Tuesday, August 20, 2013

Is Beacon Roofing Supply a Buy?

With the housing market recovery ongoing, it’s natural for investors to look for construction-related plays. As its name suggests, Beacon Roofing Supply (NASDAQ: BECN) distributes roofing materials. The stock has had a great run over the last year with a 43% rise, but its latest results were disappointing. Is this dip a good buying opportunity? Let's take a closer look.

Is Beacon a defensive or a cyclical stock?

The answer to this question is “a bit of both.”

Beacon has plenty of recession-proof qualities that make it a genuine defensive-stock candidate for your portfolio. The company’s traditional exposure to new housing build is only around 20% (although it fell to around 10% to 15% after the last housing boom), because its main activity is roofing replacement and repair work. The latter obviously has relatively stable underlying demand (economic boom or bust, leaky roofs aren’t fun), but it’s affected by weather conditions.

Moreover, Beacon can generate long-term growth by consolidating a highly fragmented roofing supply industry. In other words, a lot of its end demand comes from factors outside the overall economy.

However, Beacon does have a cyclical kicker in the form of demand from new residential builds. First, its residential supplies tend to be more profitable, boosting Beacon's margins. Second, an increase in residential new build has historically led to new commercial construction. In other words, as new residential communities appear, the infrastructure around them will also get built. Finally, if residential demand improves, it should lead into increased demand in the industry, and overall pricing should improve as roofing contractors buy more materials.

In other words, Beacon is a stock with good long-term prospects, but also some good cyclical growth kickers in 2013. It’s not hard to see why the market has bid up the stock over the last year. So what went wrong last quarter?

Beacon disappoints with its third-quarter results

In short, Beacon’s luck with weather ran out. The company has had a couple of years of "favorable" weather (tornadoes, hailstorms, Hurricanes Irene and Sandy) to generate strong demand for re-roofing activity. However, weather conditions this year are shaping up to be less extreme than in previous years, at least according to the National Oceanic and Atmospheric Association.

Moreover, hailstorms and wet weather in the quarter significantly held back roofing activity, so contractor demand for materials was a lot weaker than Beacon had expected. A look at the industry confirms that conditions were tough. For example, building supply company, Carlisle (NYSE: CSL), disclosed on its conference call on July 23 that "the quarter did not grow as anticipated, as wet weather continued to impact the number of roofing days."

This was tough for Beacon for two reasons. First, early in the year, Beacon had made significant purchases of inventory in order to get ahead of price rises from its suppliers. It was looking forward to benefitting from increasing volumes and prices. Unfortunately, the 1.2% organic growth recorded in the quarter fell below its expectations, and it proved difficult to pass on any material price increases. In its conference call, Beacon disclosed that it managed to take 1% of pricing in the quarter, when it had expected to take more than 5%.

Second, as expected, its suppliers did raise prices, and consequently, Beacon suffered some input cost increases in the quarter.

Ultimately, a combination of weaker-than-expected demand and cost increases saw Beacon’s gross margins fall to 23.5% from 25.1% last year. Due to the difficulties in the quarter, Beacon lowered its full-year EPS guidance to a range of $1.50 to $1.60, from a previous range of $1.75 to $1.85.

A beacon of hope

While its lowered guidance is disappointing, the company does have some positive signs ahead.

First, according to Carlisle, the weakness in its roofing sales wasn’t because of weak underlying demand: “Our contractors continue to have heavy backlog comprised of both new construction and reroofing projects. Reroofing appears to have been impacted more than new construction.”

If Carlisle is right, then Beacon can look forward to better conditions in future quarters. Indeed, Beacon argued that its July sales were relatively strong.

In addition, one company that supplies roofing products, Owens Corning (NYSE: OC), gave a relatively bullish outlook for its second half roofing sales. It expects:

“... improved full-year margins versus 2012. We continue to expect the full year market shipment to be flat versus last year. Based on first half shipments, we expect higher volumes in the second half ...The U.S. housing market outlook continues to support improvements in new residential construction and modest growth in re-roof."

According to Owens Corning, roofing distributors are going to take higher volumes in the second half and, at the higher prices too. This is a good indication that Beacon will be able to pass on pricing more easily.

The bottom line

In conclusion, there is a good chance that Beacon will see better conditions going forward. Furthermore, investors should not fret too much over the difficulties in the current quarter, because it looks like a weather-related issue. On the other hand, the valuation does not look generous.

The best way to look at a business like Beacon is to accept that its return on assets will be variable (it can’t control the weather), and to try and buy it when its price/book valuation looks historically favorable.

BECN Return on Assets data by YCharts

The chart above indicates that Beacon is not a good value on a book value basis, at least compared to where it has traded at over the last few years. Despite its good long-term prospects, and the chance of some better trading conditions in the near term, investors should hold out for a better entry price.

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