AGB 2021.20 - TopBuild (BLD)
AGB 2021.20 - TopBuild (BLD)
Improving Position in a Highly Cyclical Industry
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TopBuild
TopBuild is the leading installer and distributor of insulation products and other building materials for new residential and commercial construction in the U.S. The company operates two divisions. TruTeam is the installation division with over 200 branches (72% of revenues) and Service Partners is the distribution division with over 75 warehouses (28% of revenues). The company services over 40% (30% from installation, 10% from distribution) and geographically covers 95% of all housing starts in the U.S.
TopBuild was owned by Masco until the company was spun out in June 2015. Masco acquired TruTeam in 1995 and later added on Service Partners in 2001. From then to 2005, Masco acquired 150+ insulation businesses and heavily invested in growing the combined businesses until the great recession. With housing starts slowing down from 2006-2008 and then staying lower than expected from 2008-2011, Masco rightsized the cost structure of the business and removed many redundancies. TopBuild’s breakeven from a cost perspective was lowered from 1.2M housing starts to just under 750k.
TopBuild continued to rightsize its cost structure after the spin out to reach breakeven at 700k housing starts. The management team improved the work culture of the firm and put in best practices to build a more efficient operation. For example, the hiring process for new installers has become more systematic and can now be completed in one day vs. 5 days under Masco.
The insulation market is somewhat concentrated on the supplier side, with the top 4 manufacturers in Knauf, CertainTeed, Johns Manville, and Owens Corning representing almost half of the fiberglass insulation supply. TruTeam has said that the company remains supplier agnostic.
On the installation side, it’s dominated by TruTeam and Installed Building Products (IBP), combining to represent 2/3 of the market. Below the top 2 players it’s a very fragmented market, mostly comprised of small family-owned businesses that service a region with a few key local relationships.
And on the customer side, there is a higher level of fragmentation than the installation side. Aside from the few national and regional home builders, there are over 50k+ home builders and general contractors in the U.S.
Residential construction is the largest market for TopBuild. On the installation side, residential customers represent almost 80% of TruTeam’s revenues. These customers typically turn to TruTeam for installation because the company has the expertise to finish jobs quicker and more cost effectively than if the customers were to do it themselves. Customers rely on TruTeam to both source the products and manage the labor that’s required for installation. Furthermore, the company can navigate the building codes which tend to differ by region. Insulation represents only 2% of the total cost to build a home so time of completion is much more important than cost. TruTeam is either the #1 or #2 player in most of the markets the company services.
Commercial construction represents 20% installation revenues, and it’s split evenly between light and heavy commercial. Light commercial jobs are insulation projects for new restaurants, banks, small hotels, etc. The expertise needed to service these builds are similar to that of residential and TruTeam operates the light commercial business out of the same branches as residential installation. Light commercial deals typically range from $2k to $50k per deal.
Heavy commercial construction requires more specialized work and TruTeam has a small group of ~20 branches that are solely dedicated to working on heavy commercial projects. Examples of heavy commercial jobs are high-rises, stadiums, universities and hospitals. Installation is more specialized and requires additional capabilities such as fireproofing, firestopping, creating air barriers, etc. Heavy commercial builds tend to have much longer time horizons and the company has visibility into projects 2 to 3 years out for many of these projects.
Deal sizes can average above $200k and precision in the bidding process is important for the company to maintain higher margins in commercial (200-300bps) vs. residential. TruTeam has a group within the company called Commercial Hub that handles all the estimates, bidding and project management for each of the company’s heavy commercial deals. Heavy commercial builders typically hire TruTeam because they can deal with one subcontractor instead of many.
Service Partners represents 28% of revenues of which 75% is residential and 25% commercial. Customers of Service Partners are mainly small, local contractors that need help in managing their working capital. These installers aren’t large enough to purchase fiberglass insulation by the truck load directly from the manufacturers so they rely on Service Partners to buy inventory only when they need it. These customers effectively use Service Partners as a warehouse and a bank (Service Partners does provide financing to smaller contractors) to run their business. Service Partners also provides training when new technology related to insulation becomes in demand (like spray foam insulation) and marketing support through the company’s Contractor’s Club program.
Macro drivers for the company are new residential construction, commercial construction and heavy repair/remodel activity by homeowners. Housing starts are obviously the most important indicator of future growth for the company. Every incremental 50k in starts equates to $90M in residential revenue growth for the company (on average). This number has moved higher as TopBuild has grown organically and through acquisitions. At the time of the spin out from Masco, that number was $50M, moved up to $75M in 2017/2018, and $80M after the USI acquisition.
TopBuild has 3 year targets of 7.5%-10% same branch growth in Commercial, $90M/50k starts in residential revenue growth (as mentioned above) and incremental EBITDA margins between 22%-27%. This is all under the assumption that housing starts remain above 1.425M-1.475M, which has been the case for 2021 so far.
Why is it a good business?
While it’s understood that the residential and commercial construction markets are cyclical, insulation is a good business because of the market dynamics. As one of the two large competitors in insulation, TopBuild benefits from scale advantages. The first benefit is purchasing power vs. the fiberglass suppliers. TopBuild is 60% larger than the next largest insulation company, IBP, in terms of revenues and almost 2x the size in terms of volume purchased from suppliers. Through the company’s unique position of being the largest installer and distributor, sourcing product has been the most efficient at TopBuild. With its scale, the company also has the ability to flex its labor force when certain regions have more installation demand than others. TruTeam can relocate its 7,100+ installers regionally to support customers with high demand when necessary.
As the largest insulation distributor, Service Partners has relationships with many smaller installers, which can lead to acquisition opportunities. TopBuild has data on the purchasing patterns (which would relate to how much work these installers are doing in a particular region) to make better informed M&A deals. Furthermore, because TopBuild does both installation and distribution, the company can make large acquisitions like USI, which also provided both installation and distribution services.
The third scale benefit is the company’s ability to grow in the commercial insulation market and in particular the heavy commercial market. Commercial represented 22% of revenues in FY20, half of which is in heavy commercial. Commercial has outgrown the remainder of the business in recent years since it accounted for 16% of revenues in FY15. Heavy commercial projects have long completion cycles, which allows better visibility, from which the company can create a backlog of 2-3 years. TopBuild commands 11%-12% market share in commercial and is the #1 player in this market.
There are also tailwinds that benefit the insulation industry. First is the move towards more stringent energy codes for new construction both in residential and commercial markets in the U.S. Effective insulation is an important factor in keeping the interior of houses and buildings cooler in the summer and warmer in the winter. Since the early ‘80s, codes have required energy usage to go down more than 50% in commercial and almost 50% in residential. That trend is being led by the coastal and southern states.
The second tailwind is increasing housing starts that have just recently reached the historical average since the statistic bottomed in 2009-2011. The 50 year average for housing starts has been 1.4M-1.5M in the U.S. Starts peaked at 2.2M before the housing crisis and bottomed near 550k shortly after. It’s estimated that the U.S. is still short 4M homes of buyer demand and given that 200k-300k units are destroyed per year, there’s still a ways to go to meet housing demand.
Unique to TopBuild, having installation and distribution together helps lower the volatility of the fundamentals of the overall business. During markets when housing starts are rapidly increasing, the growth of the distribution business lags behind the growth of the overall business. This is especially true on the margin side because most of the costs are variable for the distribution business. However, during markets when housing starts are in decline, Service Partners will outperform the installation business due many builders and general contractors downsizing their operations. Many of these businesses get small enough where it’s not economical to buy directly from the manufacturer because minimum order sizes can’t be met and thus turn to distributors like Service Partners.
Returns on incremental capital?
Since the spinout from Masco in 2015, TopBuild has spent 1/3 of its capital on capex and the remaining 2/3 on acquisitions. Capex is mainly related to new branch and warehouses builds and new fleet purchases. The company had rented its trucks in the past, but starting in 2018 TopBuild started to buy their trucks instead, which resulted in an increase in capex as a percentage of revenues.
M&A is the company’s first priority for capital allocation. Given its unique position in the industry as being the largest installer and distributor, TopBuild is looking to acquire many of its smaller competitors. For bolt-on installation acquisitions, the company aims to pay 4.5x-6x trailing EBITDA before synergies. TopBuild can achieve another point in EBITDA savings from taking out cost redundancies and improving purchasing once the acquisition is part of the TopBuild platform.
The company has been more acquisitive in recent years after the spin. TopBuild acquired $70M in revenue in 2017 for $89M (or 1.3x), $415M in revenue in 2018 for $515M (or 1.2x) and $31M in revenue in 2020 for $93M (or 2.9x). The company only made one small acquisition in 2019 as it was digesting the acquisitions from 2018. So far in 2021 TopBuild has been very acquisitive spending $1.2B in acquisitions, most of which was for Distribution International.
USI and Distribution International are TopBuild’s two large deals of the past 5 years. USI was acquired for $487M in 2018. The company was able to expand its reach in certain key geographies (resulting in coverage of 99 of top 100 MSAs) and strengthen relationships with both large and smaller customers. USI had the largest presence in the pacific northwest and mountain regions and was a leader in spray foam insulation. TopBuild was essentially buying the #3 national player in insulation and the company was likely the only natural buyer having both installation and distribution divisions. The multiple paid was 10.2x trailing EBITDA and TopBuild was able to bring that down to 7.7x after synergies of $15M created from back office efficiencies, branch consolidations and from an improved supply chain. If we assume EBITDA is a decent (enough) proxy to cash flow, this implies a 13% return on capital.
In September of 2021, TopBuild announced the acquisition of Distribution International for $1B in cash, which is expected to close by the end of this year. The deal gives TopBuild an entry into mechanical insulation used in industrial and commercial markets, which has a $5B addressable market. The company also gets an MRO business, 100+ branches and 13k new customers. TopBuild paid 12.9x trailing EBITDA and the company is expecting that multiple to come down to 8.6x after $35M-$40M in synergies. This deal implies a 11.6% return on capital. As we can see, the larger deals tend to make up most of the use of capital and the multiples paid are much higher than the 4.5x-6x EBITDA for bolt-on acquisitions.
We estimate that TopBuild has generated returns on incremental capital between 30%-60% since becoming a standalone public company. There may have been onetime operational efficiencies that the company was able to achieve early in its life as a public company and so a more reasonable return profile would likely be 20%-30% moving forward as long as the U.S. economy is still undergoing a housing recovery.
Reinvestment potential?
The market for residential and commercial insulation is ~$11B, with the breakdown being $5B residential, $3B light commercial and $3B heavy commercial. The residential market can have the most volatility near-term as housing starts can fluctuate year to year. Commercial while also cyclical, tends to lag residential demand and has much longer completion cycles.
On the installation side, TopBuild + IBP together command over 2/3 of the residential market, which implies that 1/3 of the market is still available for acquisitions. Not all installers will be a good fit for TopBuild, but the company has relationships with many of these companies through its Service Partners division. And because TopBuild has the distribution division, there are more acquisitions available to them vs. IBP.
On the commercial side, there is ample opportunity to gain market share (currently only 11%-12% share) and perform more complex and specialized solutions specific to these customers’ needs. The company leads in heavy commercial and with the help of Commercial Hub can continue to grow heavy commercial at a faster rate than the rest of the company. TopBuild’s acquisition of Distribution International also presents an opportunity to grow in the $5B industrial insulation market.
TopBuild is working towards growing its product lines beyond insulation for residential and light commercial customers. The company provides glass installation to many of its customers in conjunction with the insulation work. Similar to insulation, the glass installation business is highly fragmented and there are meaningful opportunities to gain sourcing advantages with scale. Installation of products that are not insulation such as gutters, fireplaces, garage doors and glass make up almost 20% of TopBuild’s installation revenues.
IBP has focused more on these ancillary product categories than TopBuild in recent years with over 35% of IBP’s revenues coming from these categories. In fact, IBP has a strategy to land customers in a developing region with their insulation service and then expand into other ancillary products. In IBP’s established markets, these ancillary products make up 45% of revenues but in developing markets it’s below 10%. TopBuild has an opportunity to focus more operationally on these areas if the company made it a priority.
With a reinvestment rate between 30%-80% and a return on incremental capital between 30%-60%, we estimate that TopBuild has increased its intrinsic value between 18%-26% over the past 3 years. The reinvestment rate tends to be lumpy, depending on the timing of large acquisitions. With the largest acquisition in the company’s history of Distribution International, the reinvestment rate should remain elevated for FY21 and FY22.
What else is important?
TopBuild vs. IBP
The key differences between TopBuild and IBP is that TopBuild has the distribution division and has more exposure to commercial construction, especially in heavy commercial. In an environment where residential construction outpaces all others in the U.S., IBP should outperform. This is because in an increasing housing start environment, Service Partners revenues should lag vs. TruTeam. Furthermore, there is much less margin expansion in the distribution business with revenue growth as more of the cost structure is variable.
However, in a more uncertain or volatile housing environment, TopBuild should perform better due to the opposite effect of what was mentioned above as well as the fact that many smaller insulation installers will trade down their purchase orders. These installers will shift their purchase of insulation from the manufacturer to a distributor like Service Partners. This effect will dampen the fundamentals for TopBuild like it did in 2018.
With respect to each company’s acquisition strategy, IBP makes more frequent purchases and allocates more of its capital to acquisitions than TopBuild. However, the average purchase is smaller in size. TopBuild does fewer but larger acquisitions, especially if you count the Distributors International acquisitions from last month. The reinvestment rate for TopBuild tends to be lumpier depending on the timing of these large deals.
From a return perspective, both companies generate above average returns but it’s worth noting that both have only been public during the housing recovery since the great recession. The reinvestments rates for both companies are high, so the intrinsic value compounding is also above average. If you compare the annual stock returns of both companies, TopBuild has done much better since its spinout from Masco. IBP had their IPO a year+ before TopBuild.
Optionality
TopBuild has the enviable position of being the largest company both in installation and distribution. Aside from large acquisitions, the main area where TopBuild can further differentiate itself is in heavy commercial and industrial insulation. The company is making strides in both areas and continues to focus especially in heavy commercial.
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