Builders FirstSource Stock: Acquisitions To Drive 26% IRR (NYSE:BLDR) (2024)

The following segment was excerpted from this fund letter.

Builders FirstSource (NYSE:BLDR)

Builders FirstSource ("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 (UFPI) and 19% for Bluelinx (BXC). 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 earnings increase 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.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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