Fiscal 2019 was a good year for wallboard distributor GMS (GMS). Organic revenue increased 7%. The acquisition of Canada's WSB Titan, which closed in June 2018, proved accretive. Adjusted EBITDA increased 48%, thanks to help from Titan, a conversion to capital leases, and organic growth.
That said, it was hardly a great year. Expenses came in higher than expected in Q3 and Q4, leading to a pair of earnings misses. Gross margins - a key investor recent concern in the last two years - compressed again, if modestly. End markets saw a good deal of disruption, and there are worries about Titan's exposure to new construction in Canada. GMS shares have rallied of late, but remain down 11.7% over the past year, and off some 45% from all-time highs reached (briefly) in late 2017.
After the rally of late - GMS has risen 22% in the last eight sessions - the question is whether a merely good year is good news for the stock. From one perspective, GMS clearly has room for improvement, and easy compares as it begins a key fiscal 2020 (ending April 30). From another, the minor issues last year might be a harbinger of trouble for a company with EBITDA margins still under 10% near what may be the end of a macro upcycle.
I've been bullish on GMS going back to last year, and from here the stock still appears undervalued. GMS remains cheap both on an absolute and relative basis, particularly when looking at its closest peer. New residential construction is a concern, but GMS' exposure is manageable. End markets appear to have settled, and continued deleveraging on its own suggests reasonable upside for the equity. The risks are real, but barring a quick cyclical shift GMS should continue to rally.
A Good News/Bad News FY19 And The Bear Case
The somewhat split narrative of GMS' fiscal 2019 can be seen in the company's full-year results. On their face, they look impressive, and close to spectacular. As noted, revenue rose 7%. Adjusted EBITDA margins - a key measure for a distributor - expanded 160 bps, from 7.9% to 9.5%. GMS made substantial progress in deleveraging following the Titan deal, moving pro forma net leverage to 3.6x EBITDA from 4.2x three quarters earlier, per the Q4 conference call.
Meanwhile, the stock trades at ~6.8x EV/EBITDA (pro forma) and under 8x adjusted net income. The cyclical fears are almost self-evident, but even in that context GMS looks close to absurdly undervalued.
It's not quite that simple, however. In terms of revenue, much of the help came from pricing, not volume - with much of that benefit coming from GMS simply passing along higher input costs. Per the 10-K, organic wallboard volume rose just 0.4%, and that includes help from 8 greenfield expansions last year. On a same-store basis, wallboard volumes almost certainly declined.
Volumes were stronger in Q4, coming in at 3% per the Q4 earnings slides after a flat performance in Q3. In ceilings, steel framing, and other products, which total ~59% of revenue, full-year performance was stronger (though not disclosed). But in a still-strong economy, underlying wallboard volume growth seems acceptable, but not spectacular. GMS did seem to maintain market share in the category in the second half after talk of lost share at the end of FY18 and the beginning of FY19. Still, it's not as if top-line performance, particularly in wallboard, suggested a company firing on all cylinders.
As for margins, the news might even be considered modestly negative, despite the headline improvement in the EBITDA figure. Titan offered much stronger margins, boosting the figures. A shift from operating to capital leases accounted for about half of the 160 bps year-over-year increase. In fact, including Titan synergies, some of which still will be realized in FY20, pro forma margins at the end of last year were 10.1%, according to the Q4 FY18 earnings slides.
That suggests, on a pro forma basis, margins probably fell in the range of 50 bps in FY19, based on commentary surrounding synergy realization. ~20 bps came from gross margins - but underlying SG&A likely still deleveraged. That's with some benefit from cost savings efforts undertaken in May 2018, which were expected to provide ~$20 million in savings (a ~60 bps benefit).
Looked at another way, on the Q4 FY18 earnings slides GMS estimated pro forma Adjusted EBITDA of $302 million for fiscal 2018. A year later, it calculated pro forma Adjusted EBITDA of $302.3 million.
So there is a bear case here. New residential construction is in the range of 22% of total revenue, per management commentary - with something like ~4 points of total sales coming from Canadian single-family housing, a market that has been in a "yearlong-plus slump". Commercial construction may slow, particularly given that many (myself included) still see the U.S. as overstored in the retail sector. The macro cycle has to turn at some point (right?). GMS' underlying profit growth already stalled out in FY19. The combination of cyclical/external factors and FY19 performance would suggest that GMS is at or near peak earnings. If that's the case, given a 3.6x leverage ratio, a 'cheap' multiple isn't cheap, but merited.
The Qualitative Case for GMS
Looking under the hood, FY19 results aren't nearly as good as headline number suggests. But to stretch the metaphor, looking at the parts, GMS might well have done a solid job simply to keep profits reasonably intact and margins somewhat stable.
After all, FY19 was a difficult year in a lot of ways, despite (and sometimes because of) the strong economy in the U.S. Rising costs hit the company across the board, as detailed on the Q3 call: two hikes in wallboard, "multiple steel and ceiling grid" increases, freight surcharges, and wage inflation. GMS was integrating Titan at the same time it was managing volatile pricing environments and uneven weather, particularly over the winter. This was not a simple year - but the news has become better of late.
Notably, in Q4, GMS actually called out favorable price/cost, a reversal from recent quarters when the company was constantly playing catch-up with price increases from suppliers like USG (USG) and Armstrong World Industries (AWI). And recent commentary (going back to Q2) has emphasized a return of stability to the market, though discussion in the Q4 Q&A suggests wallboard prices could recede this summer.
Gross margins in turn seem to be settling in, with the company guiding for a 'floor' around 32.2%. That's down modestly from a reset expectation of 32.5% which sent GMS tumbling two years ago. But it's good enough given the addition of Titan and the current valuation.
As far as GMS itself goes, FY19 performance can be improved upon. But I'd argue that's good news. Margin weakness in FY20 wasn't a case of poor execution or plunging market share. The industry saw tremendous amounts of upheaval in areas - input costs and labor most obviously - that are self-evidently quite important for a distributor. GMS on the Q4 call called out 50 bps of pressure in the quarter alone just from unexpected insurance costs and the timing of corporate expenses.
This was not an easy year for the company. There's a bit more certainty looking forward, notably on the pricing front, and the company has had time to adapt to tighter labor markets. Strength continues in commercial and renovation/remodeling, which account for over three-quarters of revenue. Steel framing growth continues - and that's good news heading into FY20, given that framing is a leading indicator for wallboard demand. (The frames, used in commercial construction, are used to support wallboard. Customers don't buy framing without a plan to return for that wallboard.)
All told, I'd expect fiscal 2020 on the whole to be better for GMS (for what it's worth, analysts on average agree, though EPS is only projected to increase a little over 2%), and a solid Q4 even after the gains of late that should be enough.
Obviously, that requires further cooperation from the macro environment - but for an investor willing to take on that risk, GMS looks like an attractive choice. Construction-related stocks started falling before the broad market plunge began in early October; they've mostly rallied this year, but distributors including GMS mostly sit off the highs:
GMS still should have room to catch up. Most notably, Foundation Building Materials (FBM) has soared of late, gaining 70% just since the beginning of April. That direct peer is smaller than GMS; has lower margins; and yet trades about 0.6 turns higher (~7.5x, at the midpoint of 2019 guidance, vs ~6.9x) than GMS. GMS still trades at a discount to Beacon Roofing Supply (BECN), and it's worth remembering that Beacon paid 13x+ EBITDA for GMS competitor Allied Building Supply and USG sold L&W for a similar multiple.
An investor might cite Canadian residential exposure as arguing for a discount for GMS, but again that market likely drives something like 4% of total sales. Simply matching GMS' multiple to that of FBM suggests ~20% upside for GMS equity, moving the stock to $28 and finally erasing the loss over the last year. It's not inconceivable that the multiple could move past 7.5x, either by moving closer to peers/transaction comparables and/or by GMS receiving what looks like a deserved premium to FBM.
Deleveraging represents another potential help. GMS did see a $35 million boost to FY19 FCF of $175 million from working capital timing, which likely provides a headwind to FY20 figures. Still, the company should be able to pay down another ~$100 million of debt this year even with continued small bolt-on acquisitions. All else equal, that's another 12% boost to the stock price. Combine modest EBITDA growth, some level of multiple expansion, and deleveraging and GMS can clear $30 rather easily, which is still 32%+ upside.
Again, there are cyclical risks. But those risks seem discounted more into GMS than into peers. Meanwhile, the S&P 500 is at a record and has gained 18%+ YTD. There are valuation and macro risks everywhere. The question is reward. And, even with the rally of late, I still believe GMS has more potential reward than any stock in its space - and most stocks in the market.
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.