|Shares Out. (in M):||11||P/E||8.4x||7.9x|
|Market Cap (in $M):||155||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||49||EBIT||32||36|
On the surface, it appears that Patrick Industries is a no-growth industrial company with sales having stagnated near $300 million from 2001 until 2011. However, a more detailed look shows that while consolidated sales have remained flat, the composition of the sales has shifted substantially. In 2001, over half of the company’s sales came from an industry with a very poor outlook (manufactured housing). The MH industry was severely inflated in the late 1990’s due to conditions similar to the housing crisis a decade later – reckless lenders, overproduction and artificially stimulated demand. Logically, the industry went into free-fall once the tide went out and the company found itself over-exposed to an industry that was rapidly shrinking. In that light, the fact that the company has been able to maintain its sales level is a rather heroic performance in its own right.
Patrick Industries v.2012 has a much healthier outlook than Patrick Industries v.2001. The company’s largest industry exposure now is to the RV industry, with the remaining roughly one-third exposed to MH and housing. We discuss the industry outlooks below:
The RV industry has recovered from the financial crisis to more normalized levels of supply and demand. Tight consumer credit conditions are keeping a lid on euphoria and conditions are just south of normal but healthy. Industry backlogs are up and supply discipline exists with the industry operating as an oligopoly between Thor Industries, Forest River (owned by Berkshire Hathaway) and privately-held Jayco. Demographics are also a tailwind with many Baby Boomers (the most natural buyers of RV’s) entering retirement. Overall, the industry is expected to grow modestly in 2013. (See the Recreational Vehicle Industry Association website for details on industry shipments, forecasts - http://www.rvia.org/?esid=indicators - and demographic factors - http://www.rvia.org/?esid=trends).
As mentioned, the MH industry underwent a painful, decade-long contraction but there are signs of the industry bottoming or even recovering from current levels. First, industry shipments have now stabilized at 50k units after yearly sharp declines. Second, for the 20 years prior to the MH bubble of the late 1990’s, MH units averaged 20% of new housing starts (though they are not included in the new starts data). In the last few years of stable MH units, the industry has represented 10% of new housing starts and it appears that 2012 will be the first year of industry growth with estimated growth of 6%. Lastly, the company’s exposure to the MH industry is now less than 20%, compared with over 50% a decade ago. So, it appears that the MH industry has bottomed or may grow and at the very least, it is no longer an anchor on the company’s performance.
The housing industry underwent an enormous correction and is now recovering. Further recovery in housing starts to normalized levels should produce growth in the company’s Industrial segment – which is largely levered to residential construction with a few month lag.
Cost-cutting measures and product mix have helped the company attain more normal operating margins though there is still room for improvement
For most of its history, Patrick Industries operating with subpar operating margins as its cost structure was bloated and its sales were decreasing. The company began an aggressive cost cutting initiative in 2007 focused on plant consolidation and closure, increased efficiency and fixed cost reduction. Following the Adorn acquisition in 2007, the company closed or consolidated eight unprofitable facilities, reduced headcount by 230 and combined purchasing initiatives to drive efficiencies. The cost savings began bearing fruit in 2009 and the gross margin initiatives in 2011 as the company’s sales recovered. The evolution of the operating margins can be seen in the MD&A over the past few years:
Selling, General, and Administrative (SG&A) Expenses. SG&A expenses decreased $14.7 million or 54.8%, to $12.1 million in 2009 from $26.8 million in 2008. As a percentage of net sales, SG&A expenses were 5.7% in 2009 compared to 8.3% in 2008. The decrease in SG&A expenses is primarily attributable to our ongoing efforts to align operating costs with revenue as a result of the soft market conditions. Administrative, office, and sales wages declined $8.0 million during the year principally reflecting a reduction in headcount over the past twelve months and reductions in base compensation taken by all hourly and salaried employees in first quarter 2009. In addition, bad debt expense decreased $1.0 million in 2009 reflecting the Company’s continued efforts to maintain appropriate credit policies with customers and suppliers especially given tight retail credit standards and the level of consolidations/closures of RV and MH customers.
Cost of Goods Sold. Cost of goods sold increased $14.9 million or 6.0%, to $263.5 million in 2011 from $248.6 million in 2010. As a percentage of net sales, cost of goods sold decreased during the year to 85.6% from 89.3%. Cost of goods sold as a percentage of net sales was positively impacted during the year primarily by margin improvements that were in line with the Company’s expectations and ongoing organizational and process changes that enhanced labor efficiencies, reduced scrap and returns, and increased material yields at two of the Company’s Midwest manufacturing divisions, one of which had underperformed in 2010 compared to historical levels.
Despite the impressive margin improvements, there is still room for improvement. The closest peer for Patrick Industries is Drew Industries. In the simplest sense, on a typical $25,000 RV, Drew provides $2,700 of content and Patrick provides roughly $800. While there is some minor overlap, Drew provides more exterior and support components like chassis, exterior windows, entry doors and suspension systems while Patrick Industries is more focused on the interior products such as vinyl and paper panels, countertops, backsplashes, and cabinet doors.
Given their very similar business models and based on Drew’s historical margin performance, we believe that Patrick Industries can improve upon its current operating margin level now that its business mix is more reliant on RV market and less on the manufactured housing market.
Lastly, we think that the margins are sustainable given the estimated growth in the industry and because of the RV OEM’s reliance on suppliers. RV manufacturers like Thor Industries do not want to bring component manufacturing in-house and are happy to buy products from suppliers like Drew Industries and Patrick Industries.
There is also limited competitive risk because of the high cost of distribution. It is not economically feasible to foreign manufacturers to compete with suppliers that are located strategically close to the OEM’s. The cost of distribution as a barrier to entry can be illustrated by looking at Winnebago’s production strategy. Winnebago is largely vertically integrated because their manufacturing facilities in Iowa make it prohibitively expensive to source components from industry suppliers which are located around Elkart, Indiana – the “RV capital of the world.” We believe an OEM would prefer to outsource the production because it would create a better operating model – as witnessed by the financial performance of Thor compared to Winnebago during the industry downturn.
Indeed, one of Thor’s key selling points is that the company has been profitable every year since its inception – including through the depths of the financial crisis. Therefore, we think there is limited risk of an OEM bringing component production in-house and limited risk of foreign competitors competing based on lower labor costs or other factors.
Management is well incentivized and has shifted the focus to growth from cost cutting and balance sheet repair
CEO Todd Cleveland (age 44) joined the company when Patrick acquired Adorn Holdings in 2007 and became CEO in February 2009. Cleveland had been with Adorn for 17 years and served as CEO for the last three years. He has aggressively pushed the company to cut costs and, recently, to re-focus on growth through both organic initiatives and acquisitions. Cleveland owns 450k shares of stock (4% of shares outstanding) worth $6.3 million, compared to a salary of less than $300k.
Valuation is attractive and the company is largely unknown given lack of sell-side coverage and size
Given the fact that Patrick Industries had underperformed for so long, the stock was off many investors’ radars given that its market cap was less than $100 million and the float was even less with Jeff Gendell’s Tontine Capital Management owning nearly 50% of the shares. Even today, despite being the 2nd largest RV supplier, the company is virtually unknown among investors – with only two "analysts" covering the stock (Sidoti and EVA Dimensions) and an investor relations effort that includes no earnings calls, investment presentations or conference appearances. Regardless of those issues, we believe that Patrick Industries should be valued similarly to Drew Industries.
LTM Sales $488.4 million (including $80 million in acquisitions done in 2012 but with only $29 million reported)
EBIT $31.6 million ($28.3 million actual reported plus margins from full impact of acquisitions - excludes intangible amortization)
Interest $3.3 million run rate
Net Income $18.4 million taxed at 35%
Shares 10.9 million
P/E = 8.4x
DW trades at 22x trailing and 17x NTM earnings. Additionally, RV OEM's like THO and WGO trade at similar multiples.
Other than the fact that PATK is largely unknown (it has never been written up on VIC, SumZero, Seeking Alpha or any other blog/site to our knowledge), another aspect that has caused the stock to be dislocated has been stock selling by the company’s largest shareholder. Tontine sold some stock above $18 per share in November 2012 and distributed 276k shares of stock to its investors to meet redemptions in January. So when Patrick reported earnings on February 21 and despite announcing that sales grew 36% and operating earnings grew 58%, the stock fell 17% to under $12 – likely as many Tontine LPs sought liquidity for the in-kind shares given to them.
Generally having a large shareholder sell stock is not a good sign for a stock, but a detailed look at Tontine’s ownership history suggests that a) Tontine buying and selling has generally not been a great indicator of future stock performance, b) some of the selling may perhaps be for uneconomic reasons (such as meeting redemptions as mentioned above) and c) for whatever reason, Tontine has actually held most of its position in Patrick Industries despite a substantial reduction in total reported assets, turning Patrick from a virtually non-factor (0.2% position for Tontine at its peak AUM in 2007) to the largest position in the portfolio. While we have not spoken with Tontine, for these reasons, we are less concerned about the sales implying anything about the value of Patrick going forward. In fact, future sales may actually be beneficial as they increase the float and liquidity of the stock.
Lastly, the day after the earnings were released, the company announced a $10mm stock repurchase program. We view this as a sign of confidence by the management team regarding the company’s value and outlook.
An investment in Patrick Industries isn’t without risks.
Customer concentration: Not surprising in an industry where three player control 70% of the market, Patrick Industries does have significant customer concentration with its #1 and #2 RV customers accounting for 32% and 17% of total sales, respectively. THO does not want to go integrated
Economic sensitivity: The RV, MH and housing industries are extremely economically sensitive and are driven by credit availability and customer confidence. To the extent that the US enters another recession, all three industries will be affected. This risk may be somewhat mitigated given that current industry levels are well below historical trends.
Tontine ownership: As discussed above.
RV dealership inventories: There have been some concerns about RV industry wholesale shipments exceeding retail sales and some noted short sellers have used these concerns to focus on Thor Industries. Thor has responded that inventory levels are “right-sized” and that there has been “healthy discipline” by both wholesale and retail lenders. While there may be some slow down as retail sales catch up with wholesale inventory levels, we think the long term trends of the RV industry are healthy and the short thesis relates more to THO and its valuation specifically.
Additional commentary on the RV and MH industries
One interesting aspect is that Berkshire Hathaway owns the 2nd largest RV OEM (Forest River) and the largest MH company (Clayton Homes). It's also interesting that Berkshire bought into these businesses at much higher points in the cycle - having bought Forest River (reportedly for $800 million) in 2005 and Clayton for $1.7 billion in 2003. Berkshire's commentary on Clayton in annual letters to shareholders is an excellent read to understand the challenges and opportunities for the MH industry. Clayton also recorded its first year-over-year profit increase in 2012 and first unit shipment growth, though the figures are still substantially below peak levels in the 1990's and the earnings levels for the first few years after Berkshire bought the business. I think the fact that Berkshire made such large investments in these industries demonstrates the long term durability of these businesses over time and through cycles - though they certainly are cyclical.
Increased investor awareness as the company has indicated that they will likely start to attend investor conferences and host earnings calls