Pension fund managers gone wild

Twas the season, all right. It’s become a holiday tradition for L.T. Gibson to hop in his sleigh and cruise the countryside, slipping down independents’ chimneys and filling their stockings really full.

The day before Thanksgiving, US LBM acquired Gaithersburg, Md.-based Barron’s Lumber. Two-unit Barron’s is a fixture in the suburbs of Washington, D.C., going head-to-head with BFS’s T.W. Perry and the Lester Group’s Jim Carpenter Co. and Building Supply of Manassas for custom home builders and remodelers.

On December 1st, US LBM bought Morrisville, N.C.-based Professional Builders Supply. With 12 locations throughout the Carolinas and $426.9 million in 2020 revenue, PBS “puts US LBM in a leading position in the rapidly-growing housing markets of Raleigh-Durham, Charlotte, Wilmington, and Greenville-Spartanburg,” says the press release.

That it does. It also makes the rest of the industry a little anxious about their own stockings.

Independence has always been a source of pride for independent LBM dealers. Case in point: Barron’s tagline, “Locally Owned & Operated Since 1947.” But there are reasons why so many are cashing in their chips these days.

For one thing, it probably is true that a disproportionate number of owners are aging out. Barron’s was part of a surge of lumberyard startups immediately after World War II. If each generation of operators gets a 20- to 30-year run, the third wave would be reaching retirement age right about now.

Builder consolidation is also a factor. Some independents believe they’d have a better shot at big production builders’ business as part of a larger, better-financed organization. Or if not, at least they won’t be playing with their own money.

Most important, we are living in the Gilded Age of Equity Investment. Both the number and size of private equity deals have set new records each year since the Great Recession.

After a brief lull in 2020 for COVID, deal volume in 2021 set yet another all-time annual record—by the end of November. At this point, says The Economist, “private capital firms manage a record $10 trillion of assets, the equivalent of 10% of total assets globally.”

Why is no mystery. It’s all about interest rates—or rather the lack thereof. “In order to meet their future liabilities, institutional investors such as pension funds and insurers must achieve annual returns of 6% to 7%,” explains The Economist. “With rates at rock-bottom levels they have continued to pile into private assets where, it is argued, returns are more attractive.”

If you can get past the mosh pit. More than $3 trillion in uncalled capital—another all-time record—is just sitting in PE firms’ coffers waiting to be deployed. All that idle money has fueled competition for acquisitions, which has pushed multiples to yet another all-time record high.

In turn, that has forced PE firms to look beyond their favorite target sectors for bargains. Housing is on the radar screen because we don’t have enough of it. LBM is in the crosshairs because it’s a logical adjacency.

The upshot for LBM dealers is that securing an exit strategy is easier today than it ever has been—and maybe easier than it ever will be once the gold rush peters out. It’s no wonder so many are deciding to punch their tickets.

Everybody hates to see them go. Everybody also wonders what it means for those who stay.

Keep in mind that Yogi was right: It is hard to make predictions, especially about the future. But one thing that is almost certain is that the annual revenue rankings will soon be dominated by two publicly-held construction suppliers.

You may love the lumber business. Bain Capital doesn’t. Bain loves moseying off into the sunset with saddlebags full of cash, and the surest way to accomplish that with US LBM is to go public. Maybe not immediately—timing is critical in an IPO. But barring some catastrophe, it will happen. We won’t lack for entertainment in the meantime, either. L.T. still has plenty of holes to fill in his market coverage.

The question is how going public will change US LBM. The company has always been known for the exceptional degree of autonomy enjoyed by its divisions. Most independents would say that makes them better competitors.

Even chain operators agree that too much centralization is a liability in this business. Building codes, materials, construction practices, and buyer preferences all vary by region and market. One size never fits all, which limits economies of scale. As a result, success in any given market relies heavily on the effectiveness of local operators. Those operators need to be decision-makers to be able to respond to the quirks of their market.

That’s a tough nut for most private equity firms. PE firms are remodelers. They buy companies in order to fix them up and flip them for a profit. Just like houses, some need structural repairs while others only need a coat of paint to boost their curb appeal. But every house needs something. If it doesn’t, it isn’t worth buying.

Either way, the makeover nearly always include a unified brand plus centralization to maximize economies of scale and synergies. As Bain explains in its 2019 Global Private Equity Report, “An acquisition has to fit into a strategic logic that assumes the whole is worth more than the sum of its parts.”

That’s exactly the logic that appears to be driving US LBM these days. Its divisions are organized into six regions, each with a VP overseer. Everyone has migrated to a single ERP system. Many if not most back-office functions are consolidated, and the most significant exception—purchasing—is being reorganized right now under Senior VP-Supply Chain Pat Managan, who joined the company from ACS last fall.

Even the corporate brand is getting a test drive as a sponsor of the Pac-12 Coast to Coast Challenge college basketball tournament. No one expects the divisions to drop their own names anytime soon, but as the US LBM brand gets established in the marketplace, that’s clearly an option.

US LBM’s value proposition to both customers and prospective acquisitions has always been rooted in its stance as a loose confederation of independents. If that strategy is changing—even gradually—the key questions are 1) Is it happening for internal reasons or to meet Wall Street’s expectations? and 2) How far will it go?

So it’s worth a closer look at another very large LBM dealer that began life as a loose confederation of independents.

In 1998, NYC-based PE firm JLL Partners partnered with Stonegate Resources to buy Builders Supply & Lumber in the D.C.-Baltimore area from Pulte Homes. BSL became the platform for a buy-and-build strategy very similar to what Bain and US LBM are doing today.

Over the next three years, JLL picked up another 20 independents. Like US LBM, its targets were solid, well-run market leaders such as Pelican Cos. (S.C.), Holmes Lumber (Jacksonville), Goldston’s (N.C.), Erlanger Lumber and Western Building Products (Cincinnati), Blackstone Lumber (N.J.), and Kellogg Lumber (Denver).

Also like US LBM in its early days, JLL’s acquisitions initially retained near-total autonomy. They kept their brand names, pursued their own market strategies, and managed their own back-office functions. When Stonegate’s website called them a “family of independents,” the divisions’ former owners all pretty much agreed with that characterization.

Unlike US LBM, it didn’t last.

JLL decided to flip the business sooner rather than later. It trademarked the name Builders FirstSource in late 1999 and began rebranding its yards shortly after that.

CEO John Roach, an acquisitions expert, stepped down in 2001 and was replaced by Floyd Sherman. “Sherman’s mandate was largely to integrate the acquisitions, whittle down working capital, and ready the company for a sale,” reported Buyouts Insider.

According to Buyouts Insider, JLL tried to auction BFS in 2004. Home Depot was the high bidder, but the deal fell through. In 2005, JLL decided to take BFS public due to “a better public market environment” plus an “unexpected jump in earnings (that) was in part the result of rising timber prices.”

The IPO came in late June 2005. Initial trading was so-so, says Buyouts Insider, but JLL still managed to walk away with “roughly 3x its capital while still retaining a 55% stake.”

By independents’ standards, BFS has never been a stellar performer. From 2005 through 2020, it generated a grand total of $56.4 billion in revenue and $14 billion in gross profit. Its cumulative net income was just $543 million.

But it isn’t fair to judge a publicly-held company by the standards that apply to an independent. Public companies play a very different game.

Shareholders care about the value of their shares. If management is responsible first and foremost to shareholders, then their prime directive is to generate demand for shares and thereby tease investors into bidding the price up.

Strong profits can help that effort, but the more compelling motivator is a narrative that makes investors feel like they’re on the ground floor of “the next insanely great thing,” as Apple’s Steve Jobs used to say.

Like everyone who was heavily dependent on production housing, BFS got whacked in the Great Recession. From 2007-11, it lost over $385 million and accumulated nearly $300 million in debt. Its share price, which spent most of 2006 in the mid-$20s, bottomed out at $0.76 in Dec 2008.

When the market began to show signs of life in late 2011, analysts decided that housing had nowhere to go but up. They felt that BFS was undervalued and began to issue buy ratings that goosed the stock over $5.00 by the end of 2012. BFS lost another $100 million before turning its first post-recession profit in 2014.

By the mid-2010s, a sluggish recovery convinced everyone that we were horribly, terribly underbuilt and losing ground. Therefore, they reasoned, we must be in for the mother of all housing booms when the worm finally turned. Everyone wanted a piece of that.

In April 2015, BFS’s share price nearly doubled in a single day when it announced it was buying ProBuild Holdings. Never mind that ProBuild was the only LBM dealer on the planet that lost more money in the Great Recession than BFS.

In 2020, BFS’s stock began to surge as soon as investors realized COVID was not going to kill the housing market. It’s hard to say how much the August merger with BMC-Stock helped, but it certainly didn’t hurt.

Since then, BFS has added over $800 million to its top line with the purchases of Alliance Lumber, John’s Lumber, Cal TrusFrame, and as of yesterday, National Lumber in New England. Wall Street loves market share and doesn’t care whether you capture it or buy it.

Nowadays the narrative is shifting again. The mother of all housing booms was a no-show, and that created an affordability crisis. The obstacles are zoning and regulation, but neither one can be fixed without a functioning political system. So instead we’re reinventing the construction process.

Investment in construction technology—contech in SiliconValley-speak—was nearly $2 billion in 2021, a tenfold increase from 2010. From modularization to robotics and drones, automated assembly lines, 3D printing, BIM and VR, IoT, AI analytics and maintenance sensors, digital twins, and remote-controlled equipment as soon as 5G goes mainstream, construction is arguably on the verge of a transition more dramatic than the introduction of stud framing in 1830.

In the commercial sector, that is.

In single-family residential, the cheapest way to build is still to ignore all the flaws in the plan and let the framers fix them in the field. Stick framing lets you do that. Offsite doesn’t. It’s more efficient, but also more expensive due to engineering costs that can't be automated.

Very few investors have the background to see those distinctions, though. All they know is that contech is the next insanely great thing, so if you’ve got some, they’re in.

Last fall BFS spent $450 million to acquire WTS Paradigm. Paradigm provides software for the window and door channel. By all accounts it’s good stuff: an ERP system for fabricators, a configuration app for dealer salespeople, 3D virtual design for home builders, and an in-home sales aid for replacement contractors.

BFS itself is still using multiple ERP systems, including an ancient green screen in some regions. But as EVP-Digital Solutions Tim Page explained to HBS Dealer, “the company will now focus on a third digital domain: using technology to help its customers operate more efficiently.”

Says Page, “We believe scalable configuration and visualization technology will enable productivity, improve construction, and transform our industry.”

That may sound like a tall order for configuration software, but keep in mind that Page isn’t talking to you. He’s talking to Wall Street. If crafting a narrative that gets investors’ juices flowing is the measure of success, BFS has absolutely been a stellar performer.

Its shares closed 2021 at $85.71, up 66% since it acquired Paradigm in August, up 183% since the BMC-Stock merger in August 2020—and up 1,142% since April 12, 2015, the day before BFS announced its merger with ProBuild.

But all that doesn’t make BFS 1,142% more effective in the field. BFS is a good company and a good competitor, but its yards are no different than a group of independents: Some are excellent operators, a few are struggling, and the majority are somewhere in the middle.

Home Depot has made at least a half-dozen attempts to get into the construction supply business over the past 25 years. If size was truly an unbeatable advantage, one of them would have succeeded and everyone else would have been wiped out years ago—just as Wall Street analysts were predicting in the 1990s.

If there’s a catch, it’s that Depot probably would never have gotten the opportunity. It would have been smothered in the cradle by Wickes Lumber, the industry’s first nationwide chain and a Wall Street favorite in the 1970s.

Savvy chain operators all have yards that hold their own just fine against local competitors, but they have never been able to outmuscle independents. That’s why the explicit strategy at US LBM and Kodiak is to let their acquisitions to operate as much like independents as they possibly can.

Which is not a new idea. Independents have always worried about chains. American Lumberman columnist Met Saley debunked those concerns in 1902:

“The up-to-date local lumberman who knows by heart the people of his section does not stand in fear of such competition as is put by the average man in charge of a line yard. There is no sense in talking about line yards ‘crowding out’ single yards. They may supplant them, but if they do it will be because they come forward with cold money and buy them out.”

That’s roll-up consolidation in a nutshell: If you can’t beat ‘em, buy ‘em.

We’re going to see more of it this year, too—and probably more to follow until the next housing crash. A strong market always encourages M&A activity. But that’s a good thing for independents, too.

PE firms want bargains they can flip quickly for a profit. The problem, says Bain, is that they often can't close those deals. “When they find attractive assets, they consistently encounter aggressive corporate buyers willing to push up auction prices. These buyers are strategic, meaning they will pay more to advance corporate objectives and capture synergies.” 

BFS is a strategic buyer. US LBM will be, too, once it goes public. If you’re in need of an exit strategy, two strategic buyers ought to be twice as much fun as one—and maybe more if you can convince them that your whole is worth more than the sum of its parts.

And if you’re worried that independents will all get bought and disappear, don’t be. Whenever someone harvests a mature independent, it always shakes a few entrepreneurs loose.

All you need to do is gather them up and plant them in fertile ground. The next generation of dominant independents will sprout before you know it.

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