Core & Main: Accelerating Earnings And Attractive Valuation, But Don't Get Overly Excited
Summary
- Core & Main announced very strong 2021 fourth-quarter and full-year results, and its valuation appears attractive.
- The high PVC commodity prices, supply chain issues, and product shortages that drove strong earnings may be moderating, creating risk of a short-term pullback that is difficult to model.
- My original thesis for investing in Core & Main continues to hold, and the long-term outlook continues to be attractive.
- I would refrain from aggressively adding to my position until commodity prices stabilize, and the company's normalized earnings power becomes clearer.
Vladimir Zapletin/iStock via Getty Images
My original thesis
The investment thesis for Core & Main (NYSE:CNM) continues to hold up (figure 1). Instead of re-hashing the thesis in this article, I encourage you to refer to my original article posted on November 6, 2021 and first follow-up article posted on December 22, 2021.
Figure 1: Summary of original Core & Main investment thesis
Thesis | Update | |
1 | Investing alongside CD&R-one of the leading private equity firms with a proven track record in building material and distribution businesses | No change |
2 | A. The demand for infrastructure waterworks piping and equipment has increased, will be further boosted by the US Infrastructure and Jobs Creation Act B. Demand for fire sprinklers will continue to increase due to strong commercial construction spending | Positive ↗️ Positive ↗️ |
3 | The duopolistic structure gives rise to industry pricing discipline | No change |
4 | Industry consolidation is continuing as expected | Positive ↗️ |
5 | The industry is recession resilient | No change |
6 | The stock is under-covered by the investment community | No change |
Solid 4Q growth and full year 2021 results
On March 30, 2022, Core & Main announced solid revenue and earnings growth.
For the fourth quarter 2021
- Net sales increased 50% to $1,246 million (figures 2 and 3)
- Gross profit margin increased 170 basis points to 26.2%
- Net income increased to $79 million from zero in the prior year
- EBITDA increased 103% (figures 4 and 5)
- Adjusted EBITDA (non-GAAP) increased 113% to $151 million
- Adjusted EBITDA margin (non-GAAP) increased 360 basis points to 12.1%
Figure 2: Core & Main quarterly revenues
Created by author using publicly available financial data
Figure 3: Core & Main quarterly revenue year-over-year change
Created by author using publicly available financial data
Figure 4: Core & Main quarterly (non-adjusted) EBITDA
Created by author using publicly available financial data
Figure 5: Core & Main quarterly (non-adjusted) EBITDA year-over-year change
Created by author using publicly available financial data
For the full year 2021
- TTM (trailing twelve month) net sales increased 37% to $5,004 million
- Gross profit margin increased 150 basis points to 25.6%
- Net income increased $188 million to $225 million
- Adjusted EBITDA (non-GAAP) increased 77% to $604 million
- Adjusted EBITDA margin (non-GAAP) increased 270 basis points to 12.1%
Core & Main's main competitor, Ferguson Plc (WOSCF) reported similarly strong TTM revenue and EBITDA growth (figures 6 and 7)
Figure 6: TTM Revenue for Core & Main vs. competitor Ferguson Plc
Seeking Alpha charting
Figure 7: (Non-adjusted) 3-year EBITDA growth for Core & Main vs. Ferguson Plc
Seeking Alpha charting
The results are impressive by any measure. However, the company's volume growth was only in the mid-single digits and its revenue growth was largely driven by price inflation. Furthermore, the strong earnings growth was a result of smart buying in an environment of raw material pricing inflation and is not replicable in a stable or deflationary pricing environment.
4Q 2020-4Q2021 change | Full year 2020-2021 change | |
Revenue | +50% | +37% |
% of Rev growth from price inflation | Two-thirds (up from half for 3Q2020-3Q2021) | |
Gross margin | up 170bps to 26.2% | up 150bps to 25.6% |
Adjusted EBITDA | +113% | +77% |
Adjusted EBITDA margin | up 360bps to 12.1% | up 270bps to 12.1% |
Attractive valuation
Over the last 6 months, Core & Main stock has declined by 7.7%, while the S&P 500 has appreciated about 6% (figure 8).
Figure 8: Core & Main stock compared to the S&P 500
Seeking Alpha charting
According to Seeking Alpha charting, Core & Main's Enterprise to EBITDA multiple has ticked down to about 11x (figure 9).
Figure 9: Core & Main EV to EBITDA multiple
Seeking Alpha charting
Note: My EV/EBITDA calculation based on the company's 10-K filed with the SEC on 3/30/2022 is (equity+debt)/EBITDA = ($24.2/shr x 244.4 shrs + $1471 debt)/ $575 = 12.9x, which is higher than Seeking Alpha's but still attractive.
The price to earnings ratio remains somewhat elevated at over 44x (figure 10) due to the high interest expense on the significant amount of debt on the balance sheet but should normalize as earnings grow and the company continues to pay down debt.
Figure 10: Core & Main price to earnings multiple
Seeking Alpha charting
To summarize: the company grew fourth quarter revenues by 50% and EBITDA by over 100% year over year, and annual revenues and EBITDA by 37% and 77% respectively. Furthermore, the stock is trading at an attractive 11x EBITDA multiple.
However, before we get overly excited at the opportunity, let's dig a level deeper...
Short term revenue and earnings growth reversal is highly likely
"What goes up must come down." - Sir Isaac Newton
Revenue growth largely driven by price inflation
A company's revenue growth is the result of volume growth and price inflation/deflation. In the two most recent earnings calls, Core & Main CEO Steve LeClair noted that half of the company's 39% 3Q 2021 year-over-year revenue growth was driven by price inflation, and about two-thirds of the 50% 4Q 2021 year-over-year revenue growth was driven by price inflation; Core & Main's main competitor Ferguson similarly communicated in its earnings call for Q1 2022 (which ended November 2021) that half of that quarter's revenue growth was driven by price inflation, and that price inflation had risen from the low teens in Q1 2022 into the high teens for Q2 2022.
When pricing regresses to the mean, the strong revenue growth will almost certainly slow down or even decline.
EBITDA growth driven by price inflation and favorable timing of PVC pipe purchases
According to Steve LeClair, a key driver of the strong gross margin expansion was the company's ability to leverage its long-standing relationships with suppliers to access and purchase PVC pipe inventory ahead of cost increases, which it resells to customers at higher prices. However, when PVC pipe costs stabilize, gross margins will contract as the company loses the ability to capture the large spread. Worse, when the cost of PVC peaks and regresses towards its historical mean, the company could be forced take a loss by selling inventory purchased at higher prices to customers at lower prevailing market prices.
Management noted in the 4Q 2021 earnings call that "we continue to experience price increases across many other product lines that could offset any potential future deflationary pressure from our commodity-based products like PVC pipe". However, as commoditized PVC (together with ductile and steel pipe) makes up 32% of overall sales, it is unclear how far the continued price inflation from other product lines can offset falling PVC prices.
PVC price inflation may continue but will eventually moderate
The price of resin has increased by 35% since 2018 but pulled back from its peak reached in the 3rd quarter of 2021 (figure 11). However, plastic water pipe manufacturing costs have continued to rise (figure 12), suggesting that manufacturing capacity constraints are driving the continued increase in plastic water pipe costs (figure 13).
Figure 11: Producer price index for the plastics materials and resins manufacturing industry
Federal Reserve of St. Louis (FRED)
Figure 12: Producer price index for the plastics water pipe manufacturing industry
Federal Reserve of St. Louis (FRED)
Figure 13: Producer price index by commodity: plastic water pipe
Federal Reserve of St. Louis (FRED)
The receding congestion at US ports could lower price of imported products
The large backup of ships waiting to unload at the Southern California ports, which are responsible for 40% of all shipped containers to the US, is showing signs of easing. According to Marine Exchange, the number of container ships queuing to enter the ports of Los Angeles and Long Beach declined to 78 vessels in February, down from a record 163 in November and 123 ships in early December. The improved throughput at the ports alleviates the supply chain crisis, enabling more timely delivery of valves, pumps, meters, and pipe restraints, which should bring some relief to the high prices resulting from product shortages.
Management's observations and guidance
Demand will remain strong
Management asserted that it has not seen any slowdown in demand due to inflation or rising interest rates. Demand and bidding activity remains strong due to continued strength in residential construction resulting from populations shifts and undersupply of new homes, acceleration of volume growth in the non-residential construction market as the COVID-19 pandemic recedes, and strong municipal demand for the repair and replacement of aging infrastructure. The company also expects a further boost from the US Infrastructure and Jobs Creation Act, which will provide multiyear tailwinds for the municipal water sector beginning as early as 2023.
Acquisitions will continue to be key
Management noted that it has closed 17 acquisitions with a combined $650 million in annualized sales since it was carved out of Home Depot in 2017, highlighted its recent acquisition of Dodson Engineered Products, which allows it to expand its reach into Central / Western Colorado and enter the storm drainage, agricultural and irrigation product lines, and reiterated its strong pipeline of high-quality targets, which is a key component of my thesis.
Margins could weaken
In the 4Q 2021 earnings call on March 30, management stated that "we do not expect to repeat the significant price realization benefits [to gross margins] we achieved in 2021 during the rapid rise of inflation", which "contributed 50 to 100 basis points of onetime benefits."
Management expects first quarter gross margins to be weaker compared to fiscal 2021 fourth quarter due to "the resetting of growth-based supplier incentives" and "inventory cost catching up with market prices" - both strong indications that suppliers are asserting their pricing negotiation power and may give the company less advanced notice of price increases in the near future.
Furthermore, in response to questions from sell-side analysts, management conceded that costs could catch up with price (i.e., gross margin spreads could narrow) in the Q2 or Q3 timeframe if inventory prices start to stabilize, and that a price decline in the second half of 2022 is a "very real possibility."
Growth "Guesstimates" And Prospective Valuation
Long term investors should focus on volume growth
Even though the company has benefited from commodity price inflation over the last year, it is inevitable that commodity prices will regress to the mean. As such, long term investors should focus more on volume growth than price inflation as a driver of long term revenue growth.
To build my "guesstimates", I anchored my projections off financial results for the year-ended January 2021 - the period before commodity price inflation took off (figure 13, column H). For the period 2022-2024, I assumed the following:
- Organic revenues grow by 6%, 7%, and 8% (row 6)
- Gross margins increase by 30 basis points each year (row 8)
- Selling, General, and Administrative Expenses as a percentage of revenues decreases by 30 basis points each year (row 10)
- Revenues from acquisitions of $200 million, $225 million, and $250 million (I believe this is not unreasonable as acquired revenues for 2020 totaled about $145 million)
- Post-integration synergy acquisition EBITDA margin of 10%
- Acquisition purchase multiple of 12x post-synergy EBITDA
- EBITDA to free cash flow conversion of 60%
Figure 14: Financial guesstimates for 2022-2024, assuming normalized commodity prices
***VERY IMPORTANT NOTE: These numbers are "guesstimates" that I put together only for illustrative purposes, so please do not rely on them for your investment decisions***
Created by author for illustrative purposes only
Using the $24.2 closing stock price of March 30, 2022, and applying the above assumptions, my EBITDA guesstimate for the year ended January 2022 is $376 million based on "normalized" PVC commodity prices, which values the company at an EV/EBITDA multiple of 20.7x.
My guesstimate of a "normalized" EBITDA of $539 million for 2024 values the company at a reasonably conservative EV/EBITDA multiple of 14.4x.
Concerns
Commodity price inflation moderates, or the company is no longer able to acquire inventory ahead of price increases
- (these are my biggest concerns, and were discussed at some length above)
Slowdown in construction activity
- Management asserted that residential construction remains strong (figure 15), and that commercial construction activity is picking up. However, with mortgage rates at the highest since December 2018 (figure 16) and interest rates headed up (figure 17), housing affordability and real estate development is likely to decline, potentially leading to less construction in the near to intermediate future.
Figure 15: Private housing construction starts
Federal Reserve of St. Louis (FRED)
Figure 16: 30-year fixed rate mortgage average
Federal Reserve of St. Louis (FRED)
Figure 17: 10-year treasury yields
Federal Reserve of St. Louis (FRED)
Summary
- Core & Main announced very strong 2022 fourth quarter and full year results, and its valuation appears attractive.
- The high PVC commodity prices, supply chain issues, and product shortages that drove strong earnings growth for the company may be moderating, which creates the risk of a near term speed bump that is difficult to model out.
- My original thesis for investing in Core & Main continues to hold, and the long-term outlook continues to be attractive.
- I would refrain from aggressively adding to my position until commodity prices stabilize, and the company's normalized earnings power becomes clearer.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of CNM either through stock ownership, options, or other derivatives. 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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