I am recommending a long position in Stock Building Supply Holdings (“STCK”). I believe that STCK could easily be a double, but ascribe a conservative fair value for this company of ~$26/sh, or 91% above the current stock price.

STCK is a lumber and building products distributor that was IPO’d in Aug 2013 by the Gores Group (“Gores”), who purchased it out of a pre-packaged bankruptcy in 2009. Prior to their bankruptcy, STCK was a subsidiary of publicly listed Wolseley PLC (“WOS”). STCK has operations in 13 states (largely Mid-Atlantic, Texas, and the Southwest) and offers 39,000 products which collectively represent ~50% of the construction cost of a typical new home, including Lumber (36% of sales), Windows/Exterior (21%), Millwork/Interior (19%), Structural Components (11%) and Other (13%). The vast majority (72% in 2012) of STCK’s revenue is driven by new single family home construction, which remains ~50% below its long-term average.

I believe that STCK is dramatically undervalued and a compelling long investment because it:

1. Is highly-levered to the ongoing single-family housing recovery
2. Has a long history of strong pre-2007 operating performance which should continue again
3. Has additional opportunities to meaningfully improve operating performance
4. Has one of the best balance sheets in the industry and is a potential consolidator
5. Is very cheap at 4.6x mid-cycle EBIT, especially compared to comparables trading at 7-10x

Furthermore, I believe that the market does not reflect this valuation because STCK is ignored and significantly misunderstood for a couple of reasons:

• Lack of coverage – to date, only 5 analysts (all underwriting banks) have picked up coverage, and have only done so very recently.
• Bad timing – STCK IPO’d on August 8^th, right before a significant move downward in indices, contributing to uninspiring short-term returns and a lack of excitement towards the name.
• No significant comparables – most competitors are private companies or not true comparables.
• Lack of information – STCK’s prior bankruptcy means that the readily-accessible operating history only goes back to 2010 and shows significant losses in each year, hiding their true profitability potential.
• Incorrect information – Bloomberg financials have not yet incorporated the post-IPO capital structure, and currently overstate debt and preferred equity by a collective $89M, or ~20% of STCK’s EV.

While the market misunderstands STCK’s true prospects, the one investor with the best knowledge of the company also believes it is cheap right now – Gores elected for the IPO to predominantly be a primary offering and only sold 13% of their holdings. In fact, when demand for the deal was weaker than expected and the deal was priced at $14 rather than the expected $16-18 range, Gores reduced the size of the offering by 1.8M shares  - the entirety of this reduction was their own shares which they elected NOT to sell at $14/sh.

1. STCK is highly levered to the ongoing single-family housing recovery

While the historical level for new single-family home construction (Bloomberg ticker: THUSNUT Index) has been ~1.1M units per year, the collapse of the housing sector in 2007 pushed new starts to a low of 430k units in 2011. Since then, the market has recovered, with 590k units started in the 12 months ending June 2013 and y/y growth rates in the low 20% range. Most analysts believe that the current growth rates will persist over the next ~3 years until new housing starts reach normal levels in 2015-16.

Given STCK’s significant exposure to new single-family home construction (it accounted for 72% of revenue in 2012 and should account for more at mid-cycle), it is no surprise that the business performed poorly in 2007-09, but it should also be no surprise when the same mechanics drive significant revenue growth over the next 3-4 years.

Below is the organic revenue growth for STCK (as a subsidiary of WOS) vs. single-family starts from 2001 to 2008:

Feeding these historical figures into a regression suggests that STCK’s organic revenue growth typically equals 85% of the single-family starts growth plus an additional 200bps. Note that recent revenue growth since 2011 is consistent with the above relationship suggesting that it holds when housing starts are increasing as well.

Under an assumed 1.1M mid-cycle new starts per year in 2016 vs. 590k in LTM June 2013, STCK’s total cumulative organic growth rate should be roughly equal to 82%, (or 18.6% per year on housing starts growth of 19.5% for 3.5 years) pushing trailing revenues of $1.1B to $1.95B. If anything, this may be understating STCK’s organic growth potential – the markets in which they operate are benefiting from housing start growth that is 140bps greater than in the rest of the U.S. (25.3% vs. 23.9% in 2012).

Note that this is slightly more aggressive than, but in line with, management’s expectations. On the Q2 call, they indicated that “our current location footprint with our existing capabilities generated approximately $1.8 billion in net sales during the last up-cycle. And we believe it has the ability to do so again when the new home construction cycle recovers to more normal levels.”

They also indicated that they are gaining considerable share and that they expect to continue to do so, which may bridge the gap between the $1.8B and my estimate of $1.95B. This expectation seems reasonable given the operational improvements management has already put in place (see point #3 below), as well as the inability of some smaller competitors to take share due to capital constraints (see point #4 below). In management’s own words: “We feel like the 500 basis point growth rate above the market that we discussed in our road show has continued here in the second quarter. And so, we feel like the trends are consistent from a share gain perspective that we've been discussing of course. And relative to what we're seeing and hearing is, based upon our service capabilities, expanding that both on distribution services, we see very strong performance because of our investments in our logistic service or SLS, Stock Logistic Service capability, that continues to pay dividends as customers see the value of that, especially as they become busier.”

2. STCK has a long history of strong pre-2007 operating performance which should continue again

While STCK’s IPO filing paints a grim picture of historical profitability (due to only going back to 2010), the truth is that STCK had a long history of solid operating performance pre-2007 which is not readily apparent unless time is taken to go through the historical financial reports of WOS. See the historical performance below (all in GBP). Trading profit is essentially EBIT plus amortization of goodwill.

Note that while pre-2007 there is some variation in margins depending on the housing cycle, overall they average 5.8% without much variation, highlighting the ability to pass-through costs and the stability of the distribution model under normal operating conditions.

Compare this with the cringe-inducing historical performance seen when reading through the STCK IPO prospectus (all in USD):

Furthermore, STCK’s recent performance and management’s comments on the Q2 call suggest that incremental EBITDA margins in the low double-digits are reasonable, which implies that margins similar to the pre-2007 average will again be achievable.

Wells Fargo Analyst: “It looks like in the first and second quarter this year incremental EBITDA margins were in the 10% to 11% range, I was just wondering if that was a good kind of proxy to use going forward.”

Management: “Yeah, I think the 10% to 11% is a reasonable estimate of where we would expect the business to be. And, again, it kind of goes along with that 50% fixed, 50% variable breakdown of SG&A, because effectively that's translating to roughly half of our gross profit dollars – of incremental gross profit dollars falling to the bottom line as well.”

Alternatively, comparing LTM results to 2011 results shows that EBITDA has increased by $50M on incremental sales of $311M, implying a more significant incremental EBITDA margin of 16%.

When this operating leverage is combined with the significant revenue growth expected over the next 3-4 years, the bottom line results are very attractive, with mid-cycle EBITDA estimates of $82M - 122M. I’ve arrived at these estimates by using management’s guidance of $1.8B in sales and 10.5% incremental EBITDA on the low end, and my own estimate of $1.95B in sales (arrived at via regression) and margins consistent with those from 1997-2006 on the high end (implies incremental margins of 13%). The medium case uses my sales estimates and the 10.5% incremental margins.

3. STCK has additional opportunities to meaningfully improve operating performance

In addition to the operating performance improvements driven by the turning of the housing cycle, STCK has a number of other opportunities to meaningfully improve operating performance which build on the successes already made to date.

After acquiring STCK in 2009, Gores brought in Jeff Rea (a former GE alumnus) as CEO. Under his watch, STCK has implemented GE-like “lean” processes throughout the business, with the aim of reducing fixed costs and improving operational outcomes. As an example of these improvements, on-time deliveries have improved considerably and reached 92% last year (95% is the target for this year) vs. an industry standard 75% (per management). Management believes that further investments in technology will continue to generate benefits, and that these investments constitute competitive advantages that many competitors cannot replicate.

In addition, there are meaningful opportunities for STCK to capture a greater share of wallet, with management expecting to expand their value-added millwork and structural components manufacturing. STCK’s product and service portfolio represent ~50% of the cost of a new home, yet in their markets they only capture 7% of this opportunity, implying the possibility of future organic growth.

While my mid-cycle estimates do not reflect any of these additional operating improvements, I think it should be seen as additional potential upside.

4. STCK has one of the best balance sheets in the industry and is a potential consolidator

With only $73M of debt (asset-based, very cheap), STCK has one of the better balance sheets in the industry. This is a differentiator in a market filled with competitors who barely survived the housing downturn and have yet to generate positive cash flow. Not only will these weaker competitors be unable to reinvest in their business, but in many cases their future growth will be constrained. STCK’s net working capital is 10% of their LQA sales, implying that theoretical growth of ~20% per year eats up 2% of sales in cash flow – not a major problem for STCK, but potentially infeasible for small or poorly capitalized competitors.

Furthermore, having a strong balance sheet allows for potential consolidation opportunities. STCK is currently the 9^th largest building products distributor in the U.S., and beyond the top 10-15 players the market gets extremely fragmented, with many small companies focused on a single city/region with a handful of locations. Acquiring competitors like this should allow for significant synergies as purchasing scale improves and acquired companies can be ported onto STCK’s company-wide ERP system.

For more information on the market and competitors, the Pro Sales magazine is a useful resource, with an overview of the top 100 firms each year (http://www.prosalesmagazine.com/prosales-100-and-companies/prosales-100/)

5. STCK is very cheap at 4.6x mid-cycle EBIT, especially compared to comparables trading at 7-10x

Using the average of the three mid-cycle estimates above (a blend of management’s implied guidance and my estimates) STCK generates mid-cycle EBITDA of $101M, EBIT of $91M (ex-amortization), and has an EV of $424M ($13.77 x 26.6M fully-diluted shares + $64M net debt - $7M cash from option exercise). Under these metrics, STCK looks pretty cheap at 4.2x EBITDA and 4.6x EBIT.

While ideally we could easily compare this to other companies, there are not many other public companies of reasonable size in the building products distribution business that are as levered to single-family housing. The only company which is really comparable is Builders FirstSource (“BLDR”) which is the 7^th largest distributor in the U.S. BLDR, like STCK, is just beginning to generate positive profit, so traditional metrics aren’t of much use. However, we can compare STCK to BLDR on EV/Revenue and on a “normalized” EV/EBITDA which takes LQA revenue and applies historical margins.

BLDR has an EV of $876M and LQA revenue of $1.6B for an EV/Revenue multiple of 0.55x. At historical EBITDA margins of ~6.2% (2003-06 average), “normalized” EBITDA would be $98.5M for a multiple of 9.0x. On these same metrics, STCK trades considerably cheaper, at an EV/Revenue multiple of 0.34x and an EV/”Normalized” EBITDA of 5.6x.

Another approach is to compare STCK to other building material-related businesses that are heavily geared to single-family housing. For this analysis, I’ve included USG (drywall & ceilings), AMWD (kitchen cabinets and vanities), MAS (faucets, cabinets, paint), and BXC (another distributor). Below you can see how these companies compare on an EV/Peak profitability, EV/Average 2003-06 profitability, and EV/15E profitability (consensus estimates in all cases except for STCK). In all cases, STCK is considerably cheaper (although the comparisons to pre-2007 are a bit too generous to STCK given the substantial downsizing it completed as part of the reorganization).

Note: Historical STCK EBITDA is an estimate based on assumed D&A of 0.5% of sales

Based on the comparables above, I believe a reasonable fair value for STCK is 8.3x my mid-cycle EBIT, or ~$26/sh – 91% above the current price.

Key Risks

• Historical performance may not be a good proxy for future performance
• New single family home sales may be slow to recover or may not reach the targeted level of 1.1M houses per year (this risk could potentially be mitigated by shorting out some of the highly-cyclical names above (e.g. USG, MAS)
• STCK’s customers (homebuilders) are also consolidating which could impact margins

• Track record of continued double-digit incremental margins > 10% will generate more confidence among analysts
• Earnings momentum
• Additional analyst coverage
• Return to positive EPS and correction of net debt causes STCK to screen more favorably