Beacon Roofing: Making The Most Of Boom Times, But The Next Phase Could Be Tougher

Credit where due – Beacon Roofing Supply (NASDAQ:BECN) management has made the most of the fortunate situation they’ve found themselves in over the past couple of years. Healthy building activity has combined with incredibly strong pricing power to drive revenue, while steady margin improvement efforts have helped to offset the company’s own cost inflation pressures. At a more bottom line level, not only has the company’s debt situation improved significantly, but the company has also been able to return cash to shareholders through accelerated buybacks.

What comes next is the tricky bit – it’s easy to climb onto the roof, but getting down can be more treacherous, and I do see some risk that expectations for 2023 are too high against a weakening macro backdrop. Likewise, management’s own internal margin improvement targets may be too ambitious in the context of a less supportive end-market environment. The valuation already anticipates a lot of this, but I’d be cautious about buying in at this point in the cycle.

Another Great Quarter, With Very Strong Pricing

Maybe the worst I can say about the third quarter is that Beacon didn’t beat by quite the same margins in the third quarter, because there really wasn’t much else to pick at in a strong quarter.

Revenue rose 29% year over year, beating by more than 3%, with Residential Roofing up 21% (a little ahead of expectations), Non-Residential Roofing up 54% (strong relative to expectations), and Complementary Products up 17% (a little light of expectations). Pricing drove the performance up 20% to 21%, but volume was up 7% to 8%, accelerating from flattish volumes in the second quarter.

Gross margin fell a point from the prior year and 150bp from the prior quarter to 26.1%, but EBITDA still rose 37% yoy and beat expectations by 14%, with margin up 70bp yoy and down 120bp qoq to 11.8%. Adjusted operating income rose 37%, with margin up 60bp yoy and down 130bp to 10.6%.

The Residential business continued to benefit from healthy pricing (up at least high-teens), and the low single-digit growth in shingles volume (a reasonable proxy for overall activity) was well ahead of the 6% industry decline. In the Non-Residential business, the company continues to benefit from exceptionally strong pricing (up around 40%), but mid-teens volume was impressive as well, and the company continues to work through a backlog.

Will Deceleration Become Contraction?

Roofing is a tough market to forecast, and by extension, the same is true of Beacon’s revenue. About 80% of the business is repair/remodel, so new-build trends have only limited predictive power. What’s more, while it’s common to group “repair” and “remodel” together, the reality is that roofing is far more dominated by repair – relative few homeowners decide to replace their roof before they must.

I do expect a decline in residential housing starts next year – a high-single-digit decline with a peak-to-trough move around 10% – but again, that has only limited predictive value for Beacon. Likewise, the remodeling boom during the pandemic that I believe will undermine the results of companies like Middleby (MIDD) for a while longer has little bearing on Beacon. So, management’s call for only “marginal” weakness in the residential business in 2023 isn’t necessarily inconsistent with my overall views on housing. Moreover, weather is a variable that could drive stronger demand.

What I said about residential is largely applicable to non-residential. The main difference is that roof replacements do tend to be more scheduled – building owners will of course respond to leaks or serious damage, but it’s not uncommon to replace roofs as part of periodic refurbishments meant to maintain a desired client base and rent levels. I do think there could be some weakness here for Beacon in 2023, as I expect weaker short-term discretionary non-residential activity, but Beacon will likely go into the year with business in the backlog, which will smooth over some of that weakness.

All in all, I do see a possibility that Beacon sees a modest contraction in 2023. The biggest downside variable for me at this point is not underlying activity (though a severe recession would certainly change my views), but rather pricing. Companies are talking bravely about maintaining pricing and that these new high levels are “permanent”, but I’m suspicious, and I could see weaker realized pricing emerging as a threat to Beacon’s reported revenue in 2023/2024.

Looking at fundamental volumes, I expect recoveries in housing and non-residential construction in 2024/2025. The U.S. is still fundamentally short of housing, particularly multifamily, and while I don’t think that is a problem that gets solved quickly, it should support healthy underlying activity over the next five years.

The Outlook

Self-help can still drive results for Beacon. The company has done a good job of leveraging stronger revenue and EBITDA into debt reduction, while also returning some capital to shareholders. Management continues to drive efficiency efforts, including increased digitalization (orders, etc.), improved logistics, and so on, and the company has continued a long-standing practice of continually looking at its bottom quintile branches for improvement opportunities.

Longer term, the company also still has opportunities to grow its private label business (up 37% in this quarter) and expand its offerings in the commercial space. I expect ongoing M&A to acquire new product categories (like the recent Coastal Construction deal for commercial waterproofing), but I don’t think Beacon is going to look for the $1B-plus deals of the past – not only are there not all that many targets left of that size, but those large deals proved more disruptive to the business than expected, and I think management has learned some lessons from those experiences.

I’m expecting long-term revenue growth in the range of 4% to 5%; I do see opportunities for the company to grow more quickly in the commercial space (roofing and complementary products), and I think more management attention will go in this direction. Over time, I expect Beacon to improve EBITDA margins, but I think next year and 2024 could be a little more challenging, and likewise over time I expect the company to generate free cash flow margins in the mid-single-digits, driving strong mid-to-high normalized FCF growth.

EBITDA-based valuation gets interesting. In the past, Beacon has traded at 10x to 11x forward EBITDA, but I think that’s a little demanding relative to the margins and returns (ROIC, et al.) I expect in 2024. Moreover, I do think current results could represent a short-term peak. Even so, a 7.5x multiple on my ’24 estimate gets me to a fair value of $77.

The Bottom Line

My biggest issue with Beacon is that I think conditions are about as good as they’re going to get for a little while and that as the outlook for construction (resi and non-resi) weakens, it won’t matter to the Street that Beacon doesn’t actually have much new-build exposure. Should that all shake out and the shares correct, this is definitely a name I’d revisit. As is, I have a lot of respect for how management has been improving this business, but I just can’t get comfortable with the macro/sentiment outlook even with a seemingly attractive valuation in place today.