Description

Many may question the wisdom of even looking into a business that is highly dependent on the US residential construction market given the very sorry state of the latter.  However, you will be well served to make an exception with respect to Simpson Manufacturing.  Simply put, Simpson Manufacturing is a first class business run by first class people in a first class way - available at a mid-single digit multiple of normalized cash earnings.

Simpson Manufacturing Co. Inc. (SSD) is the largest North American manufacturer of structural connectors and related products.  The Company's products are used in residential and light commercial construction to ensure structural integrity of buildings.  SSD's history dates back to 1956 when the Company produced its first structural connector.  Since that time the business has grown substantially to command a 60% share of the North American connector market.

Due to SSD's industry leading position and depressed valuation, the Company's stock currently represents a highly attractive investment opportunity as evidenced by: 

• - SSD's stellar margins and returns on invested capital, which averaged 17.5% and 22%, respectively, over the past 15 years;
• - The Company's prodigious cash generating capabilities - historically, SSD relied exclusively on internal sources to finance its growth despite investing significant amounts of funds in capital spending projects and acquisitions;
• - Excellent financial condition, as SSD enjoys a debt-free balance sheet and has almost 20% of its market cap in cash;
• - Outstanding management team, which has significantly increased the value of the business over time through building a top-notch brand and making opportunistic complementary acquisitions, while returning excess funds to shareholders through dividends and share repurchases;
• - Substantial long-term growth potential stemming from increasingly more stringent building codes, both domestically and internationally, and from branching out into the related homebuilding product niches;
• - Dirt cheap-valuation, as SSD's stock is selling for approximately 6X CFY normalized cash earnings.

THE BUSINESS AND ITS COMPETITIVE ADVANTAGES

Structural connector manufacturing is one of those businesses, in which industry leaders, such as SSD, enjoy highly favorable economics.  The main reason behind this fact is that builders can be held liable for structurally unsound structures, which provides strong incentive to stick with the best and most-trusted connector brand in order to avoid potential headache later on.  This, in turn, enables the owner of the most reputable brand to charge a healthy mark-up vs. competing products.  The ability to extract a significant premium perpetuates the leader's dominance by keeping incumbents permanently starved of profitability.

Based on the above it is clear that SSD's main competitive advantage is the strength of the Company's brand name that stands for utmost reliability in the eyes of most end users.  Given the liability risk associated with faulty structures, architects and engineers are highly motivated to specify SSD's products - which are well-known and highly-trusted - in building codes.  In the same vein, builders have to stick with SSD to comply with the codes; even when no specific code requirement exists, builders are still better off selecting SSD product to avoid the risk associated with putting up a faulty structure.  Thanks to its strong brand name, SSD can charge a 10-30% mark up vs. competing products and can generally pass through price increases without much resistance from its customers.  For example, when raw materials prices escalated in the summer of 2008 SSD had no trouble putting through a significant price increase, despite the homebuilding market going through the worst downturn on record.  It would be very hard for an existing or new entrant to replicate SSD's brand name advantage.  To build a meaningful market presence an incumbent would have to underprice SSD by such a dramatic percentage that the economics of such market entrance would be horrific.  For example, to replicate SSD's manufacturing and product development capabilities an entrant would have to spend several hundred million dollars, whereas profit prospects would be very distant and highly uncertain at best.  (The only way an incumbent could successfully take market share away from SSD is if the Company's management dropped the ball in a big way - an unlikely even given the skill and the track record of the current executive team; I will expand on that later in the report.)

The second competitive advantage that SSD has is the company's new product development capabilities.  Management realizes that R&D is crucial to the long-term success of the business and they invest substantial amounts of money in new product development regardless of the short-term macroeconomic situation.  For example, SSD ramped up R&D spending by almost 20% in 2008, despite the company's end markets going through the worst downturn in decades.  Clearly, SSD's management understands that creating long-term value is more important than making short-term financial results look good.  SSD's fanatical approach to product development enables the Company to continuously widen the competitive moat between itself and the rivals, who spend much less on R&D both on a % of sales and absolute dollar basis and have a tendency to curtail new product development when the economy slows down.  For example, SSD is the only US manufacturer that has the capability to test structural products in a multi-story setting, which enables the company to ensure top product performance and to provide concrete performance proof to product users.

SSD's sophisticated and highly-automated manufacturing facilities represent another substantial advantage that the company enjoys vis-à-vis its rivals.  The advanced manufacturing setup enables the Company to keep its production and labor costs at a low level.  In addition, the advanced setup allows SSD to rapidly respond to its customers' demands, which in crucial for many product users.  At the same time, most SSD's competitors, which include smaller, less profitable connector manufacturers, cannot afford to build manufacturing capabilities similar to those of the Company.

Yet another advantage is the Company's global manufacturing footprint and extensive product line up.  SSD boasts a network of over 20 facilities capable of serving the entire US and over 30 other countries.  In addition, the Company's SKU count includes over 11,000 products.  Such delivery and product range capabilities make SSD an attractive partner to its customers, who may reduce their cost by consolidating purchases within one source.  At the same time, none of the company's competitors offer a comparable capability in terms of geographic presence or product range.  Due to their much smaller scale SSD's competitors would find it hard to replicate the company's geographic footprint and product breadth without substantially impairing profitability, which is not something they can afford.

In addition, SSD sets itself apart from competition through top-notch customer support.  It is critical for a builder to receive a rapid and detailed response to whatever questions may arise during the construction process.  If the builder calls SSD he can be sure that a human being, not an automated attendant or voicemail, will take his call and answer the questions promptly.  And if the SSD customer service consultant cannot provide the level of detail required, he will arrange for a lead engineer to call the builder back in no more than 5 minutes.  Further, if still more assistance is required, the SSD engineer will visit the builder on site to resolve any remaining issues.  To my knowledge no other company in the industry provides such a high level of customer support. 

Lastly, SSD's superb financial condition represents another significant competitive advantage.  As a result of the high profitability of its business model SSD has been able to fully finance its growth internally and, thus, enjoys a debt-free balance sheet and has almost 20% of its market cap in cash.  Such a strong financial position enables SSD to pursue attractive expansion opportunities even during major downturns.  In contrast, most company's rivals are hobbled with debt, which puts them at a competitive disadvantage in terms of financial strength vs. SSD.  For example, the parent company of SSD's main competitor, USP, has interest coverage ratio of approximately 1X.

FUTURE GROWTH POTENTIAL

SSD boasts substantial future growth potential.  There are three main drivers behind future growth:

1) Domestically, ever increasing public awareness with respect to the structural integrity of the buildings results in states continually adopting more stringent building codes.  Over time this trend should generate additional demand for SSD's products.  So far, only 23 states adopted the most advanced IBC 2006 code, which suggests ample growth potential for structural products, as it is expected that most states will eventually have to follow the aforementioned standard.

2) Even more dramatic changes with respect to building codes adoptions are expected to occur internationally, especially in the emerging economies of Asia and Eastern Europe.  Currently, building codes are virtually non-existent in many of the above economies, but as these countries develop, code adoptions will be up substantially, thus driving demand for products promoting structural integrity.  SSD is mindful of this opportunity and has been aggressively expanding its global footprint, which included setting up a manufacturing facility in China last year, to take advantage of the emerging demand.

3) SSD should be able to grow by expanding its product range through the introduction of complementary products.  For example, in the past several years the company successfully expanded into mechanical anchors, pre-fabricated walls, and fastener systems, all of which are related to improving structural integrity.  Given the company's cash pile, its successful track record of acquisitions, and the abundance of opportunities (both internal and external), it is likely that product range expansion will be an important source of growth for SSD. 

MANAGEMENT

SSD has a highly qualified and reputable team at helm.  The Company's Chairman, Barclay Simpson, started the business from scratch in 1956 and built it into the leading and the most profitable connector manufacturer in the United States.  SSD's current CEO Thomas Fitzmyers who assumed his role from Barclay Simpson in 1994, subscribes to the same managerial philosophy and values.  Since his appointment Tom has made an impressive contribution to the company's development by further deepening the moats around the company's competitive position.  Overall, SSD management team has an excellent track record of creating shareholder value through accomplishing industry leadership in product quality and innovation.  Notably, SSD executive team scores well both with respect to operations and with respect to capital allocation.  In terms of operations, SSD management is committed to devoting ever increasing amounts of funds to new product development, quality assurance, and employee development.  The Company stays true to its commitment no matter how tough the general economic situation is, as the executives understand that maximizing long-term value should take precedence over maximizing short-term financial results.  Further, SSD is structured in a decentralized fashion, so that the Company's regional managers have broad authority with respect to what and how they sell and are compensated based on their own "profit center" results.  The outcome is hard-working and motivated workforce striving for top results, as opposed to waiting for 5 o'clock to arrive.  SSD's management has a solid track record with respect to capital allocation as well.  Over time the company widened its competitive moats significantly through a number of acquisitions, which were smart strategically and effected at prices resulting in solid returns on invested capital.  A good testament to SSD's frugality with respect to acquisitions is that when the Company bid for MiTek back in 2001, it got outbid by none other than Warren Buffett himself.  In addition to using cash flow to finance growth, SSD has historically returned a portion of its cash flow to shareholders via dividends and share repurchases.  (As these amounts have been relatively modest, some may argue for a more aggressive share repurchase program.  However, given the returns the Company historically generated through both internal capital projects and acquisitions, it appears that investing the bulk of cash flow in growth initiatives is a reasonable approach.)

Executive compensation at SSD features a salary, which is significantly below industry averages, and a bonus, which could be quite considerable, if the recipient achieves strong returns on invested capital within his "profit center."  The Company has a significant percentage of insider ownership, as the Chairman owns about 22% of the shares, while the top four executives own approximately 1.5%.

It is worth mentioning that to promote team spirit SSD treats its executives the same way it treats all of its employees:  there are no special compensation plans for executives, no executive employment contracts, and no special severance benefits.  Further, you will not find pictures of the executives in the annual report, but you will find plenty of pictures of ordinary employees filling the pages.  In addition, to further strengthen the bond between the employees and the company SSD sponsors a scholarship program for the children of the employees.  The above speaks volumes about the character and integrity of the management team at SSD.  (Incidentally, such managerial attitude also results in low turnover, first-class workforce, and correspondingly low labor costs.)

DISCUSSION OF THE US HOMEBUILDING MARKET'S IMPACT ON SSD'S BUSINESS

I would like to precede the discussion regarding SSD's valuation with the section evaluating the impact of the US residential construction market on the Company's sales.  As the homebuilding industry accounts for well over 50% of SSD's sales, the discussion of the Company's business would not be complete without examining the state of its largest and most important market.

As the homebuilding market is currently going through the worst downturn since the records began in 1959, SSD's current period sales and earnings understate the company normalized long-term earnings power.  Therefore, to come up with sustainable "intrinsic" sales and earnings figures for SSD, one has to examine the state of the residential construction market and make certain assumptions with respect to its long term performance.  I am not an expert in macroeconomic forecasting, but I do believe that by looking at the data below one can arrive at a reasonably accurate number for the normalized amount of new housing units per year.

US Housing Starts vs. US Population

 Source:  www.census.gov

While a more conventional approach of determining a normalized level of new housing would involve using the long-term average of housing starts, I suggest looking at the ratio of Housing Units Per Capita instead to adjust for the growing population.  By examining the above table one can see that the 2009 ratio of Housing Units Per Capita will be by far the lowest on record and well below the previous trough of 4 set in 1991.  I believe that it is reasonable to assume that the future long-term the ratio of Housing Units Per Capita will approximate its long-term historical average, which was in the range of 5 to 7.  Using the bottom of the range for the sake of conservativeness indicates normalized annual housing starts of about 1.5 million.  Looking at it from a different angle, as the number of US households grows by about 1.3 million annually, it follows that the normalized level of housing construction required to accommodate that growth should be around 1.3 million units.  So, whichever way you look at it, the normalized level of annual housing construction should range from 1.3 to 1.5 million units.  SSD's 2009 sales estimate of $700 million is based on 0.6 million housing starts.  If one were to use the normalized number of 1.3 million units and assume that 50% of SSD's revenues are derived from residential construction, this would imply that the Company's normalized sales level is approximately $1.1 billion.  (However, it will probably take a couple of years to work through the excess inventory of houses built up during the 2002-2006 boom before you start seeing housing starts come back to their long term normalized values.)

VALUATION

Given the historic downturn in the residential construction industry, which accounts for a significant percentage of SSD's sales and earnings, reported earnings in the current period may be far off from the sustainable "intrinsic" earnings.  Therefore, to calculate a sustainable earnings number you have to normalize current period earnings based on certain assumptions regarding the firm's sales and margins levels.  Based on my set of assumptions, SSD trades at approximately 6X CFY multiple of "normalized" cash earnings, which indicates that the stock is significantly undervalued. 

Obviously, the earnings estimate on which the above multiple is based is only as good as the set of assumptions, and therefore I will discuss the most important of them below:

- Sales.  As discussed in the previous section I am using sales of $1.1 billion as an approximation of a normalized figure.  To quickly recap, this sales level would reflect the number of housing starts which are needed to occur to accommodate population growth. 

- Operating margin.  I am assuming SSD will be able to achieve an operating margin of approximately 17% on a long-term going-forward basis.  This is the average operating margin that the Company has generated over the past 15-year period, which includes both up and down cycles, and therefore, makes the historical margin a good baseline for estimating future long-term results.  As all the past elements of SSD's competitive advantage are still present, it is reasonable to assume that long-term future operating margin will approximate the one observed in the past.

 - I am calculating the Company's market cap net of cash on the balance sheet, because this cash is essentially "excess" in nature, and it is available for use in funding SSD's expansion, paying a dividend, or funding a share repurchase.

Here is a back-of-the-envelope calculation that details the main inputs of the normalized earnings number:

2008E

Sales................................................$1,100 million

Operating margin................................17% million

Operating income................................$187 million

Tax @ 38%........................................$71 million

Net income.........................................$116 million

D&A..................................................$30 million

CAPX................................................$20 million

NORMALIZED CASH EARNINGS................$126 million

Market cap: $910 million net of $171 million in cash = $739 million.

Catalyst

• Sheer cheapness of the stock, as it sells far below the intrinsic value;
• Recovery of the US residential housing construction market;
• Continued growth through building codes improvement both domestically and internationally and through branching out into related product lines.