Summary
- GMS has had strong sales and EBITDA growth over the past several years due to a favorable economic climate and product price increases.
- However, we could see a decline in volume sales given that rates and inflation are rising, which puts pressure on margins.
- EV/EBITDA peer comparison implies some potential upside, but this could be limited given the darkening economic outlook.
Thesis
While GMS Inc. ( GMS ), has successfully grown its sales and profits, they have been driven by its product price outpacing its input cost inflation. The current climate of high inflation and high rates could lead to a change in these dynamics and could result in a drop in volume levels, leading to a slowdown and potentially declining sales growth. Valuation implies a potential upside of around 50%, but this could decrease considering current rises in interest rates and inflation.
Intro
GMS is a distributor of wallboard, ceiling, steel framing, and complementary construction products across the US and Canada, operating 300 distribution centers across 44 states and 6 provinces in Canada. In addition to the distro centers, GMS also operates almost 100 sales, rental, and service centers for tools.
GMS's stock has followed the overall market over the past year, falling almost 20% to a share price of around 44 USD. Prior to this decline, the share price had been rising but underperformed the overall market and sector.
Financial Analysis
The company has successfully been growing sales, where CAGR over the past 3 years has been almost 20%, reaching $4.6bn in FY 2022.
A number of factors have driven these sales. Firstly, interest rates have been somewhat low over the past several years (up until now), which has led to increased demand for building materials for housing. Furthermore, there have also been favorable demographics, a solid job market, and a low supply of housing (especially as there is a gap between residential housing starts and completions right now).
More importantly, given the current supply chain disruption right now, you would expect there would be troubles. However, this is not the case, as current supply chain dynamics have led to high levels of product inflation, which has outpaced GMS's cost inflation, leading to a substantial improvement in sales and profitability.
Gross margin has remained stable during the past 3 years, hovering around 32%, and the EBITDA margin has grown significantly due to an improvement in SG&A costs.
SG&A has dropped from 24% of sales in 2020 to around 20% of sales in 2022, leading to an improvement in EBITDA margin from 9.2% in 2020 to 12.2% in 2022, an impressive improvement in a rough economic climate.
The company has not only been successful with price increases, but they have been making key strategic acquisitions that are improving both the top and bottom line of the business. Over the past year, GMS has completed five acquisitions and opened 13 new branches, increasing the company's geographic footprint and product offerings. They are clearly making use of their strong cash flow, and ABL facilities to make key acquisitions and take advantage of the current economic climate to expand their distribution and branch network. These acquisitions have no doubt added to sales and improved sales volume over the past year.
However, these sales have been driven by a favorable economic climate. Mortgage rates are currently increasing at a strong pace, and labor inflation is not far behind. GMS currently expects to have another strong year in 2022-2023 based off the current drivers, but they are hoping that their product price inflation continues to outpace their input cost inflation.
The issue here is that this could remain the case, but a continued increase in prices is bound to have an impact on volume, and therefore the company must expect a drop in volume sometime soon. The problem is when this drop in volume or product mix becomes the driver that offsets the increases in prices, leading to an eventual decrease in sales growth.
A drop in the top line, and a slight increase in costs (as input costs rise, such as materials and labor), would decrease EBITDA margin back down below 10%. However, one of the reasons costs are rising right now is due to inflation, and due to interest rate raises. If interest rates continue to rise at the pace they have been increasing to date, then we could see issues with high interest payments on GMS's debt book. While the company does have a strong balance sheet, its cash position is low (around $100 million), and its debt position is high, at around $1.4m, just under 3x EBITDA. An uptick in rates could put the company under pressure to decrease its debt.
Valuation
Looking at the company on an EV/EBITDA basis, they are undervalued compared to peers.
GMS is currently valued at around 5-6x EBITDA, whereas peers are averaging at around 8-9x EBITDA. Implying that they could potentially be undervalued by around 40-60%. On the other hand, this does depend on what happens to margins later this year when input cost inflation could outpace product price inflation, and how the company's current debt balance fares over the next 12 months.
Risks
- As discussed, GMS's financial health is very reliant on macro factors, where sales have improved over the past year due to low interest rates, favorable demographics, and a low supply of housing. However, this is likely to change, as interest rates are now being increased, we could see demand drop off a cliff as most of their sales growth has derived from residential-related demand (commercial has always been weak).
- These increased interest rates could lead to higher interest expenses for the company. GMS currently has several types of debt on its balance sheet, but the one close to maturity is a $500m term loan that matures in June 2025. The company can no doubt refinance this (or even pay it down), but their loans are variable and attached to the base rate, leaving them vulnerable to rate rises, thus lowering net income.
- Inflation and rate increases will also have an impact on wage inflation. The company has successfully improved their SG&A costs, lowering them by 400 bps roughly, but this could reverse over the next couple of years as wages continue to rise, putting additional pressure on EBITDA margins.
Conclusion
Overall, the company has historically had good sales, and right now, supply chain dynamics are in their favor as inflation is a positive headwind on the company. Their produce prices are outpacing input cost rises, leading to strong sales growth. However, sales are vulnerable to a decline as we could expect a drop in volume given that rates are rising at a fast pace, and the company's sales are very much tied to macro factors. While the company is currently undervalued to peers, with a potential upside of around 50%, this is not certain given that we could expect a drop in both sales and margins in the near future.
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GMS: Price Driven Sales Growth Could Lead To Volume Driven Sales Decline