Thursday, October 4, 2012

Beacon Roofing Supply is a Great Way to Play the Housing Recovery

Sometimes serendipity is a pretty useful investment strategy, at least I hope so because I used it to buy a stock recently. I’ve been looking to add a stock or two to the portfolio with the idea that the US housing sector is due for a recovery. With that in mind I thought it would be interesting to take a look at Beacon Roofing Supply Inc $BECN. I was pleased to discover that new residential construction would provide a marginal boost to this company’s earnings. However, I discovered that there are a whole bunch of other reasons to buy this stock. So I did.

Who is Beacon Roofing Supply?

Funnily enough the company supplies roofing, but I’m not too sure if this stretches to beacons!
The name implies that its profit drivers are cyclically aligned with housing, but actually-in normal times- its sales are 70-80% made up of re-roofing. I mention ‘normal times’ because obviously the last few years have been anything other than normal for the housing market and new build in particular has suffered. The result is that some marginal sales growth fell out of Beacon’s numbers and re-roofing accounted for 90% of sales. As such, re-roofing demand is surprisingly stable. The company believes that 88% of US re-roofing demand is non-discretionary and insulated from the broader economy.

In essence, Beacon is a stock that gives you underlying stability from re-roofing demand plus some growth kickers from an improvement in new residential build and an increased willingness of homeowners to upgrade the appearance of their roofing. It also offers upside from severe weather effects such as hail, hurricanes and tornadoes. The last point is attractive because you can use it to hedge the risk from stocks that are negatively exposed to these effects.

In order to demonstrate these themes here is long term revenue data.

Note the increase in 2006-08 as the tail-end of the housing boom kicks in (I know that housing starts declined from 2006 but construction takes time to complete and roofing is usually one of the last elements added) and then the marginal decline takes place from 2008-10. This is due to the pull back in new residential and commercial build and a slowdown in the company’s acquisition strategy.
The key point to note is that, otherwise, re-roofing demand is relatively stable. So if you think that we can see some positive contributions from new build going forward, the outlook for Beacon is one of good growth overall.

Not Just About End Market Growth

Beacon also has the chance to grow via acquisitions. With only 7% market share it is the second largest roofing supply company in the US and buying smaller private businesses has long been part of the strategy. The beauty of acquiring these businesses is that they allow Beacon to expand geographically from its original base in the North East and Texas into other parts of the US. It also creates the opportunity to create purchasing and distribution synergies where the acquired business is close to a Beacon outlet.

Given such a fragmented marketplace the opportunity for purchasing existing distributors is significant. With 5-10% organic growth and then 10-15% from acquisitions, the company feels it can potentially achieve 15-25% growth.

One big advantage is that this is not really a market that the stores like Home Depot $HD or Lowe’s Companies $LOW can encroach much on. Despite these mega-caps best efforts to expand category and market share, roofing is a specialist area and contractors have exact requirements for the timing and nature of supply. Home Depot is doing well and its management is starting to indicate a bottoming in housing but its prospects are still largely tied to GDP. It doesn't offer the same kind of upside as Beacon. As for Lowe's it recently disappointed the market with a weak set of results.

Another growth driver will be the increasing age of the US housing stock. Beacon quotes the median age at 35 and 63% of US housing was built before the end of the 1970’s. As we have seen with the auto parts distributors and the increasing age of US cars, the aging affect can result in significantly improved profitability.

The other thing I like about this stock is its US centric exposure. For example you could look at stocks like Whirlpool Corp $WHR or Masco Corporation $MAS but they both have significant overseas sales. In addition, they both have significant portions of their revenues in discretionary spending items. In other words, their profitability is far more cyclically aligned than for Beacon and they are not so much US centric plays. The other issue with both of them is debt. Masco has over 50% of its market cap in net debt and with Whirlpool it's nearly 35%. So there are a whole host of execution and competitive issues to take on board with these stocks and I think Beacon is better placed than all of them.

Sounds Good but What About the Evaluation?

In terms of the operational metrics of the business I like how free cash flow consistently exceeds net income.

Indeed, management believes that capital expenditures should not exceed 1% of revenues in the future. These numbers are very impressive for a company making acquisitions and needing to invest in inventory and operations accordingly. Analysts have EPS figures of $1.67 and $1.81 for the next two years. The stock currently trades at around $28.

Conservatively assuming that net income equates to free cash flow for the next two years would put it on a forward FCF/EV of 5% and 5.5% respectively. That is cheap for a business capable of growing earnings in double digits and with a 9 year operating income compound annual growth rate (CAGR) of 19%. It might be better priced at $33.