TopBuild - Great Play On Residential Housing Recovery And Lower Taxes

| About: TopBuild Corp (BLD)

Summary

TopBuild is a pure play on insulation, well positioned to benefit from a housing recovery, while a strong balance sheet provides opportunities to pursue bolt-on M&A deals.

These trends, continued focus on improved energy performance and potentially lower tax rate could boost earnings by a huge degree.

Unfortunately good news has already been (partially) priced in, making me a buyer on dips as I see more upside potential from here.

TopBuild (BLD) is a pure play on residential construction through its insulation installation and distribution business. Following the separation from parent company Masco in 2015, the company was left with a strong balance sheet. This allows the company to pursue bolt-on M&A, thereby creating another growth driver on top of the recovery in residential housing construction.

With current earnings power of $2 per share potentially getting a great lift from a cut in corporate taxes, there are triggers on the horizon that can boost earnings and shares in the coming years. That makes me a buyer on serious dips.

Who Is TopBuild & What Happened?

TopBuild claims to be the largest installer and distributor of insulation in the US. The company has long been part of Masco (MAS) but its ways separated back in the summer of 2015.

TopBuild is the product of acquisitions which were pursued over a decade ago as the housing downturn hit the company and its parent company Masco in a big way almost a decade ago. Shares lost 90% of their value at the worst point in the crisis.

To combat the troubles the company focused heavily on cutting costs by reducing employment as well as the breadth of the product offerings. At the same time, TopBuild rolled out a single ERP systems across all its businesses.

With the recovery picking up real steam in recent years, Masco has decided to spin-off TopBuild. Following this ¨freedom¨, management can make decisions faster, be more proactive, and control its own capital allocation.

The company has subdivided its activities across 2 segments. The largest is the TruTeam brand which totals 175 branches for residential and commercial installation of insulation. This installation business generated $300 million in sales at the time of the spin-off, accompanied by adjusted operating profits of 10.8%.

Service Partners distributes insulation and other building products through its 70 distribution centers. This business generated $174 million in sales, yet margins for the distribution business were lower at 8.9% of sales. For both segments, insulation makes up roughly 70% of sales, making it a perfect play on residential housing construction.

Growth ambitions are driven on simply a recovery in construction activity, focus on market share gains, expansion into commercial buildings, and stricter environmental regulations in terms of energy efficiency.

Modeling The Financial Performance

The 2015 annual report of TopBuild revealed how much revenues have rebounded coming out of the crisis. Revenues came in at $1.1 billion in 2011 and gradually improved to $1.6 billion in 2015. The company turned operating losses in 2011 & 2012 into modest profits, with operating profits reaching a high of $83 million in 2015.

Note that these results were achieved while housing starts barely surpassing the 1.1 million mark in the US in 2015, still far below the 50 year average of 1.5 million housing starts per annum.

If we simply model a return to that ¨starts¨ number, TopBuild should be able to post sales of $2 billion or more, accompanied by solid operating leverage.

Spin-Off, Hot Out Of The Gate

While shares of TopBuild traded at just $22 in June of 2015 when the spin-off from Masco commenced, shares rose rather quickly to $35 per share as soon as September of that year.

For the year of 2015, sales rose by 6.9% to $1.62 billion on the back of a continued recovery in housing. Operating earnings rose to $83.5 million. The reported net earnings were severely overstated on the back of tax benefits following years of losses. Taking into account interest costs of $9 million, and a 38% tax rate, earnings would have come in at $46 million, equivalent to $1.20 per share.

A $35 share price seemed a bit rich for that earnings power at the time, suggesting that shares traded at 30 times earnings. This appeared to be recognized by investors as well as shares fell back to $23 in February of 2016.

Yet the company delivered on spectacular results in 2016. A mild winter allowed first quarter sales to increase by 15.5% on an annual basis. Second quarter growth fell to a still respectable 6.9%, and came in at 5.9% in the third quarter. These revenue gains make that sales will comfortably surpass the $1.7 billion mark in 2016, as margin expansion should allow operating profits to rise towards $130 million. With merely $5 million in interest costs and a 38% tax rate, that translates into earnings of $77 million, equivalent to $2 per share.

The balance sheet is furthermore very strong, allowing for bolt-on M&A, as the company has made a small acquisition in the summer of 2016. The company operates with just $80 million in net debt, for a leverage ratio barely above 0.5 times EBITDA. The company recently used its balance sheet strength to buy Midwest Fireproofing, a fireproofing and insulation company. This deal, whose purchase price was not revealed, will add $20 million to TopBuild´s sales, or little over 1% of total sales.

On the back of these earnings improvements and the Trump post-election run, shares have risen back towards $37 per share, approaching the highest levels since the Masco spin-off. Based on the current earnings power, shares trade at market multiples of 18 times earnings.

Fairly Valued For Now, Some Triggers On The Horizon

Based on sales of $1.7 billion and operating margins of 7% at the moment, earnings power comes in at $2 per share. Assuming a further recovery in sales towards $2 billion based on historical housing start numbers, accompanied by margins of 8-9%, earnings could rise from $2 per share to the neighborhood of $2.75 per share.

The real kicker however is the tax rate which currently stands at 38%, as any reduction could have a meaningful impact on earnings.

A cut to 25% overnight could boost earnings per share towards $2.50 overnight, effectively reducing the earnings multiple from 18 times earning to 14 times in a single step. If we factor in such a tax rate on the bullish scenario of $2 billion in sales for 2019/2020, we find earnings per share could total $3.25.

Combined with a modest 15 times valuation multiple, that would be sufficient to support a $50 per share valuation by 2019/2020, for returns of 12-18% per year.

All in all there is still quite some potential for this spin-off on the back of bolt-on M&A, a strong balance sheet, further housing recovery and potentially lower tax rate. The issue if you like is the strong run up seen already through 2016. Keeping in mind this momentum run higher, and the potential drawback of higher interest rates, I am patiently waiting for a setback to the $30-$33 region.

Disclosure: I/we 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.

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