Beacon Roofing Down to Neutral (BECN) (LL)

We have downgraded our recommendation on Beacon Roofing Supply, Inc (BECN) from Outperform to Neutral. Beacon Roofing currently maintains a Zacks #3 Rank (Hold) over the short term.

Beacon Roofing’s fourth-quarter 2012 earnings came in at 60 cents per share, in line with the Zacks Consensus Estimate. Earnings increased 7% annually, attributable to higher sales on the back of accretive acquisitions and gross margin expansion; offset by higher operating expenses. Revenues increased 4% to $598 million, falling short of the Zacks Consensus Estimate.

In fiscal 2012, adjusted EPS surged 44% year over year to $1.67, helped by higher sales and gross margins, somewhat offset by higher operating expenses and a higher income tax provision. EPS was in line with the Zacks Consensus Estimate. Total revenue increased 12% year over year to $2.04 million, in line with the Zacks Consensus Estimate.

The company primarily benefited from increased re-roofing activities in the first half of fiscal 2012. Traditionally, over 70% of expenditures in the roofing market are for re-roofing projects. Re-roofing projects are generally considered maintenance and repair expenditures and are less likely to be postponed during periods of recession or slow economic growth compared to new construction projects. Driving the demand for re-roofing is an aging U.S. housing stock. Over 60% of the U.S. housing stock was built prior to 1980, with the median age of U.S. homes is over 35 years. Furthermore; weather damage homeowners looking to upgrade their homes, and sales of existing homes are also driving demand.

U.S. residential construction is finally stabilizing and is on the road to a much-awaited recovery, which bodes well for the Beacon Roofing. Housing starts have improved throughout 2012 with both housing starts and building permits attaining a 4-year high in September.

Non-residential construction is also showing signs of improvement. According to the American Institute of Architects, after languishing in the negative territory for five consecutive months, the architecture billing index (ABI) climbed back into the positive territory with a score of 50.2 in August, improving further to 51.6 in September and 52.8 in October. This is the strongest pace of growth witnessed since December 2010. ABI is an economic indicator that provides an approximate nine- to twelve-month glimpse into the future of non-residential construction spending activity and any score above 50 indicates an increase in billings. As per the American Institute of Architects, spending for non-residential construction will go up to 4.4% in calendar 2012 and accelerate further to 6.2% in 2013.

Acquisitions are an important part of Beacon Roofing’s growth strategy. Over the last 10 years, the company has grown through a combination of 22 strategic and complementary acquisitions between fiscal 2002 and 2012, opening new branch locations, acquiring branches and broadening its product offering. Sales have grown at a 10-year compound annual growth rate of 14.0%. The company’s internal growth, which includes growth from existing and newly opened branches but excludes growth from acquired branches, has averaged 4.7% annually over the same period.

The company has recently acquired Structural Materials Company in Southern California, Contractors Roofing & Supply Co. in St. Louis and Pennsylvania-based McClure-Johnston Company. Its main acquisition strategy is to target market leaders in geographic areas where it does not have a presence. Beacon Roofing also acquires companies to supplement branch openings within existing markets. Beacon Roofing remains fairly active on the acquisition front and we expect the acquisitions to continue at an accelerated pace in the near term.

However, this acquisition driven growth strategy exposes the company to acquisition related risks. Management may have trouble finding suitable acquisition candidates that provide synergies in existing markets and upfront earnings accretion.

Furthermore, a longer-than-expected downturn in residential and non-residential roofing markets will affect results of Beacon Roofing. Inability of Beacon Roofing to successfully pass on higher raw material costs to customers will also have a negative impact on its results.

Beacon is one of the three largest roofing material distributors in the United States and Canada, with more than 90% of sales coming from the U.S. Lumber Liquidators Holdings, Inc. (LL) is Zacks #1 Rank (Strong Buy) stock in the same industry.