Summary
- Builders FirstSource, Inc.'s double-digit growth over the past few years was due to acquisitions and one-off high product prices. It is not a high-growth company when these are stripped out.
- Builders FirstSource is a cyclical company whose performance is tied to Housing Starts. It should be analyzed and valued as a cyclical one.
- A valuation on such a basis shows that there is no margin of safety for Builders FirstSource, Inc. at the current price.
Investment Thesis
Builders FirstSource, Inc. ( BLDR ) achieved tremendous double-digit growth over the past few years. But this was the result of acquisitions and one-off extraordinarily high product prices. BLDR is not a high growth company when these are stripped out.
While financially sound, BLDR performance is tied to the homebuilding sector, which is cyclical. As such, BLDR should be analyzed and valued as a cyclical company. On such a basis, there is no margin of safety at the current price.
The thrust of my analysis
I am a long-term value investor, and as such I am interested in how Builders FirstSource, Inc. could perform over the next 10 to 15 years. My investment thesis is from this perspective, with the following rationales:
- BLDR is not a growth company. Its revenue growth from 2014 to 2022 is due to a combination of product price growth and acquisitions. There is no growth when these 2 are stripped out.
- It is a cyclical company. Its revenue is correlated to the U.S. Housing Starts.
- BLDR has been able to improve its gross profit margins and reduce its SGA margins over the Housing Starts cycle.
- While BLDR is financially sound, it should be valued as a cyclical company.
The key is determining the normalized values to represent its performance over the cycle. In the case of BLDR, this is challenging, as its performance was due to acquisitions and productivity improvements. But there are limits to productivity improvements. Even acquisitions are limited by funding.
The article is my attempt to estimate the normalized values given these constraints. I then used a single-stage valuation model to estimate the intrinsic value.
Revenue growth
Builders FirstSource, Inc. is a leading supplier and manufacturer of building materials, manufactured components, and construction services to the homebuilding sector. It operates approximately 565 locations in 42 states across the United States.
From 2014 to 2022 ((LTM)), BLDR revenue grew from USD $1.6 billion to USD $23.0 billion. This is equal to a 39.5% CAGR. But this growth was due to a combination of acquisitions and product price growth.
BLDR had 2 major acquisitions/mergers - ProBuild in 2015 and BMC in 2021 that resulted in a jump in revenue in the respective years.
I wanted to estimate the organic growth, i.e., without acquisitions. I thus tried to “wash out” the revenue due to acquisitions by estimating the annual organic growth. Table 1 shows the basis of my estimation.
Table 1: Basis of estimating revenue growths (Author)
Using 2005 as the base, I then derived Builders FirstSource, Inc.'s organic revenue for each year. Chart 1 compares the trends in the organic revenue with the actual revenue. You can see that without the acquisitions, BLDR’s organic revenue only grew at 8.0% CAGR from 2014 to 2022.
Chart 1: Total revenue vs Organic revenue (Author)
Note to Chart 1: The index for each year was derived by dividing the revenue in each year by the respective 2005 revenue.
But even this 8.0 % CAGR was driven by product price growth.
To illustrate the impact of the product price growth, I used the U.S. Lumber price as the reference. Chart 2 shows how lumber prices have changed over the past 20 years. You can see that the prices for the past 2 years have been extraordinarily high. But this appears to be a one-off phenomenon.
Chart 2: Lumber Price Trends (Author with data from Trading Economics)
Notes to Chart 2:
a) The top chart shows the actual Lumber prices while the bottom chart is a summary of the annual price.
b) The price for each year for the bottom chart was based on the average of the previous year’s Dec prices, and the Jun and Dec prices of the year.
To get a sense of the organic revenue without the product price growth, I estimated the revenue for the various years at the 2005 constant price.
The revenue for each year = (Actual Revenue / Lumber price for the year) X 2005 Lumber price. The Lumber price for each year was extracted from the bottom chart of Chart 2.
On such a basis, I found that the organic revenue from 2014 to 2022 shrank at a compounded annual rate of 1.7%.
This is of course a back-of-envelope analysis. But it shows that BLDR should not be seen as a high-growth company. A high-growth company should able to achieve double-digit growth organically every year without some extraordinary one-off tailwind.
Cyclical company
A significant portion of Builders FirstSource, Inc.’s business is with homebuilders. The homebuilding sector is cyclical, as illustrated by the U.S. Housing Starts in Chart 3. The latest peak-to-peak cycle appears to be from 2005 to 2022. We are now going into the downtrend part of the coming cycle.
The key feature of the 70 years’ Housing Starts is that there is no long-term growth in the annual average Housing Starts of 1.5 to 1.6 million units.
Chart 3: US Housing Starts (Trading Economics)
A comparison of Builders FirstSource, Inc. organic revenue and the U.S. Housing Starts indicates a strong link. Refer to Chart 4. There is also a strong correlation between the Housing Starts and the organic revenue for the various parts of the cycle. Refer to Table 2.
We should not be surprised by this finding, as BLDR itself acknowledged it.
“The building supply industry is subject to cyclical market pressures.” 0 BLDR Form 10k 2022.
What does the cyclical nature and the no long-term growth in the Housing Starts mean for BLDR? To grow its volume in the long run, it has to take market share away from its competitor or enter a new sector. It nothing else, it reinforces the point that BLDR is not a high-growth company.
Chart 4. Organic revenue vs Housing Starts (Author) Table 2. Correlation analysis (Author)
Valuation of cyclical companies
So, Builders FirstSource, Inc. is a cyclical company, and any analysis should be based on its performance over the cycle. Damadoran has this to say about analyzing and valuing cyclical companies:
“Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable (the commodity price or the growth in the underlying economy) than it is on firm specific characteristics…the biggest problem we face in valuing companies tied to either is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluation.”
To overcome the cyclical issue, we have to normalize the performance over the cycle. Damodaran suggested 2 ways to estimate the normalized earnings:
- Take the average values over the cycle.
- Take the current revenue and multiply it with the normalized margins.
The challenge with the first approach for BLDR is that the size of the company in 2022 is far greater than that in 2005. I thus adopted the second approach.
Operating improvements
BLDR has a strong focus on improving its operations.
“Optimize our highly scalable cost structure with operational excellence initiatives.” - BLDR Form 10k 2021.
The company prides itself in being able to extract productivity gains from its acquisitions as exemplified by the following:
“These integration capabilities should enable us to achieve annual run rate cost savings of $100 to $120 million within two years of the close date of the ProBuild acquisition. We have realized approximately $74 million in 2016 and $10 million in 2015…” BLDR Form 10k 2016.
“Delivered USD 73 million in productivity savings YTD: expect to deliver > USD 100 million in productivity savings in 2022.” - BLDR’s Nov 2022 Earnings Presentation.
The results of these improvements are illustrated in Chart 5. You can see the growth in the Gross Profit margins and the reduction in the Selling, General, and Admin ((SGA)) expenses.
If you compare Chart 5 with Chart 4, you can see that the margins moves with the cycle. It deteriorated during the downtrend part of the cycle and improved during the uptrend. Even if ignoring the productivity improvements, it make sense to consider the margins over the cycle.
There are of course limits to productivity improvements and cost savings. But I think the following is reasonable:
- Expect another USD $200 million in saving in the next few years from the 2021 and 2022 acquisitions.
- The cyclical GP margin and SGA margin in the future should be higher than those in the 2005 to 2022 cycle.
Chart 5: Productivity trends (Author)
Financial strengths
We do not know the depth and duration of the coming Housing Starts cycle. As such, I would want cyclical companies to be financially sound going into the downtrend. I would rate BLDR as financially strong based on the following:
- It has a current ratio of 1.9 and a Debt Equity ratio of 0.7 as of Sep 2022.
- Over the 2005 to 2022 cycle, it generated an annual average of USD $380 million in Cash Flow from Operations. While it had 6 years where the annual Cash Flow from Operations was negative, the average negative Cash Flow as only USD $42 million per year.
- While it has USD $85 million as of Sep 2022, this was because it has used the significant cash generated over the past 2 years to reduce Debt and buy back shares. Over the past 2 years, it had repaid USD 9.4 billion of Debt and spent USD 4.8 billion to buy back its shares.
- Based on its past 2 years’ average interest coverage ratio, it would have an equivalent AAA rating for its Debt. This is based on Damodaran synthetic rating approach.
Valuation of BLDR
I valued BLDR using the single-stage Free Cash Flow to the Firm (FCFF) model where:
FCFF = EBIT(1-t)(1-Re).
EBIT = Revenue X (GP margin – SGA margin).
t = tax rate.
Re = Reinvestment rate as determined from the fundamental equation of growth where growth= Return X Reinvestment rate.
The challenge here is determining the normalized values over the cycle. This is because the current revenue is due to its acquisitions and the extraordinarily high product prices. At the same time, there have been improvements in the GP margin and SGA margin.
Revenue
The base revenue has to reflect its current size yet ignore the extraordinarily high product price in 2022. Conceptually:
Revenue = Notional Volume X Normalized price.
Notional Volume = 2022 Revenue / 2022 Lumber Price.
Normalized price = average 2005 to 2022 Lumber prices.
Revenue = (USD 23,003 m / 728.3) X 377.8 = USD 11,935 m.
GP and SGA margins
If there were no productivity improvement trends, the normalized margins would be the average 2005 to 2022 margins. But because of the improvements, the margins in 2022 are relatively better than those in 2005.
To capture these improvements, I scaled the normalized margins. The factor I used was the average 2021 and 2022 margins divided by the average 2004 and 2005 margins. The rationale was that the future cyclical margins would be better than the historical cyclical margins. The computation is shown in Table 3.
Table 3: Deriving the GP and SGA margins (Author)
At the same time, BLDR is confident of further productivity gains in the next few years. To capture this, I modelled this separately as additional gains on top of the normalized EBIT. (Refer to item f in Table 4.)
Growth
I have shown that BLDR is not a high-growth company. That is why I chose the single-stage perpetual growth valuation model. Growth at best would be that of the long-term GDP growth rate.
Note that the FCFF is tied to the Reinvestment rate which in turn is tied to the growth rate. In other words, in the steady growth model with a growth of 4 % GDP growth rate, the Reinvestment is low.
You may argue that there is growth in the bottom line due to productivity improvements. But there is a limit to cost savings. At the same time, many of the productivity gains seem to be tied to acquisitions.
I am valuing BLDR from the perspective that there are no further acquisitions. I have two rationales for this view.
BLDR's growth strategy seems to be acquiring companies and then achieving some productivity improvements. But BLDR has reached a size that in order to move the needle, acquisitions have to be about a billion dollars. This requires funding.
The housing market is going into the downtrend part of the cycle. I would expect BLDR revenue to decline resulting in lower Cash Flow from Operations. I think funding large size acquisitions would be more difficult.
Secondly, to value BLDR with acquisitions, you would have to use a two-stage model where you project the high growth stage over the next 5 to 10 years. But I see the next 5 t 10 years as the downtrend of the Housing Starts cycle. I don't see them as the right environment for large acquisitions. Any acquisition will most likely be in the uptrend stage that is beyond the next 5 to 10 years. Dare we forecast cash flow so far into the future?
The moral of the story? It is more practical to exclude acquisitions.
Estimating the Equity value
Based on the above assumptions, I estimated the Equity value of BLDR to be USD 78 per share. There is no margin of safety compared to the current market price of USD $82 per share.
The other assumptions and basis of my computation are illustrated in Table 4.
Table 4: Estimating the intrinsic value (Author)
Note the following in my computation.
The intrinsic value of the firm = value of operating assets + value of non-operating assets.
Value of operating assets = FCFF(1+g)/(WACC – g).
Value of equity = Value of operating assets – Debt – Minority Interests.
The WACC was based on the average values from the first page results of a Google search for “BLDR WACC). Refer to Table 5.
Table 5. Deriving the WACC (Various sources)
Asset value
BLDR is a brick-and-mortar company. As such, its Asset value can provide some floor value. But the current Asset Value is distorted due to the share buybacks. I had to account for this.
Assuming that all the monies spent on the share buybacks for the past 2 years are counted as part of retained earnings, I estimated the net Asset Value to be USD $8.9 billion.
I then compared it with the Earnings Power Value (EPV). Using the template in Table 4, I estimated the EPV for BLDR by setting growth = 0.
The EPV = USD $8.1 billion.
According to Bruce Greenwald, in a competitive environment where the company does not have an economic moat, you would expect AV = EPV.
You can see that we have this situation for BLDR. This is not surprising as I would consider BLDR to be in the commodity business. While it has touted its competitive advantages as below, I would not consider them something that cannot be copied.
“We believe we have substantial competitive advantages over these smaller competitors due to our long-standing customer relationships, local market knowledge and competitive pricing.” BLDR Form 10k 2021.
My point is that the Asset Value and the AV = EPV analysis provides some sanity check for the intrinsic value of USD $78 per share.
Risks and Limitations
When you look at my analysis, you should consider the following risks and limitations:
- High WACC.
- Pegging to Lumber prices.
- Basis for estimating the normalized values.
- No acquisition.
The WACC was 10.58%. Many of the sources use the current risk-free rate and risk premium. By right we should use the values over the cycle for consistency. We know that the current risk-free rate is high due to the current high-interest rate. The current economic and political situation also means that the risk premium is high. The implication is that the value obtained using 10.58% is probably on the low side.
I used my derived annual Lumber prices to estimate the normalized revenue and margins. It is likely that if another wood product was used as the price basis, the equity value would be different.
Furthermore, the 2021 and 2022 values used in the scaling process would be very dependent on how you derived the prices of these periods. I just used 3 points to estimate the annual prices. Given the volatile situation, a better estimate would be to use monthly prices.
The normalized revenue and margins are very dependent on how I normalized them. This is especially when accounting for the changes to the historical cyclical values. A different scaling approach would give different numbers. For example, to determine the Lumber price over the cycle, I used the 2005 to 2022 figures. But these included the 2021/22 extraordinarily high prices. You could argue that these are outliers and should not be included.
I have modelled BLDR on the basis that there is no further acquisitions. It is possible that BLDR may be able to undertake another large acquisition over the next 5 to 10 years. The value would probably then be possibly higher.
In summary, the above cover both positive and negative impacts on the estimated intrinsic value. A more comprehensive approach would be for a sensitive analysis with the different scenarios. I did not do this. In mitigation, I am looking for a 30% to 40% margin of safety.
Conclusion
The premise of my analysis is that Builders FirstSource, Inc. is a cyclical company and should be valued as such. The challenge then is estimating the value over the cycle.
Based on my assumptions, I concluded that there is no margin of safety in Builders FirstSource, Inc. at the current price. You can, of course, challenge my assumptions. I hope that by providing the details, you have a template to input your assumptions.
Even if you do not agree to the FCFF approach and prefer to use relative valuation, I would argue that the denominator (e.g., earnings, cash flow or EBITDA) should be normalized values. You then have the same challenge of determining the normalized values.
The issue is not the financial strengths of Builders FirstSource, Inc. or its good track record. It is in a cyclical sector with strong mean reversion. You should not project Builders FirstSource, Inc.'s future based on the past few years' results.
For further details see:
Builders FirstSource: Don't Be Mesmerized By The Past Few Years' Performance