Description

BMHC- Short. 9/6/05:

Thesis Preview:
Oh how rarely the market does indeed get it so spectacularly wrong, as is the case here with BMHC: Building Materials Holdings Company. Which is up some 30% since Katrina hit and 15% above its pre-Katrina 52-week high, even though in a best case scenario they only see a small and temporary improvement in eps, in the face of a longer term slowdown approaching for their hottest business.

Overiew of BMHC:
BMHC has two relatively easy to understand businesses:

1) Distributing Building Materials:
a. 60% of Revenue, 50% of EBITDA before OH allocation
b. Products from many suppliers as well as some in-house mill work such as trusses, pre-hung doors etc.
2) Construction Services:
a. 40% of Revenue 50% of EBITDA before OHA
b. Framing, installation of trusses, pre-hung doors, job site management services. (Does not include product design, legal or admin services for zoning typically associated with construction services).
c. More recently moving into ‘higher value’ services such as plumbing and shell construction (pouring foundations and anchoring walls)

Without getting into the larger housing debate, let us focus on the critical parts that matter for BMHC pre and post Katrina.

Business Strategy:

About 3 years ago BMHC mgmt got the idea to not only distribute building materials, but also start building the homes themselves. Hence the construction services business was born, which is basically a roll up of large private subcontractors who serve large production homebuilders. Over the last 3 years BMHC went from $0 revenues in this business to now over $1.2 billion on an annualized basis through acquisitions and organic growth on the acquired constructions firms.

Constructions services personnel are basically sub-contractors who handle some of the lower value aspects of homebuilding. Their services include job site management, framing (installing the truss, wallboard etc), ‘shell’ construction (pouring the foundation), window/door framing and installation, and more recently slightly higher value services such as plumbing.

BMHC’s most recent acquisitions have been in the hottest of the hot markets (Phoenix AZ, Las Vegas NV, and Florida). And did you know that there is a housing boom going on in these markets? Now if you look at the homebuilders’ backlogs, most of them have already sold the next 6-9 months or more of production (records across the board), and if they could figure out a way to build more they’d sell more. Enter BMHC. All the large builders are trying to meet the strong demand by violently building as many homes as they can. This has given BMHC extraordinary pricing power on both sides of the business.

Current Conditions for Construction Services:

I will focus on the construction services side of the business because this where I think the most froth is built into the stock price and has the most opportunity for margin contraction. In addition, this is the side of the business that has driven earnings to more than double in less than a year, whereas the distribution side (BMC West) has seen less unrealistic margin expansion and less revenue growth. In short, margin reversion in Construction Services is not dependent on a housing slowdown, while distribution to some extend is. Like I said, construction services is where the beef is in the stock price, and this thesis can work even in a somewhat strong housing market for the reasons below:

Cheap money, an increasing consumer propensity to own a new production home, and short-term tightness in available for sale inventory in hot markets, has contributed to frothy retail prices in those markets. What is not as widely known is that this has caused shocks further up the supply chain with pricing power increasing dramatically for framing contractors such as BMC’s construction services group. To put this in perspective: BMHC’s consolidated operating margins for construction services is running in the ~10% neighborhood. On the most recent conference call gross margins in construction services increased 300bps QoQ. Mgmt attributed the expansion ‘almost entirely’ to LV, Phoenix, and FL which is about just over half of their construction services revenue. Therefore, I can extrapolate that its really ~6-8% margins for ‘cooler’ markets (Chicago, and yes California) and closer to 12-14% for ‘hot’ markets such as Phoenix, Las Vegas and FL. Why the extreme margins across geographies?

BMHC is essentially the big elephant supplier in these ‘hot’ markets. If you are a home builder in these markets, you realize that you’ve already sold forward the next 9-12 mos of production, and if, oh only if you could figure out how to speed up construction you can improve turns and thus ROIC. Enter BMHC. When you need to frame 40 houses on a block in record time, BMHC has proven to be a great partner, whereas the dozens of other smaller contractors are less equipped to handle the situation. BMHC has national purchasing power and demonstrated the ability to handle these insane rates of production. In short, they represent an important release valve for this ‘fast construction’ pressure.
Effect: The effect of this hyper-demand situation is that it essentially gives BMHC massive pricing power, hence 12-14% margins for these markets. In addition, high activity per construction site allows BMHC to gain some site efficiency economics of scale by levering the fixed costs associated with building at that site.

So, this is a well-run company and the builders that use them are generally happy with their performance in this can’t miss environment. But that’s just the reason to short this stock, this is indeed a ‘can’t miss’ environment. BMHC’s current return on capital is beyond both historic levels as well as human reason. Why? BMHC is currently taking advantage of their scale by ensuring their customers enough labor and bulk purchases of increasingly scarce building materials, making them indisposable in this environment. However, once the rate of constructions slows, and more importantly the rate of construction per community, their margins will come under pressure for several reasons:

-As with any services organization high workforce utilization off of a fixed overhead creates enormous margin expansion. There are few incremental fixed costs for BMHC to deploy expanded or additional work-crews to a job site they are already in.
-A temporary shortage (or fear of shortage) of certain building materials is driving the homebuilders to give more work to BMHC due to their consolidated purchasing power as opposed to smaller contractors who may not be key supplier’s biggest customers.

All of these advantages move in the opposite direction when construction slows:

-Workforce utilization declines as homebuilders slow the machine down due to either: weaker selling prices hurting deal feasibility, or flat selling prices with a contracting backlog. Substantially all of BMHC’s construction gigs have 90 day out clauses with no guarantee of follow-on work.
-In addition, current management has only been running this business in an ever increasing construction activity climate, and thus will likely not be diligent in managing down head count at the first signs of slowing.
-Community counts expanding: If you take a look at all the homebuilder’s most
recent quarters, you’ll see that they are opening new communities up for sale ahead of plan. Moreover, unless unit backlogs keep growing 15%, construction activity per open community will slow. I believe that this is because all the homebuilders have hit the wall with respect to the rate of construction per community. They realize that isn’t possible to increase the rate of production per community without stressing the local construction market to the point of them getting screwed on margins and angering current residents. In short, community count expansion is the homebuilder’s response to the gouging of local contractors and labor suppliers of last resort such as BMHC construction services. When the rate of construction per community slows, BMHC will have smaller and/or fewer work crews on the job site, de-levering their fixed overhead and opening up price competition of smaller mom and pop framers.
-Looser supplies of construction materials mitigates their ability to command a control premium on their purchasing power. This will also allow the builders to consider smaller contractors without fearing a materials shortage. Katrina may have had an impact on this, but longer term, as the large builders continue to take share from smaller private builders they are in an increasing stronger position to dictate procurement. For example, PHM is more integrated than most and they even manufacture their own trusses for homes in the South West. Truss and manufacturing services has also been a growth/gravy biz for BMC West (the distribution side of the biz).

Still not convinced that 12-14% margins are too much for 1/2 of BMC’s construction services? Or maybe you think that by adding additional services per job site in Chicago and Cali will take the 6-8% that they are doing there and move it to the 12-14% in the ‘hot’ markets. Ok here is the logic for why 12-14% moves to 6-8% and not vice versa:

To earn BMHC’s 10% consolidated margin on 1.2 bil of revenues, they only need roughly 80 mil of inventory and have little WC or purchasing obligations outside of that. Therefore pre-tax ROTA = 12 x 10% = 120%. BMHC doesn’t break out the exact purchasing prices for most of their construction services acquisitions, but if we assume that all in they’ve spent and invested in WC roughly 200 mil, pretax ROA is 60%. I know, they look like geniuses for the small amount of capital they’ve invested in building this services organization, but I think the margins and returns are likely fleeting because the only barrier to local competition pricing them down is the need of the homebuilders to have community level hyper-production in these hot markets. The homebuilders know this and are looking to grow by opening new communities to channel demand into, so that production per community becomes more manageable.

Moreover, production homebuilder operating margins (BMHC’s customers) are pretty strong right now in the 12-18% range for the group. For one of the best homebuilders, Tol Brother (which trades at similar multiples to BMHC), they did 3.8 bil of revenue with roughly 3 bil of working capital (non-cash assets minus non-debt liabilities) in 2004. This yields asset turnover of 1.3 * 17% pre-tax operating margins = 22% pre-tax return on assets. And to get this TOL must make huge speculative land acquisitions 9 years out, guarantee a home price for a customer 12 months out, while not knowing precisely how much construction will cost, possibly seller financing it, giving the customer a warrantee, while adding value by patiently prodding politicians to zone it, designing the product and master plan, flying customers in and advertising etc. BMHC construction services on the other hand carries short term inventory (12x inventory turns on services side), takes no land risk, basically no credit risk, and has no longer term cost obligations b/c of its very flexible business. Eg, the ‘subcontractor’ is doing better than the ‘general contractor.’ Clearly BMHC deserves similar operating margins and 3x the ROA of the builders!!!

More evidence that this earnings environment is passing and not maintainable can be found on the march conference call in which management said that they were ‘shifting resources’ from poorly performing contracts to better performing work. AKA, a subcontractor/consultant cherry picking work, just like when dot-com consultants got paid $200/hour to build a website for a startup, and turned down $100/hour business to deploy a network for an old industrial client.

Distribution Side (BMC West):

This side of the business is benefiting from rising same distribution center sales, driven by strong demand from new home construction and materials price inflation. In addition, West is benefiting from a favorable mix shift to mill work and ‘manufacturing services.’ Eg, taking the builders plans, pre-fabbing trusses and burning ‘attach here’ lines with a laser on the pre-fabbed lumber. ROIC are not as insane on this side of biz, but its likely above historic norms. In order for it slow, we need a general slowdown in new home construction, or additional competition/capacity. That said, this business mix shift to manufacturing services and prefab is making BMC West’s OI more dependent on well priced contracts of the homebuilders.

In short, the pushback from the homebuilders is coming, even if the housing market doesn’t slow. The builders are smart and well run, but due to the insane demand they must currently resort to BMHC as the big elephant supplier. As rate of production per community slows, smaller contractors will be more competitive and these big contractors who used to cherry pick the business, will once again be told who’s boss by the home builders.

Katrina: For some crazy reason BMHC has been mentioned on CNBC a million times over the past week as a possible beneficiary of Katrina reconstruction. Nothing could be further from the truth. While continued tightness of building supplies may result in inflation and thus ‘free’ same center sales growth on a fixed OH for the distribution side, its impact is likely not huge. As per volumes in distribution, the closest distribution center is 300 miles away from NO, located in greater Houston. The construction services people focus on new construction services for production homebuilders, and the closest group to the hurricane is in FL, and very busy with work there. The SVP of biz dev at BMHC was quoted in the San Francisco Chronicle recently as saying that they will likely see no incremental business because ‘we are not there.’ However, I think its clear that Katrina has put some momentum retail traders into the name, and the slight decline in interest rates recently give others the impression that the homebuilding cycle will last longer than anticipated. However, we all know that with homeownership now at 70%+, and ridiculously loose lending standards and that advent of options ARMs, 20 bps on the 10 year does really qualify a significant crop of potential buyers. Oh yeah then there’s gasoline and home heating oil, both of which enable the suburban sprawl all of these home buyers depend upon. In short, this is a decent thesis without a ‘bubble’ and a superb trade if this bubble pops.

Risks:
BMHC is buying mom and pop contractors for 5-6x trailing EBITDA or .3x-.5x sales and appears to be capable of exacting EBITA margins of 10% from the homebuilder customers, resulting in huge implied ROAs. However it is important to understand that they are not really buying tangible assets: they are simply securing labor for the customers, who in turn are paying them extremely well for this service and risk. The risk to the thesis here is that I’m wrong about the economics of a construction job-site. In short, maybe I am wrong that as a really big contractor you shouldn’t make 10% margins while the competition at the same price might actually only made 3% (justifying valuation due to scale). However, I think this is unlikely as framing a house, installing doors, pouring concrete etc is hard to gain insane economies of scale in.

Production homebuilders continue to take market-share from private builders and privately hired GCs. Its nice to have a client base growth 20% a year and still trade at just 12x earnings run rate. On the other hand, the homebuilder’s scale gives them the ability to push-back by dictating procurement and eventually forcing contractors to break out materials costs which flow through cogs right alone with labor costs.

Another risk is if unlike I believe, homebuilders increasing community counts doesn’t really significantly reduce construction activity per community, and therefore smaller framers aren’t able to compete effectively going forward.

Catalyst

Housing construction slowdown, Homebuilders pushback on pricing when labor markets lossen, expanding community count distributing demand across more communities thus reducing construction activity per community which both delevers fixed costs per site and opens up price competition to local mom & pop framers.