Description

Builders FirstSource (“Builders”, BLDR) stock has the opportunity to more than double over the next 3 years as it benefits from the continued cyclical recovery in single family housing starts, favorable operating leverage, completing the integration of its Probuild acquisition, and paying down debt from current leverage near 4.5x.  In FY’21 we think Builders is capable of earning >$2.60 / share in after tax free cash flow.  Assuming a 12x forward cash flow multiple (plus $5 in cumulative dividends after net leverage falls below 2.5x EBITDA), would imply a YE2020 stock price of $36 / share, a 26% IRR from the current share price.

With ~$6.5B of revenues, Builders FirstSource is the second largest distributor of lumber and building materials to the US homebuilder market.  The industry remains highly fragmented: only 9 companies in the industry have revenues greater than $1B and the average size of the top 100 distributor is ~$50M of revenue.  Builders’ scale gives it advantage in terms of bargaining power with key suppliers and also through their eligibility to participate in national contracts with the largest production homebuilders (e.g. DR Horton, Lennar, etc.).

Builders has a geographic presence in 75 of the top 100 MSAs across 40 states. 70% of Builder’s revenues are tied to single family new construction, 7% to multi-family new construction, and 23% to repair and remodel / other.  In terms of product mix, 35% of revenues are from lumber products; 20% from windows, doors, & millwork; 17% from manufactured products; 8% from roofing & insulation, 9% from siding, metal and concrete; and 11% from other categories.  The Company considers the 37% of revenues that come from windows, doors & millwork as well as manufactured products to be value added revenues.  These products tend are sold at well above average gross margins.  The Company has initiatives in place to increase their mix of value added products up to 45% of total revenue over the coming years which would bring it back in line to where it was prior to the ProBuild acquisition (see below).  Increasing focus on value added products allows Builders to differentiate itself versus smaller mom and pop competitors who can’t invest in large millwork facilities to serve multiple distribution points within a region.  The adoption of value added building products like pre-cut frames and joints has been increasing amongst the builder population as construction labor markets have tightened.  By using a greater mix of pre-cut products, builders can reduce the number of expensive on-site labor hours needed to complete a given job and therefore increase their own profitability.

Builders is headquartered in Dallas Texas and underwent a transformative acquisition in 2015 when they acquired ProBuild for $1.6B from a private equity entity affiliated with the Johnson Family of Fidelity Investments.  Standalone ProBuild earned nearly 3x as much revenue as standalone Builders in 2014.  In order to complete the deal, Builders borrowed heavily effectively creating a public LBO.  2 years later, leverage at Builders remains high at ~4.3x net debt / EBITDA.  The architect of the transaction was private equity firm JLL Partners who had initially invested in JLL prior to the housing crisis and then conducted a debt for equity swap in 2009 alongside Warburg Pincus.  In September, JLL sold their remaining stake in the Company through a secondary offering.  Of note, as part of the secondary offering, JLL Partner and Builder’s Chairman Paul Levy personally acquired 800K shares of Builders at $16.30 / share.  This $13.5M purchase was a meaningful vote of confidence in the Company. Prior to the transaction, Levy only owned ~200K shares.

Over the next 4 years, we assume that Builders revenues grow at a ~6.1% CAGR reaching $8.6B in 2021.  To get to this number we model Builders revenues by end market.  For the 70% of revenues that come from single family housing starts we look at housing starts per capita and compare the current level to the long-run average since the Census Bureau started keeping the data in 1968.  In 2016, housing starts per capita in the US were running at ~2.4 which compares to the long run average of ~4.1, implying that (at least by this measure), the single family housing market remains ~40% below a reasonable estimate of mid-cycle average.  We assume that by 2021, starts per capita rebound to ~3.2 which would still be 22% below the 4.1 “mid-cycle.”  Layering on a 0.5% annual population growth implies that single family housing starts should grow at a ~6.2% CAGR through 2021.  As for the 7% of revenues tied to multi-family end markets we assume revenue growth in line with overall population growth (~0.5% / yr) such that multifamily starts / capita rare unchanged at current levels.  Lastly, we assume ~3.5% annual revenue growth for the 23% of revenues tied to repaid & remodel.  Note these revenue assumptions assume no benefits from an improving pricing environment and / or any organic market share gains attributable to Builder’s superior scale and broader value added product offering relative to its traditional mom & pop incumbent competitors.

Given these revenue assumptions, we think Builder’s EBITDA can reach >$715M by FY’21 which would represent a ~13% CAGR from $382M of EBITDA in 2016.  Part of the bridge from the current level of EBITDA to this amount is a further $25M of merger-related synergies that Company expects to realize by the end of 2017.  Additionally, incremental revenues are expected to flow through to EBITDA at a ~14-15% margin, which compares favorably to the starting point of only ~6.0% EBITDA margins in 2016 (part of this is the benefit from a higher mix of value added products).  High relative incremental margins and cost savings together should allow margins to expand towards 8.5% by 2021 and for EBITDA to effectively grow ~2x faster than organic revenues.

To bridge from EBITDA to free cash flow, we assume that the Company continues to spend ~1.3% of revenues / yr on capital expenditures consistent with management’s guidance for 2017.  We also assume that the Company becomes a full tax payer in 2018 after the Company’s NOLs runout at the end of this year.  Management also talks about how they expect incremental working capital needs to run at ~9.5% of revenues going forward, however, we exclude the cash outflow associated with NWC from our FCF definition because the Company finances 100% of these outflows through their revolver under which they have only $99M of a total $900M capacity presently drawn (cost of revolver is L+125-175).  Putting these together and deducting interest (including the incremental charges from the NWC financing), we see a path for FCF to increase from ~$235M in 2017 (~$2.03 / share) to ~$310M (~$2.62 / share) in 2021 which represents a ~20% 4 year CAGR.

We assume that 100% of all cash generated goes towards paying down debt until net leverage declines from 4.2x to 2.5x.  Management has said that when leverage reaches 2.5-3.5x they might consider another acquisition as part of a broader strategy to consolidate their fragmented and inefficient industry where Builders’ scale could drive material operating cost synergies.  Rather than give credit for another value creating deal like ProBuild, we assume that net leverage stays constant at 2.5x EBITDA and that any excess cash that Builders generates gets paid out as dividends at the end of the holding period.

It is worth pointing out that Builder’s management walked through their own framework for modelling the Company’s earnings trajectory towards a more normalized level of housing starts on the most recent earnings call.  The following chart from management’s most recent investor presentation highlights a doubling of 2016 EBITDA by the time single family housing starts return to mid-cycle.  A doubling of 2016 EBITDA would imply $763M, pretty close to the ~$715M calculated using the assumptions outlined above.

Even on 2017 numbers and without looking out towards 2020, Builders valuation is compelling – representing a ~11.5% FCF yield.  The chart below shows the evolution of Builder’s valuation multiples between 2017 and 2021.

The charts below show share prices and IRRs from the current stock price based on different assumptions for FCF yield in each period.  With relatively undemanding expectations for multiple expansion, there is a clear price to a stock price well into the high $20s and even mid $30s.

The operating assumptions used to generate these share price targets ignore some potentially key upside levers that could drive the stock price significantly higher than what’s shown above.  For example, management has hinted on recent earnings calls about the potential for additional cost savings programs to be announced above and beyond the $25M that’s remaining for this year under the original ProBuild integration plan.  Also, we assume no margin benefit from the recent increase in lumber prices.  Over the past few quarters, margins have been hurt by the spike in lumber prices but over the long-run, higher lumber prices are positive for Builder’s margins once the temporary inventory mismatch corrects itself.  The above projections give no credit for any recovery however.  Perhaps most importantly, the revenue growth assumptions are solely driven off of the overall improvement in housing starts expected as we move back towards a mid-cycle level of construction activity.  Builders’ management compensation is tied explicitly to their ability to grow revenues above and beyond this level by taking market share from smaller competitors.  If Builders we able to grow an undemanding 2% faster than the overall housing market thanks to share gains, then 2021 FCF would be $3.20 / share rather than $2.60 / share discussed above.  Lastly, the numbers assume no benefit from a near-term spike in post-Hurricane repairs and rebuilding which could be a significant volume driver for the next 12-18 months especially when considering Builder’s large concentration of locations in Texas and Florida.

Key Risks

·    The Company remains highly levered especially when one considers the inherent cyclicality of their end market.  That said, the housing market remains well below mid-cycle and the Company’s earliest debt maturity is March 2022 and there are no maintenance covenants giving the Company plenty of time to de-lever to levels that would allow it safely weather a downturn

·    Housing recovery stalls out or takes a step backwards before moving forward despite current levels of construction that appear well below a sustainable long-run average

·    Labor cost inflation or some other issue prevents the Company from achieving their target incremental margins

·    The Company is successful in delevering towards 2.5-3.5x EBITDA, but then allocates its capital towards a value destructive acquisition

Catalyst

·    Continued recovery in housing starts towards mid-cycle

·    Continued deleveraging towards 2.5-3.5x target

·    Announcement of any further cost take out programs after capturing the remaining $25M of synergies associated with the ProBuild deal

·    Reversal of recent margin disappointments as increased lumber costs work their way through inventory to drive higher margins