Over the last 10 years, Simpson Manufacturing Co., Inc., (SSD) has done well. The year 2019 may prove to be a lot choppier, given the uncertainty presented by the U.S. housing market. This is a company in the U.S. housing construction industry that investors could potentially own for the long term. The company is priced for perfection in terms of its valuation. In the short term, it may be best for investors to wait before buying this company.
Exhibit: Simpson Manufacturing Co., Stock Performance
Simpson Manufacturing company makes wood construction products such as connectors, truss plates, fastening systems, and concrete construction products used for concrete, masonry, and steel construction. The company’s products are used in residential construction, light industrial, commercial construction, and repair and remodeling industry.
The company typically develops about 15 to 25 new products each year. The company is organized into three operating segments consisting of North America, Europe, and Asia/Pacific segments. The product lines have included connectors, anchors, fasteners, lateral resistive systems, truss plates, and repair and strengthening product lines for the marine, industrial, and transportation markets. Most of the company’s products are approved by building code evaluation agencies. To achieve such approvals, the company does the extensive testing that is certified by independent testing laboratories.
The company’s wood construction products include connectors, truss plates, fastening systems, and lateral systems, which are all made of steel. The company produces over 15K standard and custom wood construction products. The concrete construction products include anchor products, repair, protection and strengthening products. The company produces over 1,000 standard and custom concrete products.
For the full year 2018, the company saw its sales increase by 10% to $1.1 billion from $997 million in 2017. This increase in sales was driven by both volume growth and an increase in average unit prices. The company’s cost-cutting initiatives increased operating income by 28% to $176.2 million. Net income saw an even greater increase of 40% to $129.5 million compared to 2017. Diluted earnings per share were at $2.72 per share, an increase of about 40% compared to 2017.
Benefits from Share Repurchase & Lower Tax Rate
In 2018, the company purchased $111.1 million worth of their common stock. Since 2016, the company has reduced its diluted average number of shares outstanding from 48.295 million to 46.540 million shares – a reduction of about 3.6%. The share repurchase program, along with a lower tax rate, helped the company boost its earnings substantially in 2018. The company’s effective tax rate decreased to 26.4% in 2018 from 35.9% in 2017 or a decrease of about 9.5%. Without the share repurchases, the company would have earned $2.65 per diluted share in 2018 based on the 2017 diluted average number of outstanding shares of 47.774 million.
Strategies to Achieve Consistent Growth
The company has outlined a three-part strategy to achieve consistent growth. North America is the largest market for Simpson Manufacturing. That makes the company very dependent on the cyclical U.S. housing market. It is also heavily dependent on its wood connector product lines. The company plans to mitigate the cyclicality and dependency on the U.S. housing market by increasing market share and profitability in Europe. It plans to reduce its dependency on its wood connector business by growing overall share in the concrete space. These two are the first two parts of the company’s strategy. The third part of its strategy relies on the development and sales of its software solution.
There are potential upside and downsides to all three parts of its strategy. Growing market share in Europe may be a way to mitigate the cyclicality of the U.S. housing market, but Europe has been trapped in its own cycle of slow growth. Currently, Germany is amid a sharp slowdown in its growth rate. Britain is grappling with the chaos caused by its Brexit vote. So, Europe may not in a position to help Simpson Manufacturing grow its market share.
Its strategy to increase its sales of software comes with its own share of risk. Software development and sales is an expensive endeavor. The R&D expenses associated with software can be very expensive, and development takes a considerable amount of time. At the end of the software development process, there is no guarantee that the product and features that have been developed can be fully monetized. Add to that the cost and time associated with selling a software solution. Enterprise software sales cycles are long, sometimes taking as much as 6 months or more to complete a sale. A company may need to keep investing in people in both the development side and the sales side before it can see any return on that investment. An unproven software solution may have to be sold at a loss to acquire reference customers and gain reputation. For Simpson Manufacturing, the software business is completely different from its manufacturing business, and it would take it a while to master it. But there’s a huge upside for Simpson Manufacturing in the software business. The gross margins in software are in the 60% range or above. That’s almost 20% higher than the company’s current gross profit margin of about 44-45%.
The company acquired CG Visions, Inc. in 2017. The LotSpec software from CG Vision integrates with software from companies such as AutoCAD to create detailed plan estimates, designs, and production specifications. The company acquired Hyphen Solutions in 2018, which offers solutions such as BuildPro and SupplyPro. BuildPro offers construction scheduling and supply chain management. SupplyPro works with BuildPro to ensure builders and suppliers are viewing the same job schedules in real-time, view change notifications, and view purchase order information.
Efforts to Boost Margins
The company is aiming to reduce total operating expenses as a percentage of net sales to 26% to 27% range by 2020. That would result in an operating income margin of approximately 21% to 22%. Operating expenses as a percentage of sales were at 28.9% in 2018 and were above 31% for the years 2014 to 2017. The company is looking to achieve its operating income margin target of 21% to 22% by reducing costs in Europe, by being headcount neutral, except in production and sales departments, and by implementing zero-based budgeting. There are two major risks to these goals. Their growth initiatives such as increasing sales from software may require more resources and support. The efforts to control costs and increase margins in Europe may not bear fruit. In 2018, Europe had an anemically low operating margin of about 4.5%.
Dependent on U.S. New Housing Construction
The company estimates that 60% of its total product sales are dependent on housing starts. They are heavily dependent on the stability of the housing, residential construction, and home improvement markets. The other factors include unemployment and foreclosure rates, inventory loss, interest rate fluctuations, raw material and energy costs, state of credits markets.
The near-term outlook for housing starts is cloudy at best. Inflation in home prices and rents has been far outpacing growth in household income. Couple that with high student loan debt and the lack of good-paying jobs that have caused many millennials to live with their parents and put off home buying. JPMorgan has estimated that the student loan drag has prevented 2 million young adults from buying homes and that has resulted in a 1.5% lower homeownership rate. But not all is lost, consumer confidence is still strong, the unemployment rate is low.
The company noted that housing demand was sluggish in the fourth quarter, but demand in January was strong. In February 2019, Consumer Confidence Index rebounded nicely to 131.4 from 121.7 in January. The U.S. consumer continues to show strength, but can that strength translate to higher sales of new homes, given affordability concerns?
Priced for Perfect Execution in 2019 – No Room For Error
When compared to its peers such as Armstrong World Industries, Inc. (AWI) and Continental Building Products, Inc. (CBPX), Simpson Manufacturing is richly valued at approximately 18x forward earnings (forward EPS of about $3.33) and had a return on invested capital (ROIC) of 14.2%. Continental Building Products trades at approximately 11x forward earnings and had a return on invested capital of about 12.5%. Armstrong World Industries trades at approximately 16x forward earnings and had an ROIC of 15.5%. But the company has a strong balance sheet with nearly $160 million in cash and zero long-term debt. Its inventory increased in 2018 and stood at $276 million compared to about $252 million in 2017. Based on 18x forward multiple, the market is pricing approximately a 22% increase in earnings per share in 2019.
Exhibit: Return on Invested Capital
A lot must go right for Simpson Manufacturing this year for it to achieve its financial targets and justify its valuation. Affordability concerns plague the U.S. housing markets, Europe has its own troubles of Brexit, and slowing growth in major economies among EU nations. Long-term investors may have to patiently wait for better entry point before buying and for further clarity on the direction of the U.S. housing markets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.