Investors waiting for the recovery in non-residential construction are still waiting, and that's not good news for NCI Building Systems (NYSE:NCS). Although this company has attractive market share leadership in metal coating, building components, and engineered building systems, that leadership isn't worth as much in a construction market that has struggled to lift off the bottom. There does appear to be value in these shares, but the timing of that non-residential building recovery is a major unknown right now.
A Tough Quarter, But Better Than The Overall Environment
NCI posted a pretty disappointing fiscal third quarter, as reported revenue rose 6%, but came in about 10% shy of expectations on weak demand in the ag sector. The coatings business was the star of the quarter, as revenue rose almost 19% on better than 20% shipment growth in both light-gauge and heavy-gauge coated steel shipments due to strong non-construction demand (HVAC, appliances, etc.). Components revenue rose more than 17% due in part to the full inclusion of Metl-Span and improving demand for roll-up doors from end markets like self-storage. Last and least, revenue from building systems declined almost 4%, though shipped volumes rose almost 4%.
Despite an overall improvement in volume, NCI's margins weakened noticeably. Gross margin declined almost a full point, while operating income was down 39% on a reported basis and 58% on an adjusted basis, with the adjusted operating margin plunging to just over 1%. Adjusted EBITDA declined 10% from last year, but improved 60% on a sequential basis. Looking at the reporting segments, components and building systems both saw significant income declines (down 14% and 33%, respectively), while coatings earnings were up 8%.
So why do I say that these results were better than the overall environment? Well, McGraw Hill reported that low-rise commercial construction starts declined almost 11% year-on-year, but NCI's volume improved by 6% on a pro forma basis, with the aforementioned 4% growth in building systems. What's more, the backlog did improve slightly (up 2% yoy and 1% sequentially).
Even so, this was a disappointment, as volumes lagged management's own expectations due to particular weakness in agricultural. As a consequence, inventories rose 19% at quarter-end.
Slow And Unsteady Won't Win Many Races
NCI has made a lot of progress from an operational perspective over the past four years. After barely surviving 2009, the company has executed a pretty thorough restructuring that lowered its breakeven point by nearly 40%. Moreover, the company now believes that it could earn around $225 million in EBTIDA when non-residential construction activity gets back up to 1 billion square feet.
The "but" is that we're a long way from there. Activity was only at 700 million square feet in 2012 (according to McGraw Hill), and 2013 hasn't been much better. I haven't seen an up-to-date figure for square footage in 2013, but using the spending numbers provided by the Commerce Department (admittedly sort of an apples-to-potatoes comparison) suggests only a low single digit increase (about 2%) in private non-residential construction. Likewise, the ABI Index has been positive for a little while now, above 50 and at 54.2 for commercial/industrial in July, but not exactly robust.
Moreover, there was the number I mentioned earlier about an 11% decline in low-rise non-residential starts during the third quarter - a bad sign for NCI, as the company gets almost 90% of its business from low-rise construction.
It's not just the building statistics that suggest ongoing malaise. Minimill operators like Nucor (NYSE:NUE), Steel Dynamics (NASDAQ:STLD), and Gerdau (NYSE:GGB) all have exposure to the non-residential construction market and all have pointed to sluggish activity here as an ongoing headwind. Likewise, companies that sell various building control systems, including Honeywell (NYSE:HON) and Johnson Controls (NYSE:JCI), have lamented the slow pace of recovery in this market, as have smaller companies like ARC Document Solutions (NYSE:ARC).
Solid Opportunities For The Patient Investor
While current conditions are disappointingly slow, there are reasons to like this company for the longer term. The company is a strong player in metal coil coating, with 40% share in heavy-gauge (making it the #1 company) and 11% share in light-gauge (making it #2 behind Precoat Metals).
Likewise, while the company's 15% market share in components (roofs, wall systems, doors, panels) may seem small, it's twice that of the next-largest rival. Not only could NCI ultimately see more consolidation opportunities, but it could grow organically as well. Metal roofing is only about 10% of the commercial roofing market and should grow from there. Additionally, the company's acquisition of Metl-Span and its insulated panel systems should add another leg of growth to this business.
Last and not least, the company's engineered building systems should benefit from that eventual recovery in non-residential construction. NCI designs, builds, and distributes pre-fabricated steel-framed building components like structural members and panels, going from order to on-site ready-to-assemble delivery in six to 12 weeks. These components can significantly reduce the construction time and cost of new buildings, and NCI enjoys strong market share. This is a pretty thoroughly consolidated business, with the top three players holding about three-quarters of the market - NCI is tied for #1 at 28% share, while Nucor's Nucor Building Systems is third at 24%.
Better Day On The Way?
Non-residential construction activity has historically lagged residential by about 12 to 18 months, so the improvements in residential construction are encouraging. Moreover, today's level of new square footage is well below the levels seen during the last building boom (about 40% to 50% lower). Couple a recovery in activity with a better margin structure, and there are reasons for optimism here.
All told, I'm looking for long-term revenue growth of almost 8%, with a big spurt (around 12% annually) between now and 2017. With that, I also see the possibility of the free cash flow margin moving back into the high single digits in 2017, before easing back down to a mid-single digit "steady state" level.
Unfortunately, that doesn't work out to a great fair value. The company had to do a convertible preferred offering with Clayton, Dublier, & Rice a few years back and the resulting dilution has nearly quadrupled the share count. That said, my fair value estimate of $13 is still above the price today and could go higher if the recovery gains steam and/or the company outperforms on cash flow generation.
The Bottom Line
Last night's disappointing earnings report seems set to send the shares down more than 10% if pre-market indications prove accurate. While I might want to wait for the dust to clear a bit, I do think there's enough value here to make this a worthwhile stock to investigate further. Given the company's market share and the economics of the components and pre-fabricated systems the company provides, I do believe it is a good play on that eventual non-residential recovery, even though the wait for that recovery could be longer and more unpleasant than investors hoped at the start of 2013.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.