Builders FirstSource: Higher Interest Rates Already Priced In, Cheaply Valued Stock

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Investment Thesis

Builders FirstSource (NYSE:BLDR) is a supplier and manufacturer of building materials to professional homebuilders. Its share price has stumbled in the past few weeks as investors were ”surprised” by the likelihood that the Fed will have to meaningfully raise interest rates to slow down the economy.

The bearish argument is that high interest will dampen the purchasing power of home buyers, reducing the appetite for new homes.

However, I contend that insight has now been factored in many times over into the share price.

To the point that I make the argument that paying 7x this year’s free cash flow makes these shares a very compelling risk-reward proposition.

Furthermore, Builders FirstSource announced in February its third share repurchase program in approximately 8 months. This newest program intends to deploy $1 billion to repurchase approximately 10% of its market cap this year.

Investor Sentiment Fizzles Out

Data by YCharts

The past several weeks have been brutal for companies with exposure to lumber prices.

The overwhelming worry here is that if the Fed is forced to go beyond the interest rate rise of 50 basis points rate hike expected in May, this will dampen the housing market. Indeed, if interest rates start to get close to 4% or 5%, many investors believe this will fully ”kill” the housing market.

Also, the worry for investors right now is that many homeowners are locked into very low 30-year mortgages rates. With higher interest rates currently being offered, this dampens homeowners’ enthusiasm to move home and lose their favorable locked-in mortgages.

These two dynamics, in and of themselves, are enough to depress investors’ willingness to get involved with Builders FirstSource. Or for that matter, any company that supplies building materials to homebuilders.

With that overhang out in the open, let’s now turn our focus on why I’m bullish on this stock.

Why Builders FirstSource? Why Now?

Builders FirstSource is the supplier of building products to homebuilders. They have both value-added products and commodity-like products.

Builders FirstSource, investors presentation Q4 2021

I’ve already gone into the background of what the company does here.

In today’s analysis, I’ll turn the focus on the near-term dynamics that are weighing on the stock. Specifically, given that lumber prices are the input cost for Builders FirstSource, any material weakness in lumber prices will impact Builders FirstSource.

Trading Economics, lumber prices

As you can see above, lumber price has been very volatile in the past twelve months.

Furthermore, as lumber price increases Builders FirstChoice will attempt to pass these higher lumber costs onto its end customers, via price increase.

How Lumber Prices Lead To Strong Operating Leverage

Allow me to provide you with a brief example of how operating leverage works for Builders FirstSource. Here I’ve estimated 20% gross profits as a quick and easy round number.

Note, for this gross margin figure I’m assuming that Builders FirstSource passes its increased input costs onto customers.

Example A: revenues $100, costs $80, gross profits $20 (20% gross margins). SG&A $10, operating profits. $10.

Example B: revenues $150, gross profits $30 (gross margins 20%), SG&A $10, operating profits $20.

As you can see above, in example B, revenues were up 50%, but operating profits were up 100%!

And that’s really why I find this investment seriously attractive. Small increases in revenues, when you have a high fixed cost base can lead to massive bottom-line EPS growth.

Next, let’s drill down to its valuation.

BLDR Stock Valuation – Incredibly Cheaply Priced

Builders FirstSource guides for $1.6 to $2 billion of free cash flow in 2022. This puts the stock priced at 7x free cash flow. It’s remarkable, that means that investors paying for the stock today would get their capital back in 6 years, with anything after that, being upside potential. And this factors in no growth further free cash flow.

Furthermore, keep in mind that Builders FirstSource has announced $1 billion share repurchase programs three times in the past eight months. The latest share repurchase program was announced in February.

Hence, given the relatively stable lumber prices we saw during Q1 2022, I wouldn’t be surprised to see even more buybacks announced together with its Q1 earnings next month.

Nevertheless, even without any further ”additional” buybacks announced, Builders FirstSource’s open share repurchase program of $1 billion would repurchase approximately 10% of its market cap this year.

For a stock priced at 7x free cash flow, for it to repurchase 10% of its market cap too, that’s really undeniably cheap. Particularly given that the business hasn’t got any terminal issues.

The Bottom Line

So far, sanctions against Russia haven’t led to a pronounced and sustainable rise in lumber prices. The illusion by most market participants is that a ceasefire would immediately lead to a resumption of the lumber market being inundated by Russian and Belarusian lumber.

However, with the passage of time, an increasing number of investors have come to disregard that hypothesis. Investors are now starting to accept that sanctions are stickier than many initially envisioned.

Thus, the biggest worry right now for investors is if the Fed has to be aggressive in raising interest rates to cool the economy. This, in turn, will lead to the housing market cooling off and demand for lumber decreasing.

And while I fully recognize that insight, I don’t agree with that point of view. I continue to believe that there’s a lack of housing inventory and that demand for housing, even at close to 5% interest rates will remain elevated.

In conclusion, paying approximately 7x this year’s free cash flows already factors in the majority of all concerns. Whatever you decide, good luck and happy investing.