Beacon Roofing Supply: Cheap At 11x Normalized FCF (NASDAQ:BECN)

Shares of Beacon Roofing Supply (NASDAQ:BECN) are down 17% from their 52-week high as investors are concerned about the sustainability of current results. While I agree that the business likely over-earned in 2022, I believe the company is capable of generating normalized free cash flow in the neighborhood of $5 per share (discussed below).

With 80% of revenue coming from repair and replacement demand, Beacon should hold up relatively well even if the housing market remains in the doldrums. Further, management initiatives could drive free cash flow per share to $8 per share looking out to 2025. While my base case fair value is $65-$75 (20-40% upside), should management achieve its targets, Beacon’s stock could double.

Positive Change Comes to Beacon

After disappointing execution following the 2018 acquisition of Allied Building Products for $2.6 billion, Beacon’s current CEO Julian Francis took over in late 2019. Francis wasted no time in bringing in a new team – as shown below, 3/4 of the top management team is new to Beacon.

Under new management, Beacon has undergone fairly significant operational change, including:

• Extraction of operating synergies from M&A. Beacon has been built through a series of acquisitions which have tripled the size of the business since 2010. Past management had been slow to realize the consolidation of back office functions, IT system consolidation, delivery route optimization, and pricing harmonization (discussed in next bullet point). New management’s more aggressive approach to synergy extraction has borne fruit.
• Better price-cost management – asphalt shingle costs experience volatility based on input costs, and Beacon must work tirelessly to align its product pricing with cost of goods sold. The implementation of improved pricing tools (CRM system) and salesforce incentives based on gross profit have enabled Beacon to capture more gross margin.
• Improvement in the performance of underperforming branches – Beacon had hundreds of branches producing sub-optimal performance. By benchmarking branch productivity, Beacon believes it can improve the EBITDA of the bottom quintile $75 million by 2025 (roughly halfway there in 2022).
• Digitization – the building products industry has been notorious for being slow to adopt digital tools to enhance productivity. Today, nearly 20% (up from single digits a few years ago) of Beacon’s orders come through its website/app, which lowers its cost to serve customers.
• Increased sales of higher margin private label ancillary product sales.
• Improved cross-selling of adjacent products such as waterproofing.

Record Results in 2022

The positive operational change coincided with a housing market boom (starting in 2H20) and lead to an explosion in Beacon’s profitability. Beacon expects 2022 revenue of ~$8 billion and EBITDA of $885-$910 million. As shown below, 2022 expected EBITDA is up over 100% from levels achieved in 2018-19.

The strong housing market has not only driven volumes higher but also tightened availability of roofing products (mainly asphalt shingles) and had a significant favorable impact on pricing. Gross margins have surged from the 23-25% historical range to 26-27% in 2021-22. A surging top line and higher gross margins coupled with fixed cost leverage have driven Beacon’s EBITDA margins north of 11% in 2022.

Outlook for Normalized Free Cash Flow and Valuation

Trading at less than 7.5x 2022 expected free cash flow per share, the market (and myself) views current results as unsustainable. The surge in the housing market coupled with a positive underlying change has made it difficult to disaggregate the impact of Beacon’s self-help initiatives from the positive tailwinds of the housing market.

While it is impossible to pinpoint how much of Beacon’s profitability improvement is sustainable, below I show my attempt to estimate normalized free cash flow.

To estimate revenue, I estimate volumes by assuming a 25-30% decline in volumes related to new housing construction. I further assume that remodeling volumes revert back to 83-84 million (from 91 million in 2021 as shown below) as remodeling likely benefited from a strong housing market and low interest rates in 2021 (roof replacement costs $10-$15,000 and many of these projects are financed using home equity loans). Relative to Beacon’s 2021 results, I adjust revenue upward by 15%, reflective of inflation and assume that Beacon maintains its current 20% market share. This gets me to $7.2 billion in revenue (down 10-11% from expected 2022 levels).

As for EBITDA, my $650 million estimate assumes a 9% margin. My 9% estimate falls between the 6-8% Beacon has achieved historically and management’s 11% target for 2025 (and actual results thus far in 2022). This recognizes the positive operational change at Beacon while also being cognizant that margins will likely decline from 2022 which is benefiting from the favorable conditions which were present in the housing market until recently.

After taking into account interest, taxes and capital expenditures, this gets me to free cash flow per share of just under $5. At $54.20, Beacon trades at ~11x my normalized free cash flow per share estimate.

I think a reasonable multiple for Beacon is somewhere in the neighborhood of 13-15x free cash flow, suggesting a fair value of $65-$75 (20-38% upside). 13-15x is reflective of the company’s strong market position (with 20% market share, Beacon is the second-largest distributor of roofing products behind competitor ABC Supply which has 24%), the company’s relatively stable revenue profile, and favorable outlook going forward (aging housing stock). 80% of Beacon’s revenue comes from replacement and repair demand. This is in contrast to other building supply companies like Builders FirstSource (BLDR) and TopBuild (BLD) which derive the vast majority of their revenue from new home construction.

As shown above, management targets $9 billion in revenue and $1 billion in EBITDA in 2025 (11% margin). While I consider these targets ambitious given a darkening macro backdrop. Should the company achieve these targets, this would result in over $8 per share in free cash flow which would suggest a share price of $105-$125 using a 13-15x multiple.

Insider Buying

As shown below, insiders seem to agree that Beacon is undervalued. Both management and largest shareholder Clayton, Dubilier & Rice have been acquiring shares at prices slightly higher than where Beacon is currently trading.

Conclusion

While it is likely that Beacon’s 2023 earnings will come in below 2022’s record results, as shown above, I think the company is capable of generating normalized free cash flow of $5 per share. Should management achieve its targets, shares could double. I see this as an asymmetric investment opportunity and have purchased shares.