Description

Builders FirstSource (“BLDR”) is the largest US building products distributor (2.6% market share) serving large single family and multi-family homebuilders and re-modelers. BLDR has over 115,000 customers with a 90% customer retention rate.  In addition, BLDR has over 30,000 employees at over 570 sites including 160 truss and 120 millwork facilities serving 89 of the top 100 MSAs in the United States in 43 states.  Over 75% of revenue is associated with value-added or specialty products. The large portion of value-added and specialty products and services allows BLDR to generate industry leading gross margins of 35%.

The predecessor to BLDR (Builder’s Supply and Lumber Company) was purchased by JLL Partners in 1998.  In 2005, BLDR went public via an IPO.  BLDR’s first large acquisition was to acquire a large  competitor, ProBuild with 400 locations, in July 2015.  In January 2021, BLDR merged with BMC, another large competitor with 550 locations.  In August 2021, BLDR purchased WTS Paradigm, a housing rending software and services company, extending BLDR’s support to housing design & building material supply.  Since 2021, BLDR has made 14 tuck-in acquisitions.  The new CEO, David Rush, lead the integration of the acquisitions BLDRs has made since 2015. 

BLDR has integrated acquisitions and has used technology to reduce operating costs by $275 million annually.  Some areas of focus include truss plant automation, price optimization, warehouse automation, delivery optimization and customer service tracking. After each large acquisition, there has been consolidation and optimization of distribution yards and millwork and truss plants.  Since the BMC acquisition, truss productivity has increased by 5% per hour and millwork by 9% per hour.  BLDR has developed an installation service business that is bundled with its truss and millwork products.  This business generates $2.5 billion of revenue from about 33% of BLDR’s footprint. The remaining 67% of the BLDR’s footprint is a growth opportunity.  Providing installation service with distribution is a proven high ROIC strategy in the insulation distribution/installation business with both TopBuild and Installed Building Products having consistently industry leading RoICs.

A distribution productivity measure is return on working capital, profit/working capital.  One of the best distributors in Europe, Bergman & Beving, has a goal of 45% return on working capital. BLDR has a current return on working capital of about 100%. This exceeds some of BLDR's competitors/comparables with returns on working capital of 29% for UFP Industries and 20% for Bluelinx.

Beginning in 2015, management acquired businesses to expand BLDR’s geographic reach, scale and functional capability (including truss and millwork installation).  The return on equity also increased to 40%s from single digits before 2015 and free cash flow conversion increased from 33% to almost 90% in 2022.  The business acquisitions were financed primarily by debt which was paid down from cash flow generated from the acquired firms. Since 2015, management has acquired 25 firms, two large firms and 23 tuck-in acquisitions.  The resulting unlevered RoIIC (see calculation below) has been over 100%, which includes returns from both organic growth initiatives, acquisitions and COVID.   

BLDR has five levers for cash flow growth: 1) buying a value-added product and distribution firm; 2) expanding within existing markets; 3) operational improvements; 4) paying down debt; and 5) distributing excess cash as dividends or buying back shares. The acquired firms generate cash flows in excess of what is needed to modestly grow the firm, which is used to purchase firms in its target or adjacent markets. If no firms can be found that meet management’s operational and valuation criteria, then management will buy back shares as the shares have typically traded at modest valuations reflecting modest organic growth. BLDR currently spends about 15% of operational cash flow on capital expenditures leaving 85% for buy-backs and mergers and acquisitions. 

The business sector in which BLDR competes are subject to economies of scale from distributing and value-added product manufacturing of building products and have route density characteristics in the distribution of building products.  Evidence of the increasing scale is BLDR has the highest margins amongst its building product distributor competitors and increasing margins over time as BLDR has gained scale.

Value-Added Products and Distribution Services

BLDR competes in the building products distribution and value-added building products markets in the United States.  BLDR is the largest building products distribution company in the US with a 2.6% market share in a market with an estimated size of $874 billion in 2022.  This market is expected to grow by 3% per year over the next few years.  The top firms in the distribution market have a 7.9% market share.  The market is very fragmented and can benefit from automation and more efficient operations as illustrated by BLDR’s improvements over the past few years described above.

Building products distributors can be thought of receiving a royalty on a capital-intensive homebuilding/re-modeling industry. Value-added products & services (such as truss and millwork products and services) and software will enhance returns on capital and add stickiness to customer relationships. This has led to a 90% customer retention rate for BLDR. The market is a local market versus a national market so BLDR is a competitor in 89 MSA markets, many of which BLDR is the leading firm. 

A key driver for building supply distribution firms is homebuilding.  Housing demand in the US is expected to remain high as there has been a cumulative underbuilding 2 to 3.5 million since the great financial crisis.  The key to the lollapoluzza effects of these homebuilding trends is to provide these homebuilding products and services in an efficient manner and can be illustrated by the relative returns on capital by market participants.  BLDR has illustrated this with the best in class returns on capital of over 20%.

Another aspect of building products distributors versus other firms in the housing value chain is the capital light nature of these firms.  Most home builders and building product manufacturers are more capital intensive and have lower free cash flow conversion.  The capital light nature of the business leads to higher returns on capital.  These factors and consolidation have generated above average returns on capital for the large more scaled firms in the building products distribution industry.

Building products distribution is also a slow-moving business with many firms in this business being over 100 years old. This allows consolidation to occur with disruption being less of a threat than in telecom, media or computer hardware industries. 

BLDR also barriers to entry including:

• The scale/cost of BLDR’s distribution platform, the largest in the United States, providing purchasing and efficiency cost advantages;

• The manufacturing and installation of value-added products across markets to regional and homebuilders; and

• In the medium term, long lead times and scarcity of new equipment and homebuilding personnel.

As described above, organic growth in these segments is expected to be 5% annual growth rate[1] with any other growth coming from identified growth projects, acquisitions or share repurchases.

BLDR operations have become better over time as two acquisitions accelerated BLDR’s scale quicker than competitors. The return on equity has increased from 7% in 2012 to 2015, to 43% in 2022 and is expected to normalize the high 20%s to low 30%.  Free cash flow conversion also increased from 33% in 2014 to about 90% in 2022.  The drivers included increases in net income margins from 3.2% in 2014, to 17.9% in 2022, and slight increase in inventory turnover from 9.5x in 2014, to 9.8x in 2022. Leverage also declined from 6.3x to 0.8x EBITDA. 

The incremental return on invested capital over the past five years is close to 100%, which has increased BLDR’s RoIC over the past five years. The non-large merger/COVID RoIIC is close to 30-40% as seen in 2018 and 2019.  See the calculations below.

Downside Protection

BLDR’s risks include both operational leverage and financial leverage. Operational leverage is based upon the fixed vs. variable costs of the operations. There are economies of scale in terms of purchasing and local manufacturing operations, as the business is primarily clustered around its 89 MSAs in the United States.

[1] Based upon management’s estimates of 3-5% market growth rate plus market share gains. The total 5-year projected annual revenue growth is 9% with the historical revenue annual growth rate of 26%. 

Financial leverage can be measured by the debt/EBITDA ratio. BLDR has a low net debt/EBITDA of 0.8 versus other building products distributors (like Beacon Roofing, BlueLinx, GMS, Installed Building Products, TopBuild and UFP Industries) and versus BLDR’s history. The history and projected financial performance for BLDR is illustrated below.

Management and Incentives

BLDR’s management team has developed an M&A engine and an operationally efficient firm in the building products distribution and value-add building products industry. They perform M&A when targets are available at the right price partially financed by debt, pay down debt, and return capital via buybacks when there are no opportunities to invest organically or via M&A. 

The base compensation for the management team (top five officers) ranges from $5.4 million per year for the former CEO to $3.4 million per year for the President of the Central Division. Over the past year, the top 5 management folks' total compensation was about $21m per year, about 0.7% of net income per year.  The CEO currently holds 109,000 million shares and options (worth $18.1 million), which is more than 7 times his 2022 salary and bonuses.  The CEO’s compensation is structured to include a $587k base pay and up to a $1.874 million performance bonus.  Short-term management incentive pay is based upon meeting stretch EBITDA and working capital/sales targets and is paid in cash.  Long-term management incentive paid in RSUs has two parts 25% time based and 75% performance-based vesting. The performance-based vesting is based upon yearly RoIC and three-year average ROIC targets overlayed by relative total shareholder return (“TSR”) to a peer group.   

Board members have a significant investment in BLDR. The board and management owns 3.15 million shares, about 1.9% of shares outstanding ($388 million). Option grants, provided management & employees, were equal to 0.8% per year of the shares outstanding over the past three years.  The CEO is required to hold 5x his salary in common stock, other C-level management 3x their salaries and the board 5x their annual retainer.

Valuation

The key to the valuation of BLDR is the expected growth rate. The current valuation implies an earnings/FCF increase of 1.9% in perpetuity using the Graham formula ((8.5 + 2g)). The historical 5-year earnings growth has been 25% per year including acquisitions and the current return on equity of 13%.

A bottom-up analysis based upon market growth rates of BLDR’s markets’ (single family and multi-family homebuilding and remodeling) results and market share growth was used to estimate an organic growth rate of 5% for BLDR.  This is based upon management’s estimate of market growth.  This does not include any future acquisitions. If we include 4% growth for acquisitions, then the base revenue growth rate is 9%.  Factoring in operational leverage and planned buy-backs, the estimated EPS growth rate is 13%. Historically, BLDR’s EPS growth rate was 71% per year driven by fourteen smaller and one larger acquisition over five years.  If we assume half of the number of acquisitions over the next seven years and a forward return on equity of  mid-twenties, declining from the current rate of 26%, retaining 100% of earnings, then the incremental 13% growth per year is conservative. Using a 13% expected growth rate, the resulting current multiple is 35x of earnings, while BLDR trades at an earnings multiple of about 12x. If we look at building product distributors with similar RoICs, they have an average earnings multiple of 18.5x. If we apply 18.5x (see details below) earnings to BLDR’s current 2023 earnings of $13.25, then we arrive at a value of $245 per share, which is a reasonable short-term target. If we use a 13% seven-year growth rate, then we arrive at a value of $466 per share. This results in a five-year IRR of 23%.  These values assume BLDR will not do another large acquisition like ProBuild or BMC.  

Growth Framework

Another way to look at growth and the valuation of companies is to estimate the EPS five years into the future and see how much of today’s price incorporates this growth.  We are also assuming 85% of net income will be used for buy-backs, consistent with management’s guidance. Using the same revenue described above results in a 2027 EPS of $22.75, or 7.3x the current price. If we assume a steady-state average growth rate from 2027 on of 7%, then this results in a fair value Graham multiple of 22.5x or $609 per share, higher than the five-year-forward valuation above of $466 per share.

Comparables and Benchmarking

Below are the building product distribution firms located in the United States.  Most of BLDR’s competitors are private firms.  Compared to these firms, BLDR has debt on the low end of the range, has better inventory turns and margins and high RoIC.  The low debt will allow BLDR to return much of its generated cash flow to investors via share buy-backs.  BLDR also has one of the highest RoEs and RoICs with multiples lower than firms that have similar RoICs (Top Build and Installed Building Products).

Risks

The primary risks are:

•  slower-than-expected acquisition growth (currently projected to be 50% of the historic acquisition growth rate);

• lower-than-expected growth in BLDR’s end markets offset by the small market share BLDR has in its markets; and

• a lack of new investment opportunities (mergers and acquisitions) coupled with higher stock prices making buybacks less accretive.

Timeline/Investment Horizon

The short-term target is $245 per share, which is almost 50% above today’s stock price. If the continued acquisition/consolidation thesis plays out over the next five years (with a resulting 13% earnings per year growth rate), then a value of $540 (midpoint of the two methods described above) could be realized. This is a 26% IRR over the next five years.

Disclaimer

No Recommendation: The mention of or reference to specific companies, strategies or instruments should not be interpreted as a recommendation or opinion that you should make any purchase or sale or participate in any transaction.

Catalyst

The primary catalysts are:

• higher-than-expected acquisition growth (including another large acquisition);

• faster growth in BLDR’s end markets or higher penetration into these markets; and

• increased local scope or purchase of local scale in new markets.