Description

Thesis:   stable business, straightforward thesis; recently completed large/very accretive and strategic acquisition, earnings power further boosted from tax reform; industry consolidator historically with big multiple now trading for >9% pro forma FCF yield with further upside optionality from imminent product price increases and de-levering

Overview:

• Roofing distribution:   boring but good market within building products, revenues historically split 65/35 residential/commercial;  local/regional business served out branch network as materials are very heavy and don’t travel long distances well (asphalt shingles ~70% of the market)
• Stable base of business as 80-90% of all roofing projects are re-roofing and largely non-discretionary and non-cyclical (drivers are leaks, end of useful life and importantly weather damage); 10-20% remainder is from new construction; U.S. housing stock now median ~40 years old plus all the homes built in the ~5 years leading up the 2006 peak entering time frame where re-roofing becomes necessary (pent-up demand)
• Growth drivers:
• Organic:  historically able to grow mid-single digits on base market growth + market share gains w/scale + opening greenfield branches (80+ since IPO)
• M&A:  BECN has been the principal consolidator of a historically fragmented industry over the last decade or so, done 40+ deals culminating in two recent large ones (RSG and Allied) as further discussed below; deals are very accretive as driven by increased local/regional scale (key driver) + more buying power from roofing OEMs + cost cuts largely driven by in-market branch consolidation
• Industry structure much improved:  roofing OEMs have consolidated from 10+ players to only 4 now representing ~90% of the market, these are converting businesses that are acting much more rationally than in the past; at the same time, the distribution side has also become more consolidated with the top 3 representing ~50% of the market (BECN is #2, ABC is #1 a family owned company and #3 is private equity owned (Berkshire Partners) and currently reported to be for sale)

Roofing Supply Group (RSG) and Allied Building Products:

• RSG:  large deal $1.1B in 2015 bought from private equity firm Clayton Dubilier (CD&R), was very successful deal, BECN beat their synergy target by a good amount and importantly de-levered quickly following the transaction back at their ~3x target within 24 months
• Allied:  
• Larger deal but similar integration and more strategic; announced in Summer 2017 and closed in January 2018; $2.6B deal financed with debt (new bank/bonds), a new convertible preferred issued to CD&R and a public common equity secondary
• Allied was bought from publicly traded global building products company CRH where it was a non-core asset that had been run as cash cow and starved of growth capital; headline price was high but marketed at 8.7x EBITDA including synergies; BECN levered up well into the mid 4s to do the deal; plan is to de-lever back to 3x again within 24+ months (asset light, low capex business, good FCF conversion)
• Allied was another large consolidating play but also brought some new core geographic market strength to BECN (i.e. Northeast); in addition, Allied has a good sized interior building products distribution business (wallboard, ceilings), which is a decent business undergoing a similar fragmented-to-consolidated market shift and provides BECN another growth market opportunity down the road; pro forma, interior products represent ~15% of total revenue
• Underwrite-able synergies ($110M target) based on BECN’s deep M&A and particularly RSG integration experience; management has provided in-depth discussion of the process and their assumptions; synergies are cost side only and largely based on (i) purchasing power / scale, both companies buy the same SKUs from the same OEMs and detailed analysis of best pricing done, (ii) branch consolidations in overlapping markets, also relatively straightforward and done before, (iii) basic SG&A and overhead cost cuts; furthermore given the size of the RSG deal, the company brought in outside consultant help (Bain) for both analyzing and implementing that successful combination; the same consultants were used for Allied and the same processes; for the Allied deal, mgmt disclosed that Bain came back with a range of $110-$160M and for purposes of guidance they chose to use the low end of $110M; furthermore, senior BECN mgmt incentive comp is directly tied to beating and exceeding these synergy targets

What happened / why interesting now:

• Market initially didn’t love/focus on the deal as it was announced the last week of August, the headline price was expensive, they needed to raise common stock (overhang) and the terms of the convertible preferred were too favorable to CD&R (agree)
• However, once the pro forma earnings power (discussed below) was better understood and the company got good execution on the debt financing, market started paying attention and couple things happened:
• Base earnings before the deal was ~$3.15, the deal was very accretive to the tune of 25-40%+ using first year ($50M) and then the full year two $110M synergies gets to $4-$4.50 of earnings
• Then the 3 large hurricanes hit in 2H17 and severe weather is a major driver of incremental re-roofing demand, much is funded out of insurance and this had the effect of increasing volume and tightening up the market some on price
• Lastly, tax reform was passed, BECN is a 95%+ domestic operation (Canada remainder); went from a full taxpayer 38-39% to 26-27%, adding another ~40c or earnings and getting close to $5 earnings per share
• Stock ran from the mid-high $40s up to $67 and has since come back down to $54; believe this is because (i) the recent conference calls and guidance were messy as the company did not do a great job explaining the effect of deal-related amortization on EPS (i.e. cash vs. book earnings), and the headline number was confusing as the annual guidance (Sept fiscal) only included 3Q of Allied and did not include the full benefit of the new tax rates either, both obscuring real cash earnings power, (ii) the stock got caught up in the sell-off of homebuilding/building product stocks even though only a very small % of BECN volume is sold into new construction (80-90% is re-roofing), (iii) importantly, gross margin % had a miss the quarter due to a timing mismatch between price and raw materials, discussed further below
• Price vs. raws:
• Company has been dealing with raw material deflation for years which has had a negative net effect; inflationary environments are a much better backdrop for roofing distribution as they can typically raise price in excess of cost inflation and get some gross margin expansion which levers nicely to the bottom line as most of the rest of a branch’s cost are fixed
• This past quarter was the first time in literally years that pricing was up as base commodity inputs have spiked (asphalt/derivs) and both OEMs and distributors are now raising price; earnings in roofing, both OEM and distribution, historically do very well in these environments and is when the stocks work best; on the last call:  “Given the inflationary raw material trends, strong product demand and a favorable economy, we remain quite optimistic about Spring pricing opportunities”; after they get through the seasonally weak March qtr (end of Winter), price vs. raws should become a tailwind, potentially multi-year, and gross margin % should inflect; company guidance for 2018 is based on flat pricing so any momentum is upside
• In addition to raws, increased demand of course also helps and demand has picked up organically and the market got tighter after the hurricanes and continues to be firm as there is still a lot of pent-up storm related re-roofing that needs to be done in 2018
• Lastly, in the due diligence on AIlied, BECN management learned that Allied’s comparable gross margins were actually better than legacy BECN by 150-250bps on like for like product, this is despite BECN’s larger size and better scale purchasing; the key learning was that Allied was actually more disciplined on pricing and had better systems/controls, did pricing more centrally (i.e. less room for the field to cut deals) and the combined company believes it can improve margins based on this improved practice (this is all upside and is not in the $110M or $160M synergy number)

Summary:

• Stable business, straightforward thesis, several earnings power drivers
• Base earnings power of ~$4.25 including full year synergies ($50M) and new tax rate, gets to $4.85 with full $110M synergies and >$5.30 if get the $160M; this all assumes only modest organic increases in the base business; on top of this, every 1% net price increase on just the residential roofing side can be more than 25-30c accretive plus de-levering also adds ~15c per year
• Above gives several ways to get to >$5 in earnings power and the stock is trading at <11x this pro forma number; the stock in the past has garnered mid-high double digit P/E multiples given its growth and FCF; at 14-16x earnings stock could be up 30-50%+; key risk here is not “cheap” on EBITDA and fundamentally the balance sheet as mid-4s levered and needs to be worked down
• Catalysts:  (i) de-levers the balance sheet, (ii) price realization sticks, gross margin expands starting in the June quarter, (iii) synergy targets are met and then beat, (iv) heavy 2018 storm season

Catalyst

(i) de-levers the balance sheet, (ii) price realization sticks, gross margin expands starting in the June quarter, (iii) synergy targets are met and then beat, (iv) heavy 2018 storm season