Description

Although Bluelinx has been well-analyzed on VIC for several years, I want to put on my portfolio-manager hat to argue that Bluelinx is currently a significantly better risk-reward than most stocks.  Here is the argument summary:

• Bluelinx currently enjoys three big tailwinds and the cessation of a big headwind
  • A demographically-driven homebuilding boom that should last for 10-15 years
  • A virus-driven and work-at-home driven homebuilding boom that should last at least another year
  • A virus-driven disruption in lumber supply that, combined with the demand surge, has pushed lumber prices to all-time highs
  • The annual lapping of, and slow recovery from, the loss of a large siding supplier
• Thanks to these trends and successful asset sales, just this month Bluelinx's equity fully escaped the existential risk posed by its large debt load and accompanying leverage covenants.  Bluelinx is now fully out of the woods.
• The stock looks too cheap in absolute (~3x-4x next year's earnings), relative to its history (still down >50% from 2018 peak and 33% from late-2019 price despite better fundamentals), and relative to other homebuilding stocks.  Few people know how much financial results are about to improve for this unfollowed microcap that doesn't issue guidance.  It seems likely that the stock will continue re-rating as the company reports strongly improved earnings and an improved balance sheet.
• The largest risk for most stocks is that expectations for interest rates rise off their 2,000-year lows and equity discount rates also rise, which would deflate the newly-inflated valuation multiples and could send some high-growth stocks down 50%.  Bluelinx is firmly in the value-stock basket and should suffer less than most stocks if that happens.

BUSINESS BASICS AND THE BAD TIMES OF 2018-2019

For a fully detailed description of the business and where its history over the last few years, you should read the two excellent write-ups from 2018, here and here, including the comments.  The short version is: Bluelinx is a distributor of homebuilding products.  They buy from manufacturers and sell to dealers, industrial manufacturers, manufactured housing producers, and home improvement retailers.  Their primary value-add is to consolidate the volumes of slower-moving SKUs from multiple downstream players in a given geographic area into a single warehouse and distribution network, so that even huge full-footprint players like Home Depot find it more efficient to use a third-party distributor for these SKUs rather than their in-house network.  Sales are categorized into "structural products" (mostly lumber and plywood) and "specialty products" (engineered wood, moulding, siding, etc.).  The revenue split is 35-45% structural and 55-65% specialty, depending primarily on where lumber prices are at the time.  (E.g., when lumber prices double, the revenue mix shifts towards structural products).  Like most distributors, Bluelinx has high fixed costs and razor-thin margins, so that small changes in business conditions can produce wide swings in profits.

In early 2018 Bluelinx announced the acquisition of similarly-sized Cedar Creek, which was paid in cash and funded with debt.  The combined company was supposed to -- and did -- consolidate overlapping warehouses and transportation networks, cut additional fixed costs, and significantly boost margins and total profits, all else equal.  These boosts were supposed to be more than enough to boost EBITDA by far more than the added debt's interest payments, such that Bluelinx would significantly boost its cash earnings and could rapidly pay down the debt.  But all else was not equal; the company quickly ran into three significant problems.

First, lumber prices and other building products prices reached a cyclical peak precisly when the merger closed and then fell sharply.  Lumber prices are highly volatile and routinely double or halve in multi-year cycles.  Prices had doubled from 2015 through early 2018; then they experienced their sharpest fall in decades, halving in about six months.  These moves can have dramatic effects on Bluelinx's margins.  After my many years of watching Bluelinx stretching back to 2005, talking to management about the margin effects, and parsing many earnings call discussions about them, I still don't understand precisely how or precisely why.  (To my knowledge, no one else on VIC does either; management has never been able to make it clear.)  Without getting into the details about the seeming inconsistencies, the basics are clear: higher absolute prices are better, because dollar revenues are higher, gross margin percentages seem roughly constant at different absolute prices, and Bluelinx can spread the higher revenues and gross profits across a relatively fixed SG&A cost base.  Lower absolute prices are worse, for the inverse reasons.  Rising prices are also modestly better on a temporary basis, because Bluelinx is carrying inventory purchased at lower prices that it can now sell at higher prices.  Falling prices are worse for the inverse reasons.  Unfortunately the rising/falling dynamic appears to be mostly a one-way ratchet: it seems like in rising price environments, Bluelinx gives away the available excess margin to its customers such that margins don't rise much, while with falling prices Bluelinx has to match spot prices and takes a bigger margin hit than it gains on the way up.  In any event, the simple picture is, higher prices and rising prices are good, lower prices and falling prices are bad.  Bluelinx endured a sharp price fall throughout 2018, and although prices then stabilized at the new low level, the year-over-year comparisons continued looking horrible throughout most of 2019.

Second, management had thought it could perform all its facility  and network consolidations and gain all the cost savings without losing customers or revenues.  Instead, some customers left, and others shifted some of their volumes to other competitors.

Third, Bluelinx played hardball over pricing with a significant siding supplier, and the supplier cut them off.  This one supplier loss cost Bluelinx $160m of revenue in 2019, 6% of total revenues, and another $49m in 1H20.

The net effect of these three factors was to reduce adjusted EBITDA for the pro-forma merged company from $102m in 2017 to $80m in 2018 to $71m in 2019, despite the cost savings.  That decline pushed cash flows to near-zero, prevented debt paydown, and put Bluelinx at serious risk of blowing the leverage covenant in its loan agreement.  Bluelinx avoided breach only by negotiating several covenant-loosening amendments and selling off not only the redundant facilities it had closed, but also a number of operating facilities in sale-leaseback transactions.  The initial COVID-19 panic looked like the death blow for Bluelinx, as the covenants would finally be tripped and further real estate sale attempts would find no buyers.  Its stock price fell from a high of $45 just after its Cedar Creek merger closed to a low of $4 in late March.

What a difference a few months can make.  Now everything has changed, and the future looks very bright.

THE CURRENT TAILWINDS

1. Demographic-driven housing boom.  Our primary reason for liking Bluelinx isn't any of these company-specific events, but rather the strong boost to the entire U.S. homebuilding industry that will be caused by the large "Echo Boomer" age cohort reaching prime home-buying ages, paired with years of under-building by the industry following the 2006-2011 housing bust.  I'll copy and paste from my May write-up of LGI Homes:

Single-family housing starts have steadily increased since the 2011 trough but have not yet regained their long-term average level.  The industry built about 900,000 homes in 2019, still below the 1-million average for the last 50 years:

The industry has been significantly undersupplying the market for 12 straight years.  The historical 1-million average is, not coincidentally, the amount necessary to keep up with U.S. population growth.  Every year brings about 2.5 million new people, which is 1.5 million new households and, at a 65% homeownership rate, about 1 million new home buyers.  In the chart above, all the white space between the recent years’ bars and the red line represents undersupply that has more than soaked up the oversupply from the 2002-2006 bubble.  Even as housing starts have increased, inventories of unsold new homes have been decreasing.

This undersupply is just starting to meet a powerful, demographically-driven demand boost for the next 10-15 years.  Everyone is familiar with the Baby Boomer generation’s profound effect on demand for whatever products or services Boomers were consuming at a given stage of life – for example, baby food and toys in the 1950s, schools and colleges in the 1960s and 1970s, cars and investment products in the 1980s and 1990s, healthcare and Alaska cruises today.  Less well known is that the Boomers’ children, the Echo Boomers, are more numerous than the Boomers themselves and represent almost as much of a population increase from the preceding age brackets as the Boomers did in their day.

The Echo Boomers’ impact on consumer demand levels is just as large.  And starting roughly last year, the biggest item that Echo Boomers will need to buy is a home.  The average U.S. marrying age has risen to 29, and the peak Echo Boomer cohort turned 29 last year.  The first Echo Boomers turned 35 three years ago.  The homeownership rate jumps from 36% for households under age 35 to 60% for those aged 35 to 44.  As the Echo Boomers hit their peak home-buying age, the single-family home market should experience a slow-moving but unstoppable surge – the blue line on this chart:

This tailwind just got started in 2017.  It can be overcome by other factors in the shorter-term -- as it was for all homebuilders in 2018 and for Bluelinx in 2018-2019 -- but it may nonetheless be the most important investment factor if you are considering a multi-year investment.

2. COVID-driven single-family-home boom.  Our prediction in May's LGIH write-up that COVID would drive people out of city apartments and condos and into single-family homes, and that the Fed's COVID-spurred promise to keep interest rates low forever would further drive home sales by making them more affordable, has already proven true, to a greater extent than we thought.  After an initial dip in March-May, June's U.S. new home sales grew 14% YoY and July's grew 36% YoY.  The spike stands out strongly even on a 60-year chart:

Note that the reported new-home sales numbers includes new contracts for both completed homes and homes that are not yet built.  Homebuilders have been depleting their inventory and will take many months to catch up, so even the reported June home-sales numbers are mostly not yet reflected in Bluelinx's results.

The demand burst seems unlikely to stay this strong, but it should sustain to a meaningful extent, because mortgage rates will likely stay low, some people who shifted to work-at-home will continue doing so regardless of virus risk, and the virus is likely to stay with us at a lower level for a while.

3. Lumber price boom.  The virus-driven increase in lumber demand and disruption of supply is causing the highest and sharpest lumber price spike of all time.  Prices have more than tripled off their April bottom and are still headed up.  Calculated Risk helpfully updated its lumber price chart yesterday:

As with the volume boom, almost none of this price boom is reflected in Bluelinx's results so far, because prices didn't really start moving until June.  Lumber prices are certain to fall once supply even partially catches back up with demand.  On their recent 2Q earnings call, management stressed that they are doing all they can to prepare for that event.  But we think it likely that prices will settle in for a while at a materially higher level than they were in 2019.

4. Receding effect from lost supplier.  The siding supplier defection left a large hole that management has gradually, partially filled with other suppliers' products.  For the last six quarters, management has been giving an estimate of lost sales from the defecting supplier.  That effect peaked a few quarters ago and fell to $17m in 2Q20, from $42m a year earlier.

5. The cost cuts did work.  It's worth pointing out that Bluelinx's margins were already improving strongly pre-virus, despite the strong headwinds from reduced revenues and the added lease costs from the sale-leasebacks.  Its gross margin for structural products rose from 7.0% in 2018 to 8.7% in 2019, and it rose another 60bps in 1Q20 and 160bps in 2Q20.  Gross margin for specialty products rose from 14.9% in 2018 to 15.9% in 2019; it rose another 120bps in 1Q and 140bps in 2Q.  Overall adjusted EBITDA margin rose from 2.4% in 2018 to 2.7% in 2019 and rose another 40bps in 1Q and 100bps in 2Q.

NO MORE COVENANT RISK

Bluelinx had to sell a lot of real estate to fund debt paydowns and avoid tripping its leverage covenant, but it succeeded in doing so.  It has made a steady series of sales announcements over the last year, including a new $11m sale two weeks ago.  Its term loan balance has fallen from $147m last September to $69m as of June to $58m now, after the most recent sale.  Its "consolidated total debt" -- term loan + most recent month's asset-backed credit facility + equipment finance leases, less up to $10m of unrestricted cash -- has fallen from $530m last September to $408m in June to somewhere-lower now.  "Consolidated leverage" -- debt divided by TTM adjusted EBITDA plus minor add-backs -- has fallen from 7.2x last September to 4.9x in June.  This amount is miles below the COVID-spurred amended covenant of 8.75x and well below the earlier-amended covenant of 6.5x.  If Bluelinx shrinks its term loan to $45m or less, the covenant goes away entirely.  That goal is now entirely in reach, via any combination of (a) more real estate sales (they still have three unsold empty properties and another five available for sale-leasebacks), (b) operating cash flow now that fundamentals have improved so much, and (c) tapping the asset-backed loan facility.  August's real estate sale announcement was the point at which I was finally willing to say that Bluelinx has fully escaped its covenant risk.

One debt-related side note: over 80% of Bluelinx's debt is its asset-backed revolver, which exists solely to fund Bluelinx's net working capital (mostly inventory) and carries a weighted-average interest rate of only 2.6%.  It is therefore less costly and less risky than a quick look at the balance sheet would suggest.

THE STOCK IS FAR TOO CHEAP

Unlike many stocks these days, Bluelinx looks far too cheap, despite quadrupling off its March lows.  The reasons for it looking cheap are understandable and should dissipate fairly quickly: It's a $200m market-cap stock with no sell-side coverage.  Management doesn't give guidance, and little of the recent tailwinds made it into their 2Q results.  Results from 3Q onward should look much better. 

Predicting Bluelinx's precise earnings for any given period is a fool's errand given the wide swings, but my best guess is something like $6.00 per share in 2021, based on the following assumptions:

• Revenues grow 10% in 2020 and another 10% in 2021
• Gross margin 14.4% vs. 13.5% in 2019 (1Q and 2Q results already put them on pace for this much improvement, before the new homebuilding and lumber booms)
• S&GA/sales 10.0% vs. 11.5% in 2019, on leverage from more revenue (1Q and 2Q results are on pace for this, too)
• Interest expense $42m vs. $54m in 2019, on lower debt levels
• Tax rate 20% (they have some NOLs)

That puts the stock at 3.4x forward GAAP earnings.  "Normalized" free cash flow will be better than this because their D&A is higher than required capex, although they will take a temporary working capital hit in the short term from the higher lumber prices.

Two other ways to show it's too cheap are to compare its price to history and to the moves in homebuilders stocks.  Both of these are overly simplistic analyses yet do provide useful information.  Bluelinx was a $32 stock just before their disastrous 3Q19 release, which first showed the full extent of the harms from the siding supplier loss, other merger revenue losses, and continued low lumber prices.  Bluelinx is now in a much better position than it was last October at $30-35 -- the homebuilding boom, lumber price boom, much lower interest rates, and better balance sheet significantly outweigh the small continued revenue losses from the siding supplier.

Indeed, because Bluelinx's operating model and debt make it a leveraged play on homebuilding, arguably Bluelinx's stock should be doing better than homebuilding stocks have done since just before Bluelinx's big fall in early November.  Since then, the homebuilding ETF (ITB) is up 20% and the high-beta homebuilding stock we know extremely well, LGI Homes, is up over 40%.  Bluelinx's stock needs to more than double to catch up to LGIH: 

Catalyst

• Significantly improved quarterly results should move the stock much more than most stocks, given the lack of guidance from management, the small market cap, and the complete lack of sell-side coverage.
• Continued debt paydown improves the leverage ratios and makes the quants happier (most stocks of companies with heavy debt levels have done especially poorly this year).
• Elimination of the term loan's leverage covenant as the term loan balance drops below $45m.