Is Boise Cascade a reverse value trap? (Part 2 of 2)

Value Investing Case Study 11-2:  In my Seeking Alpha article “Boise Cascade: Overpriced And A Potential Value Trap”, I used the Jan 2020 Damodaran data for my valuation.  Damodaran’s Jan 2021 data is now available and I have used them in this post. The valuation results are different from those in the Seeking Alpha article. Refer to the valuation section of this post to see how I have handled this.  

In Part 1, I have argued that a reverse value trap is a growth trap. I have shown that Boise Cascade's (BCC or the Group) revenue is correlated with the US Housing Starts that had a CAGR of 5.8 % from 2013 to 2020. Does this mean that BCC is a growth stock?

As of 1 Mac 2021, BCC is trading around a historical high of USD 49.94 per share equivalent to 2.3 Price to Book multiple.

It is accepted that a value stock is one with a low Price to Earnings or Price to Book multiple and the reverse applies to growth stocks. While the multiples suggest that BCC is a growth stock, you should not rely on multiples.

Multiples can be skewed by share buybacks.

Join me in Part 2 of this series as I showed the circumstances in which BCC can be a buying opportunity from a value investing perspective. An update was published on 22 May 2022

Should you go and invest in BCC? Read my disclaimer.

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Contents

• Did Top Management Seize Opportunities?

• Is there an Awesome Buying Opportunity?

• Will there be Spectacular Growth in Shareholders’ Value?

• How to Secure Your Investment by Minimizing Risk

• Pulling it all together

Did Top Management Seize Opportunities?

In 2019 (at the time of writing, the 2020 Proxy statement with the shareholdings info has yet to be filed by BCC):

• The directors and executives of BCC collectively held a 1.4 % share of the company.

• 4 institutions (Blackrock, Vanguard, Dimensional Fund, and Macquarie Bank) collectively held 42.9%.

I would not classify BCC as an owner-managed group given the low ownership by the directors and executives.

However, BCC has an executive compensation program with a significant at-risk performance-based component. This is to incentivize the team to increase long-term shareholders' value.

From 2017 to 2019, the incentive components in the form of stock-based compensation averaged 5.7 % of BCC’s EBITDA.

In its 2020 SEC filings, BCC reported:

• 6 Executive Officers with an average age of 55 years and 10 years average tenure with the Group. 5 of them have been with BCC before its listing.

• 7 key managers with an average age of 50 years and 10 years average tenure with the Group. 3 of them have been with BCC before its listing.

With such an alignment and long tenure, how did senior management perform?

Operations

BCC has identified many competitors in its 2019 and 2020 SEC filings of which 5 were still listed as of Feb 2021. I used these to form the peer group to compare revenue and returns. 

In terms of revenue as can be seen from the chart, I rate BCC performance as average. From 2013 to 2019 (to exclude the impact of the pandemic), BCC revenue grew at 6 % CAGR whereas the peers' CAGR ranged from - 1.7 % to 30.3 % with a mean of 8.8 %. Note that the mean was skewed by Builders FirstSource's performance due to an acquisition in 2015.

Chart 1: Peer Revenue Index

In terms of Return on Assets, BCC achieved an average performance. 

Company	Average ROA 2011 to 2019
BCC	5.0 %
BlueLinx	(0.4) %
Builders FirstSource	2.0 %
Louisiana Pacific	5.5 %
UFP	7.7 %
Weyerhaeuser	2.9 %

Table 1: Comparative ROA

Chart 2: Peer Return on Assets

Looking from another perspective, in 2019 BCC has an ROE of 11.5 % compared to the industry (Source: Damodaran Jan 2020).

• The ROE was 14.1 % for the building materials industry.

• The ROE was 2.1 % for the paper/forest products industry. 

Capital allocation

Over the period 2013 to 2020, BCC generated about USD 1,223 million of cash from operations.  Of these

• USD 562 million was spent on CAPEX (excluding acquisitions).

• USD 360 million was for acquisitions.

• USD 185 million was paid out as dividends.

• USD 139 million was used for share repurchases

Chart 3: Deployment of cash from operations

You will notice that the above cash outflow exceeded the cash from operations by USD 23 million. This is not surprising as BCC debt increased by USD 137 million between 2013 and 2020. 

In the context of capital allocation.

• The amount "paid" to shareholders (dividends and buybacks) is about half of the net income for the period. This is an attractive pay-out ratio.

• Cash increased by USD 287 million from 2013 to 2020.  The current cash position as of the end of Dec 2020 is 29.3 % of the TCE. Considering the low returns from holding cash this could have been better deployed.

• I have some concerns about the CAPEX and acquisitions.

• USD 725 million was spent for the Wood Products segment over the past 8 years. But this segment's total operating income was only USD 502 million over the same period.

• On a group basis, the total amount spent exceeded the corresponding period EBIT by over 6%. This is not a sustainable reinvestment rate. 

While management is good at operations, I would question their capital allocation performance.

Is there an Awesome Buying Opportunity?

I generally use two approaches in assessing the intrinsic value ie Asset-based and Earnings-based.

• Asset value is broken down into several components - Graham Net Net, NTA, and Book value. 

• Earning value is broken down into the non-operating assets, Earning Power Value (EPV), and Earning with growth.

• I have assumed that BCC grew at 4% per annum for the Earning with growth scenario.

As can be seen from the chart and table below:

The Earning Power Value is about 30% higher than the Asset Value. This could be due to the fact that there was a large share buyback (equivalent to USD 3.54 per share based on the current number of shares). Normally I would draw strategic insights by comparing Asset Value with Earning Value.   I would hesitate to draw any conclusions for cases like BCC where there is large share buyback. 

Over the past 5 years, the highest market price has been around the level of the Earning Value with growth. In fact, the current price is around the 5 years’ high.

Chart 4: Valuation

The conclusion is that at the current market price, there is no margin of safety for BCC.

Table 2: Valuation metrics

The other key assumptions used in the above valuation are:

• The base revenue is set to the average 2013 to 2020 revenue.

• The gross profit margin is based on the 2013 to 2020 average given the cyclical nature of the business.

Further details on the valuation methodology and assumptions are listed in Note 1.

Case Notes I have earlier mentioned that the BCC reinvestment rate is not sustainable as shown by the following estimates. I estimated that from 2013 to 2020, the average actual reinvestment rate is 58 %. The reinvestment rate based on fundamentals [ ie dividing growth rate by the EBIT(1-t) ] is 55 %. The high reinvestment rate will lower the free cash flow and hence result in a low value for the Group. Given the high reinvestment rate, it would not be realistic to use a single-stage growth model when valuing BCC.  You would think that a two-stage growth model may be more appropriate. I also carried out a valuation of BCC using the two-stage growth model as follows I have a 2-stage growth model based on 10 yrs of high growth. I computed the Free Cash Flow for each year based on deducting the reinvestment from the EBIT(1-t). Due to the high reinvestment rate, the valuation assumed a 5.8 % growth (equal to the Housing Starts growth rate) during the high growth stage.   I also assumed a 4 % terminal value growth.   The Earning Value based on these assumptions is USD 45.56. This is lower than the EPV of USD 51.55. This can be interpreted as a situation where growth will “destroy” value due to the high reinvestment rate. To improve the business economics, BCC can either: Find a more effective CAPEX and/or acquisition plan. This is getting more bang for the bucks it spent on CAPEX or acquisition. Improve its returns. Improving the returns will reduce the reinvestment required for a given growth. As you can see, valuation is more than just using some formula. There are choices to be made in terms of which formula to use and what to assume.  So, if you are just starting out to analyze and value companies, it may be helpful to supplement it with third-party analyses and valuation.   There are several financial advisers who provide such analyses. Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Case Notes

I have earlier mentioned that the BCC reinvestment rate is not sustainable as shown by the following estimates.

• I estimated that from 2013 to 2020, the average actual reinvestment rate is 58 %.

• The reinvestment rate based on fundamentals [ ie dividing growth rate by the EBIT(1-t) ] is 55 %.

The high reinvestment rate will lower the free cash flow and hence result in a low value for the Group.

Given the high reinvestment rate, it would not be realistic to use a single-stage growth model when valuing BCC.  You would think that a two-stage growth model may be more appropriate.

I also carried out a valuation of BCC using the two-stage growth model as follows

• I have a 2-stage growth model based on 10 yrs of high growth. I computed the Free Cash Flow for each year based on deducting the reinvestment from the EBIT(1-t).

• Due to the high reinvestment rate, the valuation assumed a 5.8 % growth (equal to the Housing Starts growth rate) during the high growth stage.  

• I also assumed a 4 % terminal value growth.  

The Earning Value based on these assumptions is USD 45.56. This is lower than the EPV of USD 51.55. This can be interpreted as a situation where growth will “destroy” value due to the high reinvestment rate.

To improve the business economics, BCC can either:

• Find a more effective CAPEX and/or acquisition plan. This is getting more bang for the bucks it spent on CAPEX or acquisition.

• Improve its returns. Improving the returns will reduce the reinvestment required for a given growth.

As you can see, valuation is more than just using some formula. There are choices to be made in terms of which formula to use and what to assume. 

So, if you are just starting out to analyze and value companies, it may be helpful to supplement it with third-party analyses and valuation.  

There are several financial advisers who provide such analyses. Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Can its growth be justified?

The growth assumptions used should be seen in the light of the following historical growth.

Table 3: Growth comparisons

What are the drivers of growth?

• The current US Housing Starts is at about the historical average level. As shown in Part 1, there have been periods where this has been exceeded.

• Any Biden administration stimulus plans will provide additional impetus.

The challenge for a cyclical sector is whether the price levels in future cycles would be higher than those in the past.

Which parameters to use?

In my Seeking Alpha article, I had used a simple dividend discount model transformed into the following for the valuation.

However, for this post, I used the conventional free cash flow-to-firm model. Conceptually both models would result in the same value. But the values obtained from both methods are different. This is not because of the models, but because the discount rates have changed significantly.

For the Seeking Alpha article, I used the Jan 2020 Damodaran data to derive the cost of equity and WACC. For the current blog post, I used the Jan 2021 Damodaran data.

This has resulted in the current cost of equity and WACC being 22 % lower compared to the earlier values as shown below

Table 4: Comparing valuation inputs

The question you would ask is why would the discount rate reduce by so much? This is because the Jan 2021 data is based on information in 2020 which is the pandemic year. This has resulted in a lower risk premium, lower cost of capital, and lower Beta.

Which is the “appropriate” discount rate to use?  I would argue that 2020 is an abnormal year so, we should ignore the data for this year if we are looking for long-term performance. So, more realistic values for BCC are those presented in the Seeking Alpha article.

Nevertheless, even based on the Jan 2021 data, the analysis still showed that BCC is overvalued. If nothing else, I hope it demonstrated that valuation is more than mere number crunching. 

Will there be Spectacular Growth in Shareholders’ Value?

There are several perspectives to gauge whether BCC has been able to grow shareholders' value. On an overall basis, the answer is positive.

• From 2013 to 2020 the average after-tax return on total capital employed was 9.9 % compared to its WACC of 6.6 %.

• From 2013 to 2020 the Book value of BCC grew by 9.4 % CAGR. As there was no new infusion of capital (apart from those due to stock compensation and/or options), this growth was due to retained earnings.

• Assuming no dividend was paid, the net income from 2014 to 2020 would have grown the 2013 shareholders’ funds at 11.7 % CAGR.

Furthermore, if a retail investor had bought a share in BCC at the end of the IPO year of 2013 and held it on until 31 Dec 2020, he would have gained USD 23.06 per share as shown in the table below.

	USD per share
End Dec 2020	47.80
End Dec 2013	29.48
Capital gain	18.32
Dividend declared	4.74
Total gain	23.06

Table 5: Shareholders' gain

His investment today including dividend would have increased at a CAGR of 8.6 %

Considering the cost of equity of 7.5 % and a WACC of 6.6 %, I would consider all the above returns positively.

What are other points to consider?

• BCC only started to pay dividends in 2017 and the current dividend yield is about 4 %.  

• Not all the share buyback exercises added to shareholders value as some were purchased at prices higher than intrinsic values

Share purchase

SDI began to repurchase its shares from 2013 onwards. 

Table 6: Share repurchases

The appropriate way to assess whether the share buyback is value-additive is to compare the purchased price with the intrinsic value. If the purchased price is lower than the intrinsic value, I would conclude that the share buyback has added to shareholders' value.

In this case, instead of computing the intrinsic value, I used the Book Value as a proxy.  In my valuation, I found that the EPV to Book value is 1.3 while the Earning value with growth to Book Value is 2.4.  

Assuming that these ratios are “stable”, I would conclude that :

• The 2013 and 2014 share purchases would not have resulted in adding value for the shareholders.

• The 2015 and 2018 share purchases were likely to have added shareholders’ value.

• On a volume-weighted basis, the share purchases would not have resulted in adding value for the shareholders. 

How to Secure Your Investment by Minimizing Risk

In its Form 10K, BCC listed 20 principal risk factors that could affect the business of the Group. 

The factors listed are operational and business risks all of which BCC faced being in a commoditized cyclical sector. Management has a reasonable operating track record and should be able to meet most of these challenges. 

I believe that the biggest business risks are the expansion risk and the capital allocation challenges.  

BCC's strategy is to grow its EWP sales and expand its distribution capabilities. This will mean further investments and acquisitions. 

But the Wood Products segment business economics do not look promising. Historically the amount spent on investments far exceeded the cash flow generated. No business can sustain such a situation.

BCC needs to review its business model and growth plans. Would the new CEO be able to manage this? From an investor’s perspective, this poor business economics affects the valuation. 

The Case Notes illustrated the relationship between intrinsic value and business economics. I have shown earlier that BCC valuation with growth does not provide any margin of safety due to the high reinvestment rates.

For any significant margin of safety, management has to review its capital allocation plan.  It has to ensure that the amount invested is within the cash flow generated by the operations

Pulling it all together

• Management has been able to perform better than its peers from an operational perspective.

• There are issues with capital allocation. Over the past 8 years, the Wood Products segment investment has been doubled the segment operating income for the same period.

• At the current price, BCC is overpriced.

Chart 5: BCC share price    Source: Yahoo Finance   

Over the past 5 years, BCC's share price has gone through more than 2 cycles where the price has declined by about 50% of the cycle peak price. Refer to Chart 5. This price movement may not be market sentiments driven.

Given that BCC product prices are cyclical, part of the share price movements could be due to the market reacting to the product price cycle.

The chart below shows the relationship between BCC share price and the Producer Price Index for Plywood and Engineered Wood Products (Source: FRED). There is a 0.73 correlation between these 2 price indices.

  

Chart 6: Share price index c/w Producer price index

If history repeats itself, you are likely to see another share price decline when the prices for plywood and EWP decline. 

The investment thesis is that while waiting for the price to decline to below the EPV level, BCC must also improve the business economics.  Otherwise, there is no margin of safety at this level. 

This requires both a change in the capital allocation approach as well as improvements in the returns. Or else it could be a potential value trap.

End of Part 2 of 2

An Update was published on 22 May 2022

Notes

1) Valuation methodology

• The valuation is based on the Free cash flow to the firm model as per Damodaran.

• Valuation with growth is based on a single-stage growth model.

• Free cash flow = EBIT X (1 - tax rate) X Reinvestment rate.

• Reinvestment rate = Growth rate / Return.

• The Selling, General & Admin expenses were based on 2017 to 2019 average SGA excluding incentive compensation as % of revenue.  I used the 2017 to 2019 period as the 2021 Proxy Statement has yet to be filed.

• The interest rate is based on 2020 (including lease).

• The profit-sharing amount was based on the 2017 to 2019 average of 5.4 % of EBITDA where the EBITDA is before the profit-sharing component.

Reading guide

If you are a first-time visitor to this blog, you may not be familiar with some of the concepts that I have used in my analysis and valuation.  I suggest that you check up the Foundations series - Fundamentals 01,  Fundamentals 02, and Fundamentals 03.   I also have a Definitions page in case you are not familiar with the terms I have used. 

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If the above article was useful, you can find more insights on how to make money in my e-book. The e-book is now available from Amazon, Kobo and Google Play.

PS: If you are in Malaysia or Singapore, the e-book can only be download from Kobo and Google Play. 

Disclaimer & Disclosure

I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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