Boise Cascade - beware of illusory valuations
Value Investing Case Study 11-3: This is an update of Boise Cascade taking into account the Q1 2022 results. The focus is on valuation. Different assumptions lead to different conclusions. The challenge is deciding on a realistic picture.
I last covered Boise Cascade Company (BCC or the Group) in my blog in March of 2021. I concluded then that with BCC trading at USD 49.49 per share, it was over-priced.
The price had continued to rise so that as of 10 May 2022 it was USD 78.36. In my Mac 2022 article for Seeking Alpha titled “Boise Cascade - The Risk Is In The Valuation” I had opined that there is currently a margin of safety. This was based on a revised valuation.
You may be forgiven for being confused. Why would a higher market price provide a margin of safety when a lower price last year was deemed a buying risk?
The reason is not the company analysis. In my articles last year, I concluded that BCC was fundamentally sound. Based on an updated company analysis, the conclusion remains unchanged.
The reason was the valuation. My Mac 2022 Seeking Alpha valuation was based on higher revenue and a lower discount rate. The discount rate was estimated based on pre-Ukraine invasion parameters. I believe that we are now facing a different economic scenario with higher risks. We should expect a higher discount rate.
Join me as I illustrate how the changes in assumptions impact the value of BCC. If you are not familiar with the Group, I would suggest that you first read the following articles:
Should you go and buy it? Well, read my Disclaimer.
Contents
- Summary
- Fundamentally strong
- Uptrend in Lumber and Wood Products prices
- Cyclical Housing Starts
- Valuation
- Conclusion
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Valuations are based on assumptions about the future. If there is a significant change in the outlook, we should be prepared to re-visit our assumptions. The only time you retain the valuation is if the assumptions are still valid.
The Ukraine invasion and the high inflation rates meant a different economic picture. I have thus reviewed the valuation relative to the Mac 2022 Seeking Alpha one. I have assumed a higher discount rate to reflect the higher risk. However, I have retained the same revenue projection that was based on the cyclical lens.
Summary
- BCC is fundamentally sound based on several metrics. It is strong financially. It has a good growth and ROE track record. It is also one of the better performers among the listed peers.
- From 2010 to 2021, BCC revenue grew at a CAGR of 12.2 %. This growth was a function of demand growth as well as price growth. I estimated the demand growth by looking at the changes in the annual revenue at the 2010 constant price. On a constant price basis, revenue grew at 2.5 % CAGR from 2010 to 2021.
- Based on the FRED Producer Price Index, I estimated that product price grew at 4.8 % CAGR from 2010 to 2121. The average product price for the period from 2010 to 2021 is 21% higher than the 2010 product price.
- For the past 12 years, there is a 0.88 correlation between the Housing Starts and BCC revenue at the 2010 constant price. The Housing Starts is cyclical without any growth in the long-term average Housing Starts. I expect the Housing Starts to mean revert from its current uptrend. When this happens, I also expect BCC revenue to mean revert.
- BCC’s long-term average demand can then be pegged to the Housing Starts long-term average units. I estimated the long-term average revenue for BCC by multiplying the BCC’s long-term average demand by the average product price.
- Based on this long-term average revenue, I estimated the free cash flow and subsequently the intrinsic value of BCC. I also estimated a discount rate based on Damodaran’s Jan 2022 datasets.
- I looked at three Scenarios. Two of the Scenarios had values significantly higher than the market price. The conclusion is different from what I had arrived at last year. The difference is due to the different input parameters. The main investment risk is the valuation risk and not the business one.
- The challenge is then determining which is the more realistic scenario. That is why fundamental analysis is important.
- I would consider the value of BCC as best represented by the assumptions under Scenario 3. With the computed value of USD 92.56 per share, there is thus an 18% margin of safety compared to the market price of USD 78.36 (as of 10 May 2022).
Fundamentally strong
For Q1 2022, BCC achieved USD 2.3 billion in revenue and US 303 million in net income. Compared with the performance of Q1 2021, the current revenue is 28 % higher while the net income is slightly more than doubled. Management has attributed this to the favourable demand environment for new residential construction.
I rate BCC as a fundamentally strong group. It is financially sound with a good operating track record. BCC’s financial strengths came from the following:
- It has a D/ (D + E) ratio of 0.24 (end Mac 2022). According to Damodaran's Jan 2022 datasets, the ratio for the paper/forest products industries is 0.29.
- Over the past 12 years, except for 2011, it had been able to generate positive cash flow from operations every year. On average, BCC generated USD 161 m per year cash flow from operations compared to its average annual net income of USD 110 m.
- It currently has USD 923 m cash (end Mac 2022). This is about 42 % of the Total Capital Employed (Debt + Equity) as of the end of Mac 2022.
Over the past 12 years, BCC achieved an ROE of 14.7 % compared to its cost of equity of 6.3 %. Growth will thus create shareholders’ value. The Group has been able to improve its ROE from - 8 % in 2010 to 53 % in 2021. A Dupont analysis of the ROE showed that this was driven mainly by changes in the profit margins.
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| Chart 1: DuPont Analysis |
You should not be surprised by the 2021 profit margins as there was a substantial increase in product prices in 2021 compared to 2020. According to BCC, it experienced the following price increases:
- 84 % for Composite panel.
- 82 % and 72 % respectively for Western Fir plywood and Southern Pine plywood.
- 94 % for OSB.
- 49 % for Composite lumber.
The 2021 results had skewed its growth, but even if you ignore this, BCC growth is good:
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| Table 1: Comparative Performance |
I also compared BCC’s performance with 3 other listed peers. Looking at the past 12 years’ comparisons, I would rate BCC’s performance as good.
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| Chart 2: Peer Revenue |
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| Chart 3: Peer ROA |
The only concern I have is the high Reinvestment Rate. I computed the overall Reinvestment rate for the past 12 years as
= (CAPEX + Net acquisitions - Depreciation & Amortization + Net Working Capital) / Net income = 50 %
I considered this high as the theoretical Reinvestment rate is about half of the historical Reinvestment rate. The theoretical rate was derived using the formula of Growth rate = Reinvestment rate X Return.
One reason for the high historical Reinvestment rate was the CAPEX and acquisitions of the Wood Products segment. This was due to BCC’s plans to diversify from plywood to engineered wood products. In my earlier blog articles, I had already highlighted this unstainable Reinvestment rate. But, the high profits in 2021 had helped to reduce the rate. But this is something that BCC needs to watch out for.
The uptrend in Lumber and Wood Products prices
The revenue of BCC is a function of the demand and product prices.
Based on the FRED Producer Price Index (PPI) for lumber and wood products, the PPI has been on an uptrend since 2010. But 2021 was an extraordinary year for product price growth as can be seen from the chart.
- The PPI grew at a 4.8 % CAGR from 2010 to 2021. A significant part of this growth was due to the price increase in 2021. From 2010 to 2020, the PPI increased by a 3.7 % CAGR.
- The average 2010 to 2021 PPI was 21.2 % higher than the 2010 index value.
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| Chart 4: Producer Price Index Source: FRED Note: I took the Dec index to represent the index for the year for my computation of the growth rates. |
Given the uptrend in the prices, I wanted to estimate BCC revenue growth that was independent of the product price growth. This will then represent the demand (as a proxy for sales volume) for BCC’s products.
This was estimated by determining the revenue for the various years based on the 2010 constant price. Given the PPI for each year, I could derive BBC revenue at the constant 2010 price as shown in the following example for 2010 and 2015.
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| Table 2: Computing the Index |
Based on the revenue at the 2010 constant price, I found that:
- BCC revenue grew at a 2.5 % CAGR from 2010 to 2021.
- There is a 0.88 correlation between BCC constant price revenue and the US Housing Starts.
Cyclical Housing Starts
The US Housing Starts is cyclical and over the past 70 years, there was no growth in the long-term average Housing Starts of 1.5 million units.
For more details on the housing cycle, refer to my Seeking Alpha article on MDC Holdings.
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| Chart 5: US Housing Starts Source: Trading Economics |
The Housing Starts is currently on the uptrend and will over-shoot the long-term average values. But it will peak and mean revert.
There is a correlation between the Housing Starts and BCC’s demand.
“Demand for the products we manufacture, as well as the products we purchase and distribute, is correlated with new residential construction, residential repair-and-remodeling activity, and light commercial construction.” BCC Form 10Q, Mac 2022.
As such, I would expect BCC’s current revenue to also peak and mean revert eventually.
The implication is that BCC’s revenue at the 2010 constant price will be cyclical. And BCC’s long-term average revenue at the 2010 constant price will also be pegged to the long-term average Housing Starts of 1.5 million units.
In 2021, the US Housing Starts was 1.68 million units. Based on this, I estimated the long term BCC average revenue at 2010 constant price = BCC 2021 actual Revenue X (1.5 / 1.68) = USD 4,240 million
But this is the revenue at the 2010 constant price. To estimate the revenue at the “current price” I multiplied this by 1.212. This was the average 2010 to 2021 PPI relative to the 2010 PPI.
On this basis, I estimated BCC’s long-term average revenue to be USD 5,139 million.
If you accept that BCC revenue is cyclical, then the long-term average revenue would be the long-term average. In other words, in valuing BCC, the financial model should be based on this long-term cyclical average of USD 5,139 million. This is more reflective of the cyclical nature than taking the 2021 values.
Valuation
I valued BCC using a single-stage discounted free cash flow to the firm (FCFF) model.
Value = FCFF X (1 + g) / (r - g)
FCFF = EBIT(1 - tax rate) - Reinvestment
EBIT = Gross profit - SGA - Depreciation & Amortization. Note that the gross profit here is before deprecation and amortization and hence has to be deducted to derive the EBIT.
Reinvestment = CAPEX + Net Acquisitions - Depreciation & Amortization + Net Working Capital
r = WACC. I derived this following Damodaran's approach with a 1.51 % risk-free rate, unlevered Beta of 1.0 for the paper/forest products sector, and a 30 % tax rate.
g = growth rate. I have assumed this to be the long-term US GDP growth rate of 4 %. Note that this is lower than the PPI growth rate of 4.8 % for the past 12 years.
Total Capital Employed (TCE) = Revenue X (average TCE/Revenue ratio). The ratio was based on the past 12 years’ average.
Gross profit = Revenue X Gross profit margin. The Gross profit margin was computed before depreciation & amortization.
SGA = Revenue X SGA margin.
I assumed that the Gross profit margin and SGA margin were based on the past 12 years’ average margins.
I looked at 3 scenarios:
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| Table 3: Valuation Scenarios |
The 27 % Reinvestment rate was derived based on the fundamental formula of Growth rate = Reinvestment rate X Return. It assumed that BCC had managed to control the historically high Reinvestment rate. The 38 % Reinvestment rate was the rate used in 2021.
The 5.6 % WACC was derived based on Damodaran’s Jan 2022 datasets and reflected the situation before the Ukraine invasion and high inflation. The 6.6 % was the one used in 2021 and reflected the Covid-19 situation.
Scenario 1 can then be considered a conservative position while Scenario 2 is an optimistic one. Scenario 3 is one where the Reinvestment rate has been brought under control but reflected a higher risk situation.
The other assumptions used in the valuation are summarized in that table below. I have also shown the assumptions used in my 2021 valuation.
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| Table 4: Valuation Assumptions |
Based on the above, the values of BCC are as follows:
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| Table 5: Valuations Notes (a) The 2021 Book value was as of the end of Dec 2020 while the others was as of the end of Dec 2021. (b) 2021 market price was as of 1 Mac 2021 whereas the others were as of 10 May 2022. (c) Comparing the Earnings Value with growth with the respective market price. |
Comparing the various valuations.
In 2021, I had valued BCC’s Equity value with 4% growth as USD 51.54 per share. The values for 2022 were based on the same valuation model as that used in 2021 except for the following key changes.
- The EBIT for 2022 is 38 % higher than that for 2021. This was due to higher revenue for 2022.
- For Scenario 2, the WACC is 15 % lower than that for 2021.
- The Reinvestment rates for Scenarios 2 and 3 were 29 % lower than that used in 2021.
The questions then are:
- Does Scenarios 1 to 3 revenue of USD 5.1 billion better reflect the long-term outlook?
- We are now entering a high inflation period with a possible lower economic growth. Does the lower WACC under Scenario 2 reflect the long-term risk?
- Would the company be able to control the Reinvestment rate?
The Scenarios 1 to 3 revenue is realistic as it was built up based on 2 conservatively estimated components.
- 2010 constant price component that is pegged to the long-term average annual Housing Starts. This is similar to the physical sales volume. Given the strong link between BCC performance and the housing sector, this is a realistic long term view.
- The price was based on the average 2010 to 2021 price relative to the 2010 price.
However, for the WACC, I would expect a higher risk compared to that computed based on the pre-Ukraine war and high inflation environment. As Damodaran has no updated datasets, I used the 2021 rate of 6.6 % to reflect the higher risk.
As for the Reinvestment rates, given the other strong fundamentals, I would think that management would be able to address the high Reinvestment rates. As such I would use the Reinvestment rate derived from the fundamental growth formula.
All this meant that Scenario 3 is the most realistic one.
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Conclusion
BCC is a fundamentally sound company. The real issue is whether there is a sufficient margin of safety at the current price. This is dependent on the valuation which in turn is dependent on the assumptions employed.
In my valuation, I looked at 3 Scenarios. Of these, 2 have values with significant margins of safety. This was different from the 2021 valuation which had only a marginal margin of safety. In fact, there was also only a marginal margin of safety under the 2022 Scenario 1
In my Mac 2022 Seeking Alpha article, I had a more optimistic EBIT of USD 249 million but with a 50% Reinvestment rate. That resulted in a value that is about the same as that under Scenario 2.
It is obvious that the values would depend on the assumptions. The challenge is then to select a set of assumptions that best reflect reality. In the case of BCC, I would consider Scenario 3 as the most realistic and take the intrinsic value as USD 92.56 per share.
I think the case study illustrates that fundamental analysis is not some mindless number crunching exercise. You have to understand the situation and the basis of the model. Valuations are forward looking estimates of the prospects of the company. If the are significant changes to the prospects, you should revisit the various assumptions.
If nothing else, I hope that this article demonstrated that:
- You should always invest with a margin of safety.
- You should not rely on just one valuation approach. I generally also look at the Acquirers’ Multiple and the Magic Formula to triangulate the value.
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Disclaimer & Disclosure
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