Quanex Building Products (NYSE:NX) operated through the following two segments before the divestiture (see below):
The engineered products group (EPG) sells window and door components to original equipment manufacturers used primarily in residential remodeling and replacement (R&R) and new home construction.
The aluminum sheet products segment (Nichols) sells aluminum sheet used in the residential building and transportation markets.
The housing play isn't over - you just have to look somewhere else
Although the housing market remains healthy, the rally in the more visible, early cycle names (e.g. homebuilders, appliances) should gradually transition to later cycle plays driven by increasing R&R activity, which typically lags new construction by ~12-18 months. NX is positioned to benefit from this trend given that R&R accounts for ~70% of EPG revenue. Moreover, the recently strong top and bottom line growth provides a glimpse into the significant peak earnings potential.
In the mrq, revenue increased 9% to $202 million while EBITDA increased to $5.7 million from a loss of $4 million. This growth was primarily driven by an impressive performance in EPG, including record 1Q revenue (up 19% to $126 million) and a 47% increase in EBITDA to $15.1 million, which was offset by persistent weakness in Nichols.
This higher demand (from the following three primary drivers) should generate significant EBITDA growth given the increasing operating leverage and lower SG&A run rate (partly driven by shifting resources from a new ERP system in favor of organic growth opportunities with greater return potential).
Going green. The global secular trend towards greater environmental awareness, along with encouragement from governments (e.g. increasing efficiency standards, tax credits, Energy Star program to raise awareness) should continue to drive increased demand for energy efficient doors and windows. Although management noted in the most recent 10-K that the U.S. government has been reluctant to enforce stricter energy standards, this is less of a negative than it appears.
Consumers don't need the government to encourage them to save money or protect the environment as they are already doing this on their own, which results in these incentives merely being "icing on the cake". Moreover, consumers are moving beyond more exciting ways to express environmental awareness (e.g. driving a Tesla) to more "boring" but equally powerful ones such as installing a Nest thermostat (or an energy efficient window).
The recovery in the core domestic market should be driven by four primary factors. First, and most importantly, housing starts and home prices (two of the most important demand drivers) continue to increase. The National Association of Homebuilders projects starts to increase from 0.9 million in 2013 to 1.2 million in 2014 and 1.5 million in 2015. Management noted greater optimism on the most recent conference call and said growth could be in the low double-digit range (PDF alert) if current trends continue compared to its previous estimate of 5-6% growth. NX is in a better position than most of its competitors to respond to this increased demand with its broad network of modern manufacturing facilities and just-in-time delivery capability.
Second, management said that R&R activity remains sluggish as energy efficiency is less important during periods of relatively low energy costs. However, these costs are at a cyclical rather than secular low and should eventually reverse, driving a renewed interest in energy efficiency. The Northeast already experienced skyrocketing energy prices this past winter as natural gas could not be transported due to a lack of pipelines.
Third, the relatively unchanged level of R&R activity since 2009 is largely due to the high cost of replacing doors and windows as well as the fact that homeowners are only beginning to recover some of their "lost" equity. However, sales should eventually pick up as homeowners are running out of excuses for delaying purchases any longer. Moreover, the realization that the zero interest rate environment is coming to an end may bring forward demand given the desire to take advantage of favorable financing conditions.
Fourth, NX is expanding organically into the commercial market and through acquisitions with the bolt-on acquisition of assets of Atrium Windows and Doors. The latter resulted in a greater presence in one of the strongest parts of the country (the south), reduced its dependence on R&R and expanded its lower-priced offerings (currently the most popular although demand for higher priced windows should materialize if home prices remain high).
International growth. There is plenty of growth runway given that <20% of EPG revenue is international and the insulating glass spacer market in continental Europe and the U.K. is ~2x as large as North America (although the latter receives much more investor attention). Moreover, Europe is actually taking the lead with new energy efficiency standards, which should drive increased demand as cold-edge spacers (an older technology) that account for ~60% of the market are replaced with more energy efficient warm-edge spacers.
Another transformative divestiture but not another reward from the market?
Last month, the new CEO already left his mark by announcing the sale of Nichols for $110 million in cash (already received regulatory approval and sale should close on 3/31/14). Moreover, NX will pay little cash taxes on this gain due to the $45.9 million of net deferred tax assets. There are two key benefits to this divestiture.
Higher margins. NX should receive a higher multiple given the order of magnitude increase in profitability. For example, the ttm operating margin for EPG is 14.4% compared to only 1.7% for Nichols.
Lower volatility. After this divestiture, strength in EPG will no longer be effectively offset by weakness at Nichols. As shown in the charts below, the former has a history of consistent top and bottom line growth (which deserves a higher multiple) while the latter is subject to uneven growth and significant volatility.
Moreover, the overall gross margin should increase as EPG enjoys greater pricing power while Nichols is a commodity-driven and spread business. Furthermore, NX will no longer be subject to extremely volatile aluminum prices (or have to deal with hedging and the well-known warehousing issue at the LME).
In 2007, NX spun off its building products business and merged the vehicular products business with Gerdau. Similar to the first spin-off, NX will now be a pure play with stronger cash flow, higher EBITDA margins, significant scale and virtually no debt.
However, the market has effectively ignored this significant transformation as the stock "only" increased 7% after the announcement compared to a 33% gain after the 2007 spin off, creating an opportunity as the new NX should not go unnoticed forever.
The slight discount to its peer group and high absolute valuation do not alter the investment thesis for two reasons. First, the previously mentioned transformation is not nearly fully reflected in the share price, especially given that overall EBITDA has been suppressed by Nichols. Second, the multiple should come down as EBITDA growth accelerates as R&R demand picks up.
Although management said the sale proceeds could be used for acquisitions (which would be acceptable given their experience in successfully integrating acquisitions and rationalizing capacity), there are two other potential uses. First, the dividend could be raised to a more meaningful level (last raised in 2011). Second, a significant amount of shares could be immediately repurchased, especially as 905,663 shares remain under an expanded repurchase program and there were no shares repurchased in the mrq or the past year.
The following are the primary risks to the investment thesis, in order of importance:
- NX is highly leveraged to the cyclical housing industry.
- Its customers may vertically integrate their business or transfer manufacturing capacity to lower-cost countries.
- The changing regulatory (e.g. increased energy efficiency standards) and technological environment results in the need for steady R&D/capex spending.
A price target of 24 over the next 12-18 months should be attained as the market gradually prices in the effect of this transformation and as the R&R market recovers. Moreover, any share price gains should be accelerated by the reduced effective float (e.g. the top 10 institutional holders own ~68%). A stop loss should be placed below recent support at ~19 or ~5% below. Risk can be further reduced by going long put options.
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.