Value Line Institutional Services

 

May 2017

 

Near-Term Investment

Builders FirstSource (BLDR)

By Jeremy Butler, Editorial Analyst

Builders FirstSource (BLDR) fabricates and supplies building materials for the construction of residential homes in the United States. Its products include factory-built roofs and floors, trusses, wall panels, and stairs. It also manufactures aluminum and vinyl windows; does custom millwork and trim; produces engineered wood products; and assembles interior and exterior doors. BLDR operates roughly 400 locations in 40 states. The company sells its products to large national homebuilders as well as smaller local builders. It also supplies materials to remodeling contractors and light commercial builders. The company has approximately 14,000 full-time employees and is headquartered in Dallas, Texas.

Builders FirstSource was formed in 1998 as BSL Holdings. On October 13, 1999, BDL became a publicly traded company, was incorporated in Delaware, and listed on the NASDAQ as Builders FirstSource, Inc. In 2015, according to ProSales magazine, BLDR was the largest non-specialty building products supplier in the nation. This was thanks to its game-changing acquisition of ProBuild Inc. in July of 2015. Pursuant to this purchase, BLDR’s annual sales rose a whopping 123%, from $1.60 billion in 2014 to $3.56 billion in 2015. This acquisition was crucial for Builders since the move enabled it to supply a broader range of higher-margined materials to more metropolitan areas throughout the country. It also become less reliant on any one customer or product. Indeed, at the end of 2016, its top-10 customers accounted for 16.8% of sales, and no single customer accounted for more than 5% of revenues. Builders’ customers include a wide range of commercially successful, publicly traded homebuilders, such as D.R. Horton, PulteGroup Inc., Lennar Corp., Hovnanian Enterprises, and CalAtlantic Group. Lastly, no raw material supplier accounted for more than 7% of total materials purchased. Indeed, Builders has over 6,000 suppliers.

Investment Thesis
In our view, BLDR is a good pick in a solid industry. The homebuilding industry was hit hard during the Great Recession of 2007-2009. But since 2011, the company has steadily recuperated. In 2016, the single-family residential construction market was estimated to be worth $243.4 billion, according to the U.S. Census Bureau. This is a far cry from the all-time high of $413.2 billion (achieved in 2006), but exemplifies the fact that the industry still has significant potential. Data from the U.S. Census Bureau also indicated that single-family housing starts grew 9.4% in 2016, and the National Association of Homebuilders estimates that this figure will rise by 8.4%, to 781,500 in 2017. Trends that indicate the U.S. housing market will likely continue to recuperate include historically low interest rates (despite recent upticks); the aging of the housing stock; population growth; rising home prices; and increases in household formation and housing turnover. In addition, wage growth, higher stock prices, and rising consumer sentiment are prompting more people to buy homes and renovate the ones they already have. BLDR has positioned itself at the forefront of the homebuilding construction supply market and therefore is expected to capitalize on the aforementioned trends. 

Growth Strategies
Now that the July, 2015 ProBuild acquisition has been integrated into operations, BLDR intends to capitalize on the housing market gains by increasing its sales force and marketing expertise to enhance its market share. The company is planning to offset the added expense associated with sales force increases by cutting duplication costs related to acquisitions. Thanks to having made 33 minor acquisitions since 1998, duplication cost cutting is a skill Builders has honed to perfection. The company is also planning to reduce costs by having its wide array of suppliers compete more for its business. In addition, the company is expanding its already comprehensive range of products to truly be its customers’ “one-stop shop”. Besides consummating minor acquisitions, BLDR intends to allocate capital to streamline its IT capabilities, thus optimizing online ordering and delivery tasks. Lastly, any excess cash flow will likely be used to reduce long-term debt, which was 85% of total capital at the end of 2016. We think this is a wise move, given the likelihood of further interest rate hikes.

Financials
The company is due to report first-quarter results after the market closes on May 8th. We are looking for share earnings of a nickel on sales of $1.49 billion. This compares with the year-earlier bottom-line deficit of $0.15 (which was weighed down by integration costs related to the ProBuild acquisition) and sales of $1.397 billion. In the second quarter, we look for share earnings of $0.35. For the full year, we estimate earnings of $1.05 and sales of $6.83 billion. In 2018, the top and bottom lines are expected to rise to $7.24 billion, and $1.45, respectively.

As mentioned, the ProBuild acquisition was a game changer for Builders. The purchase resulted in BLDR’s stock price jumping from $6.40 to $14.20. Annual sales, which had increased from $678 million in 2009 to $1.60 billion in 2014, jumped to $3.56 billion in 2015 and $6.37 billion in 2016. Cash flow, too, skyrocketed to $2.28 a share in 2016, from $0.49 in 2015. We look for cash flow of $2.90 in 2017. However, along with greater sales and earnings, came higher debt. We are expecting the long-term debt to total capital ratio to be in the mid-80% range at the end of the March quarter. Paying down this debt, used to consummate the ProBuild buy, is one of management’s priorities.

As for the Trump Administration’s proposed 20% tariff on softwood lumber imported from Canada, investors generally shrugged off the news as it related to Builders FirstSource. Indeed, the company’s focus is more on value-added products rather than pure lumber, which would dampen the tariff’s impact. Also, the company will likely be able to pass on higher costs to its customers.


Conclusion
ProBuild was a large fish to swallow, so we don’t look for another purchase on that scale in the near term. Rather, BLDR’s leading position in an industry that continues to recuperate should enable it to increase its annual top and bottom lines at a double-digit pace. The company has good relationships with a wide array of customers on both the local and national levels. It is working hard to become the “go-to” company for all things related to residential construction, and is well positioned to be the building supply company of choice.

While these shares are not cheap, we look for this growth stock to perform well over the next year or so. That said, it is best suited to aggressive accounts, as BLDR sports an elevated Beta and our Lowest (5) Safety rank, based in large part, on its high debt load.

At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.

 

Long-Term Investment

Evolent Health, Inc. (EVH)

By Kevin Downing, Editorial Analyst

Evolent Health, Inc. (EVH) uses proprietary technology, processes, and services to help health systems and physician organizations (i.e., providers) transition from fee-for-service (FFS), to value-based payment models. Fee-for-service means providers are paid after each service is rendered. Thus, they are incentivized to perform more tests and procedures. Conversely, value-based payment models give financial incentives to providers for keeping patients healthy and preventing/controlling chronic illnesses. 

Most customer relationships begin when a partner engages the company to develop a customized value-based care plan. The platform and operations phase comes next, and is governed by a long-term contract. Pricing is determined by the size of the client’s operation, the number of new patients brought into the plan, and how many EVH services and applications are used. At the end of 2016, Evolent had more than 25 partners (the average contractual relationship is five years), with the three largest, Passport Health Plan, Indiana University Health Plan, and MedStar Health, Inc., comprising 19.6%, 14.5%, and 12.7%, of revenue, respectively. Transformation revenue accounted for 13.4% of the 2016 total, while platform and operations revenue was responsible for 86.6%.

Identifi is the company’s technology platform that aggregates and analyzes data and standardizes work flows. Data such as electronic medical records, lab reports, and pharmacy information are collected from disparate sources and maintained. They are run through software, and the findings are used to optimize clinical and financial performance; improve patient knowledge and satisfaction; identify high-risk patients; and help physicians proactively engage them. The company believes that more and better data optimize reimbursement rates and improve the quality of care.

Several other services round out Evolent’s value-based operations. Population Health Performance is a suite of solutions that supports the work of physicians to reduce unnecessary procedures/office visits and improve overall patient health. Some of the end goals of these offerings include targeting the right patient intervention at the right time, engaging patients to make sure they are properly following through with treatment, and identifying opportunities to close gaps in care and improve documentation. Financial and Administrative Management services include assessing the risk of patients not paying, performance reporting (such as population health analytics and physician effectiveness), and administrative capabilities (sales, product development, regulatory, compliance, claims administration, etc.) required to launch and operate provider-sponsored health plans. 


Growth Opportunities 
In 2016, U.S. healthcare spending was estimated to be more than $3.0 trillion, $1.0 trillion of which the company believes to have been waste. Evolent thinks the waste is created because the healthcare industry is still in the early stages of transitioning to value-based care programs. According to the company, approximately 10% of healthcare payments were made through value-based care programs as of June, 2014. It estimates that the number will balloon to over 50% by 2020, driven by price pressures in fee-for-service, innovation in data and technology, and growth in government payment programs. In March of 2016, The Department of Health and Human Services announced that it reached its goal of tying 30% of Medicare payments to models that value quality over quantity of care. Too, insurer Aetna has set a goal to have 75% of spending go through value-based contracts by 2020. 

Demand for value-based care is growing, but most providers are not meeting their goals as data and system complexity grows. According to a 2016 study by McKesson, only 22% of hospitals that have switched strategies have reached their administrative cost-cutting goals; 26% have adequately lowered healthcare costs; and 40% have satisfactorily improved patient outcomes. The study also reports that payment reconciliation, or ensuring that the costs of services are covered by payments, is the highest priority among transitioning payers and providers. The ability to aggregate data and analyze performance to identify improvement opportunities was another highly sought after IT functionality. 

Meanwhile, Evolent’s management addressed the potential impact from a repeal and replacement of the Affordable Care Act. Although recent efforts to change the legislation failed, possible future efforts remain relevant to this stock’s investment case. Even if the status quo changes, management believes the primary drivers of its business would endure. As more of the population moves to Medicare and Medicaid, federal and state budgets would be stretched, putting pressure on them to lower costs and increase patient value. On the commercial side, employers are likely to continue placing more of the financial burden on employees via high-deductible plans, again, spurring demand for more efficient value-based systems. Too, cutting fee-for-service rates across the board would probably be difficult to accomplish politically, which is why the company thinks regulators and law makers will favor value-based models. 


Recent Results and Guidance 
Fourth-quarter adjusted revenue rose 92.5%, to $90 million. This was largely driven by the number of people on Evolent’s platform rising to two million, a year-over-year increase of 181.5%. More patients at existing clients boosted scale, which helped the adjusted gross margin rise 260 basis points in the quarter. Adjusted SG&A expense as a percentage of revenue fell from 58.4% to 49.9%, owing to solid cost-cutting efforts. This marked the fourth-consecutive quarter where SG&A as a percentage of revenue declined, and this should continue to be the case going forward. 

For the full year 2017, the company is forecasting revenue to rise 62%-66% year over year, to $415 million-$425 million. Based on expectations of the ramp-up in services provided to the current partner base, the top line will likely hover around $100 million for the first three quarters before jumping in the fourth. Adjusted EBITDA should be in the range of negative $8 million to $0, and EVH looks to break even by the third quarter. Evolent is scheduled to release first-quarter results on Tuesday May, 9th.

Conclusion 
Evolent Health appears well positioned to benefit from the transition to value-based healthcare systems in the United States. The market opportunity is significant, and growth will likely come despite potential changes to the Affordable Care Act. A lack of earnings may dissuade conservative investors, but those with patience and a moderate risk appetite should consider these shares, in our view. 


At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.

 

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