NEW YORK (TheStreet) -- Entirely too often, equity-focused traders, investors, analysts and pundits pay little attention to how companies fund their operations. In a world of cheap debt, this can mean that stocks are far overvalued or undervalued, depending on their capital structures.
This creates distortions in equity pricing and valuation, but more importantly, this lack of respect for credit fundamentals by some creates opportunity. Companies without debt, all else being equal, should be undervalued relative to their theoretical value with a more optimal capital structure (e.g., a lower cost of capital). The stock of companies with a lot of debt can be overvalued, especially in the current environment of historically low interest rates. This can also be true for many companies and industries with unsustainably high operating profit margins.
This isn't just theory though; we see the capitalization-related under/overvaluation in the market virtually every day. Activist and private-equity investors love companies with strong balance sheets and cash flow so they can lever them for buybacks, dividends and leveraged buyouts. On the other hand, short-sellers look for highly-leveraged companies whose cash and profits can be wiped out with even a short period of poor performance.
When the equity market doesn't pay attention to these basics, don't be surprised to find even more distortion and opportunity, that is, when you dig a little deeper.
Doing a proper analysis can be time-consuming and complicated; even some Wall Street analysts only do it half way. However, anyone capable of a little arithmetic can do enough work in a short period to understand how a company's debt can affect the stock. (Especially since you can find most of the information easily on the Web for free.)
A 'Sure Thing'
Would you want to own the stock of a leader that supplies an industry -- home construction -- that is set for years of double-digit growth? An industry with oodles of government support, that's a critical part, if not the foundation, of the American dream that is home ownership?
How could this not be a sure thing?
Residential housing starts are still way below the 40-year median. The last time they were this low before the financial crisis was in early 1982. Back then, a 30-year fixed rate mortgage was around 15%, vs. 2014 rates in the low 4% range, and unemployment was 10%, vs. around 5% now.
Similarly, new units under construction are about 40% below the median since 1975. We may have built a lot of houses in the bubble years of the mid 2000s, but the correction following the bursting of the housing bubble seems to have overshot to the downside. New units dropped 74% from peak (2005) to trough (2011), and despite being up 42% since the bottom in 2011, there's a lot of room just to get back to average. Economic and demographic data suggest we're in the very early stages of another housing boom, this time driven largely by actual demand rather than speculation fueled by loose credit.
If the housing resurgence is inevitable and margins are high, you'd be dumb not to own this company's stock; it's basically a "sure thing," right?
Obvious Trades: Beware What Lurks Beneath
If we look at this so-called sure thing another way and start to dig a little below the surface, the obvious looks not so obvious. Although residential housing construction may surge over the next few years, we can't just buy this stock and ride the wave; there's a few other things about this company we have to consider, for example:
- Significant (nonenergy) commodity exposure
- Operates in an industry heavily reliant upon various forms of government subsidies (notice how a positive can also be a negative?)
- Recently completed a large merger likely to distract management from running the core business
- Paid high price for acquiring much larger competitor
- Has grown largely by a roll-up strategy (acquiring smaller, similar companies) rather than by organic growth
- Likely to recognize some asset writedowns/impairments or other charges as result of serial acquisitions
- Controlled by private equity owners (almost 50%)
- Has little if any pricing power
- Faces demand inversely related to interest rates
- Highly leveraged
The first few issues should be reason enough to be skeptical about investing in this company. But leverage is also important to address because it tends to get ignored or minimized by equity investors, who focus on the equity. Although this seems obvious, the problem is that you can't value a company's equity without first understanding its credit situation. Remember, as an equity holder, your claim on the company's cash flows and assets is last in line. If there's too much debt, your stake gets impaired, if not wiped out entirely.
Credit 101 for Equity Investors
Short of doing a complete discounted-cash-flow analysis, a company can be valued as a multiple of its earnings before interest, taxes, depreciation and amortization, or EBITDA. This is a common practice when valuing leveraged companies. But this raises the question of whether you use simple EBITDA, adjusted EBITDA (and adjusted for what?) or some other fantasy version where the company adds back every item it can think of to juice a number -- appropriate or not. In the case of Builders FirstSource, the difference between the last-three-months (LTM) simple EBITDA and the fantasy, adjusted EBITDA is almost 80%, so this is not a trivial matter.
This is what happens when a midsized leveraged company takes on even more leverage to buy a larger, already highly leveraged competitor. Builders FirstSource's simple leverage ratio is almost twice as high as the S&P/LSTA average issuers', while the "middle-ground" adjusted EBITDA ratio is still much higher than average for a leveraged company. Of course, if we use the "fantasy" adjusted EBITDA, it looks like there's no reason to worry about Builders FirstSource's debt load any more than we would that of any other company. Use whichever EBITDA value you want, but I strongly suggest erring on the side of caution.
Debt levels in and of themselves are important, but for a company without any near-term debt maturities in a cyclical industry like homebuilding, debt service coverage is more of an immediate concern:
Even using management's "fantasy" EBITDA figure, Builders FirstSource has much lower interest coverage than similar leveraged companies.
If and when interest rates (finally) rise, if commodity prices drop some more, if demand doesn't pick up as expected, if housing numbers come in short, if management isn't able to recognize merger synergies or keep expenses from rising... If even one or two of these things come to fruition and operating profit comes in below expectations, the company's huge interest payments are going to magnify the impact.
The picture looks even less bright when we consider the company has not just cash inflows but outflows as well, such as capital expenditures to cover property/equipment maintenance and expansion.
The company doesn't have a ton of leeway to absorb lower-than-expected cash flow to make interest payments, which means the company would have to dip into its cash to avoid default. Whether you consider this an issue or not depends on how you think the company does the next few years. Here are some base-case projections:
If the company achieves moderate growth with unspectacular but stable margins and capital expenditures, all else beiing equal, it'll be burning some of its $127 million cash every year just to keep chugging along. At this rate, again all else being equal, Builders FirstSource burns through all its cash by the end of 2017. You'd hope that management would slash its expenditures, but cutting staff, closing locations and shelving maintenance/expansion plans don't happen overnight and usually result in additional costs to boot.
Default in 15 months can be scary. This is one of those situations where taking the time to read the company's Securities and Exchange Commission filings, particularly the MD&A section of the 10-q's and k's, can make or break an investment or opportunity. Builders FirstSource has another $430 million available under its ABL facility (pg 48) and $300 million on its First Lien facility (pg 36) to raise cash, but both have restrictive covenants limiting the amount actually available subject to both leverage and coverage ratios. This is pretty standard in the bank loan market, but to put it into perspective, it's kind of like if your credit card company verified your income and spending every few months and adjusted your limit accordingly; when your need to borrow is highest, your ability to do so gets curtailed. Fun, right?
The base-case projection assumes 6.5% compound average topline growth and flat margins, so if you think the company can do better than that, you're looking at a longer runway that 2017. For example, in the following bullish case:
With higher growth and higher, expanding margins Builders FirstSource cash burn is short-lived, peaking in 2016 before going cashflow positive in 2017. Here are some bear-case projections:
Slight variations in revenues and margins turn into much larger swings in profitability, as is evident just comparing these three projection cases.
Leverage giveth, and leverage taketh.
Valuation - Bringing It All Together
Builders FirstSource is trading at around 15.7x simple LTM EBITDA (ex leases), or a much more reasonable (but not exactly cheap) 8.8x "fantasy" adjusted EBITDA. If we accept the middle ground, "adjusted" EBITDA, as kosher, the company is trading at 12.6x. Using my base-case projections, Builders FirstSource is trading at 16.4x this year's EBITDA estimate and 12x 2020 EBITDA. As a point of reference, the average purchase price multiple of LBO transactions is in the high 9-10 multiple range over the past decade, which typically includes a 20%-plus purchase price premium. Looks like this company, the enterprise value at least, is on the rich side.
What about the equity?
The value of the company is debt plus equity minus cash, so backing out debt from the company's value provides the value of the equity. Of course, the value of the firm depends on profitability (EBITDA) and how much you're willing to pay for that profit (EBITDA multiple):
You can see for yourself what Builders FirstSource stock is worth at various levels of profitability and valuations. The bordered cells in each table capture 2015 EBITDA expectations and the valuation range just above, and slightly below current levels.
Put another way: If EBITDA comes in at $250 million, the stock likely sheds some growth expectations and trades at a lower multiple. You lose 60%. If it comes in at $350 million, the multiple may expand slightly, and you can make 50%.
These aren't probability-weighted values or returns (that's up to you to figure out), but if 20% more downside than upside sounds like a good trade to you, you really shouldn't be trading at all.
As always: caveat emptor.
This article is commentary by an independent contributor.
Neither Stone Street Advisors LLC nor any of its members or clients has or has had any position in BLDR. The opinions here are solely those of Stone Street Advisors LLC and do not represent any recommendation or offer to buy or sell securities. Stone Street Advisors LLC makes no representation or warranties as to the accuracy of the information contained herein. Stone Street Advisors LLC disclaims any and all liability arising from errors or omissions contained in this presentation, which is to be used for informational purposes only and does not constitute investment advice. Stone Street Advisors LLC is not an Investment Advisor.