Stone Street Advisors LLC

Transcription

1 Summary Playing the U.S. Housing Recovery the Hard Way With Builders FirstSource Jordan S. Terry 10/10/15 Builders FirstSource, a materials and component supplier to the residential construction industry, recently acquired much larger competitor ProBuild Significant profitability risk from lumber price decline, failure to reduce OpEx/recognize merger synergies, lower than expected housing # s, macro uncertainty Both firms are PE-sponsored levered rollups; acquisition is a levered rollup of levered rollups with BFS sponsors controlling ~40% at close Combined firm is levered to the hilt: o Pro forma Long-term debt (ex-leases)/adjusted LTM EBITDA stands at 7.1x, 34% higher than average for S&P LSTA Issuers as of 2015q2 o Adjusted EBITDA/Interest Expense is running at 1.9x versus 3.4x for LSTA Issuers, or 43% lower than average o (Adjusted EBITDA-CapEx)/Interest Expense is 1.3x Our base-case projected 2015 adjusted EBITDA is $262mm o Long-term Debt/Adj. EBITDA 7.4x o Adj. EBITDA/Interest Expense 1.6x o (Adj. EBITDA-CapEx)/Interest Expense 1.0x BLDR stock pricing in high growth v. our projections. As of writing at $14.40: o 13.1x EV/2015e Adj. EBITDA or 9.6x 2020e EBITDA o 20.7x EV/(Adj. EBITDA-CapEx) or 15.1x 2020e EBITDA o At 11x EBITDA, difference between $250mm and $350mm is $5.60/share v. $15.30; - 61% downside v 7% upside 1

2 Knowledge is Opportunity Entirely too often I see equity-focused traders/investors/analysts/pundits paying little (if any) attention to how firms fund their operations, day-traders and a disturbing amount of professionals alike. This creates distortions in equity pricing and valuation, but more importantly, this lack of respect for credit fundamentals by some creates opportunity for others. Firms with no debt, all else equal, should be undervalued relative to their theoretical value with a more optimal capital structure. The stock of firms with a lot of debt can be overvalued, especially in the current environment of historically low interest rates, and for many firms/industries, unsustainably high operating profit margins. This isn t just theory though; we see the capitalization-related under/over-valuation in the market virtually every day! Activist and PE investors love firms with strong balance sheets and cash flow so they can lever them up for buybacks, dividends, and LBOs. On the other hand, short sellers look for highlylevered firms whose cash and profits can be wiped-out with even a short period of poor performance. When the equity market doesn t even pay attention to Valuation 101, don t be surprised to find even more distortion and opportunity when you dig a little deeper. Let s take a look at one of my current favorite stocks residential building supply company Builders FirstSource (BLDR) - for a real-life example, shall we? A Sure Thing Would you want to own the stock of a leader in an industry that is set for years of double-digit growth? An industry with oodles of government support, that's a critical part, if not the foundation of the American Dream that is home ownership? 2

3 2, , , ,400.0 U.S. Housing Starts Still ~40% Below 40-Year Median 80.0% 60.0% 40.0% 1, , % 0.0% -20.0% -40.0% -60.0% Housing Starts Y/Y Change Median Starts Source: U.S. Census Bureau How could this not be a sure thing? Residential housing starts are still way below the 40yr median. The last time they were this low (pre- crisis) was in the early 1982 when a 30-year fixed rate mortgage was around 15% compared with 2014 rates in the low 4% range, and unemployment was 10% v. around 5% now. 12,000.0 New Units Under Construction ~40% Below 40-Year Median 40.0% 10, , , , , % 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% New Units Under Construction Y/Y Change Median Units Under Construction % Source: U.S. Census Bureau Similarly, new units under construction are about 40% below the median since We may have built a LOT of houses in the bubble years of the mid 00 s, but the correction seems to have overshot to the 3

4 downside. New units dropped 74% from peak (2005) to trough (2011), and despite being up 42% since the bottom in 2011, there s a lot of room just to get back to average. Economic and demographic data suggests we re in the very early stages of another housing boom, this time driven largely by actual demand rather than loose-credit fueled speculation. (This is consensus rather than fact, to be fair.) If the housing resurgence is inevitable, growth and margins are high, you d be dumb not to own this company s stock; it s basically a "sure thing," right? Obvious Trades: Beware What Lurks Beneath If we look at this sure thing another way and start to dig a little below the surface, the obvious looks, well, not so obvious. While residential housing construction may surge over the next few years, we can t just buy this stock and ride the wave; there s a few other things about this company we have to consider, for example: Significant (non-energy) commodity exposure Operates in an industry heavily reliant upon various forms of government subsidies (notice how a positive can also be a negative?) Recently completed a large merger likely to distract management from running the core business Paid not-cheap price for acquiring much larger competitor Has grown largely by a roll-up strategy (acquiring smaller, similar firms) rather than by organic growth Likely to recognize some asset writedowns/impairments or other charges as result of serial acquisitions Controlled by PE owners (~40%) Has little if any pricing power Faces demand inversely related to interest rates Very highly leveraged The first few issues should be reason enough to be skeptical about buying BLDR, but I'd like to talk about the last one, leverage. The following is tailored to equity folks, but for those of you in credit, I think you ll find the situation has a lot of risk (particularly if you re thinking about buying the s). 4

5 Credit 101 Short of doing a complete DCF analysis, we can value a firm as a multiple of EBITDA, common practice for levered firms. But this raises the question of whether you use "simple" EBITDA, "adjusted" (for what?) EBITDA, or some other "fantasy" version where the company adds back everything they can think of to juice the number, appropriate or not. In this case, the difference between the LTM simple EBITDA and the "fantasy" adjusted EBITDA is almost 80%, so this is not a trivial matter. This is what happens when mid-sized levered company takes on even more leverage to buy a much larger, already highly-leveraged competitor. BLDR s simple leverage ratio is almost TWICE as high as the S&P/LSTA average issuers, while the middle ground Adjusted EBITDA ratio is still much higher than average for a leveraged company. Of course, if we use the fantasy adjusted EBITDA it looks like there s no reason to worry about BLDR s debt load any more than we would that of any other company. Use whichever EBITDA value you want, but I strongly suggest erring on the side of caution. Debt levels in and of themselves are important, but for a company without any near-term debt maturities in a cyclical industry like homebuilding, debt service coverage is more of an immediate concern: Leverage S&P LSTA Issuers 2015q2 LT Debt/LTM EBITDA 10.2x 5.3x % over LSTA Average 92% Ex Leases 8.8x % over LSTA Average 67% LT Debt/LTM Adj EBITDA 8.2x % over LSTA Average 54% Ex Leases 7.1x % over LSTA Average 34% LT Debt/Fantasy Adj EBITDA 5.7x % over LSTA Average 8% Ex Leases 5.x % over LSTA Average -6.1% 5

6 Interest Coverage S&P LSTA Issuers 2015q2 LTM EBITDA/Interest Exp 1.3x 3.4x % under LSTA Average -60% Ex-Leases 1.5x % under LSTA Average -54% Adj. EBITDA/Interest Exp 1.7x % under LSTA Average -51% Ex-Leases 1.9x % under LSTA Average -43% Fantasy Adj. EBITDA/Interest Exp 2.4x % under LSTA Average -30% Ex-Leases 2.7x % under LSTA Average -19% Even using management s fantasy EBITDA figure, BLDR has much lower interest coverage than similar leveraged firms. If/when interest rates (finally) rise, if commodity prices drop some more, if demand doesn't pick up as expected, if housing numbers come in short, if management isn't able to recognize merger synergies or keep expenses from rising... If even one or two of these things come to fruition and operating profit comes in below expectations, the firm's huge interest payments are going to magnify the impact. The picture looks even less good when we consider the firm has not just cash inflows but outflows as well, like capital expenditures to cover property/equipment maintenance and expansion. Interest Coverage LTM (EBITDA-CapEx)/Interest Exp.8x Ex-Leases.9x (Adj. EBITDA-CapEx)/Interest Exp 1.1x Ex-Leases 1.3x (Fantasy Adj. EBITDA-CapEx)/Interest Exp 1.9x Ex-Leases 2.1x The company doesn t have a ton of leeway to absorb lower than expected cash flow to make interest payments, which means it would have to dip into its cash to avoid missing interest payments. I don t have the figures for the LSTA group, but the average cash flow coverage for the 10 largest LBOs has been in the x range for the past few years (per CapitalIQ), significantly higher than what we see with 6

7 BLDR. Whether you consider this an issue or not depends on how you think the firm does the next few years. Here s my base-case projections: P&L Case Base Capex Case Base Builders FirstSource ProBuild Holdings Pro Forma Combined New BLDR CAGR CAGR EBITDA 62, , , , , , , , , % 6.5% EBITDA Margin 3.9% 3.5% 2.8% 3.3% 3.3% 3.3% 3.3% 3.3% 3.3% % Change 24.2% 5.0% 7.5% 7.5% 7.5% 5.0% Adjusted EBITDA 66, , , , , , , , , % 6.5% Adjusted EBITDA Margin 4.2% 4.3% 4.3% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% Interest expense, net 30,349 45, , , , , , , ,791 CapEX 25,716 65,109 90,825 95, , , , , , % 6.5% Ratios Leverage LT Debt/EBITDA 11.5x 9.2x 8.8x 8.2x 7.6x 7.1x 6.7x LT Debt/Adj. EBITDA 7.5x 7.4x 7.1x 6.6x 6.1x 5.7x 5.4x LT Debt/(EBITDA-CapEx) 24.7x 16.9x 16.1x 15.x 13.9x 13.x 12.4x LT Debt/(Adj. EBITDA-CapEx) 11.5x 11.7x 11.1x 10.4x 9.6x 9.x 8.5x Coverage EBITDA/Interest Expense 2.1x 3.4x x 1.3x 1.4x 1.5x 1.7x 1.7x Adjusted EBITDA/Interest Expense 2.2x 4.3x x 1.7x 1.8x 1.9x 2.1x 2.2x (EBITDA-CapEx)/Interest Expense 1.2x 2.x.5x.7x.7x.8x.8x.9x.9x (Adj. EBITDA-CapEx)/Interest Expense 1.4x 2.3x 1.x 1.x 1.1x 1.1x 1.2x 1.3x 1.4x Valuation EV/EBITDA 20.3x 16.4x 15.6x 14.5x 13.5x 12.5x 11.9x EV/Adj. EBITDA 13.3x 13.1x 12.5x 11.6x 10.8x 10.1x 9.6x EV/(EBITDA-CapEx) 43.7x 30.x 28.5x 26.6x 24.7x 23.x 21.9x EV/(Adj. EBITDA-CapEx) 20.5x 20.7x 19.7x 18.4x 17.1x 15.9x 15.1x If the company achieves moderate growth with unspectacular but stable margins and capital expenditures, all else equal, it ll be burning some of its $127 million cash every year just to keep chugging along. At this rate, again all else equal, BLDR burns through all its cash by the end of You d hope that management would cut back on expenditures, but cutting staff, closing locations, and shelving maintenance/expansion plans doesn t happen overnight, and usually results in additional costs to boot. Default in 15 months is pretty scary, no? This is one of those situations where taking the time to read the firm s SEC filings, particularly the notes to the financial statements, can make or break an investment or opportunity. BLDR has another $430mm available under its ABL facility (pg 48) and $300mm on its First Lien facility (pg 36) to raise cash, but both have restrictive covenants limiting the amount actually available subject to both leverage and coverage ratios. This is pretty standard in the bank loan market, but to put it into perspective, it s kind of like if your credit card company actually verified your income and spending every few months and adjusted your limit accordingly; when your need to borrow is highest, your ability to do so gets curtailed. Fun, right? The base-case projection assumes 6.5% compound average topline growth and flat margins, so if you think the company can do better than that, you re looking at a longer runway that For example, in my bullish case: 7

8 P&L Case Bull Capex Case Base Builders FirstSource ProBuild Holdings Pro Forma Combined New BLDR CAGR CAGR EBITDA 62, , , , , , , , , % 10.1% EBITDA Margin 3.9% 3.5% 2.8% 3.6% 3.8% 3.8% 4.1% 4.1% 4.1% % Change 41.9% 16.1% 7.5% 14.6% 7.5% 5.0% Adjusted EBITDA 66, , , , , , , , , % 10.1% Adjusted EBITDA Margin 4.2% 4.3% 4.3% 4.5% 4.7% 4.7% 5.0% 5.0% 5.0% Interest expense, net 30,349 45, , , , , , , ,791 CapEX 25,716 65,109 90, , , , , , , % 7.5% Ratios Leverage LT Debt/EBITDA 11.5x 8.1x 7.x 6.5x 5.6x 5.3x 5.x LT Debt/Adj. EBITDA 7.5x 6.5x 5.6x 5.2x 4.5x 4.2x 4.x LT Debt/(EBITDA-CapEx) 24.7x 13.8x 11.5x 10.7x 9.x 8.3x 7.9x LT Debt/(Adj. EBITDA-CapEx) 11.5x 9.8x 8.2x 7.6x 6.5x 6.x 5.7x Coverage EBITDA/Interest Expense 2.1x 3.4x x 1.7x 1.8x 2.1x 2.2x 2.3x Adjusted EBITDA/Interest Expense 2.2x 4.3x x 2.1x 2.3x 2.6x 2.8x 2.9x (EBITDA-CapEx)/Interest Expense 1.2x 2.x.5x.8x 1.x 1.1x 1.3x 1.4x 1.5x (Adj. EBITDA-CapEx)/Interest Expense 1.4x 2.3x 1.x 1.2x 1.4x 1.5x 1.8x 2.x 2.x Valuation EV/EBITDA 20.3x 14.3x 12.3x 11.5x 10.x 9.3x 8.9x EV/Adj. EBITDA 13.3x 11.5x 9.9x 9.2x 8.x 7.5x 7.1x EV/(EBITDA-CapEx) 43.7x 24.5x 20.4x 18.9x 15.9x 14.8x 14.1x EV/(Adj. EBITDA-CapEx) 20.5x 17.3x 14.5x 13.5x 11.5x 10.7x 10.1x With higher growth and higher, expanding margins BLDR s cash burn is short-lived, peaking in 2016 before going free cashflow positive in Those who consider themselves big believers in a major housing recovery may even consider 11.5x 2015 Adj. EBITDA a fair price for 10% annual growth. Just remember this is not riskless or even low-risk growth; you have to take into consideration the downside, too: P&L Case Bear Capex Case Bear Builders FirstSource ProBuild Holdings Pro Forma Combined New BLDR CAGR CAGR EBITDA 62, , , ,615 56,920-2,921 71, , , % 8.3% EBITDA Margin 3.9% 3.5% 2.8% 1.9% 0.9% 0.0% 1.2% 2.2% 2.7% % Change -30.1% -52.0% % % 92.5% 28.9% Adjusted EBITDA 66, , , ,540 70,800-3,633 88, , , % 8.3% Adjusted EBITDA Margin 4.2% 4.3% 4.3% 2.4% 1.2% -0.1% 1.5% 2.7% 3.4% Interest expense, net 30,349 45, , , , , , , ,791 CapEX 25,716 65,109 90,825 85,159 77,890 58,418 77,082 80,937 98, % 2.9% Ratios Leverage LT Debt/EBITDA 11.5x 16.4x 34.2x x 27.3x 14.2x 11.x LT Debt/Adj. EBITDA 7.5x 13.2x 27.5x x 22.x 11.4x 8.9x LT Debt/(EBITDA-CapEx) 24.7x 58.1x -92.7x -31.7x -328.x 34.7x 24.8x LT Debt/(Adj. EBITDA-CapEx) 11.5x 31.2x x -31.3x 170.3x 21.7x 16.x Coverage EBITDA/Interest Expense 2.1x 3.4x 1.0.7x.3x.x.4x.8x 1.1x Adjusted EBITDA/Interest Expense 2.2x 4.3x 1.5.9x.4x.x.5x 1.x 1.3x (EBITDA-CapEx)/Interest Expense 1.2x 2.x.5x.2x -.1x -.4x.x.3x.5x (Adj. EBITDA-CapEx)/Interest Expense 1.4x 2.3x 1.x.4x.x -.4x.1x.5x.7x Valuation EV/EBITDA 20.3x 29.1x 60.5x x 48.4x 25.2x 19.5x EV/Adj. EBITDA 13.3x 23.4x 48.7x x 38.9x 20.2x 15.7x EV/(EBITDA-CapEx) 43.7x 103.x x -56.2x x 61.5x 43.9x EV/(Adj. EBITDA-CapEx) 20.5x 55.2x x -55.5x 301.7x 38.5x 28.4x Slight revenue declines from lower input prices combined with lower margins (from e.g. unfavorable product mix, inability to trim or contain operating expenses) lead to much larger swings in profitability. In my bear case, the company will exhaust its cash and borrowing capacity in Leverage giveth, and leverage taketh. 8

9 Valuation Bringing It All Together BLDR is trading at around 16.4x my simple projected 2015 EBITDA or a much more reasonable (but not exactly cheap) 13.1x adjusted EBITDA. As a point of reference, the average purchase price multiple of LBO transactions, to which the BFS-ProBuild acquisition is similar, is around 10x over the past decade, which typically includes a 20%+ purchase price premium. Looks like this company, the enterprise value at least, is a bit on the rich side, eh? But what of the equity, you ask? The enterprise value of the company is debt + equity cash, so backing out debt from the firm value gives us the value of the equity. Of course, as we discussed, the value of the firm depends on profitability (EBITDA) and how much you re willing to pay for that profit (EBITDA multiple): 9

10 Builders FirstSource Valuation Enterprise Value Multiple EBITDA 7.x 9.x 11.x 13.x 15.x 17.x 50, , , , , , , ,000 1,050,000 1,350,000 1,650,000 1,950,000 2,250,000 2,550, ,000 1,750,000 2,250,000 2,750,000 3,250,000 3,750,000 4,250, ,000 2,450,000 3,150,000 3,850,000 4,550,000 5,250,000 5,950, ,000 3,150,000 4,050,000 4,950,000 5,850,000 6,750,000 7,650, ,000 3,850,000 4,950,000 6,050,000 7,150,000 8,250,000 9,350,000 Equity Valuation Multiple EBITDA 7.x 9.x 11.x 13.x 15.x 17.x 50,000 (1,764,961) (1,664,961) (1,564,961) (1,464,961) (1,364,961) (1,264,961) 150,000 (1,064,961) (764,961) (464,961) (164,961) 135, , ,000 (364,961) 135, ,039 1,135,039 1,635,039 2,135, , ,039 1,035,039 1,735,039 2,435,039 3,135,039 3,835, ,000 1,035,039 1,935,039 2,835,039 3,735,039 4,635,039 5,535, ,000 1,735,039 2,835,039 3,935,039 5,035,039 6,135,039 7,235,039 Share Price /8/2015 Multiple EBITDA 7.x 9.x 11.x 13.x 15.x 17.x 50, , , , , , Share Price Return Multiple EBITDA 7.x 9.x 11.x 13.x 15.x 17.x 50, % -100% -100% -100% -100% -100% 150, % -100% -100% -100% -92% -74% 250, % -92% -61% -31% -1% 30% 350,000-80% -37% 5% 48% 90% 133% 450,000-37% 18% 72% 127% 182% 236% 550,000 5% 72% 139% 206% 273% 340% You can see for yourself what BLDR stock is worth at various levels of profitability and valuations. The bordered cells in each table capture my 2015 EBITDA expectations and the valuation range slightly 10

11 below where the stock is currently trading. Put another way: If EBITDA comes in at $250mm the stock likely sheds some growth expectations and trades at a lower multiple. You lose 61%. If it comes in at $350mm the multiple stays around 13x, and you can make 48%. These aren t probability-weighted values or returns (that s up to you to figure out), but if 20% more downside than upside sounds like a good trade to you, you really shouldn t be trading at all. As always: CAVEAT EMPTOR 11