BlueLinx Holdings Inc. (“BlueLinx”, or the “Company”) was written up roughly two years ago on VIC. Despite the fact that shares have more than doubled since then (on a split-adjusted basis), and are up more than 60% since a near-term bottom three months ago, I believe that they still have plenty of room to appreciate in the near-to-medium term. BlueLinx has the combined advantages of i) significant industry tailwinds, ii) a major self-help margin improvement story, iii) a rapidly improving credit profile, and iv) a P/E multiple that is arguably only 3x a couple of years out. Opportunities like this have become increasingly difficult to find in the current market environment.

BlueLinx is a distributor of building products. Close to 40% of the Company’s revenue comes from distribution of structural products (plywood, strand board, rebar, lumber), with the balance generated from a broad range of other products including roofing materials, insulation, molding, and vinyl siding. The Company does business out of 39 distribution centers located in the central and eastern U.S., distributing over 10,000 SKUs to thousands of end customers. BlueLinx is what is known as a two-step distributor, effectively operating as a middleman between hundreds of different building products manufacturers and building products retailers, industrial manufacturers, and manufactured housing providers. The Company’s building products retail customers include regional dealers (Carter Lumber, Hammond Lumber), national dealers (Builders FirstSource, BMC, 84 Lumber), and home improvement centers (Lowe’s, Home Depot). Competitors include both the captive distribution arms of large forest products companies (Boise Cascade, Weyerhauser) as well as other independent two-step distributors like Huttig Building Products. The sustainability and necessity of the two-step distribution model has often been questioned; however, it has persisted in the building products space. I personally think of it as an outsourced inventory management function, whereby building products end-retailers who do not necessarily want to purchase in “bulk” (due to storage limitations and/or financial considerations), pay a small fee to effectively rent the two-step distributors’ storage space and balance sheet. The two-step distributor then provides order management, less-than-truckload delivery service, and stocking services while passing on some of the bulk pricing discounts that it is able to negotiate. Two-step distributors also often provide milling and fabrication services, whereby they take standard-sized building components (like doors), and resize them for the specific needs of a given retailer and/or manufacturer.

BlueLinx began its corporate life in 1954 as Georgia-Pacific’s captive plywood distribution arm. Over the subsequent 50 years, it grew from its initial base of 13 distribution centers to encompass 60 distribution centers, before being sold in early 2004 to Cerberus Capital Management (“Cerberus”). Cerberus took the Company public later that same year, selling half of its ownership stake. Several years thereafter, like many of its competitors, BlueLinx was hit hard by the U.S. housing crisis. The business subsequently continued to limp along, ultimately undertaking a series of equity financings between 2011 and 2013 to help ease its stressed balance sheet.

In 2014 BlueLinx brought in a new CEO, Mitchell Lewis. Since arriving, Mr. Lewis has replaced the senior management team and moved aggressively to both restructure and reposition the Company. He has reduced the fixed cost base by shuttering over 20% of the 50 distribution centers that were in operation when he arrived. In addition, he has refocused the sales effort from a volume orientation to one driven by profitability. This pivot has meaningfully reduced working capital intensity, which has in turn yielded improvements in the Company’s return on invested capital. The focus on profitability has helped drive a near-doubling of the Company’s operating margins, with EBITDA margins expanding from 1.1% in 2014 to 2.1% on an LTM basis.

Despite these improvements, a cursory look at the Company’s financials makes it appear as if the business is one with a challenged top line and substantial financial leverage. This combination leads to quick dismissal by many potential investors. The underlying reality, though, is more nuanced.

BlueLinx has indeed shown consistent revenue declines for the past four years running. However, this has been driven by the aforementioned aggressive closure of unprofitable and marginally profitable distribution centers. On a same-center basis, sales have been growing in the mid-single-digit range. More importantly, same-center profitability is up by nearly 150% over this time period.

Stated leverage ratios are likewise misleading. BlueLinx currently has roughly $40mm of run-rate EBITDA and had over $300mm of debt as of the last filed balance sheet (Sep 30, 2017), thus implying a leverage ratio >8x. This simple analysis, though, fails to account for an aggressive ongoing sale-leaseback strategy which management has undertaken with its owned real estate. Most of these centers are on prime industrial real estate, with adjacency to major rail lines. Some, in major metropolitan areas, have also attracted interest for residential development projects. The Company has multiple independent appraisals of its owned real-estate which it claims support an aggregate fair market value for that real estate that exceeds its book value by approximately $250mm. This excess value has been supported to-date by sale-leaseback transactions of multiple facilities. Most recently, the Company executed a sale-leaseback of four properties earlier this month that netted $110mm in proceeds. Note that this $110mm in proceeds effectively represented the entirety of the net book value of all 37 owned facilities prior to the sale. While the Company admittedly has likely been doing sale-leaseback transaction on the most valuable properties first, the $250mm in mark-to-market guidance may well prove conservative. The $110mm in proceeds from the recent sale-leaseback has been used to retire an outstanding $98mm mortgage (which was the highest cost debt @ 6.35%); pro-forma for this transaction the leverage ratio should drop to <6x. With the Company continuing to wholly-own 33 of its distribution centers, I would expect further rapid improvement in the leverage ratio as the SL strategy progresses.

Management’s playbook from here is to continue its focus on profitability, driving further margin gains, while continuing to delever through additional sale-leaseback transactions. With respect to modeling, I don’t find comparisons of absolute gross margin levels between competitors particularly instructive, as the mix of value-added vs. pure distribution revenues can differ considerably between companies (to the extent it is even disclosed). Thus, I have instead chosen to look at the margin improvement profile for competitor Huttig. Several years ago, Huttig undertook a similar shift from a volume-orientation to one focused on product line profitability. This yielded a 250bp improvement in its gross margin over roughly five years. BlueLinx, by contrast, is only part way through this process, having to-date improved gross margin by roughly 100bp over a three-year period. Thus, I believe there is still ample room for margin improvement.

At the same time that the Company continues to drive the self-help story on the margin front, it should benefit from ongoing improvement in the single-family housing market. With 2017 single family starts in the 835-850k range, the market is still 20-25% below a normalized number of single family starts somewhere north of 1mm. Single family permits continue to trend nicely (up high single to low double digits), homebuilder sentiment is at its highest level since before the collapse, and ongoing favorable wage and employment trends may finally start driving household formation and home ownership levels back towards historical averages. Optically, with the footprint rationalization now largely complete, BlueLinx should start showing revenue growth on a reported basis, negating the cursory assessments (and quant screens) which seem to show a declining business.

Putting all this together, I see revenue growing from $1.8bn (2017) to $2.3bn in a normalized single-family housing environment. Pro-forma for the recent $110mm sale-leaseback, the Company is doing roughly $35mm in run-rate EBITDA (assuming $4-5mm in rent on the sold facilities), for an implied pro-forma margin of 1.9%. I believe that it can get that to 3.0% through a combination of continued focus on product line profitability + some operating leverage. This yields the following P&L (in mm except per-share amounts):

Revenue                2,300 (25% growth from current; single family housing normalization + some SSS growth)

EBITDA                69 (3.0% margin, 110bp improvement from current)

D&A                       10 (run-rate)

EBIT                      59

Int exp                   9 ($220mm @ 4% on revolver)

Pre-tax                   50

Net income           38 (assume 25% blended rate)

EPS                         $4.10/shr (9.1mm shrs)

Cash EPS               $4.75 ($6mm favorable spread between D&A and normalized capex)

 Admittedly, these are rough numbers, but I feel like they are order-of-magnitude achievable. What is a fair multiple for normalized earnings in a mediocre business? Pick your number, but it’s likely well in excess of 3x. Moreover, with book value per share somewhere north of $20 after marking real estate to market, there should be reasonable downside protection even after the recent run-up.

Below is a very simple look at the Company’s earnings power for 2017, 2018, and on a normalized basis at various margin levels. Note that even w/out meaningful margin expansion the shares look reasonably cheap at <6x cash earnings. For those more partial to EV:EBITDA multiples, pro forma for the recent $110mm SL the shares are roughly 7x on 2018 numbers and 5x on a normalized basis.

Cerberus exited its entire stake in October. This drove the stock from $10/shr to $8/shr. While the exit of a control shareholder might normally be cause for concern, in this case not only had Cerberus held the investment for over 13 years – well beyond its normal holding period – but the aggregate value of its stake ($35mm) was relatively meaningless in the context of its overall portfolio. With the free float now doubled, liquidity (although still limited) has improved to the point that a significantly larger group of institutional investors will at least find it worth their while to take a look. Further ameliorating the signal sent by the Cerberus sale, senior members of management have subsequently made several large open market purchases.

The Company sits on a sizable cache of NOLs ($164mm per verbiage on the last conference call). Cerberus’ sale of its control stake was an incremental negative for the value of these NOLs, given that change of control provisions now kick in. However, my understanding is that these limitations do NOT apply to the extent the NOLs are used to offset gains from sale of real estate. This is good news, as gains on sale-leaseback transactions are likely to eat up most, if not all, of these NOLs over the next couple of years.

As mentioned, I wouldn’t qualify this as a high quality business. That said, as the SL strategy unfolds, I can see it generating low double digit ROICs (10-11%) and 20%ish ROEs on a normalize basis (and after marking real estate to market).