Ply Gem Holdings

Executive Summary

I am recommending a long position in Ply Gem Holdings (PGEM).  As one of the largest manufacturers of residential exterior building products, it is highly levered to the ongoing housing recovery but has been abandoned by investors due to

• the extreme pessimism that has developed on the sell- side due to missing expectations every quarter until its most recent Q2 results,
• a lack of attention from the buy side due to its limited float, and
• decreased confidence in the turnaround of the underperforming Windows segment

PGEM has been in freefall since its IPO but Q2 results indicate a possible inflection point as pricing increases have begun to flow through and recent macro data on SFHS has alleviated some concerns around the pace of the recovery.  The biggest concern is around the unprofitable windows segment but at these levels, the thesis is agnostic to whether or not management can execute a successful turnaround.  Either the window industry will regain pricing discipline or it won't and PGEM can sell of the division to an industry consolidator which will unlock significant value by highlighting the strength of the Sidings business.  These are not near term events but in the meantime as a result of its debt refinancing earlier this year and minimal capex requirements to support growth, PGEM will generate record amounts of FCF going forward with 2015E FCF yield in the mid-teens.  The CEO also bought $274K of stock in May at $10.96.

Background

PGEM was initially acquired from Nortek in February 2004 for $570MM by PE firm CI Capital Partners.  Since then, PGEM has acquired 8 additional businesses to consolidate market share in their two primary segments.

PGEM is one of the largest manufacturers of residential exterior building products in North America and Western Canada.  The company IPO'd at $21 in May 2013 and since then, due to a disappointing housing recovery and a string of  missed earnings and guidance, has seen its shares fall to <$9 prior to their recent Q2 earnings release.  The company floated about a third of its shares (18.2MM) with CI Capital selling no shares and retaining a 67% stake. 

Business Description

PGEM operates in two segments: Siding, Fencing, and Stone (54% 2013 sales) and Windows and Doors (46% 2013 sales). 

The two segments produce a comprehensive product line of vinyl siding, fencing, railing, and stone veneer; and vinyl windows and doors which are used in both the new construction and residential repair and remodeling (R&R) market in the US and Canada.  Vinyl building products have the leading share of sales volume in siding and windows in the US.  The Windows and Doors segment is heavily weighted to new construction at 80% of sales vs. R&R at 20% while the Siding segment is the opposite with R&R exposure at 65% vs. new construction at 35%.  This results in an approximately even split across the entire business: new construction (55%) and R&R (45%). 

PGEM is the #1 manufacturer across several of its business lines:

• Vinyl siding in U.S and Canada
• Aluminum accessories in the U.S.
• Vinyl and aluminum windows in the U.S
• Windows in Western Canada

Vinyl siding is a fairly mature and highly consolidated industry with the top 4 players commanding over 90% market share with PGEM holding the dominant share at nearly 40%.  As a result, this segment has demonstrated impressive pricing power and has adapted well to fluctuations in raw material commodity prices (PVC resin).

The window industry, on the other hand, is much less consolidated.  Although PGEM holds the leading market share in vinyl and aluminum windows, the overall market for windows of all substrates is highly fragmented with the top 4 players having <60% market share (2012 data has PGEM at #5 with 5%) and more than a dozen other players competing over the remainder.  Gross margins in this segment collapsed during the crisis and are still substantially below pre-crisis levels which has led to annual operating losses since 2008. 

Bearish/Consensus View

Despite a positive surprise in Q2 results, analysts continue to be overly cautious and are reluctant to raise estimates until they "see proof that recent trends are sustainable."  It's indisputable that PGEM stands to benefit from the ongoing housing rebound, but due to disappoints this year around the pace of single family housing starts, analysts believe a re-rating won't take place until the market gains further confidence. 

The above dynamic can be said for multiple building products related companies and pretty much any stock leveraged to a housing recovery but I believe PGEM is particularly interesting due to the pessimism that has developed as a result of missing analyst expectations quarter after quarter since the IPO and the specifics of the bear thesis put forth by GS who has a sell rating and one of the lowest price targets (10.50) on the street.

GS released a report covering several Building Products companies in June that outlines their bearish thesis.  In the report, GS raises their "coverage view of Building Products to Attractive as the stocks have lagged, estimates have been revised lower and US macro (where correlation is high) is accelerating higher." 

While the report makes several good points, I think PGEM is unfairly penalized in the context of a set of peers that I don't believe to be very good comps.  In addition, GS is overly pessimistic with their concerns around longer term trends in vinyl siding and doesn't give enough credit to PGEM's "idiosyncratic [margin improvement] story" in their Window segment.  Their bearish bias became all the more clear when GS lowered its price target following Q2 results that handily beat expectations along with commentary from management that positive trends and momentum were accelerating into Q3.

PGEM is set up to look bad by being compared to the wrong peer group:

I would think the fact that PGEM has zero exposure to a couple of the main themes in the report (NA non-res and Europe) would be a reason to exclude it from the group rather than downgrading it especially when housing starts still have 50%+ upside to normalized levels over the next few years.  I understand the point they are trying to make and maybe GS will be right over the next quarter or two and non-res will outperform res but I don't believe this extreme focus on predicting short term macro data is the best way to invest.  Does this mean one should sell all other residential focused building products co's and shift to non-res and hope to jump back in right before the residential recovery inflection point?   

On to the company specific negative catalysts mentioned in the report:

1. "Vinyl siding share loss is accelerating– The characteristics of new homes completed in the US came out earlier this month and showed vinyl siding share loss accelerated in 2013. Vinyl siding does not benefit from where most new building is occurring (West and South) but is also losing share in its primary Northeast and Midwest markets. We are seeing strong competition from products including SmartSide and Fiber Cement."

Variant View:  This marks a reversal from GS comments made less than 3 months prior: "we are more forgiving towards siding which was clearly hit by weather and we do not see any structural issues in that business."  So what new data could have caused this 180?

GS is referring to the US Census Bureau's data from "Characteristics of New Single-Family Houses Completed: Principal Type of Exterior Wall Material."  The data clearly shows that vinyl siding has been losing share since 2002 when it peaked at 40%.  Also, when viewed in context, one can see that despite losing share, the number of houses completed with vinyl siding is still growing nicely at +8% in 2013 and is still well below half the normalized level of houses completed pre-crisis.  While share losses to alternative materials is definitely something to keep an eye on, PGEM's subsequent strong Q2 siding results and Q3 comments that sales rose nearly 10% in the U.S. in July, with momentum continuing in early August should have provide some comfort (instead GS lowered its price target again from $11 to $10.50).  And contrary to the comment about vinyl siding not benefiting in the South, a leading siding, window and roofing installer in Texas stated that most of the siding supply houses in Houston, TX were reporting that Vinyl Siding sales were up 10-15% over 2013.  The same installer also commented that many homeowners in the Houston metro area are re-evaluating Fiber Cement vs. Vinyl Siding and that Vinyl Siding is making a comeback due to the increased upkeep and maintenance for Fiber Cement siding.  To be fair, GS did end with "We admit that this is going to be a slow decline but this business, while strongly cash flow generative, is less favorable than other building products that are more evenly distributed throughout the country." 

1. "Windows segment is highly fragmented and not exposed to multifamily – The Windows segment is highly fragmented, making pricing power hard to get, and PGEM does not participate in surging multifamily. We do expect the company’s profitability in this segment to improve but believe we have already appropriately factored this ramp and given the fragmented sector, the recovery may not be linear."

Variant View:  This is a fair point and speaks to the well-known challenges in the Window industry.  However, PGEM's announced pricing increases were positively reflected in Q2 results with gross margin increasing to 13.9% from 11.2% in the prior year - GM would have been 15.9% excluding the impact of near-term Gienow Integration/Unfavorable FX which would mark the highest gross margins achieved in the business since the crisis - management also commented that only part of the price increases were realized in Q2 with the majority to hit in Q3.  Furthermore, GS admitted that a new window manufacturer was under financial pressure which "could allow for greater price increases as more manufacturers begin to focus on profitability rather than share gain."  There isn't much else to say here since the details of the GS report erroneously referenced siding margins instead of window margins but I believe the valuation section will show that even using conservative forward margin estimates results in a valuation range far in excess of today's levels.

1. Slower FCF ramp pushes back deleveraging – While we still expect FCF to ramp it may only deleverage to 3X by 2017 from 6.4X at the end of 2013. Given our lower estimates we think this deleveraging process may be more drawn out than the Street is expecting.
2. Valuation – 1.4X premium to peers but has in-line EBITDA growth.  Our 9X multiple in our price target assumes no premium to peers

Variant View:  These two points are obviously dependent on estimates which I believe to be far too pessimistic - refer to valuation section.  One point to highlight here is that despite lowering its price target following favorable Q2 results, GS also revised its 2015 free cash flow estimates upward by 38%.

Investment Thesis

I suspect the reason for the opportunity is minimal interest from the buyside stemming from the limited float, an analysts community that has become overly cautious after multiple downside revisions to their estimates, and the above GS report; all of which has culminated in PGEM becoming an abandoned stock.

However, I believe PGEM is a stock with meaningful upside assuming either a modest turn around in the windows business or, if that fails, a sale of the division altogether.  Due to minimal capex requirements and its debt refinancing earlier this year, PGEM will generate record free cash flow going forward which will be used to rapidly de-lever. If mgmt fails or if industry conditions deteriorate, then separating the windows business through a sale would allow investors to focus on the profitable and cash flow generative Sidings business and should result in a more than doubling of today's stock price.  

Analysts have voiced concerns about the level of debt with net debt-to-cap around 100% but PGEM's debt position has vastly improved since their re-financing in January (prior to which analysts had price targets in the high teens/low 20's range).  PGEM has consistently achieved >$100MM in adj. EBITDA since 2005 yet has never had meaningful FCF due to its outsized interest expense, restructuring and integration expenses, debt re-financings costs, early tender and call premiums, and losses on extinguishment of debt.  PGEM has paid over $90M in debt issuance costs (since 2006) and over $200M in losses on debt modification and early tender and call premiums (since  2011). 

The refinancing has drastically reduced their cash interest (stated interest savings of $22M but actual cash interest savings of over $32M) and has finally set up their balance sheet so that they won't need to keep bleeding financing related cash flows.  PGEM also has sufficient incremental capacity to support over one million SFHS without significant capex (2-2.25% of sales).  Valuing PGEM on 2015E FCF Yield vs. other building product peers gives a range of $15-23.

The billion dollar question is whether management will be able to turn around the Windows business.  Windows are one of the few remaining new construction building products that have yet to meaningfully recover from the downturn with shipment volumes still 40% below peak.  Market research firm Ducker Worldwide sees 2014 shipments increasing 12.5% in new construction windows and 4.2% in R&R.  Window shipments data has also continued to show market share gains in vinyl windows in both R&R (62% market share in 2004 to 75% in 2013) and new construction (48% in 2004 to 59% in 2013). 

The industry is fragmented and has struggled to re-gain pricing power and margins since the crisis but PGEM has led the way by implementing several pricing increases over the past year which have been matched by competitors - a sign that the industry may finally be turning.  Other company specific issues in the window segment like insufficient well trained labor has been addressed with management reporting training time being reduced from 90 to 30 days and the soon to be completed implementation of their "Enterprise Lean" initiative (launched in 2012 with a full roll out by year end) which seeks to provide greater manufacturing flexibility by consolidating SKUs and improving efficiency.  If management succeeds, it has previously guided to mid-cycle EBITDA of $400M.  This is a huge IF and the thesis today is not predicated on management achieving that type of earnings power. 

In fact, the best part of the thesis is that if management fails to achieve its expectations for the windows business, then I believe it's likely that CI Capital will have PGEM sell off the windows business which would unlock significant value.  I don't ascribe a very high probability to this in the near term since CI Capital, by not selling in the IPO, signaled that it believes there is significant upside beyond $21/share in fixing Windows and riding the housing recovery but if fragmented window industry conditions prove too difficult to overcome then that would also imply that further industry consolidation would be necessary to improve profitability and PGEM, with its high debt balance, would be a logical seller.

I believe having CI Capital as a heavily incentivized majority owner mitigates the risk that PGEM management muddles along or is irrational about future transactions that would unlock value.  CI Capital has owned PGEM for over 10 years now and based on its cost to assemble the current PGEM is right around breakeven which is why I don't see this happening unless market conditions force them to but I believe investors are more than covered (2x current stock price) in that scenario as outlined below. 

Valuation

Current Valuation

Financials

I approached valuation in three ways:

2015E FCF Yield

The recovery in the window division will extend beyond 2015 so here I focus on FCF generation in the near term with EV/EBITDA valuation used for 2017E EBITDA.

PGEM's 14% 2015E FCF Yield compares favorably to the peers in the GS report as well as a set of building products peers with higher exposure to residential construction:

BECN - residential roofing products (49% sales) and other exterior building products including siding, windows, and doors (14% sales), Non res roofing (37%)

BCC - 88% of Boise Cascade’s revenues across its wood products manufacturing and building distribution businesses are tied to housing, with about 66% of sales tied directly to new residential construction, and 21% to residential R&R

CBPX - leading manufacturer of gypsum wallboard with new residential construction activity (35% of sales), residential R&R spending (20% of sales), commercial (45%)

LPX - Major OSB (oriented strand board) manufacturer with sales highly levered to US residential housing market

DOOR - Residential door manufacturer with sales highly levered to new construction and R&R

The highest sell side estimates I could find for each was 3.30%, 6.4%, 16.7%, 6.6%, and 3.7%, respectively.  With the exception of CBPX (written up a couple months ago and also attractively priced), the group trades at a 2015E FCF Yield in the low to mid-single digits with the highest at around 6.6%.  AWI, USG, and OC, the peers in the GS report with highest exposures to non-res, have 2015E FCF Yields of 4.9%, 6.7%, and 8.7% respectively.  If PGEM traded on the average to high end of this metric its shares would be worth anywhere from $15.71 – $23.75.  This doesn’t take into account the effects of the tax receivable agreement entered into with CI Capital in connection with the IPO due to uncertainty in the calculation and timing of those payments.  If, however, I assume PGEM pays out 85% of estimated EBT at a 35% tax rate then shares would be valued in the range of $12.16 - $18.32.  This near term valuation estimate serves as a bridge to the longer term methods below.

2017E EV/EBITDA

Looking at EV/EBITDA, the street has used multiples of 9-10x EV/2015E EBITDA to value PGEM which would value shares on my estimates at $13-15.50 but I think it’s better to look out to 2017E EBITDA which would be right around the start of "mid-cycle" or "normalized" earnings.  I believe my 10% topline growth estimate is conservative in the context of normalized housing starts being 50%+ higher than today’s levels.  I also have adj. EBITDA margins simply recovering to historical levels.  These improvements are all driven by my assumption that W/D gross margins recover to 19% by 2017 which is still well below pre-crisis levels and EBIT margins in the W/D business recover to 4.9% which is less than half pre-crisis margins.  My assumptions in the Sidings business are that gross margins are maintained near today's levels with EBIT margins rising as a result of increasing sales leverage.  The 9-10x EV/2015E EBITDA used by analysts translates to 6.25-7x EV/2017E EBITDA assuming a 20% discount rate for the additional 2 years which results in a valuation of $17.40 - $20.20.

Sale of Windows Segment

Finally, if mgmt fails to turnaround the windows business or if industry pricing doesn't improve in the next couple years, especially in the midst of a housing recovery, then it will be evident that further consolidation is necessary and I assume CI Capital will consider exiting the business.  Due to its levered balance sheet, PGEM is a logical seller.  The business would be at $750-850M in annual revenues and if they maintain their 5% market share then I believe the business would be an extremely attractive asset to a number of strategic acquirers looking to consolidate the industry and firm up pricing.  Totaling up the cost of all the window related acquisitions leads to a total cost of 686MM (30% of Ply Gem's business when acquired from Nortek in 2004 was Windows/Doors).  I think this represents a very conservative lower bound on the business considering all the improvements invested in by PGEM over the last 10 years.  These proceeds along with FCF generated over the prior 1-2 years should enable PGEM to pay off nearly all of its outstanding debt.  Valuing the remaining Siding business which should be generating EBITDA of ~$180MM at just 8x would imply a share price more than double today's levels but still below its initial IPO price in 2013. 

Catalysts

Near term: Q3 results that reflect the full impact of pricing increases and FCF generation

Longer term: Further evidence of pricing discipline in window industry or sale of the windows business if margin initiatives fail

Near term: Q3 results that reflect the full impact of pricing increases and FCF generation

Longer term: Further evidence of pricing discipline in window industry or sale of the windows business if margin initiatives fail