2023-08-15 08:00:00 ET
Summary
- TopBuild experienced significant revenue growth, driven by acquisitions, price and volume growth. It may be less impacted by the Housing Starts cycle, providing potential for continued growth.
- Installation segment is the largest contributor to revenue and earnings, with improving returns. While there are good growth drivers for BLD, I have concerns about its financial position.
- While fundamentally ok, TopBuild looks overpriced. A valuation based on a 2-stage growth model suggests there isn't much margin of safety.
Investment Thesis
TopBuild Corp. (BLD) has 2 business segments – Installation and Distribution. Both serve the construction sector. BLD was listed in 2015 and over the past 8 years, its revenue growth rate is about 3 times the growth rate of the US total construction spending.
Part of the high growth was due to acquisitions. But there was also price and volume growth. The growth led to improved gross profit margins and SGA margins that drove improvements in the ROE. But I have some concerns about its financial position.
Unfortunately, while fundamentally ok, I don't see not enough margin of safety. It is not an investment opportunity at the current market price.
Business Profile
BLD was listed in 2015 following the separation from its parent company. It is a leading installer and distributor of insulation and other building material products for the US and Canadian construction sectors.
BLD has two operating segments - Installation and Distribution. Chart 1 shows how the business has grown since its listing. On average, the Installation segment accounted for about 2/3 of the group revenue.
Chart 1: Revenue Trends (Author)
The company had 2 significant acquisitions over the past 8 years:
- 2018 - USD 0.5 billion acquisition of USI, a leading distributor and installer of insulation in both residential and commercial construction markets. Note that the BLD had total assets of USD 1.8 billion in 2017.
- 2021- USD 1.0 billion acquisition of Distribution International, a leading supplier of commercial and industrial insulation. BLD total assets in 2020 were USD 2.8 billion.
Inclusive of the acquisitions, revenue grew at 17.5% CAGR from 2015 to 2022.
To get a sense of the organic growth, I considered the average revenue growth rates for the following 2 periods:
- 8.6% CAGR from 2015 to 2017 to exclude the effect of the USI acquisition.
- 6.8% CAGR from 2018 to 2020 to exclude the effect of the Distribution International acquisition.
This back-of-envelope analysis shows that about half of the overall growth came from acquisitions.
There was not enough information to get a sense of the split between price and volume growth from 2015 to 2022. The company only provided detailed breakdowns only from 2019.
Based on these, I estimated that over the past 4 years, volume growth was at 4% CAGR compared to the overall growth of 20%. Acquisitions accounted for about half, leaving about 6% for price growth.
Although the % revenue contribution from the Installation segment was relatively “steady” over the past 8 years, this was not the case for operating profits. Refer to Chart 2.
Chart 2: Operating Profits Trends (Author)
You can see from Chart 2 that in 2015, the Installation segment accounted for about 52% of the group's operating profits. But this had increased to 66% by 2022.
Over the past 2 years, the total assets employed by both segments were about the same. However, the returns were different.
Chart 3: Operation Profits/Total Assets Trends (Author)
Chart 3 shows the returns for each segment as measured by the respective operating profits/total assets. The return for the Installation segment has been improving so that it overtook the Distribution segment around 2017. Today it far exceeds that of the Distribution segment.
The other change that has occurred is that the commercial market has become a larger portion of the revenue. In 2017, the commercial sector accounted for about 20% of the total revenue. This had increased to 35% in 2022. Refer to Chart 4.
This meant that the company's performance is less impacted by the Housing Starts cycle. This is reflected in the 0.44 correlation between its revenue in Housing Starts from 2015 to 2022.
Chart 4: Residential vs Commercial Revenue Trends (Author)
Note to Chart 4: The company did not provide any breakdown before 2017.
What are the takeaways from the above analysis?
- The Installation segment is the biggest revenue and earnings contributor.
- While both segments used about the same level of total assets, the Installation segment delivered not only better, but also growing returns.
- Leaving aside growth via acquisitions, revenue growth seemed to be driven by both price and volume growth.
- The company may be less impacted by the Housing Starts cycle.
Performance
I look at 3 metrics to get an overview of the performance – revenue, profit after tax (PAT), and gross profitability (gross profits/total assets).
Chart 5: Performance Index (Author)
You can see from Chart 5 that the net income growth rate was about double that of revenue. What drove this higher growth in net income?
A DuPont analysis as shown in Chart 6 shows that the growth in the ROE was driven mostly by growth in the operating margins and leverage. The impact of the operating margins was much bigger.
There was not much change in the asset turnover. The relatively poor asset turnover is reflected in the low growth in the gross profitability as shown in Chart 5. In other words, there is not much improvement in the capital efficiency.
Chart 6: DuPont Analysis Trends (Author)
Drivers of Growth
The growth in the operating margins was due to both an increase in the gross profit margins and a reduction in the selling, general, and administration ((SGA)) expenses. Refer to Chart 7. You can see the spread between them widening from 2015 to 2022.
Chart 7: GP and SGA Margins trends (Author)
I had shown earlier that BLD had both price and volume growth. I think these both drove the gross profit margin and SGA margin improvements.
These in turn were driven by the growth in the US total construction spending. Refer to Chart 8.
From 2015 to 2022, there was a 0.97 correlation between BLD's revenue and total construction spending. You should not be surprised by this, as the link is acknowledged by the company.
“Demand for our insulation products and services is driven by new single-family residential and multi-family home construction, commercial/industrial construction, residential remodel and repair activity…” Form 10k 2022.
Chart 8: US Total Construction Spending (FRED)
But don’t be misled by the correlation. From 2015 to 2022, total construction spending grew at 6.7% CAGR. This was much lower than BLD's 17.5% CAGR. Of course, the BLD growth rate included acquisitions. But this does not change the picture that BLD probably increased its market share.
The growth in total construction spending covers both price and volume changes. To get a sense of the volume and price changes, I compared the following growth rates from 2015 to 2022:
- FRED total construction spending = 6.7% CAGR. This covers both price and volume changes.
- Turner building cost index = 4.6% CAGR. This focuses on price changes.
Both indices may not be using the same source of information. But it does illustrate that the growth in total construction spending is driven more by price changes rather than volume changes.
The other interesting thing is that total construction spending over the past decade diverged from Housing Starts. Refer to Chart 9.
Of course, Housing Starts are in physical units while total construction spending is in dollars. You could argue that the divergence is due to the cost or price increases over the past decade.
Chart 9: Total Construction Spending vs Housing Starts (Author)
Note to Chart 9: To plot them on one chart, I converted them into indices based on the respective values in 1993 as 1.00
What are the key takeaways?
- While there may be a slowdown in the Housing Starts, total construction spending does not appear to be slowing down. This will provide growth for BLD in the immediate to short term.
- We have to value BLD using a two-stage valuation model that has a high-growth stage followed by a lower, steady long-term growth rate.
Financial Position
I have some concerns about BLD's financial standing.
As of the end of Dec 2022, it had USD 240 million in cash. This is only about 5% of the total assets.
It has a high Debt Equity ratio of 0.87 as of the end of Dec 2022. The high ratio was due to the debt taken in 2021, partly for the acquisition of Distribution International.
Its cash conversion cycle has been deteriorating, rising from about 15 days in 2015/16 to about 45 days over the past 2 years.
But on the positive side, it has managed to generate positive cash flow from operations every year since its listing.
It also has an excellent earnings-to-cash conversion ratio. From 2015 to 2022, it generated USD 243 million in cash annually, compared to its average net income of USD 220 million.
In mitigation, if BLD can continue to grow over the next few years, it would be able to generate enough cash flow to lower the Debt Equity ratio.
Valuation
I valued BLD using a 2-stage Free Cash Flow to the Firm model. I consider 2 Scenarios:
- Scenario 1 – this is a conservative one. I assumed that BLD will continue to grow over the next 5 years at a rate that excluded the DI acquisition. The gross profit and SGA margins were assumed to be the 2015 to 2022 averages.
- Scenario 2 – this is an optimistic one. I assumed that BLD will continue to grow over the next 5 years at its historical growth rate. The gross profit and SGA margins are at the 2022 rates.
Table 1 summarizes the results. You can see that there is no margin of safety under Scenario 1. I have a target 30% margin of safety. On such a basis, I would not even consider investing in BLD under Scenario 2.
Table 1: Valuation Summary (Author)
Notes to Table 1:
a) This is the revenue growth for the next 5 years, the high-growth stage. Thereafter, I assumed terminal growth at 5%. Scenario 1 = 2015 to 2020 growth rate. Scenario 2 = 2015 to 2022 growth rate.
b) Gross profit margin for Scenario 1 = 2015 to 2022 average. For Scenario 2 = 2022 rate.
c) SGA margin for Scenario 1 = 2015 to 2022 average. For Scenario 2 = 2022 rate.
Valuation Model
Table 2 shows my valuation model. This is a 2-stage Free Cash Flow to the Firm model where:
- I assumed 5 years of high growth followed by a terminal value with a 5% growth rate based on the long-term GDP growth rate.
- The key parameters for the 2 Scenarios are the 5 years high-growth rate, the gross profit margins, and the SGA margins.
- I assumed that the tax rate, reinvestment rate, and WACC are the same under both Scenarios.
Table 2: Valuation model (Author)
Notes to Table 2.
- The tax rate was based on the 2020 to 2022 average rates.
- The Reinvestment rate was derived based on Growth = Return X Reinvestment rate. I assumed a 5% growth rate.
- Return = EBIT(1-t)/TCE.
- TCE = Total Capital Employed = Equity + Debt – Cash equivalents.
- The Return was based on the (average 2015 to 2022 EBIT/TCE) multiplied by the (2020 to 2022 average tax rate).
- The WACC was based on the first page of a Google search for the term “BLD WACC” as shown in Table 3.
Table 3: WACC (Various)
- The terminal value was based on the Year 5 FCFF with 5% perpetual growth rate.
- The Net Present Value of the terminal value was based on discounting the terminal value at the Year 5 discount rate.
- The value of Equity = Value of the Firm + Cash equivalents + Long term investments – Debt – Minority Interests.
- The Cash, Long term investments, Debt, and Minority Interests were based on the Dec 2022 values.
Risks and Limitations
There are 3 issues to consider when looking at the results of my valuation.
- High-growth rates
- Sustained gross profit and SGA margins
- Low Reinvestment rates
Over the long term, the construction sector is cyclical. You can see the last downtrend from 2007 to 2011 as per Chart 9. My growth model assumes that we will not experience a downtrend over the next 5 years. But the Housing Starts have begun to show some weaknesses, as per Chart 9. If Housing Starts go into a downtrend, I am sure it will affect the total construction spending.
Note that in my valuation model, I have used a growth rate that is more than double the historical growth rates for the total construction spending. My Scenarios are aggressive.
In my model, I have also assumed that the gross profit margins and SGA margins can be sustained. But these were driven by revenue growth – more by prices than volume. If there is a slowdown in the total construction starts, I worry whether these margins are sustainable.
Finally, the Free Cash Flow in the model is dependent on how much is deducted for Reinvestments. I have assumed the Reinvestment rate to be 44%. This was based on a 5% growth rate. Over the past few years, inclusive of the acquisitions, the Reinvestment rate was about 2 times higher. If I had used the historical Reinvestment rates, the FCFF would be close to zero.
Thus, in my model, I had assumed that the company could continue to grow at the high rates (especially the 17.5%) but without incurring the high historical Reinvestments. In other words, it is an optimistic view.
At the same time, the Installation segment is the biggest revenue and profits contributor. Any decline in the total construction spending will impact this segment. Because of the sizable contribution, this will lead to a sharper decline in revenue and earnings. I have not considered this in my valuation. This makes my valuation an optimistic one.
The key point is that despite the aggressive and optimistic assumptions, there is not enough margin of safety.
Conclusion
Over the past 8 years, BLD has benefited from the growth in total construction spending. The company used the tailwinds to grow its revenue and profits. But the profit growth was driven more by price (margins) growth rather than improvements in capital efficiency.
All seems rosy because of the growing total construction spending. The construction sector is cyclical, and the company has positioned itself to mitigate the cyclical impact:
- It had reduced the contribution from the residential market.
- It had improved its gross profit and SGA margins.
- Its higher market share meant wider reach.
But I have some concerns about its financial position. If the construction sector continues to be strong over the next few years, this financial position would not be an issue because of its strong cash generation ability.
But while fundamentally sound, the market has overpriced the stock. Based on an optimistic 2-stage valuation model, there is no margin of safety.
I am a long-term fundamental investor. As such, I try to look at how the business will perform over the next decade or so. My valuation is also from this perspective. This is not an analysis or valuation for those looking for gains over the next few months.
For further details see:
TopBuild Corp.: Benefiting From Growing Construction Spending, But I See No Margin Of Safety