This year has seen a significant bifurcation within financial markets and companies. COVID has led to significant losses for capital and labor-intensive companies such as industrials, energy, and most small in-person businesses while it has led to significant gains for most technology and e-commerce firms.
One area of surprising outperformance is home development and improvement as seen in significant gains in homebuilders and home upgrade companies. This trend has been spurred by a decline in discretionary spending on travel, restaurants, etc. which has given many homeowners the savings to upgrade their homes. This has led to extreme gains for companies like the pool supplier Pool Corporation (POOL) and solar companies (TAN). Another company that has seen overall gains is the roof supplier Beacon Roofing Supply (BECN).
Importantly, demand for new roofs is high today from a long-term perspective. The 2020 spike has been far less extreme than it has for those looking for a backyard pool and solar, but strong all the same. This can be seen in Google Trends search volume for the terms “Roof Repair” and “New Roof”:
As you can see, seasonal-adjusted search levels for these terms are generally at a 10-year-high. This means that Beacon Roofing Supply is likely to see strong demand for its products over the coming year and potentially longer. Housing industry analysts have found that the U.S. features a large stock of older homes with roofs reaching the end of their lifespan. Combined with a relatively inexpensive lending market, the residential roofing industry is set for very strong long-term growth.
Value, Growth, and Turnaround Potential
In my opinion, the best stocks offer growth potential at a sufficiently cheap price. The best opportunities are in low “P/E” companies that are facing a secular improvement (long-term demand growth) and are making strides to improve profit margins. I believe Beacon Roofing fits the bill perfectly. The company trades at a lower forward “P/E” ratio of 12.6X, is expected to see long-term demand growth, and is showing signs of improving its profit margins.
Despite small gains this year, BECN is still trading at around half of its all-time high set in 2018. The company has actually grown its revenue by a significant level over the past two years, however rising operating expenses have led to a severe decline in the company’s profitability. See below:
Over the past few years, the company has made considerable acquisitions which have caused it to be the largest publicly traded roofing distributor in North America. However, this has come at the cost of burgeoning operating expenses due to executive compensation and other operating costs.
Fortunately, the company is well-aware of this issue and has made efforts to reduce inefficiencies. This year has seen a slight decline in the company’s headcount, a small decrease in operating expenses, and an improvement in worker productivity and gross margins. See below:
(Beacon Roofing – November Investor Presentation)
While these are not significant improvements, they have come despite very difficult operating circumstances due to direct impacts from COVID. As you can see below, there has been a considerable decline in sales in COVID restricted markets (i.e., California) and a small increase in sales in non-impacted markets:
(Beacon Roofing – November Investor Presentation)
The company has improved its margins despite operating difficulties. As COVID restrictions are lifted in 2021 and demand for new roofs continues to rise, Beacon may see its Opex/Revenue level finally trend lower which should bring strong earnings. Indeed, current analyst expectations estimate that Beacon’s annual EPS will climb to $4.22 by 2024:
(Seeking Alpha – Beacon Earnings Estimates)
It is also worth pointing out that Beacon has managed to beat its earnings expectations by a significant level over the past two quarters. If these estimates pan out, BECN’s long-term forward “P/E” level is only 8.6X, and one-year forward “P/E” 12.3X. This makes BECN far cheaper than most stocks today which usually trade at a forward “P/E” 20-30X with an arguably less stable economic outlook.
An Opportunity Not Without Risks
Overall, Beacon appears to be undervalued given a strong demand outlook for roofing, efforts to improve margins, and its low valuation. That said, we remain in a period of high economic uncertainty. Permanent unemployment continues to rise which may create a cyclical decline in demand for roof products. Demand has remained strong thus far, but it may decline temporarily in 2021 as the lasting economic impacts of COVID are fully realized.
As you can see below, the company is currently operating at a high leverage ratio due to recent acquisitions:
The company’s high leverage ratio has caused it to see a credit downgrade to B2 with a negative outlook earlier this year. Moody’s rating rationale highlights the decline in the company’s profit margins due to operating expense growth as well as its high financial debt. Moody’s also cited potential negative impacts from COVID.
Beacon’s credit risks are mitigated by the fact that it has no significant debt maturities until 2025 and its management team is making considerable efforts to reduce its net leverage ratio. Still, if roofing demand is not as strong as I expect in 2021 and/or the company fails to decrease operating expenses, it could run into more credit issues.
The Bottom Line
Overall, I believe Beacon Roofing is a solid long-term buying opportunity. It is trading at a very low valuation, particularly if strong earnings growth expectations pan out. Still, there is reason to be cautious in the short-run due to Beacon’s high debt level and potential year-end profit-taking activity.
I estimate the fair value of the company is around $50 which would give it a more reasonable forward “P/E” of 14-17X (depending on timeframe). I believe the stock will outperform the market over the long-run, but I will not personally buy until there is a correction, ideally at a price of around $30 per share.
Interested In More Alternative Insights?
If you’re looking for (much) more research, I run the Conviction Dossier here on Seeking Alpha. The marketplace service provides an array of in-depth portfolios as well as weekly commodity and economic research reports. Additionally, we provide actionable investment and trade ideas designed to give you an edge on the crowd.
As an added benefit, we’re allowing each new member one exclusive pick where they can have us provide in-depth research on any company or ETF they’d like. You can learn about what we can do for you here.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BECN over 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.