Thursday, December 27, 2012

Beacon Roofing Supply Has Strong Long Term Prospects

It’s always interesting to chat with young investors, not least because it forces you to go through the discipline of crystallizing thoughts and expressing them in a concise manner. In a recent discourse, an economics student was telling me he had studied a mathematics course designed to help predict the operational performance of a company. Such things are interesting and good to integrate into investing, but I think they are a small part of the picture. My response was that the real key to investing is trying to appreciate the meaning behind the numbers.

In other words, analysts can model companies and knock up discounted cash flow (DCF) models into perpetuity but it won’t necessarily mean they understand why the numbers are what they are, whether they will be that way in future or how to make money out of them. I have two points here.

Firstly, the numbers themselves (return on equity etc.) are only reflective of market conditions in the period within which they were created, and conditions change over time. Secondly, even the numbers don’t decide how/if you make money. Consider a DCF for a tech stock that gives a value X in 1998. A similar one in 2007 also gives a value of X.  In both cases the stock is bought. The first guy generates huge returns, the second loses his shirt. Is one an investing genius and the other an idiot? However you try to hide it, taking a long only position with equities is a manifestation of a macro-economic viewpoint.

What on Earth Does This Have to do With Beacon Roofing Supply?

I’ve covered Beacon Roofing Supply (NASDAQ: BECN) in some detail in an article linked here and I would advise going back and reading it after finishing here.

My point with BECN is that I think it has a few earnings catalysts that are not immediately apparent in the numbers. Moreover, these metrics should be able to improve in the future and investors should be willing to pay more for them.

  • A fragmented marketplace within which it can acquire and grow geographically
  • A niche market sector (roofing) that non-specialists cannot encroach
  • Strong recurring revenues from non-discretionary re-roofing that protect it in a downturn
  • Upside exposure to natural disasters
  • Small but relevant exposure to new build

If you put these arguments together I think you could make a case for BECN to carry a supra-market rating because it does offer stability of earnings plus good long term upside.

Moreover, the ‘growth kicker’ of a recovering new build market (BECN claims to be well positioned in the markets where new build is prominent at the moment) is underrated in my opinion. It’s very easy for investors to point at the housing market stocks and conclude that ‘they have had a good run, it’s time to take profits off the table, the evaluations look stretched etc.’ but before you do that I suggest looking at the current metrics in line with where the market is now and where it could be in a few years. I’m not going to labor the point, sufficed to refer you to this article linked here where you can see graphical evidence of what I’m talking about.

Investing isn’t just about looking at, say, Lowe’s (NYSE: LOW) and concluding that the PE is too high. Maybe its growth prospects and leverage opportunities will make it seem cheap in the future?  I happen to think it will.

But Back to Beacon

I thought the latest BECN numbers were good. They were in line with analyst estimates and I admit I was a bit cautionary ahead of them (having sold out after it hit my price target earlier in the year) because Home Depot (NYSE: HD) and others had mentioned weak results in roofing. In addition, after Sandy took place a host of journalists had been pitching up the stock as a key beneficiary. Frankly this concerned me because, as Home Depot argued, Sandy was more of a water damage event as opposed to the wind effect of Katrina. This may not be an issue for HD, but it could disappoint newbie BECN investors. Moreover, BECN is not particularly strong in the areas where Sandy had the most impact.

No matter, the good news is that BECN hasn’t baked much from Sandy into its guidance. Instead the key catalysts going forward will be growth from acquisitions, favorable gross margin shifts from an increase in higher margin residential roof sales, and some ‘kicker’ from new house building. If you look at what Masco and Whirlpool are saying, there is a real and tangible uptick in spending on larger ticket items within the US Housing markets (and on the discretionary side too).

However, the real imponderable is pricing. Again I was somewhat concerned here because weaker market conditions usually make it harder for corporations to take pricing. BECN is currently lapping strong growth from Katrina, and it built up its inventorie, so pressure on pricing was likely. As it turned out pricing was flat year on year for the quarter and was declared as being sequentially up for the last two quarters.

Where Next for Beacon?

BECN guided towards 5% organic growth (volume based), which gives around $102 million, and acquisition related growth of around $138 million, which totals around $240 million. However, it suggested a figure of around $275 million for revenue growth, which suggests a 1.7% assumption over pricing. This may prove conservative given that pricing was up sequentially and (at least in residential) was described as being up 1-2%. Ultimately it will be guided by the local markets BECN serves, and I think there is cause for optimism.

Moreover, BECN declared itself comfortable with the current analyst consensus of $1.82 for 2013. I argued in the first article that it tends to convert its income into free cash flow very well, so assuming a par conversion would give around $85 million in free cash flow or around a forward FCF/EV yield of around 5%. I’m willing to pay more for the reasons outlined above, but not much more, and it’s hard for me to justify paying more than $33. I’m willing to wait/hope for a handle in the $20’s before buying.

Perhaps that’s something the economic student would agree with me on?