Description

Cornerstone Building Brands Inc. ("CNR") spiked 10% intraday last week to $9.79 on a broker report that provided a $29/share target.  Unfortunately, the report didn't provide sufficient support for the target and the stock shed the majority of this surge - closing Friday at $9.08/share.  I see $29/share as a stretch target in the next 12-18 months and will provide more support below.  While $29/share isn't realistic today, I believe it should trade at least 15+/share based on intrinsic value and public comps.  Forthcoming 4q-19 results will hopefully put to rest questions on the commercial segment outlook and catalyze the stock to $15+/share. From there, I believe it can grind toward $20+ as the year progresses.  Considerable potential exists beyond that.

Merger Background:  CNR is a publicly traded portfolio company of Clayton, Dubilier & Rice ("CD&R").  CD&R had a longstanding investment in NCI Building Systems ("NCI") which was trading publicly.  CD&R gained control of NCI via a distressed for control investment in October, 2009.  The merger preserved some value for minority shareholders.  As a result, the stock has traded publicly continuously since 1993.  (CD&R NCI Investment Details: https://www.cdr-inc.com/news/press-release/nci-building-systems-completes-recapitalization-transaction-clayton-dubilier-rice). NCI supplies commercial construction companies with steel products that form outside walls, support beams and other uses.  CD&R was gradually exiting NCI in the mid 2010's as the commercial construction market came back.  In January 2018, CD&R bought Ply Gem Holdings ("Ply Gem").  Ply Gem is a residential building products company that supplies Vinyl siding, windows and doors.  Ply Gem represents about 60% of revenues with legacy NCI providing 40%.  In mid 2018, CD&R proposed merging Ply Gem with NCI.  The merger went through in late 2018 and the company changed its name to Cornerstone.  As a result, CD&R's stake in MergerCo went back up to 49.4%.  The stock trades well below levels before the merger.

What went wrong?  1)  The merger was instanteously panned with stock down sharply on the announcement.  While the merger provides scale and leverages SG&A forming the basis for modest synergies, the two companies operate in distinct markets with different supply chains.  The merger rationale is not particularly robust.  This was exascerbated by the fact that the commercial construction market was on fire and NCI was trading at an enormous multiple with a clean balance sheet.  The housing market was strong but Ply Gem was not growing at nearly the pace.  PF the company had exposure to two markets with materially more financial leverage.  The merger changed the investment thesis dramatically over night.  2)  Both the housing market and commercial construction market were peaking in 2018.  I won't elaborate on the slowdown in 2H-18 to 1H-19 in US housing and its subsequent recovery as I believe that is well understood.  Nonetheless, the weak housing market placed pressure on CNR's stock.  The more material impact came in commercial construction which experienced a far more violent correction.  The Trump administration's steel tariffs pushed up steel prices materially in 2018.  Commercial contruction investors and project managers saw this inflation and rushed to start/complete projects.  This pulled forward demand and drove a sharp acceleration in 2018.  At the same time, debt costs were rising as the Fed was raising rates.  The rise in steel prices drove customers to swap into alternative materials when possible (concrete & wood.)  As we moved into 2019, the combined impact of a pull forward in demand, higher LIBOR and a loss of share to alternative materials drove a mid-teens correction in NCI's legacy business.  Investors fled the stock which troughed at $3.94 in August 2019.

What is the opportunity? 

1)  While the stock has recovered off the lows, it still trades at a tremendous discount to its building product peers at 7.0x 2020E EBITDA and >20% LFCF yield. 

2)  There is growing evidence that the commercial construction market is switching back to steel from alternatives and should resume growth in 2020 - a key bull case factor that the equity market appears to miss or mistrust.  CNR's niche commercial construction segment (sub 5 story) typically lags US housing by 1 year - point to volume gains combined with share retrenchment in the not to distant future.

3)  While the merger had $50mm+ of pure synergies, the management team has an ambitious cost saving plan which will continue to drive results.  This cost savings program may moderate after 2020 but the management team sees tremendous potential to continue drive annual cost savings as the business is far from optimized.  There is a long list of opportunities.  We don't have specific figures but based on management descriptions it sounds like this could be $20-50mm/year for foreseeable future.  Ultimately, managment hopes to generate margins like Masco and its peers.  With continued revenue growth, this could yield EBITDA of $900mm+ in 3-5 years.  The combined impact of $250mm+ of FCF a year and marked EBITDA growth will rapidly deleverage this company.  If CNR were to trade at peer valuations at that point, this would provide stratospheric returns as the stock could trade at $70/share.  A lot has to happen for this to all work but this stock has tremendous long-term potential - well beyond the $29/share target posited earlier this week.

4)  I suspect that the company will be able to guide at or above 2020 Sellside EBITDA in March.  However, I suspect that as the year progresses they have the potential to beat and raise consistently based on the following rationale.  60% of sales is in US housing.  Ply Gem has a fair bit of repair/remodel which will lag the new construction market.  As a result, this segment should grow at 3-4%.  The real question is on the commercial side.  As I mentioned above, concerns remain here.  If you read the 3q-19 transcript, the management team bungled the outlook here and made it sound like the segment was still in decline.  There is far less data on their niche segment.  Follow-up with management suggests that backlog grew appreciably in commercial in 3Q-19 with volumes up >10% sequentially and year over year.  Based on a 3-4 month lag, this should drive growth in early 2020.  The comps get appreciably easier as the year progresses.  This could easily drive a 5% growth rate on commercial.  If the combined business grows at 4% with a 25% incremental margin, this adds $50mm of EBITDA.   The company cut costs throughout 2019 and will obtain a $15mm year over year lift from 2019 cost actions in 2020.  Management believes it can reduce costs by $60mm more in 2020.  If CNR can hit the $564mm of 2019 ebitda, this points to $564+50+15+60=$689mm.  The company did benefit from the drop in steel in 2019 which I assume won't repeat.  I suspect this is a $25mm drag.  Cost structure inflation will be a drag too.  However, it appears that early 2020 price actions have held in the industry which could counter inflation.  Given that management can't control demand, my suspicion is that they guide at or above the current estimates but have room to beat if my volume forecasts are accurate.  If this plays out, the company will generate a lot of FCF and could end the year at 4.75x net leverage.  The combination of deleveraging, medium-term upside to mid-cycle on housing, continued margin expansion potential and most importantly confidence regarding the commercial construction recovery should drive multiple expansion.  By year end, if CNR trades at 9.0x 2020E EBITDA of $675mm and has generated $250mm of FCF, that supports a stock price of $22.5/share.  Note:  This will be backward looking multiple at this point and could be much higher.

5)  The company's CFO came out of operations and knows how to cut costs.  He is impressive and articulates the opportunity well.  He also bought a lot of stock personally when he joined this summer at very attractive levels.

Other: 

1)  NCI operates in an attractive market place with 2+ competitors.  The concentrated industry allowed it hold onto price as steel pices collapsed.  It also allowed it to rapidly retrieve steel price inflation in 2018.  This isn't an oligopoly by any means - just an attractive industry structure. 

2)  35% of NCI is focused on a highly attractive segment in insulated panels which form exterior walls.  This product has the following benefits.  a)  Rapid assembly time - important in a labor constrained market.  b) superior insulation characteristics to alternatives c)  more efficient use of space - making the building interior larger.  After labor costs, it is priced neutrally to alternative materials - driving share gains.  the company only has 1 real competitor in this segment.

3)  Ply Gem was rolling up the industry and had purchased atrium in 2018 as the Ply Gem / NCI merger was progressing.  A large part of the cost save story comes from synergies from legacy mergers at Ply Gem that were in progress just as NCI/Ply Gem closed.  The vinyl siding business is a slower growth segment as it is dominant in the Mid-west and North East where housing growth isn't as robust.  The door and window opportunity is robust and not regionally limited.  Further, they expect to lauch a new product that will compete with Hardie Plank and LPX's Smart side at a substantial price discount.  This could expand their regional presence and become a real growth opportunity.

4)  The company does have the ability to generate cross selling opportunities.  The largest is in commercial windows.  Plygem has the ability to produce the product and NCI could distribute it.  This isn't on the immediate agenda.  Given it's a revenue synergy, I wouldn't count on it.

Overall, I would say NCI is a slightly better business based on its industry structure and product offerings.  Ply Gem has some optionality around this new product but its a larger source of cost optimization.  Further, the residential sector has more medium-term potential to expand to mid-cycle which I think is starting to place pressure on capacity utilization in this segment - but I need to do more work on this.

Risks:

1)  Decline in housing and commercial construction

2)  Considerable LTM financial leverage 6.0x.  Company has a beautiful cap structure with no maturity or covenant questions if we experienced a recession - providing a long-term option.  Kudos to CD&R and mangement for setting this up.

3)  Management execution on cost saves.

Catalyst

4q-19 results which put to rest commercial construction returns.  Continued execution in 2020.