Description

We believe that TopBuild represents an attractive way to play the US housing recovery.  While timing the housing cycle is difficult, significant evidence suggests that TopBuild has a substantial growth runway for the foreseeable future.  As the housing sector rebounds and awareness grows, we believe TopBuild will re-rate substantially as the name trades at ~5.7x our view of normalized earnings, before taking into consideration potential value accretion from buybacks or M&A.  Further, the company has an underappreciated, exceptionally clean balance sheet that provides significant optionality to increase returns to equity holders.  At current prices, we believe TopBuild will compound at a ~40% IRR over the next 3 years, although the value accretion could come much more quickly. 

 Spinoff Background:

TopBuild (“BLD”), an insulation installation business, was spun out of Masco (“MAS”) on June 17^th and began regular way trading on July 1^st.  TopBuild possesses many of the characteristics typically present in attractive spinoffs: (1) parent in the S&P, (2) significantly smaller than parent, and (3) worse business than the parent.  We particularly like that all of management’s unvested MAS options and RSUs were converted to BLD shares based on the trading price of BLD for the first 3 days following the spin, which we believe led management to provide conservative guidance.  

Business Description:

TopBuild is the #1 installer of residential insulation in the country, with a national footprint that spans 95% of housing starts across 99 of the top 100 markets[i]

TopBuild’s leading market share provides it with a number of competitive advantages:

1.      Purchasing Discounts: BLD's significant size in a very fragmented industry enables it to extract price discounts from insulation manufacturers (our research suggests 5-10% discounts on avg)

2.      Scale Efficiencies: BLD should have significant scale efficiencies relative to the small, fragmented group of localized contractors it competes against (streamlined IT, business processes, etc)

3.      Beneficial for Large Builders: BLD's national scale gives it the ability to service national and large regional builders across multiple geographies

BLD has two primary business segments: (1) Installation ("TruTeam") and (2) Distribution ("Service Partners")

1.      Installation - This segment conducts the actual product installation

o   Clients are custom builders (40%), national builders, (25%), regional builders (25%), and multi-family builders (10%)

o   While the large builders are key clients, no customer is greater than 3% of installation sales revenue

2.      Distribution - This business distributes insulation to small contractors, particularly those who purchase less than a full truckload of insulation

o   Distribution is less cyclical, as small builders buy less on a direct basis in a tough market (will often need smaller shipments that are less than truckload)

o   In a down cycle, this business has more stable margins (7% in 2012 vs. -5% in installation), but margins do not have the same expansion potential.  Mgmt says this business has never lost money

TopBuild's business model has evolved from a sprawling rollup model to a leaner cost structure that we believe is well positioned for an industry rebound

1.      Early Phase: Focus on Residential New Construction - During the pre-'05 period, BLD focused on rolling up the insulation installation industry to build scale and purchasing power

o   During this time, BLD acquired more than 150 businesses

o   Our research indicates that BLD was not thoughtful with regard to acquisitions, often paying high prices (on peak earnings) without doing intensive diligence on the acquired businesses

o   This dynamic would prove problematic given that the acquired businesses were typically run by entrepreneurs who had developed local relationships

o   Post-acquisition, the entrepreneurs would join BLD for a couple years but often left to restart their own business once their non-compete ended

2.      Rationalization Phase: Adjusting to Downturn - As housing starts fell from 2.0mm to 0.5mm, BLD was left with a bloated cost structure and too many branches (forcing them to downsize)

o   BLD closed 110 of its 300 branches, rationalized the list of products it installed, and began to explore other channels that were less cyclical (Repair & Remodel and Commercial)

o   Costs were cut substantially (over $200mm of fixed costs) and acquisitions were integrated (including the implementation of a nationwide ERP system)

§  The company's breakeven volume level declined from 1.3mm housing starts to 750k starts 

3 .      Current Phase: Positioned for Growth - Management believes that BLD is now well-positioned for margin expansion as the housing market recovers (incremental margins of 20%+)

o   The company plans to focus on organic growth, which will require limited capital investment to grow (working capital neutral and limited capex) unlike other companies in the space

o   Beyond residential starts, growth is also expected in commercial (organic and potentially inorganic)

o   BLD's growth will ultimately be largely driven by housing starts (insulation installation typically lags housing starts by 3-6 months; at this point in the cycle, results more closely resemble completions)

We believe the setup is very favorable for pronounced growth and margin expansion, driven by four key factors:

1.      Housing Recovery: Housing starts should benefit from improving employment, wage inflation, household formation, low inventory levels, and continued low interest rates

2.      Energy Efficiency: Energy code standards have increased substantially, which is driving increases in the amount of insulation used per square foot (~200bps+ per annum benefit)

o   Consumers also prefer increased energy efficiency (saves money / more comfortable), which has led certain builders to make homes even more efficient than the codes require

3.      Share Increase in Residential: Management has repeatedly stated that they are going to gain share in residential new construction

4.      Expansion of Commercial Business: Management believes the business is well equipped for growth in light commercial, as they believe they can easily leverage their residential expertise

o   This market is very fragmented but is several billion dollars in size; we understand that BLD is the biggest player in this market as well

We believe that growth will flow through at attractive rates as BLD leverages fixed costs (fixed costs represent ~25% of the cost base and margins are quite low currently). Investors will also get to keep this cash flow as the company is NWC neutral with limited capex 

Housing Environment:

In analyzing the current house start environment, one element that is discussed less frequently is the mix between single family and multi-family housing

·         During the recession, many individuals chose to rent rather than buy due to economic and employment uncertainty (increased demand for rental drove multi-family starts higher)

·         There remains an element of uncertainty with regard to whether a secular shift towards multi-family has taken place

o   However, the majority of survey-based evidence we have encountered suggests that the movement towards multi-family is cyclical rather than secular

o   Survey data suggests young adults continue to want to own a home given sufficient economic certainty and income; the big barriers to single family start growth have been high millennial unemployment, delays to family formation (later marriage and child birth), a limited number of affordable homes, tough lending standards, and economic uncertainty

o   While there may be a secular trend on the margin, there are real reasons to believe that the current mix of single family starts is too low

·         Most importantly, while multi-family completions are back to mid-cycle levels, single family completions have more than 50% upside to the long-term average

While TopBuild is described as "levered to housing starts," TopBuild is particularly levered to single family starts

·         TopBuild generates 2/3^rd of its revenue from residential new construction, 90% of which stems from single-family home construction, positioning it to benefit from this change

·         We believe single family starts are set to accelerate relative to multi-family, although we don’t think this needs to occur to generate very attractive returns

Further, we believe that TopBuild has significant pent-up revenue growth yet to flow through in terms of started but not completed homes.  Single family starts are 715k homes over the past 12 months while completions are just 647.5k.  This dynamic has been driven by the normal lag of completions to starts in a growth environment and homebuilder labor shortages in terms of framing homes.  As completions catch up to starts, we expect TopBuild to grow into a normal multiple (with 50%+ upside to normal single family starts/completions at 20%+ incremental margins).

There are a number of reasons to believe that single family home starts will begin to accelerate:

1.      Permits for single-family homes are at post-2007 highs, which is a positive leading indicator for housing starts

2.      The National Association of Home Builder Confidence Survey has been running at post-2005 highs since it hit 60 in June (a reading above 50 indicates more builders view conditions as good than poor).  Increases in builder confidence have historically been correlated to starts

3.      Survey data suggests private homebuilder orders are pacing up ~15-20% (typically 5% ahead of public comps), another positive leading indicator

4.      Inventory is extremely tight relative to historical levels, which should help to facilitate increased starts

5.      Builder conversations suggest that we will soon see an increased focus on the affordable housing segment, which is important in terms of getting mix shift back towards single family

6.      Household formation data has been extremely robust.  The census data is very volatile (took a huge spike to over 1.5mm this year) and other surveys have picked up increasing household formation trends for the past three years.  The lag in formations that took place post the crisis likely represents a lag in terms of millennial life decisions vs. previous generations (later to get married and have kids, especially)

Valuation:

Getting the precise timing of the earnings recovery is difficult, but we think there is a very straightforward framework for thinking about TopBuild.  TopBuild is trading at an ~8.5% cash flow yield on our 2016E (~12.6x earnings, as cash flow exceeds earnings), which we think is slightly above a fair multiple of ~12.5x for the business on a normalized basis.  We believe the company is trading at an ~18% normalized cash flow yield, assuming no value accretion from buybacks or acquisitions (i.e., we assume all capital is returned via dividends). To get to normalized cash flows in 2018/2019, we think there are several key factors.  In each of these circumstances, we believe that management guided the Street conservatively in order to set low expectations (with the added benefit of having stock based comp re-struck at a lower stock price):

·         Single Family Completion / Start Growth: We model normalized single family completions of 1.04mm homes by 2019 (~10% below the historical average)

o   This assumes the mix shifts back towards normal levels, which management does not include in guidance despite their belief that a mix shift is likely to occur

·         Incremental Margins: We model incremental margins of ~23%, which we think is conservative.  Prior to the spin, management suggested that analysts model 20% incremental margins, although they will likely be “between 20% and 25%.”  We think incremental margins are likely 25%+ vs. analyst estimates of 20%.  We back into these numbers in several ways:

o   Management has stated that their cost structure is 20% fixed, 10% semi-fixed, and 70% variable.  If you use these assumptions, incremental margins are in the high 20s with reasonable revenue growth assumptions

o   Incremental margins in the first half of 2015 would have been 27.5% if management had been able to pass along the cost of material inflation (as they typically do).  This was a one-off factor and historical results suggest BLD and IBP have always been able to pass those costs on.  We solve for 27.5% by assuming flat gross margins yoy (we also back out stock based comp in all of our EBITDA calculations)

o   Disclosed incremental EBITDA margins since 2012 have been 25.7%

o   Management has also recently emphasized that they are working hard to cut costs in the business, particularly by removing excess overhead that existed due to Masco’s more bureaucratic organizational structure.  This would provide a tailwind to the strong incremental margins that exist organically for the business

·         Price Increases: We model price increases of ~2.75%.  This seems conservative relative to 5% price increases in 2013, 3% price increases in 2014, and recent trends in the ~3-5% context.  We believe price increases are more likely to increase than decrease as completions accelerate from their slow growth this year (single family completions growth is 4.6% YTD vs. single family start growth of 10.2% YTD).  This compares to management’s assumption of minimal price increases

·         Energy Codes: Changes in energy codes are increasing the amount of insulation per home (20%+ increase in insulation required in some markets).  Our analysis suggests these changes will drive a 200bps+ acceleration in insulation volumes.  We model a 2% benefit in the residential new construction business vs. management’s assumption of 0% (although management acknowledges they are seeing a benefit)

·         Share: Conversations with management and industry discussions suggest TopBuild is currently taking share.  Despite this dynamic, management assumes they take no share in their guidance.  We model share gains as offset by shrinking house size (more affordable homes as the single family market rebounds), but this provides potential additional upside

One way to think about upside beyond housing market growth is to see that TopBuild has grown installation revenue ~9.5% YTD vs. single family completions up just ~4.6% YTD.  Consolidated revenue growth has been slowed by some pricing weakness in the distribution business, which has seen flat pricing this year on the back of slower single family completions. 

Further, TopBuild has a highly underappreciated balance sheet with the potential to drive significant value.  Net debt is just ~$89mm, less than 1x adjusted EBITDA this year.  Management has suggested a willingness to run the business at 2x EBITDA, or even at higher leverage given where we stand in the cycle and the capital-light nature of the business.  With potential mid-cycle EBITDA of $250-300mm, this is potential incremental debt capacity of ~$400-500mm on a ~$900mm market cap.

Management indicated that capital return and acquisition discussions are set for the first half of 2016, which may act as a catalyst over the next 6 months.  TopBuild currently has $108mm of cash and can borrow money at L+200, which can drive substantial value if management optimizes the capital structure.  Management has discussed a desire to deploy capital through acquisitions and return capital to shareholders, and they are aware that they are becoming increasingly under-levered.  While we do not model increased financial leverage beyond the constant return of excess cash, we think this is a valuable upside ticket. 

TopBuild also has some value from tax shields.  They will save ~$20mm in taxes over the next 3 years from the amortization of intangibles.  Management also has $31mm in deferred tax assets from NOLs on the balance sheet.  Their absolute deferred tax asset from NOLs is actually $434mm, but the rest is expected to be used by Masco via a tax sharing agreement through the end of 2015.  Management has gone out of its way to say the other $31mm of DTAs will also be used by Masco (and we do not model value for the NOLs), but it seems interesting that the $31mm does not have a valuation allowance against it (like the rest of the NOL). 

Conclusion:

Ultimately, we believe that the management team was incentivized to be very conservative with its guidance, earnings expectations were based on that guidance, and there is strong evidence that assumptions are too low.  Management has guided to $45mm of revenue per 50k starts, even though they have done meaningfully better in the past due to the benefits of pricing, building codes, and a mix shift back towards single family.  Management assumes 20% incremental margins, even though they have been doing mid-20s.  In a year with a bad pricing issue (this year), they still are doing 20% incremental margins. 

We believe traditional spinoff dynamics have set TopBuild up as a particularly asymmetric way to play the housing recovery.  We believe it is rare to purchase a stock at an ~18% normalized cash flow yield while getting paid ~8.5% to wait.  This setup is particularly rare for a company with a very clean balance sheet, whose optimization is likely to drive significant earnings accretion.  In an environment with tight housing inventory, low interest rates, low oil prices, increasing wage inflation, and years of historical data suggesting 50%+ upside to single family completions, we think TopBuild is likely to be a good investment over the next 3 years.   

Disclaimers:

The views expressed herein are for informational purposes only, and are not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision for any purpose or for legal, accounting or tax advice.  This information does not constitute an offer to sell, or the solicitation of an offer to buy, any security.  The author makes no representation as to the accuracy or correctness of the information contained herein and expressly disclaims any liability to any person from relying on such information.  The information and views contained herein are provided as of the date this summary was posted and present the views of an investment firm that currently holds a long position in the company’s securities.  The author has no obligation to update any of the information provided herein.  The author reserves the right, in light of, among other factors, its ongoing evaluation of the company’s financial condition, business, operations and prospects, the market price of the company’s stock, conditions in the securities markets generally, general economic and industry conditions, its business objectives and other relevant factors, at any time, to decide to purchase, sell, or engage in any other transaction involving, the company’s securities as it deems appropriate.   Past performance is neither indicative nor a guarantee of future results.  There can be no assurance that an investment in the company will be profitable or that the assumptions regarding future events and situations will materialize or prove correct.  

Catalyst

• Announcement of capital return in H1 2016
• Quarterly earnings reports highlight stronger incremental margins 
• Acceleration in single family housing starts