Description

I recommend buying GMS (GMS Equity). Originally known as Gypsum Management & Supply, GMS is the largest wallboard and ceiling distributor in the US. Benefiting from the wallboard pricing cycle and industry consolidation, EPS could grow from $3 in FY 2021 to $5 in FY 2024, which at 10x earnings would result in a $50 stock (+18% IRR from $30/share today).

Thesis

1. Wallboard pricing cycle

• The wallboard market has recently tightened due to housing strength. With housing starts increasing to 1.5mm, wallboard capacity utilization has improved from 75% to 90%.

• Wallboard prices have recently spiked. The industry’s October price increase was accepted (November wallboard PPI up +4% YoY, the first increase in two years). The industry recently announced a January price increase.

• GMS benefits from higher wallboard pricing. Sensitivity: each +10% increase in wallboard prices results in +14% EBITDA and +25% EPS growth. 

• Following the wallboard price increases, we estimate GMS’s EPS grows from $3 today to $4 in FY April 2022 (+25% above consensus $3.29) and $5 in FY 2024.

2. Industry consolidation
   

• The wallboard industry is consolidating from 4 large companies into 3. Foundation Building Materials (FBM Equity), the #2 wallboard distributor, was acquired by American Securities, a private equity firm, on November 15 for 8.5x EBITDA. One month later, on December 21, American Securities acquired Beacon's Allied interior business, the #4 wallboard distributor, for 11.5x EBITDA. GMS, the industry leader, currently trades for ~7x EBITDA.

• The FBM merger proxy, released on December 4, shows that 6 companies tried to buy FBM, including GMS. GMS could be acquired by one of the losing private equity bidders, or potentially merge with FBM after the Beacon Allied integration. The status quo is GMS continues rolling up mom & pop distributors, which has attractive returns.

• Coliseum Capital filed a 13-D in GMS on November 9. They could help accelerate industry consolidation. 

GMS is a small ($1.3bn market cap, $10mm ADV), under-followed company (1 Buy, 7 Holds, 0 Sells). With few publicly traded wallboard stocks since the acquisitions of USG and Continental Building Products, we believe the wallboard pricing cycle has been overlooked by the market.

GMS background

GMS is the largest US distributor of building interior products such as wallboard and ceilings.

• $1.3bn market cap, $2.2bn enterprise value, ~$10mm ADV.

• The company was founded in 1971 with one branch. After going public in 2016 with 160 branches, GMS currently has 262 branches with $3.2bn revenue and $300mm EBITDA.

• GMS distributes wallboard (40% of sales), ceilings (15%), steel framing (15%) and other products (30%, mostly insulation, lumber and ready-mix compounds).

• GMS is 45% residential / 55% non-residential. Wallboard is 75% residential; ceilings and steel framing are largely non-residential. 

Building interiors distribution is a fragmented market.

• GMS is the largest wallboard distributor with 15% market share (= 4bn sqft in a 28bn sqft industry). 

• The next largest distributors are $2bn revenue Foundation Building Materials (acquired by private equity in November 2020), ~$1.5bn revenue L&W Supply (acquired by ABC Supply from USG in 2016) and ~$1bn revenue Allied Building Products (acquired by Beacon Roofing Supply in 2018). 

• After the 4 national players are a long tail of 400+ small mom & pops that make up ~50% of the industry. They are slowly being consolidated by GMS, FBM and L&W Supply. 

GMS has been rolling up the industry.

• GMS has made 60+ small acquisitions. The acquired companies are locally run but benefit from GMS’s purchasing rebates. Like many distribution industries we follow (such as electrical equipment, roofing and insulation), the industrial logic for consolidation has increased in recent years due to supplier consolidation.

• Since the 2016 IPO, GMS has made ~30 small acquisitions for 56 branches and $600mm revenue. We calculate they paid $273mm for these deals, which represents 0.4x sales and 5x EBITDA (at GMS’s 9% EBITDA margins), well below GMS trading multiples of 0.6x sales and 7-8x EBITDA. These are attractive acquisitions.

• Their biggest deal was the $627mm acquisition of WSB Titan in 2018 for 9x EBITDA. Titan is the largest Canadian interiors distributor, but Canada’s housing market immediately rolled over. GMS recognized a $63mm impairment in the quarter ending April 2020. We like the acquisition, and even the price paid, but not the timing. 

• GMS also opens ~5 greenfield branches per year (+2% annual branch growth), expanding their geographical coverage outside of their Southeast origins. 

GMS has an attractive financial profile – it is a surprisingly good business! 

• EBITDA margins of 9%, above competitors 7% due to scale and efficiencies. EBITDA margin has increased by +200bps since IPO due to accretive acquisitions (Titan had 15% EBITDA margins, which added +110bps to company margins) and organic growth (10-15% incremental EBITDA margins). This is the business model every branch-based distributor shares: run more volume through the box!

• Gross margins of 32.5%. GMs have increased +60bps since IPO, the only distributor we follow where gross margins have been flat-to-increasing in an age of price transparency. 

• Inventory turns a consistent 7x per year (~50 inventory days) – these are fast turns of commodity products with little obsolescence risk. Tangible assets turn 2.5x per year, leading to good returns on capital. 

• FCF generation targeted at 40-50% of EBITDA, with 56% average since IPO (helped by 93% conversion in FY April 2020, which will be followed by ~40% conversion in FY April 2021 as they rebuild inventories). The company has ~110% EPS-to-FCF conversion – this business is very cash generative. 

• ROIC of 12%, up from 7% at IPO. Excluding the benefit of tax reform, we estimate incremental ROIC has been 16%, with an incremental ROE of 19% after 2x net debt / EBITDA leverage. Since they spend all their capital on acquisitions (minimal capex, no dividends or buybacks), this roughly ties to their acquisition returns (= 5x EBITDA after 22% tax rate = 6.1x EBITDA after tax => 1 / 6.1x = 16% ROIC). 

• EPS has grown +20% per year since the IPO. The stock has only returned +7% per year, as the P/E multiple de-rated from 14x to 9x, but over the long run the stock should compound at the rate of EPS growth / incremental returns on capital. With a large fragmented market, GMS has decades of acquisitive growth ahead of it. 

Wallboard cycle

Like most building products, wallboard was oversupplied from 2007-2020 – that’s a long time! 

• Wallboard (often called gypsum board or drywall) is used in residential new construction (40% of demand), residential R&R (25%), multifamily (10%), commercial new construction (5%) and commercial R&R (20%). Wallboard demand typically follows housing starts, see chart below.

• The industry was tight during the early 2000s housing bubble, which led to a wave of supply: capacity expanded from 30bn sqft to 40bn sqft, just in time for a -50% demand shock (from a peak of 36bn sqft in 2005 to a trough of 17bn sqft by 2010). Capacity utilization fell from 97% to 50%, and wallboard prices collapsed.

• The wallboard industry has been rationalized over the last decade: the number of companies fell from 8 to 6, plants from 76 to 63 and plant capacity from 40bn sqft to 34bn sqft (-15% capacity reduction).

• There were two pricing cycles in 2012 and 2017 as the industry bounced off the bottom. But with housing weakness in 2018, wallboard prices fell again in 2019, see PPI chart below.

The wallboard market has recently tightened due to housing strength.

• We estimate that wallboard demand has grown from 25bn sqft in 2019 (at 1.3mm housing starts) to ~30bn sqft run-rate today (at 1.5mm housing starts), which has tightened capacity utilization from 75% to 90%, typically the threshold for pricing power in a capital intensive industry. 

• Wallboard, along with fiberglass insulation, will be one of the main bottlenecks to the US housing market growing beyond 1.5mm starts. Without capacity increases, we calculate the wallboard industry will run at 100% utilization at 1.7mm housing starts. 

• The industry responded with price increases. The October price increase stuck, with November PPI showing prices up +4% YoY, the first increase in two years. The industry followed with +20% list price increases for January, of which we estimate +5-7% should stick as net price increases. 

• Wallboard being a cyclical commodity industry, the industry also responded with capacity additions. In October, Georgia Pacific announced it was tripling the capacity of a Texas plant – the plant would add +650mm sqft (+2% industry capacity expansion). But with two-year lead times, the plant will only “start production in late 2022”, which likely means 2023 after delays and ramp-up. Wallboard prices should stay high for years. 

Investors are overlooking the wallboard cycle because there are few publicly traded companies in this industry.

• Wallboard is a 6-player market: Knauf (private), CertainTeed (owned by St. Gobain, public European conglomerate), National Gypsum (private), Georgia Pacific (owned by Koch Industries, private), Eagle Materials (public US conglomerate) and PABCO (private). 

• With Knauf’s acquisition of USG in 2019 and Saint Gobain’s acquisition of Continental Building Products in 2020, there are no manufacturing pure plays left for investors to follow. 

• GMS and FBM benefit from wallboard pricing, but are under-followed companies due to their small size (GMS has $10mm ADV, FBM $5mm). With FBM now private, GMS has scarcity value as the only remaining wallboard pure play (unless you include Eagle Materials (EXP Equity) which is a cement / wallboard conglomerate, but has promised to spin off its wallboard business due to activist pressure). 

GMS benefits from higher wallboard pricing.

• With higher pricing, GMS can earn the same gross margin on higher revenue, leading to higher gross profit spread across a fixed SG&A base – this leads to margin expansion. 

• We estimate a +10% wallboard price increase would lead to +4% revenue growth (= wallboard is 40% of sales), +4% gross profit dollar growth (= flat gross profit margin), +14% EBITDA dollar growth (= fixed SG&A base) as EBITDA margins expand +100bps from 9% to 10%, and +25% EPS growth (= financial leverage). 

• GMS has benefited from prior wallboard pricing cycles. In FY 2014-2015, wallboard prices were up +21% and EBITDA margins expanded by +170bps; from FY 2018-2019, wallboard prices were up +6% and EBITDA margins expanded by +150bps (we estimate +40bps excluding the Titan acquisition). 

Wallboard Shipments vs. Housing Starts

Wallboard Capacity Utilization

Source: Gypsum Association