If you are looking for the best ideas for your portfolio you may want to consider some of Choice Equities Capital Management’s top stock picks. Choice Equities Capital Management, an investment management firm, is bullish on BlueLinx Holdings Inc. (NYSE:BXC) stock. In its Q2 2019 investor letter – you can download a copy here – the firm discussed its investment thesis on BlueLinx Holdings Inc. (NYSE:BXC) stock. BlueLinx Holdings Inc. (NYSE:BXC) is a wholesale distributor of building and industrial products.
On July 24, 2019, Choice Equities Capital Management had released its Q2 2019 investor letter. BlueLinx Holdings Inc. (NYSE:BXC) stock has posted a return of -44.6% in the trailing one year period, underperforming the S&P 500 Index which returned 13.8% in the same period. This suggests that the investment firm was wrong in its decision. On a year-to-date basis, BlueLinx Holdings Inc. (NYSE:BXC) stock has risen by 24.8%.
In Q2 2019 investor letter, Choice Equities Capital Management said the fund posted a return of -0.5% in the second quarter of 2019, underperforming fund’s benchmark the S&P 500 Index which returned 4.3% in the same period. Let’s take a look at comments made by Choice Equities Capital Management about BlueLinx Holdings Inc. (NYSE:BXC) stock in the Q2 2019 investor letter.
“BXC – As for Bluelinx, we have recently been rebuilding our position in shares given the current setup again looks quite compelling. One reason is because shares look like quite a bargain in the low $20s versus near term earnings power of $7. Another reason is the market’s strikingly similar treatment of their recent acquisition to a prior well-regarded acquisition by fellow building product distributor Builders Firstsource (“BLDR” or “Builders”). Though Builders is a one stepper primarily focused on serving builders as their end market customers and Bluelinx is a two-stepper focused on serving lumberyards as their end customer, the parallels that can be observed from the market’s treatment of Builders’ acquisition of peer ProBuild in 2015 appear too numerous to dismiss.
Investors initially loved the ProBuild acquisition, and it’s not hard to see why. Builders’ paid a full 10x EBITDA for a quality company, but massive cost synergies realizable from consolidating the two overlapping networks suggested their effective purchase price would be closer to 6x EBITDA after a successful integration. The combined entity would be more than three times as large and benefit significantly from economies of scale in purchasing, footprint rationalization, logistics and an expanded product offering. The new company would become the second largest distributor serving the building products space, and perhaps more importantly, would be the largest in most of their geographical markets. Once synergies would be realized, the company anticipated cash flows would be up over threefold. Shares quickly doubled.
Six months later, sentiment would change abruptly. Shares would soon be cut in half. Housing market conditions would soften, and the company’s expected cash flows would be rerated down on the back of slower end market growth. Shareholders that once praised the company for using debt instead of equity to finance the deal would shift their focus to the debt load and softening end markets instead of the potential earnings accretion. And then a new factor would emerge that would perhaps prove most poisonous to sentiment about the merits of the deal: revenue disynergies.
Despite the disynergies’ relative surprise, their emergence is not an illogical outcome given the natural tendency of buyers to want a few competing sources of supply, particularly in times of relative disruption that can often accompany acquisition integrations. Think of it this way. If buyer A in town B wants to source product C competitively, buyer A will likely get a couple quotes, a process often colloquially referred to as “three bids and a buy”. If distributor X, Y and Z compete to supply those bids and distributors X and Y who are the generally preferred suppliers join forces, it seems reasonable that distributor Z may win some incremental business, if only so buyer A can ensure a consistent source of supply of product C as needed. Though these changing purchasing allegiances are a deterrent to the realization of the targeted synergies, they often prove temporary as price and service will eventually win the sale. Given the purchasing power distributors X and Y gain from consolidating operations, these lost sales can often be recaptured as business disruptions subside once operations have been integrated.
But in the case of BLDR, even though the revenue disynergies would prove marginal relative to the cost synergies and in many cases temporary, the cash flow shortfall from prior expectations and questions around the synergy case would be enough to cause investors to doubt the merits of the deal. Many would dismiss it as a top of the cycle misallocation of corporate resources – until just a few quarters later when sentiment would again swing. Interest rate increases would go on hold. Housing market conditions would improve. And Builders’ would begin to show clear execution on the ProBuild synergy case. Ultimately the originally expected cash flows and earnings stream would show up. It would turn out that the synergies which had been doubted, had only been deferred. Shares would triple.
So how does this compare to Bluelinx thus far? It looks like we may be about halfway there. Shares enjoyed their big surge last spring as investors greeted the highly synergistic deal with great enthusiasm. But two quarters later surging interest rates would curtail growth in the housing market. Investors expectations of near-term cash flows would be revised down, and shares would ultimately get cut in half. In the 1Q 2019 report, a few revenue disynergies showed up, causing some to doubt the merits of the deal.
So, where do we go from here? As always, it’s impossible to know for sure. But there are many positive signs. Interest rates have come in meaningfully from year ago levels, suggesting housing conditions may again start improving in the back half of this year consistent with the six to nine month lag in improvement we have seen in recent declining rate environments. Lumber mills have curtailed production at some of their of less profitable mills, rationalizing supply and likely putting a near-term bottom in on lumber prices. And we have already seen considerable improvement in gross margins from purchasing synergies which will likely continue. Though the coming 2Q report will not be great from an organic growth perspective given still negative year-over-year growth in housing starts, it will likely mark an inflection point to improving conditions. It will also feature nearly $60M in proceeds from real estate sales that will help pay off the debt used to finance the deal. Counting real estate monetization proceeds and expected cash flows from operations, we see an opportunity for the company to pay off their term loan in its entirety by the end of next year, leaving it with a normalized capital structure featuring only a moderate revolver to finance working capital needs. So soon, we’ll have clean consolidated financials, and maybe even some sellside analyst coverage shortly thereafter. The setup again looks quite attractive.”
In Q1 2020, the number of bullish hedge fund positions on BlueLinx Holdings Inc. (NYSE:BXC) stock decreased by about 14% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t seem to agree with BlueLinx’s growth potential. Our calculations showed that BlueLinx Holdings Inc. (NYSE:BXC) isn’t ranked among the 30 most popular stocks among hedge funds.
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Video: Top 5 Stocks Among Hedge Funds
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Disclosure: None. This article is originally published at Insider Monkey.