I understand the reasons not to buy building products distributor GMS (GMS). GMS is cheap by any measure: 6x pro forma EBITDA, ~5x free cash flow. But that alone isn't enough: it's dangerous to buy a ~4x leveraged cyclical because it's "cheap" in any market, and especially this one. And valuation aside, there are plenty of risks here.
New home construction figures are weak, particularly in single-family. Input costs are rising, potentially pressuring margins. GMS itself has highlighted intensifying pricing competition over the past few quarters, amplifying that pressure. The distributor model itself has some long-term concerns. Indeed, I've raised those concerns multiple times as an ardent bear toward medical products distributor Owens & Minor (OMI), a very different story but one with some similarities.
Millennials can't afford to buy houses and don't want to anyway because they all want to live in tents and yurts, or something like that. The economy is headed for recession because of the yield curve, interest rates, tariffs, and China.
There are risks here, to be certain. But back in October, I called GMS the best play in the building product space, and three months later, that's still the case. GMS, even with a recent bounce, is even cheaper - but the story remains intact. The company remains profitable; in fact, margins are expanding. Share losses are a concern, but the news looked better in last month's fiscal Q2 report. The balance sheet is leveraged, yet that also creates a nice deleveraging story that can further drive equity gains. Even 25% off the lows, there's plenty of upside left in GMS and plenty of reason to believe the myriad risks here still are priced in, or close.
The Fundamental Case
The fundamental case for GMS has four basic pillars:
- GMS is cheap on an absolute basis, at 6.2x pro forma EBITDA and potentially sub-5x normalized FCF based on guidance for FY19 (ending April) conversion. The cash flow, in particular, gives GMS flexibility to either deleverage, buy back shares, and/or continue its roll-up strategy.
- GMS is cheap on a relative basis, trading at a one-turn-plus discount to other peers like Beacon Roofing Supply (BECN), Builders FirstSource (BLDR), and Foundation Building Materials (FBM), and in the ballpark of lower-margin operators like BlueLinx (BXC) and BMC Stock (BMCH).
- Yet GMS still is growing revenue and expanding EBITDA margins.
- The nature of wallboard and ceilings (cheap on a per-square-foot basis, close to immaterial as a percentage of overall project costs, difficult to transport) provides some competitive protection, and what appears to be a ~25% share of sales from new construction limits exposure to a market that even GMS management admits is slowing.
Nothing materially has changed on that front over the past few months. GMS was at 7.1x EV/EBITDA back in October (6.7x adjusted for synergies from the acquisition of Canada's WSB Titan, which closed June 1st); it's now a bit cheaper. The bounce of late hasn't materially closed the gap with peers: the entire sector has benefited from a dead cat bounce or relief rally, depending on one's perspective:
chart since December 24th
Meanwhile, GMS still is growing. In fiscal Q2, revenue rose 29%, and Adjusted EBITDA increased over 60%. Titan was a major contributor, admittedly. But base revenue still grew 8.7% year over year. Wallboard organic volume declined just 0.6%, according to the 10-Q, with pricing driving base revenue growth in that category of 3.7%. Ceilings base revenue increased 10% with volume positive - and I'd note that GMS has a close relationship with Armstrong (AWI), one of the few construction stocks to hold up of late. (AWI is flat over the past year, which counts as a significant win in the context of the space.)
Steel framing organic revenue rose 21.9% - and while higher steel prices (passed along to end customers) obviously are a factor, there, too, volume was higher. That's good news looking forward as well: framing demand is an indicator of wallboard sales, since steel framing is basically useless without wallboard attached to it. Sales of other products (accessories, insulation, tools, lumber, etc.) rose 58%, mostly thanks to Titan, who helped diversify the portfolio, and climbed 8%+ on an organic basis.
Gross margins did decline 60 bps year over year (more on that in a moment). But SG&A leveraged 200 bps, even excluding a ~70 bps benefit from a shift to capital leases from operating leases. EBITDA margins rose to 10.5% as reported, thanks mostly to higher-margin Titan but also due to organic leverage and cost savings actions implemented last year. Even the balance sheet improved, with the net leverage ratio dropping to 3.8x for 4.2x at the end of fiscal Q1.
Again, this is backward-looking analysis - and investors have been looking at the forward risks to the sector and GMS itself. But the numbers still are solid - and management said repeatedly on the Q2 conference call that the industry was stabilizing. Sharp increases in pricing led to some disruption in past quarters, but CEO Michael Callahan said the company expected ~flat market share in 2019, and there was no sign of erosion in the Q2 numbers. In the Q&A, the CEO noted that there was "a little bit of softness" in single-family residential, but said "my view on commercial is that that's going to be the bright spot for [CY]'19 and we've got good visibility on that".
The sense from the Q2 call is that business is getting back to normal after multiple price increases from suppliers and more competitive activity from rivals that started to reverse last quarter, per management commentary. Even in Titan's home market of Canada, where investors are more worried about residential weakness, Callahan cited a strong backlog.
Management could be wrong, admittedly. But Q2 isn't showing the weakness that investors have been pricing in. Rather, it's showing a more rational market after some potentially concerning commentary around share losses and pricing in the past quarter. GMS is taking pricing in its key categories, and its volume numbers seem in line with the market. There's still some "drag", as Callahan put it, in matching price to cost in the quarter, which should moderate as a February price increase is passed along. But there's basically zero in Q2 to suggest a noted change in GMS's competitive positioning or 2019 outlook.
The Qualitative Bear Case
GMS did sell off after the quarter; a headline $0.05 EPS miss may not have helped the proverbial cause. And bears/skeptics might point to the aforementioned gross margin compression as a reason for caution. 60 basis points is a reasonably significant move against pro forma annual EBITDA margins below 10%, and one potentially amplified by the nearly 4x leverage on the balance sheet.
The primary concern about GMS beyond a cyclical downturn is pricing. GMS stock tanked after Q4 results back in June 2017 after the company talked down forward-looking GM expectations to a level closer to 32.5% from ~33%. The stock fell sharply again a year later, when the company posted a decline in wallboard volume in the fourth quarter and former CFO Doug Goforth said on the Q4 call that the company had lost about 50 bps amid "continued competitive challenges".
So, the obvious risk here is that construction demand softens, which leads to a loss of pricing rationality in the market. Input costs, depending on how trade plays out, potentially still could be rising in that scenario. Take ~100 bps off margins and that alone drops GMS shares something like 25%; add in revenue declines and/or SG&A deleverage from lower volume and this can get ugly in a hurry.
And the one figure from Q2 results that does look concerning is the gross margin compression. But that figure needs to be considered in context. First, the year-prior figure was higher than expected - and in fact, strong enough that helped GMS reverse the post-Q4 fears about margin and send the stock to an all-time high. Secondly, there still are price-cost factors hitting current results.
Perhaps, most importantly, even 32.2%, rather than 32.5%, is the new baseline, there's still enough room in the valuation and in SG&A to manage that easily. Fuel expense alone hit Q4 profits by over $1 million, per that quarter's call, a ~15 bps impact. That's going to reverse. There are efficiencies to be found, and more stabilized pricing from suppliers should help GMS's own pricing strategies going forward.
Valuation in 2019
The bear case for GMS remains out there - and to be blunt, there's no way to disprove it. The economy is going to weaken at some point, presumably. Even what GMS has described as a "balanced mix" of commercial and residential new construction and repair/modeling revenue is going to face headwinds in that scenario.
But I'd rather take on that risk at 6x+ EBITDA and ~5x free cash flow than 8x/10x. And what I see in the past six quarters of results are some challenges - but also a company managing through a period of volatility in its business. Pricing has spiked, and demand is uneven - yet GMS continues to grow on an organic basis. This is a company that's been around for 48 years (though obviously on a much smaller scale for most of that stretch); there simply isn't evidence of some wholesale crumbling of that business model. Residential housing is a worry - but it's manageable in the context of the business, given a likely 25% contribution to revenue. (I'm also not quite convinced of a multi-year downturn in that category, given muted post-crisis growth, but that's a different article.)
Valuation admittedly isn't everything - but it matters. And even the improvement from Q1 to Q2 in terms of the balance sheet and the pro forma P&L is material to the share price. TTM pro forma EBITDA rose $6 million q/q; at 6x, that's $36 million in incremental equity value. Net debt came down $83 million, according to GMS's figures. Theoretically (and admittedly just theoretically), that's $100 million-plus in added valuation against a current market cap of $734 million.
Back in October, I modeled potential upside/downside in a range of different simple scenarios. At the time, with GMS at $21, even a deleveraging scenario - no growth, no multiple expansion, just FCF going to debt - suggested 33% upside to ~$28. A downside scenario moved the stock to $11. Coming out of Q2, the range looks stronger, with GMS cheaper and the balance sheet modestly improved:
|Scenario||2-Year Target Price||Upside||Notes|
|Deleveraging||$25||41%||No growth, no multiple expansion; equity slice of current EV grows through $300M in debt reduction|
|Multiple Expansion||$31||77%||EV/EBITDA multiple moves to 8x (in line with many peers w/similar margins)|
|Growth, Delev, Multiple Expansion||$42+||144%||EBITDA grows 4% annualized plus $20M in synergies; delev to $1B in net debt (-$184M); multiple to 8x|
|Margin Pressure, Multiple Compression, FCF Disappoints||$10.50||-40%||EBITDA margins down 150 bps; revenue declines 3%; multiple to 5.5x; debt reduction ~$100M/year|
Again, the argument here isn't that $10+ is a floor: a wipeout in residential construction and pressure on R&R can lead to sharper top-line declines and wider margin compression. But a negative near-term scenario clearly is priced in here, and then some (5.5x would be a historically low multiple - and if the cycle is turning, in theory multiples are supposed to be expanding). Even muddling through - flat EBITDA, flattish multiples - positions GMS for a return to $20+ easily. If and when confidence returns, there's a not-terribly-unrealistic path to a double.
Even in a market where cyclicals have been hammered, this is one of the better fundamental "buy the dip" cases out there. And it's a case that's worth riding out volatility for - and trusting that GMS can muddle through even if new construction slows. If that's the case, and I believe that is, GMS is going to be a huge winner when confidence finally returns.
Disclosure: I am/we are long GMS. 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.