For most of this decade, Quanex Building Products' (NX) stock has traded in a tight range between $16 and $22. And for the most part, that range has made sense.
The window and cabinet component manufacturer has made some significant changes, exiting its aluminum business in 2014 and moving into the cabinet industry in late 2015. But in recent years, Adjusted EBITDA has been flat (in fact, it's declined modestly from FY16 levels) as the company's growth projections have been far too optimistic.
Most notably, Quanex said in late 2014 that "mid-cycle" EBITDA would be at least $115 million. The acquisition of cabinet door and component manufacturer Woodcraft the next year added another $45 million to the estimate. The midpoint of fiscal 2019 (ending October) guidance suggests just $102.5 million in Adjusted EBITDA.
Guidance aside, this simply has been a difficult business. Switching costs in the window business are quite high (as manufacturing lines have to be altered for the new components). That makes share gains difficult (though not impossible) and leaves Quanex at the mercy of broader window demand. The Woodcraft acquisition has been a disappointment: trailing twelve-month Adjusted EBITDA for the North American Cabinet Components segment has been just $16 million, dramatically below projections at the time of the acquisition. Plunging demand for semi-custom cabinets has been the key headwind, and has offset cost improvements that helped margins in the first half of FY19.
That said, I've owned NX stock on three different occasions in recent years, most recently stepping in around December lows. There has been a case for owning NX at the right price, as the company promised deleveraging and margin expansion. The issue after a 75% gain from those December (and seven-year) lows is that $19, right in the middle of that long-term range, doesn't seem cheap enough given a weakening outlook for growth.
The Domestic Window Business
Quanex's North American Fenestration segment generated 60% of segment-level Adjusted EBITDA through the first three quarters of fiscal 2019. In recent quarters, the segment's reliance on end market demand has proven a double-edged sword.
As far as the Quanex share price goes, the correlation to the industry has been good news. Housing-related stocks have soared this year after plunging in last year's fourth quarter sell-off. The iShares U.S. Home Construction ETF (ITB), which has a small portion of its assets in NX stock, has gained 51% so far in 2019 and has bounced 58% from its late 2018 lows. Many names in the industry, whether manufacturers or distributors, have matched or exceeded the ~80% gains Quanex stock has seen since a December sell-off.
But operating results in the NA Fenestration segment have been pressured by lower window demand. A reduction in full-year consolidated revenue growth after the second quarter — from an initial 4-6% to 2-3% — was driven by the cabinet business, according to the Q2 conference call. But a second cut, to flat performance y/y per the third quarter earnings release, was driven by broader weakness in the window industry.
As COO George Wilson noted on the Q3 call, Ducker Worldwide lowered its shipment growth estimate for the full year from +0.7% to -1.2%. Quanex has managed to take some modest share in North America and drive revenue growth in the segment, but industry weakness has offset some of those share gains.
Again, the fenestration businesses both in North America and overseas are heavily exposed to end market demand. Quanex has taken market share of late, with CEO Bill Griffiths talking up new business on the first quarter conference call. The company is focusing on its screen business as another way to drive revenue growth, as more manufacturers look to outsource those products.
But as Griffiths noted after Q3, screens have the lowest incremental margins in the portfolio. And in the spacer and extrusion businesses, the industry's performance this year has to be a concern. The economy is strong. Housing admittedly has been choppy, particularly in new construction, but as management has pointed out in the past Quanex's business is mostly based on remodeling and renovation.
The risk is obvious. Industry shipments are set to decline this year in an economy running seemingly on all cylinders, with both interest rates and unemployment near all-time lows. Both factors are strongly bullish for R&R spend — yet end user demand is roughly flat. What happens when one of those two tailwinds inevitably reverses? It certainly seems like end market demand should be stronger given macro factors, but it may be that windows are better and last longer, or that the tailwind from consumers moving to higher-efficiency products has faded.
It's worth noting that one of the sector's underperformers has been window and door manufacturer (and Quanex customer, at least in the past) JELD-WEN (JELD), whose shares have traded sideways since February. That company gave disappointing preliminary numbers for Q3 last month, and guided for a year-over-year decline in revenue. That guidance is good news for NX in one sense — it seems to confirm Quanex management's explanation for its own reduced outlook — but it also highlights the broader challenges to an industry that Quanex needs to grow.
Again, Quanex is taking market share, and Q1 commentary suggests NA Fenestration revenue should grow in fiscal 2020. The company has taken pricing as well, which benefited revenue growth YTD by roughly 1.5 points, per commentary from the 10-Q. Those price increases have helped drive margin expansion as well, with segment Adjusted EBITDA margins improving 50 bps to 12.3% in the first nine months.
Still, the outlook for growth in FY20 and beyond seems muted. Quanex might be able to grind out some increase in revenue and some margin expansion. But in a business that's driving 60% of profit, that's about all investors reasonably can expect at the moment.
Surprising Success in Europe
The surprising bright spot in fiscal 2019 has been the company's operations in Europe. Year-to-date, sales have increased 5%, with constant-currency growth more than double that. Segment Adjusted EBITDA has grown an impressive 27% through the first nine months, with margins moving to 16.2% from 13.4% over the same period last year.
It appears that the performance has surprised even Quanex management. On the Q1 call, Griffiths attributed an impressive quarter for the segment to customer stockpiling ahead of Brexit. By Q2 and Q3, however, the driver seemed to be above-market growth. Price increases taken to account for raw material increases have provided another tailwind. Meanwhile, those input cost spikes have reversed, providing a boost to margins.
The strong results don't seem likely to fade any time soon. After Q3, management projected strong results in Q4 as well. Looking further out, almost all of the overseas business, per the Q2 call, is repair and remodeling. And energy efficiency regulations have provided a driver for window replacement which should continue to drive demand in that category.
Quanex is looking to take advantage. On the Q3 call, Griffiths floated the idea of expanding capacity in the company's spacer manufacturing facility in Germany. In the UK, the company steadily has taken share since entering the market via the acquisitions of Edgetech in 2011 and a $145 million purchase of HL Plastics in 2015.
EU Fenestration unquestionably has been Quanex's strongest segment this year. But there are three potential issues. First, the EU business is much smaller than the domestic business, generating just over a quarter of YTD segment profit. Second, macro issues still can raise their head, whether it's the interminable drama of Brexit or weakness on the Continent. And, third, the strength in the European window business may well be offset by weakness in the company's cabinet business.
The North American Cabinet Components started the year off weakly — and the news only has gotten worse. A 3.7% year-over-year decline in the first quarter was attributed to poor weather and downtime at customer manufacturing facilities. But a 0.3% increase in Q2 included some business that had slipped into the quarter, and clearly disappointed relative to expectations. As noted above, Quanex after the quarter reduced its outlook for the segment, a key contributor to a ~three point reduction in consolidated revenue guidance.
Then in the third quarter, sales plunged almost 10%. Adjusted EBITDA declined 32%, thanks in large part to fixed-cost deleverage driven by the reduced revenue. Hoped-for margin expansion on a full-year basis now looks unlikely despite a 60 bps improvement in the first half.
This is a business that, simply put, looks like it's in trouble. Segment-level EBITDA margins last year were just 7.1%, and are guided to be roughly the same this year. An ongoing shift to cheaper stock cabinets from semi-customs is pressuring the business — and that shift seems unlikely to abate. Griffiths admitted after Q3 that the company was not going to increase prices in 2020, and chasing after low-cost, low-margin business in stock may require capital that Quanex doesn't want to commit for paltry returns.
The good news is that the cabinet business is the smallest from an earnings standpoint: guidance suggests the segment will drive something like 14% of total profit for the full year. That said, NA Cabinet Components remains at least somewhat material — and there really isn't an answer here in terms of even dodging further profit declines. The company already has taken out cost, which drove the margin expansion in the first half. Gross margin improvement seems unlikely in the current pricing environment.
Griffiths said after Q2 that the company was assessing the long-term strategy for the business, but it's hard to see what good options Quanex really has. A sale would come at a minimal price. Current ROIC is substandard. And if Cabinet profits keep declining, that offsets at least some of the potential growth seen in Europe. If the NA Fenestration segment stays relatively stagnant, than a segment-by-segment review strongly suggests that consolidated results will do the same.
And the problem with NX at $19, in 2019, is that stagnant or something close isn't really good enough. That hasn't always been the case in recent years. At $16-$17, let alone the December lows, when I last bought the stock, flattish EBITDA growth was enough to still suggest some upside. Quanex had some ability to take costs out of the business, and deleveraging (along with a pair of refinancings that lowered interest costs) offered potential benefits to earnings and equity value.
Those structural drivers largely have played out, however. Leverage should move from close to 3x EBITDA to a target of near 1.5x at year-end. Costs have been taken out. Raw material spikes that impacted fiscal 2018 margins have moderated both in Europe and the U.S., and price increases now have caught up to those higher input costs. Improvements from here have to come from day-to-day operations, but headwinds in NA Fenestration and NA Cabinet Components suggest those improvements will be difficult to grind out.
Meanwhile, NX stock trades at 8x the midpoint of EBITDA guidance, and in the range of 7.8x based on the projected year-end balance sheet. (Q4 free cash flow should be solid, as historically has been the case thanks to working capital help.) Normalized free cash flow at that midpoint is over $50 million, which suggests a potentially more attractive ~12x P/FCF multiple. (Net income multiples look high, as D&A in the range of $50 million annually is well above capex, which is guided to a normalized level around $25-$30 million.)
Neither multiple is particularly expensive, admittedly. Assuming the company does hit its leverage target, shareholder returns may again ramp in 2020 after the company doubled its dividend and added a buyback program following last year's third quarter.
But even with the huge gains in construction/housing stocks in 2019, ~8x EBITDA and ~12x P/FCF multiples are available elsewhere in the space. Relative valuations aside, both multiples seem to price in relatively flattish growth. That's what Quanex has delivered since acquiring Woodcraft:
source: author from Quanex press releases. 2019 figures based on company guidance
Again, going segment-by-segment, the mid-term outlook doesn't seem terribly different. Quanex probably needs a bounce back in the U.S. window industry. But on that front, JELD looks potentially more attractive (if higher-risk), particularly with Masco (MAS) selling its windows & doors business for what looks like almost 12x 2018 EBITDA.
It's not difficult to get the sense that NX is back to where it's been: a stock that's probably going to hover around current levels. Again, that's been the case for most of the 2010s:
Over that stretch, owning NX at the right price, and particularly amid a somewhat questionable December sell-off, was a good move. But a "right price" was generally in the $16-$17 range. That once again seems to be the case. And unless Quanex can find a way to unlock growth — which looks difficult — the range that has held for years seems likely to hold going forward as well.
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.