Bonhoeffer Fund commentary for the fourth quarter ended December 31, 2023.
Dear Partner,
Throughout 2023, Bonhoeffer Fund replaced slower-growth firms with durable, growing firms in temporarily depressed sectors and continue to identify similar opportunities in this new year. We have identified opportunities in the following industries: specialized construction, natural resource royalties, distributors, logistics companies, housing, and specialty finance. New investments have a combined expected growth rate (RoE * (1-payout ratio)) plus earnings yield of 30 to 40%.
Q4 2023 hedge fund letters, conferences and more
Turning to the portfolio, I am confident we hold some of the highest-quality businesses in the fund’s history. This is due to our focus on adding faster-growing durable companies, with a discount that continues to persist as the market fails to realize the improvement in our firms’ positions. We believe high quality is reflected in free cash flow growth with highly recurring revenues (such as in subscription businesses) and returns on equity that are higher than less-risky alternatives, like well-underwritten debt which currently has yields in the low-teens. The Bonhoeffer Fund returned 12.9% net of fees in the fourth quarter of 2023 and 17.0% for 2023 overall.
In the same time period, the MSCI World ex-US, a broad-based index, returned 9.8%, and the DFA International Small Cap Value Fund, our closest benchmark, returned 9.3%. As of December 31, 2023, our securities have a weighted average earnings/free cash flow yield of 13.8% and an average EV/EBITDA of 5.2. The current Bonhoeffer portfolio has projected earnings/free cash flow growth of about 13.5%. The DFA International Small Cap Value Fund had an average earnings yield of 12.3%. Bonhoeffer’s and the indexes’ multiples are slightly higher than the previous quarter, primarily due to share price increases.
Bonhoeffer Fund Portfolio Overview
Bonhoeffer’s investment portfolio consists of value-oriented special situations, as well as growth-oriented firms that exhibit unique qualities when applying a value framework. We are particularly interested in companies that are focused in a market niche and are growing organically and/or through transition or consolidation. We also like to see active capital allocation to fund organic growth, opportunistic buybacks, and synergistic acquisitions. Finally, we like to see durability, as measured by increasing recurring revenues in our portfolio companies.
There were modest changes within the portfolio in the fourth quarter, which are in line with our low historical turnover rates. We sold some of our slower-growing investments and invested some of our cash into three specialty financial services firms, FFB Bancorp (OTCMKTS:FFBB), Northeast Bank (NASDAQ:NBN) and United Bancorporation of Alabama, Inc. (OTCMKTS:UBAB), described below.
As of December 31, 2023, our largest country exposures included: United States, United Kingdom, South Korea, Canada, Latin America, and Norway. The largest industry exposures included: distribution, telecom/media, real estate/infrastructure, and consumer products.
Conclusion
Last quarter, we revised the formatting of the quarterly letter to simplify the content flow. We will start with a one-page summary of the portfolio followed by a detailed description of our themes including a discussion of investment topics on which I have thoughts to share. We will end each letter with a case study covering my research thesis on a select position.
As always, if you would like to discuss any of the investment frameworks or specific investments in deeper detail, then please do not hesitate to reach out. As always, thank you for your continued confidence in our work and I look forward to investing by your side in 2024.
Warm Regards,
Keith D. Smith, CFA
Investment Themes
Compound Mispricings (21.9% of Portfolio; Quarterly Performance 26.0%)
Our Korean preferred stocks and the nonvoting shares of Wilh. Wilhelmsen all feature characteristics of compound mispricings. The thesis for the closing of the voting, nonvoting, and holding company valuation gap includes evidence of better governance and liquidity. We are also looking for corporate actions such as spinoffs, sales, or holding company transactions and overall growth.
Vistry Group PLC (LON:VTY) (“Vistry”), a current holding, is a compound mispricing in that its partnerships business is going to be the surviving portion of its combined legacy homebuilding/partnership business. The partnerships business is capital light homebuilding and remodeling business without land ownership, similar to the business model of homebuilder NVR. With the merger of Vistry and Countryside, Vistry became the largest partnerships business in the UK and will receive benefits from scale in this market. As part of Vistry’s plans going forward, they will receive proceeds from land sales as a result of its exit from the homebuilding business. These proceeds will be used for share repurchases of a more durable stand-alone partnerships business. Vistry plans to use the £1 billion in proceeds, representing about 30% of the current market capitalization, to buy back stock over the next three years. Vistry’s strategy of buybacks combined with transformation has successfully increased the intrinsic values of some of our holdings such as Builder’s FirstSource and Ashtead Group.
Public Leverage Buyouts (LBOs) (49.4% of Portfolio; Quarterly Performance 11.7%)
Our broadcast TV franchises, leasing, building products distributors and dealerships, plastic packaging, and roll-on roll-off (“RORO”) shipping fall into this category. One trend we find particularly compelling in these firms is growth creation through acquisitions, which provides synergies and operational leverage associated with vertical and horizontal consolidation. The increased cash flow from acquisitions and subsequent synergies are used to repay the debt and repurchase stock; and the process is repeated. This strategy’s effectiveness is dependent upon a spread between borrowing interest rates and the cash returns from the core business and acquisitions. Over the past 12 months, interest rates have been increasing, which has reduced the economics of this strategy; but a large spread still exists if assets can be purchased at the right price. Increasing interest rates have affected the returns on public LBO firms. Some firms have been reducing debt to reduce the impact of higher rates on earnings.
The Asbury Automotive Group, Inc. (NYSE:ABG) (Asbury), a US-based automobile dealer group, a portfolio holding, is an example of a private LBO. Given Asbury’s current valuation of an 18% earnings yield and, more importantly, a five-year forward earnings yield of 38%, buybacks are accretive. Management has developed a long-term plan that includes acquisitions and operational leverage from internet sales and pre-paid service plans. The net income annual growth is expected to be 25% over the next two years based upon management’s plan. Holding the current modest 6 times multiple of earnings constant, the rate of earnings growth implies a 25% total return.
Below is the history of Asbury’s RoE and RoIIC.
Based upon the historical data above, the estimated total return for Asbury is about 35% (five-year average RoE * (one-payout ratio) + dividend yield) given Asbury’s payout ratio of 0% and no dividends. The incremental return on invested capital over the past five years has been 25%. With this level of RoIIC, Asbury has been able to maintain a 35% return on equity. A DCF from this ROIIC analysis, in combination with management guidance from its recent investor conference, yields:
These assumptions assume modest organic and M&A growth and that 25% of net income (not used for cap-ex or M&A) is used for share repurchases. Most of the EPS growth is coming from increased revenues (from acquisitions) and repurchases.
Distribution (41.1% of Portfolio; Quarterly Performance 8.1%)
Our holdings in car dealerships and branded capital equipment dealerships, building product distributors, automobile transportation logistics, and capital equipment leasing firms all fall into the distribution theme. One of the main key performance indicators for dealerships is velocity, or inventory turns. We own some of the highest-velocity dealerships in markets around the world.
One of our holdings in the distribution theme is Ashtead Group plc (LON:AHT), an equipment leasing firm. Ashtead operates in the three locations (US, Canada and the UK) and the after return on invested capital is quite different in each location. In the US, the after-tax RoIC is over 23% while it is 15% in Canada and 8% in the United Kingdom. Ashtead has grown in the US market via acquisitions and organic growth. Based upon the current RoICs and RoEs (21% to 30% over the past 5-years) a 25% payout ratio and a large total addressable market, the expected growth rate of earnings is expected to be in 15 to 20% range. A DCF analysis, based upon the assumptions above, of the Ashtead Group is below:
These assumptions assume modest organic (7-10%) and M&A growth (3-4%) and that 20% of net income (not used for cap-ex or M&A) is used for share repurchases. Most of the EPS growth is coming from increased revenues (from organic growth) and repurchases.
Telecom/Transaction Processing (21.9% of Portfolio; Quarterly Performance 16.7%)
Within this theme, we are witnessing growth opportunities due to the increasing use of transaction processing in the markets of our respective firms, as well as the rollout of fiberoptic and 5G networks. Given that most of these firms are holding companies and have multiple components of value (including real estate), the timeline for realization may be longer than for more mono-industry-focused firms. We are seeing event-driven situations unfold in Consolidated Communications Holdings Inc (NASDAQ:CNSL). With CNSL, there has been an increase in the revised Searchlight offer to $4.70 per share to be paid in Q1 2025. We have decided to sell our CNSL position and re-deploy the proceeds into growing durable financial services businesses.
Consumer Product (15.1% of Portfolio; Quarterly Performance 9.4%)
Our consumer product, tire, and beverage firms comprise this category. The defensive nature of these firms can lead to better-than-average performance. One theme we have been examining is the development of category-killer retail franchises. These firms have developed local franchises which have higher inventory turns, margins, and sales per square foot than competitors. These factors resulted in great unit economics and high returns on incremental invested capital. They also have some unique characteristics, such as a specialty niches (i.e., tire stores or athletic shoes) or offering something the competitors will not (i.e., selling hunting supplies).
Real Estate/Construction (33.4% of Portfolio; Quarterly Performance 8.0%)
The current cement and construction holdings (in US/Europe via Builders FirstSource and Vistry, and in Korea via Asia Cement) should do well as the world recovers from COVID shutdowns and governments worldwide incentivize infrastructure programs.
New Portfolio Ideas
The Continued Search for Durable and High RoIC Firms
In searching for durable high RoIC opportunities with multi-bagger potential, some industries that are currently out of favor have some interesting opportunities. Specifically, the distribution industry has interesting candidates including electronics, building products and electrical, plumbing and HVAC distributors. Some distributors are world-wide, such as in electronics but others are more regionally based, such as building products and electrical, plumbing and HVAC products. An example of a high RoIC building products distributor is included as this quarter’s case study, Builder’s First Source. A common characteristic of distributors is their capital light nature with typical net income to free cash flow conversion ratios in the 90%’s. Another favorable characteristic is a service component (such as installation and design) in addition to the base distribution service provided.
A key performance indicator (“KPI”) for distribution types of businesses is return on working capital. If we look at electronics distribution, we see a clear leader in return on working capital of 30% in Arrow Electronics, Inc. (NYSE:ARW) (“Arrow”) versus Avnet Inc (NASDAQ:AVT) (“Avnet”), Arrow’s closest competitor, at 12%. Arrow and Avnet are the two largest electronics distributors in the world. Another way for distributors to add value is to provide services in addition to distributing the product itself. Again, in Arrow’s case they provide design services for their suppliers based upon customer’s needs and outsourced supply chain management services. This allows Arrow to generate higher net income margins than Avnet of 3.9% vs. 2.9%, respectively. These advantages also show up in the 10-year EPS growth rates (13% per year for Arrow versus 7% per year for Avnet) and returns on net working capital and invested capital.
Financial Services Niches
The financial services industry is an out-of-favor industry whose participants engage in multiple businesses. As a review from last quarter’s letter, some background of the banking industry is provided below.
Most banks have both a lending franchise and deposit franchise. The lending franchise generates value by originating creditworthy loans at interest rates that more than compensate for loan losses, impairment, and the cost of funds. Banks can have niches (such as SBA loans and mortgages) in which parts of the loans or the whole loans are sold to third parties, and the originator retains the servicing, making the operations capital light. Some banks specialize in the purchasing of third-party-originated loans from the FDIC (in the case of failed banks) or as a result of a regulatory stipulation in a bank merger. The leading KPI in the lending franchise is the total asset return or yield (equal to yield plus fees plus principal less any losses). Losses can be estimated based upon the historical write-offs and losses incurred. Banks reserve for expected loan losses via loan loss reserves. Recent financial reporting changes have introduced the metric of criticized loans to get an idea of which loans are having problems before becoming nonperforming and actual losses. Since banks are levered firms, small amounts of losses can result in large declines in equity.
The deposit franchise will have value when a bank can generate below-market-rate deposits from a sticky customer base whose reason for choosing the bank is not deposit yield. These can be value enhancing when combined with a great lending franchise. Examples of valuable deposit franchises include prepaid gift and debit card float, transaction processing float, providing value-add service for demand deposit accounts, and catering to a specific demographic group (minority or low-income folks). The leading KPI for a deposit franchise is cost of funds. Combining asset yield and cost of funds results in an important KPI: net interest margins.
Banks can emerge in other lines of business such as trust services, transaction processing services, multi-family GSE origination, and import/export financing. Some of the larger banks also provide asset management and custody services, investment banking, and advisory services. Occasionally, these services are the primary services provided, with lending and deposit services acting as introductions to these other services.
All banks incur costs associated with the services they provide. One way to measure the efficiency of a bank’s operations is through the efficiency ratio—another important KPI—which is equal to the non-interest expense/ (net interest income plus non-interest income). The average efficiency ratio for banks is currently 56%. Many times, efficiency is culturally based. A consistently low efficiency ratio is not common and can signal exceptional management stewardship of the bank’s assets—primarily personnel and money. Banking is a business of controlling surpluses versus generating scarce profits as found in most other industries, so stewardship as reflected in compensation is a KPI well worth reviewing.
Specific niches within the banking industry have allowed for compounder-type returns over time despite the relatively mature, slow growing, stable and fragmented market. Sticking with those niches and not diluting them over time with lower return opportunities is a key skill in finding financial services compounders.
Today, there are some financial services firms competing in niches that generate 20% returns on equity, can reinvest most of their earnings and are selling for valuations (less 7.5x times earnings) which make for a good investment. In addition, at such share prices, share buy-backs are very accretive. Each of the firms described below have efficient operations and focus on specific lending or service niche. Two of these banks have low-cost deposit franchises combined with significant non-interest fee income. The third has a high yielding floating rate loan book sourced from either national internal origination or purchases from the FDIC.
The first, mentioned in the last letter, is United Bancorporation of Alabama (“UBAB”), a CDFI bank operating in southwest Alabama and northwest Florida. UBAB has a low-cost deposit base (0.6% annual cost of funds in Q3 2023). It has increased its loan book at 17% annually over the past three years because it is located in a fast-growing region of the country (Gulf Coast beach communities) and it has benefitted from low-cost capital from CDFI specialized lending programs. UBAB’s current net interest margin is 4.6%. UBAB has a good underwriting process which has generated, as of Q3 2023, NPAs of 1.0% with corresponding loan loss reserves of 1.7% and criticized loans of 6.0% (impaired loans and loans on a watch list). UBAB’s efficiency is above average at 48% for Q3 2023. UBAB has utilized the various programs available to CDFIs such as financial assistance awards, BEA Program awards, and the Small Dollar Loan Program to generate fee income, as well as the low cost of funds. UBAB has a division that focuses on low-income real estate development and utilizes the New Markets Tax Credit Program and Community Housing Capital. These programs have generated fee income of about 20-25% net interest income over the past few years. Although not predictable in advance, these programs have provided steady non-interest income in the past.
UBAB also participated in the Emergency Capital Investment Program (“ECIP”), in which the government provided $124 million of preferred equity (UBAB’s common equity is $100 million) with a yield of somewhere between 2% and 0% depending upon the amount of the ECIP funds deployed. This preferred equity increases UBAB’s common equity to assets to 13x from 6x pre-ECIP. An important KPI for banking is return on equity. Given UBAB’s net interest margin of 4.6%, non-interest income of 20%, efficiency ratio of 48%, tax rate of 22%, and leverage of 13x, the resulting return on equity is 28% (28% = 4.6%*(1.2)*(1-0.48)*(1-0.23)*13). UBAB has a modest P/E of 5.1x 2023 earnings. The key to generating these returns is finding creditworthy customers to finance. UBAB has two drivers for loan growth: 1) the growth in government subsidized CDFI loans; and 2) the growth in real estate development in the Gulf Coast beach communities, which is amongst the highest in the country. Management holds about 4% of shares outstanding. 0.3% of shares per year have been issued as performance based restricted stock over the past 3 years. UBAB has repurchased net 6% of shares outstanding over the past two years.
The second is FFB Bancorp (“FFBB”), a card processing bank located in Fresno, California. FFBB has a fast-growing loan book (23% per year over the last five years) and a low-cost deposit base (0.8% cost of funds) resulting in part from card processing deposits. FFBB deposit growth has also increased by 27% per year. FFBB’s loan book is primarily commercial real estate loans in Central California and multi-family bridge and permanent loans in Southern California. Most of FFBB’s loans have personal guarantees. FFBB also originates SBA loans. The new loans being added to the loan book have yields from about 7% for CRE to 11% for SBA loans. About 7% of the loans have a government guarantee. FFBB has a good underwriting process which has generated, as of Q3 2023, NPAs of 0.5% with corresponding loan loss reserves of 1.1% and criticized loans of 1.6% (impaired loans and loans on a watch list). FFBB’s current net interest margin is 5.2%. FFBB’s efficiency is above average at 40% (not including the processing expenses) and 47% (including processing expenses) for Q3 2023.
An important KPI for banking is return on equity. Given FFBB’s net interest margin of 5.2%, non-interest income of 40%, efficiency ratio of 47%, tax rate of 27%, and leverage of 10.5x, the resulting return on equity is 30% (30% = 5.2%*(1.4)*(1-0.47)*(1-0.27)*10.5). FFBB has a modest P/E of 7.3x 2023 earnings. The key to generating these returns is finding creditworthy customers to finance, continued growth in transaction processing, and continued receipt of fee income and low-cost funds from processing customers. FFBB has two drivers for loan growth: 1) the growth in Southern California CRE and multi-family loans; and 2) the growth in SBA loans which are driver for C&I loan growth. Management compensation is in check (7.5% of net income) and cash incentive compensation is based upon parameters set by the Board of Directors. Management holds about 24% of shares outstanding with the CEO holding 2.8%. 1.2% of shares per year have been issued as performance based restricted stock over the past three years.
The third is Northeast Bancorp (“NBN”), an originator and purchaser of third-party loans from the FDIC. Currently, NBN’s loan book is about 30% originated and 70% purchased loans. NBN was a bidder but did not win the bid for Signature Bank’s or Silicon Valley Bank’s loans. Richard Wayne, the CEO of NBN, founded Capital Crossing Bank in 1998 with a similar operating model of originating and purchasing loans from the FDIC in the 1990s and 2000s. Between the time of Capital Crossing Bank’s IPO (1997) to its sale to Lehman Brothers (2007), the bank returned 22% annually. In 2010, Richard became CEO of NBN and is running a similar playbook and has generated great returns thus far. The current Q1 FY2024 RoE is 20%. NBN has a fast-growing high yielding loan book (24% per year over the last five years) driven by FDIC loan purchases with a market interest level deposit base (3.9% cost of funds). NBN deposit growth has also increased by 15% per year. In 2022, NBN had to raise $50 million in equity capital to support this loan growth. NBN’s loan book’s largest collateral types are multi-family and retail with a weighted average loan to value of 47%. Most of NBN’s loans have personal guarantees. NBN has a good underwriting process which has generated, as of Q1 FY2024, NPAs of 0.6% with corresponding loan loss reserves of 1.0% and criticized loans of 1.3% (impaired loans and loans on a watch list). NBN’s current net interest margin is 5.3%. NBN’s efficiency is above average at 41% for Q1 FY2024.
A leading KPI for banking is return on equity. Given NBN’s net interest margin of 5.3%, non-interest income of 5%, efficiency ratio of 41%, tax rate of 27%, and leverage of 8.5x, the resulting return on equity is 20% (20% = 5.3%*(1.05)*(1-0.41)*(1-0.27)*8.5). NBN has a modest P/E of 8.1x 2023 earnings. The key to generating these returns is finding creditworthy customers to finance, continued purchasing of FDIC and merger-related divested loans and continued efficient operations. Management compensation is in check (14% of net income) and incentive compensation is based upon pre-tax earnings targets for the cash bonus and achieving return on asset thresholds for the stock-based compensation. Management holds about 15% of shares outstanding with CEO holding 9%. 1.3% of shares per year have been issued as performance based restricted stock over the past 3 years.
Moving forward, a financial services theme will be included in the portfolio’s investment themes section reported above.
Case Study: Builders Firstsource (BLDR)
Builders FirstSource, Inc. (NYSE:BLDR) (“BLDR”) is the United States’ largest building product distributor (2.6% market share). It serves large single family and multi-family homebuilders and re-modelers. BLDR has over 115,000 customers with a 90% customer retention rate. 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 its revenue is associated with value-added or specialty products. This large portion of value-added and specialty products and services allows BLDR to generate industry leading gross margins of 35%.
The predecessor to BLDR was Builder’s Supply and Lumber Company which was purchased by JLL Partners in 1998. In 2005, BLDR went public through an IPO and in July 2015, the company completed its first large acquisition of ProBuild, a large competitor with 400 locations. In January 2021, BLDR merged with BMC, another large competitor with 550 locations. In August 2021, BLDR purchased WTS Paradigm, a housing design software and services company, extending BLDR’s support to housing design and supplying building materials to homebuilders. Since 2015, BLDR has made 23 tuck-in acquisitions. The current CEO, David Rush, has served as the lead on the integration of the acquisitions BLDR has made since 2015.
BLDR has used technology to facilitate the integration of acquisitions, which resulted in reducing operating costs by $275 million annually and have focused on 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. In addition, BLDR has developed an installation service business that is bundled with its truss and millwork products. The installation business generates $2.5 billion of revenue from about 33% of BLDR’s footprint; extending these services to the remaining 67% of BLDR’s footprint is a growth opportunity. Providing installation service with distribution is a proven high ROIC strategy in the insulation distribution/installation business considering both TopBuild and Installed Building Products have consistent industry leading RoICs. For details, see the Comparables and Benchmark section below.
As a distributor, it is worth analyzing BLDR’s distribution productivity by examining its return on working capital (i.e. 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 71%. This return exceeds some of BLDR’s closest competitor/comparables with returns on working capital of 41% for UFP Industries and 19% for Bluelinx. For details, see Comparables and Benchmark section below.
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 has also increased to 40% 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 including two large acquisitions and 23 tuck-in acquisitions. The resulting unlevered RoIIC (see calculation below) has been over 100%, which includes returns from organic growth initiatives, acquisitions and economic recovery after 2020’s COVID shutdowns.
BLDR has five levers for cash flow growth: 1) buying a value-added product and distribution firms; 2) expanding within existing markets; 3) operational improvements; 4) paying down debt; and 5) distributing excess cash by buying back shares. The acquired firms generate cash flows in excess of what is needed to modestly grow the firm, which is then 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 its operational cash flow on capital expenditures, leaving 85% for buy-backs and mergers and acquisitions and they have leaned into share repurchases, buying back over 40% of its stock since the acquisition of BMC in 2021.
BLDR’s competitive landscape features the following characteristics: 1) economies of scale from distributing and value-added product manufacturing of building products; and 2) route density characteristics in the distribution of building products. As evidence of the benefits of their economies of scale, BLDR’s margins have increased over time and they now have the highest margins amongst its building product distributor competitors.
Value-Added Products and Distribution Services
BLDR competes in the building product distribution and value-added building product markets in the United States. BLDR is the largest building product 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 5% per year over the next few years. The top five 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.
Building product distributors can be thought of receiving a royalty on a capital-intensive homebuilding/re-modeling industry. Value-added products and 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 local, rather than national, 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 of 2 to 3.5 million homes since the great financial crisis.1 The key to harnessing the lollapalooza 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%. For details, see the Comparables and Benchmark section below.
Another aspect of building product 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, along with consolidation, have generated above average returns on capital for the larger, more scaled firms in the building product distribution industry.
Building product distribution is also a slow-changing 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 has 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 rate2 with any other growth coming from identified growth projects, acquisitions or share repurchases.
BLDR’s operations have improved over time with two acquisitions helping to accelerate BLDR’s scale quicker than its competitors. The return on equity has increased from 7% in 2012 through 2015, to 43% in 2022 and is expected to normalize in 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 a 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 decline in leverage allowed BLDR to aggressively buyback shares.
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.
Financial leverage can be measured by the debt/EBITDA ratio. BLDR has an average net debt/EBITDA of 0.8 versus other building products distributors like Beacon Roofing, BlueLinx, GMS, Installed Building Products, TopBuild and UFP Industries. BLDR’s net debt/EBITDA is within its historical range. 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 product industries. They perform M&A when targets are available at the right price partially financed by debt. They then pay down the debt, and return capital through buybacks when there are not opportunities to invest organically or through M&A.
The base compensation for the management team, in this case the 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 five management members’ total compensation was about $21m per year, about 0.7% of net income per year. The CEO currently holds 109,000 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. In the short term, management’s incentive pay is based upon meeting stretch EBITDA and working capital/sales targets and is paid in cash. Longer-term, management’s incentive is paid in RSUs with vesting schedules that are 25% time based and 75% performance-based. 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 to management and 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 is required to hold3x their salaries and the board is required to hold 5x of their annual retainer.
Valuation
The key to the valuation of BLDR is the expected growth rate. The current valuation implies an earningsincrease 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 is 13%.
Given the market growth rates for single family and multi-family homebuilding and remodeling as well as BLDR’s growth in market share, a bottom’s up analysis estimates BLDR’s expected annual growth rate to be 5%. 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 in the 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 in the range and has better inventory turns, margins and return on working capital and a 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 (TopBuild 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.
Potential Upside/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.
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.
