NCS: Contrary on Construction with NCI Building Systems

This article is a reprint of my 14 August 2008 RealMoney column

I know, I know … the construction industry should not be touched with a 10-foot pole right now. But the depth of conviction investors have in that belief sends my contrarian side looking for names that might buck conventional wisdom. I didn’t have to look far to find one.

Despite a market capitalization under $800 million, NCI Building Systems (NCS) is one of North America’s largest integrated manufacturers and marketers of metal products for the nonresidential construction industry. With 44 manufacturing facilities located in 18 states and Mexico it sells metal coil coating services, metal components and engineered building systems, offering one of the most extensive metal product lines in the building industry.

The metal-coil-coating segment cleans, treats, paints and slits continuous steel coils before the steel is fabricated for end use. The metal-components segment sells metal roof and wall systems, metal partitions, metal trim, doors and other related accessories. The engineered building systems segment manufactures mainframes and Long Bay Systems, and includes value-added engineering and drafting. This last segment is both the largest and the highest-margin business for NCI.

NCI management pursues a four-pronged strategy of (1) developing new markets and products; (2) successfully identifying strategic growth opportunities; (3) controlling operating and administrative costs; and (4) managing working capital and fixed assets. The limited focus seems to be working.

New market opportunities include the shift toward metal roofing systems from conventional tar and gravel systems. Though more expensive to install, metal roofing systems are more durable and require less maintenance. As a result, they are gaining share in commercial-building applications.

For NCI, “strategic opportunities” means just that. The 1998 acquisition of Metal Building Components Inc. doubled its revenue base, making the company the largest domestic manufacturer of nonresidential metal components. The 2006 acquisition of Robertson-Ceco II Corporation resulted in product and geographic diversification, a stronger customer base and a more extensive distribution network.

Control over operating and administrative costs is exemplified by the fact that SG&A expense declined from 18.1% of revenue in the first half of 2007 to 17.7% in the same period this year. Meanwhile, working capital has been reduced, as have expenditures on fixed capital.

The operational discipline is translating into financial success. Sales in the second quarter grew 13.1% from the year-ago period. The $0.76 in earnings per share reported far exceeded the consensus analyst expectation. The company also narrowed its guidance for full-year 2008 earnings per diluted share to $3.19 to $3.44, compared to the prior consensus estimate of $2.90 per share. Estimates for 2009 were subsequently boosted from $2.88 to $3.39.

Over the last 12 months, NCI has generated $114 million in free cash flow (measured as cash from operations less capital expenditures). At 14.6% of market capitalization, the free-cash-flow yield is enticing enough that I don’t really require any growth to justify an investment. I could even tolerate some declines in cash flow, particularly if they were of a temporary nature related to the economic cycle.

Analysts, however, expect the company to grow 13% annually over the next three to five years. I think that estimate is probably too high — at least without tapping external financing. The sustainable earnings growth rate based on ROE is closer to 11%. With a 1.3 price/book multiple (in line with the industry average) and a P/E of just 11.5, I think the valuation is more than reasonable.

I think the shares could trade to a free-cash-flow yield of 10%, which would ultimately justify a $58 share price (45% above the current level), based on the most recent year’s free cash flow. While this may take some time to play out, I think double-digit returns over the next three to five years are quite possible.

Disclosure: At the time of publication, William Trent has no financial position in the companies mentioned in this article.