Friday, February 15, 2013

Beacon Roofing Supply Has Hidden Upside

Beacon Roofing Supply (NASDAQ: BECN) gave results recently and served notice that its near term upside drivers from a housing market recovery are in place for 2013. Meanwhile, its long term objective of consolidating the roofing supply industry in the US continues apace. In summary, I like the company and the stock, but it doesn't look cheap. If you are aggressively seeking exposure to US housing then the stock is compelling. However, if you are like me and don’t like buying stocks without a margin of safety then you might want to try to get a better entry point.

Beacon Roofing’s Exposure to New House Building?

Firstly I want to clarify a key point. Traditionally BECN’s exposure to new housing is only 20%, but in recent years (with the slowdown in construction) that has fallen to around 10-15%. So why is BECN a play on new housing construction?

The answer to this is twofold. First the marginal contribution from an increase in new build will have its affect on the bottom line. Second, if new build comes back then the demand pull is likely to drag up pricing for the whole roofing industry.

Lumpiness in Revenues

With that said, this isn’t a linear process. BECN’s top line is always subject to a certain amount of lumpiness thanks to weather uncertainty. Indeed, last year was a classic example with a lot of activity in the sector being pulled forwards at the start of the year thanks to seasonally clement weather.

This is amply demonstrated in the Architectural Billings Index from the American Institute of Architects.

Both Home Depot (NYSE: HD) and Lowes Companies (NYSE: LOW) reported the pull forward effect in their results, and some investors were disappointed when their mid year results didn’t match expectations, which were artificially high thanks to this effect. No matter, things got better from the autumn onwards as the underlying strength in housing started to kick in. It is particularly noticeable that Home Depot is talking about strength in categories that are more discretionary in nature. In addition, Lowes is achieving a lot of success in its program to restructure and simplify its product lines. I don’t believe in coincidences and I suspect Lowes is able to do this because it now has favorable end markets.

All About Pricing

In common with the home goods stores BECN is seeing signs of strength in some of the more discretionary elements of sales. For example Complimentary Building Products pricing was up 3-4% in the quarter and this helped sales in existing markets to be up 2.9% in this segment. It’s a good early indicator of some cyclical strength.

However, Complimentary only makes up 14.6% of sales at present with Residential Roofing providing 47.2% and Commercial Roofing at 38.2%. Commercial Roofing saw pricing flat and I think it’s fair to argue that its growth tends to lag residential growth. The main driver to upside in 2013 will be from the residential market. As such, it was easy to be disappointed by the 3% decline in Residential pricing in the quarter. Throw in the 5.4% fall in existing market sales and disappointment might start turning into despondency.

If so, it would be a mistake! Pricing and sales may be down on a yearly basis but they are up against some very tough comparisons (remember the pull forward effect and the re-roofing activity created by Katrina?) last year.  BECN’s management argued that sequential pricing was up sequentially, and by my reckoning that is three quarters in a row. Another good sign.

Where Next for Beacon Roofing Supply?

Analyst estimates are for $1.81 in earnings, and management declared that they were comfortable with these numbers. The game changer will be if BECN manages to get the planned price rises in Residential to stick. Indeed, the company spent significant sums on inventory in order to take advantage before industry prices rise. BECN reported that January was a good month with its order backlog growing, and there is a real sense that any weakness in the winter was temporary.

With a current stock price of $37, the forward PE is over 20.4, which looks a bit pricey to me. It isn’t ‘pricey’ if you start baking in some increased pricing in Residential Roofing pricing. I’m willing to do this but not without some margin of safety. Another one for the monitor list.

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