise. To date, CD&R has been very active in deploying capital in the covid environment (Epicor, Huntsworth, Cheney) also in the building products distribution space (acquisition of White Cap from HD Supply for $2.9bn, Conforama distressed buyout, 2021’s £308m carveout of Wolseley plc from Ferguson).
   2. Take private optionality / Consolidation makes complete sense: SIG’s market leadership, scale, strong brand, and quality management makes sense for CD&R to deploy it as a platform for disciplined bolt-on transactions within the sufficiently fragmented specialty distribution industry, many of whom are family-owned businesses started by entrepreneurs during the post-war 60s-70s housing boom and are looking to exit as they reach retirement. This is an unglamorous industry and their children are unlikely to be interested to run the business. The top 3 players control about 35% of the market, and there are significant cost synergies in acquiring smaller players from distribution and branch rationalization. Also, because this is a sufficiently fragmented industry, it is unlikely that there will be material anti-trust issues. When We pressed to ask why CD&R did not moot the idea of a control transaction, the CEO responded that it is an ‘option’ but that they are 100% focused on the turnaround, which leads me to believe that a take-private is a real prospect. We think the real reason is it makes no sense to sell a good business in a Covid environment at a highly depressed price, but shareholders and management would actively consider the prospect once they return to 2019A levels.
   3. Finally, we believe it is rational for CD&R to do so – if they are going to dedicate resources (fixed costs in terms of investment professionals and operating advisors) to support the turnaround, why share the upside with the public markets when they can enter at a price lower than their entry? £83m is also considered a relatively small equity check for CD&R, thus it would make sense for them to dedicate more capital for control and expansion to make them worth their while.
5. Capital structure and liquidity: In the restructuring process, the company converted its drawn RCF of £70m into a Term Loan maturing in May 2023, and private notes maturing in 2020-2021 were extended to May 2023 (£34m). The company has a net debt of 72m, which is <1x of 2019 EBITDA, and they have total liquidity of £300m, with no debt maturities until May 2023 and generally a covenant-lite package with covenant holidays until Q1 2022. While it is true that the company will need to refi the 2023 notes, rates in UK are now negative, thus there are strong prospects for a successful refi in a downside case. In our downside case, there will be adequate liquidity (2.1x net leverage) given an over-equitized capital structure. Furthermore, we think the new covenant-lite capital structure is a good indication, as the banks would have had access to private information to determine the company’s solid fundamentals.
6. Management and Insider purchases: Management is elaborated above. In addition, senior management also has a large portion of their compensation in stock which is also deferred for 3 years, and voluntarily cut their pay from March and ongoing. Furthermore, during this recent share price depression, CEO Stephen Francis bought 208k shares, Chairman Andrew Allner bought 40k shares, and Alan Lovell the NED bought 80k shares.

Value drivers and investment case

My base case is a decent operational turnaround back to 2017 levels by 2023 (£2.339m revenue and £83m EBITDA – 3.5% margin). The key to this is maintaining sales/branch of 11m (£385k EBITDA per branch), driven equally by branch openings and decentralizing PnL thus increasing SSS, primarily in the UK segment but also in Germany. We are underwriting zero expansion in the rest of Europe (47%) in my base case. There will be a slight margin expansion (2.7% to 3.5%), driven primarily by lower fixed costs from lower executive management compensation, as well as lower central costs and furloughs. If we apply an 8x fwd EBITDA multiple on 2023 #’s (assumes management hits 2019 EBITDA in 2021, 2018 EBITDA in 2022), we get to a 55p price target which presents an IRR of >40% from today’s price. None of these estimates are aggressive. We think management is clearly capable and knows the business inside out, and has the capital for deployment.

Risks / The bear case

Based on primary evidence of orders and shipments, we believe a business recovery is underway. Thus, we think that the main business risk is a failed operational turnaround, which will be our downside case. Assuming the stellar management adds zero value, ie. “do-nothing scenario”, the company fails to regain some market share and remain at 13% market share, and new branches bring in zero revenue, a normalized, post-covid environment brings us to return to FY2019 numbers (2148 revenue and 56 EBITDA), at 8x we will have an EV of 448 resulting in an 18% IRR ~ 16-month hold in the downside case. Note that this is a conservative multiple, and no margin expansion and a slight de-rating from a normalized environment to reflect a failed turnaround.

We agree that the company may choose to expand quickly, inversely mirroring the mistakes of previous management. However, we believe the risk is limited as the UK CEO is very experienced in this industry, knows the right locations and people to be selective about branch reopenings.

Conclusion:

SIG is an attractive long at current prices, a valuable brand that has been mismanaged in recent years. It recently transitioned from a weak CEO to an A++ CEO with a proven track record at this company. Investors can buy into an asset-light near-term sustainable organic EBITDA grower at a 15% 2019 FCF yield. Shares could roughly double over the next three years just by going back to the basics.

Catalyst

• Short term (6-8months): 

1. Better than expected H2 results (announcement next week), exceeding estimates by a wide margin

2. Further CD&R open market purchases 

3. Covid-led home building rebound 

4. Company continues showing strong credit quality 

• Medium term (8-16 months):

1. Successful operational turnaround 

2. CD&R take private

3. Relist play in US: Irish peer CRH plc is listed on NYSE at a premium valuation 

4. More analyst coverage