"To put the odds in your favor, you have to change the game" - Joel Greenblatt, The Big Secret For The Small Investor.

Simpson Manufacturing (SSD) falls under the category of companies I gravitate towards. The hallmark of these companies is a combination of excellent performance over the years and lower popularity among investors. This lower popularity is primarily due to size. Such companies go unnoticed because they are often too small for large institutional investors, analysts don't cover them very well, and many retail investors focus on the best-known companies in the main indexes.

With data and information readily available to everyone, larger companies are rarely mispriced. When we decide to buy a stock, whatever genius rationale we think we have, the market most likely already priced it in. To some extent, the market is very efficient in setting the price of equities. The few opportunities to get something at a discount often arise in the wake of collective emotional swings when Jerome Powel sneezes or when COVID-like events make the world believe a civilizational change is about to happen. Therefore, if we buy what everyone else is buying, our results will be the same as everyone else's, which is not necessarily bad. But when we leave the path of index fund investing, whether we admit it or not, we hope to edge out the market in one way or another; otherwise, why bother? Let's see if Simpson Manufacturing is one of those game-changing opportunities.

Simpson Manufacturing Co., Inc. (SSD) is an industry leader in the design, engineering, and manufacturing of Wood and Concrete construction products. Its wood segment comprises 86% of sales and includes connectors, fasteners, and lateral resistive systems used in commercial construction and DIY projects. Under the Concrete category, the company provides anchor products such as adhesives, mechanical anchors and drill bits, along with products intended to repair, protect and strengthen concrete structures (grouts coatings, sealers, etc.). Based in Pleasanton, CA, the company has production facilities in North America and Europe. North American sales represent 86.6% of revenues, and the European market is responsible for the remaining 12.5%. Although the company offers its products in Asia, sales are insignificant in this region.

With a market cap of $3.87 billion and a three-month average volume of 189K shares traded daily, Simpson is not as "obscure" as some small caps, but it's not very popular either. But low popularity might be just the beginning of the edge. The following two essential criteria I tend to favor the most are:

1- Profitability with High Return On Invested Capital (ROIC)

The first ensures I am investing in a highly profitable company, and the latter gives me peace of mind in case an unexpected macroeconomic event is lurking down the road - ahem - the dreaded interest rate hikes.

Simpson Manufacturing passes the profitability test with flying colors. Over the last ten years, Net Income and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) have grown hand in hand at a clip of 25% and 18%, respectively (Figure 1). If we go back to 2006 and look at these metrics' rolling 10-year and 5-year growth, we will not be disappointed either. Except for the hiccup caused by the 2008 financial crisis that led to negative growth, the trend is clearly up and to the right (Figure 2).

Figure 1: Simpson Manufacturing Net Income, Free Cash Flow And EBITDA Growth (Author) Figure 2: Simpson Manufacturing EPS, EBITDA and FCF Growth in 10 And 5-Year Rolling Periods (Author)

Figure 1: Simpson Manufacturing Net Income, Free Cash Flow And EBITDA Growth (Author)

Figure 2: Simpson Manufacturing EPS, EBITDA and FCF Growth in 10 And 5-Year Rolling Periods (Author)

It is worth noting that even during the great financial crisis, despite the negative growth, Net Income, EBITDA, and Free Cash Flow (FCF) were positive nonetheless.

To illustrate Greenblatt's "changing the game" approach, we could look at Deere & Company (DE), also in the broader Industrials sector Simpson Manufacturing belongs to. The company's rolling 10-year Earnings Per Share (EPS) compounded annual growth rate (CAGR) obliterates that of DE, and whereas DE is trading at a Price to Earnings (PE) of 18.1, SSD's PE is only 11.7 (Figure 3). Everyone knows DE, but I bet not many of DE's investors know SSD. This is not a guarantee that SSD will outperform DE or the market, but it tells us an enticing story that SSD might be flying under both the value and growth radars.

Figure 3: Simpson Manufacturing and Deere & Company Rolling 10-year EPS Growth (Author)

Figure 3: Simpson Manufacturing and Deere & Company Rolling 10-year EPS Growth (Author)

FCF growth has been a bit choppier, with a clear drop in 2021 (Figures 1 and 2). Growth has recovered somewhat in the Trailing Twelve Months (TTM) - $152.8 million - but is still below 2019 and 2020 levels - $168.1 million and $169.7 million, respectively. A look at the latest 10-K reveals the culprits:

1- Accounts Receivable are negative and more than doubled compared to 2020 ($67.9 million, up from $22.1 million)

2- Inventories increased sixfold compared to 2020 ($164.2 million, up from $27.2 million)

These can be worrisome signs if those receivables are in danger of being collected and if inventory consists mainly of finished goods, a possible indicator of a deceleration in sales. However, diving into the latest 10-Q, we see that the allowance for doubtful accounts is only 0.58% of the Trade Accounts Receivable. No worries here, it seems. And inventory levels don't seem to be out of line either. Although roughly 55% consists of finished goods, this is not far from the approximately 51% level for the same period in 2020, 2019, and 2018.

If we were to correct the FCF for the abnormal inventory levels of 2021, we would arrive at a FCF of roughly $244 million, a 43% improvement over 2020. This would also align with the same period's 42.4% Net Income growth. Since management stated the company has not experienced significant supply chain disruptions, we can infer that the sharp increase in inventories is a preventive measure to ensure that the reliable service and product availability the company is known for is not disrupted.

Despite the analysis above, the latest growth figures are a bit deceiving. Although the TTM revenue has grown 21% compared to the previous full fiscal year, the latest SEC filing reveals that this was primarily the result of price increases implemented in 2021 and a boost of $80 million in sales related to the acquisition of ETANCO in Europe, more on this later. Sales in North America have indeed decelerated, likely due to future economic uncertainty. To get the doom and gloom out of the way, Gross Margin has also fallen to 43.7% from 47.9%. This drop is also attributable partly to the ETANCO acquisition and partly to higher raw material costs.

Should we worry? A trader with a crystal ball probably should. An investor, I don't think so. We should be driven by value and the quality of a business, not by "what ifs" in the future we cannot control.

Cycles come and go, but the fundamentals of high-quality companies tend to remain stable and improve over more extended periods. By this standard, SSD is indeed a very high-quality company. Gross Margin has not dropped below 43% since 2012, Net Margin has grown from 6.4% to 17.4% in the same period, and ROIC has also improved from 6.8% to 18.8% (Figure 4), more than double the Weighted Average Cost of Capital (WACC) which currently stands at 8.4%. Simpson Manufacturing is highly efficient in investing capital and creating value for shareholders.

Figure 4: Simpson Manufacturing Profitability And Efficiency (Author)

Figure 4: Simpson Manufacturing Profitability And Efficiency (Author)

When analyzed in the context of its sector and industry, SSD leaves most of its peers in the dust. GuruFocus places SSD in the Forest Products industry where the average Gross and Net Margins are 3.08% and 21.6%, respectively. The average ROIC in this industry is 10.7%. If we were to use the Building Materials industry, a more suitable fit for the company, the average Gross and Net Margins are 29.19% and 6.76%, respectively (Figure 5). These still pale in comparison to SSD's performance. No matter how one slices it, these are outstanding profitability and efficiency numbers. Not only is the company growing, but it is also very profitable as it does so, and it does it better than most of its industry peers.

Figure 5: Simpson Manufacturing Profitability (Seeking Alpha)

Figure 5: Simpson Manufacturing Profitability (Seeking Alpha)

Simpson Manufacturing has grown both organically and through strategic acquisitions. ETANCO, a manufacturer of fixing and fastener products headquartered in France, is the most recent purchase in Europe and by far the most expensive of all acquisitions. The deal was closed in April 2022 for $805.4 million and added $80.3 million to Simpson's net sales since. Previous European investments include Gbo Fastening Systems AB in 2017 for $10.2 million and Multi Services Decoupe S.A. in 2016 for $6.9 million. In the United States, Simpson acquired CG Visions Inc. in 2017 for $20.8 million, Blue Heron Enterprises LLC., and Fox Chase Enterprises LLC in 2015 for $3.4 million.

Excluding ETANCO's deal, Simpson's acquisitions since 2015 totaled roughly $41 million, but its revenue grew from $794 million to $1.57 billion in 2021, a 98% increase. Accretive acquisitions are not the only explanation for the formidable growth the company has experienced. The evident organic growth that fills in the gap is the result of:

- New products and solutions developed in-house through innovation and R&D, including product testing in state-of-the-art test labs

- Focus on customer relationships; this includes seminars with architects, engineers, and contractors, strong customer support and education, and product availability within 48 hours

- Development of software applications to make customers' jobs more efficient

- Expansion of the distribution channels for its products. The company is working with Original Equipment Manufacturers (OEM) within the engineered wood products industry on the commercial side, and, to strengthen its presence in the DIY markets, Simpson's made a comeback to Lowe's in 2020

- Working with building officials to improve building codes

This growth recipe is clearly yielding results (Figure 6). The company's market share is 53% for Wood Connectors and Truss products, 28% for Fasteners, and 21% for Concrete products (Figure 7). One does not need to invest in growing but unprofitable companies when both growth and profitability can be had at the same time.

Figure 6: Simpson Manufacturing Revenue Growth (Author) Figure 7: Simpson Manufacturing Market Share (Simpson Manufacturing August 2022 Investor Presentation)

Figure 6: Simpson Manufacturing Revenue Growth (Author)

Figure 7: Simpson Manufacturing Market Share (Simpson Manufacturing August 2022 Investor Presentation)

The unfortunate war in Ukraine will eventually require the reconstruction of the country. Simpson's expansion in the European market might very well position it to benefit from those efforts given ETANCO's production site in neighboring Poland.

Now, the peace of mind portion. Because the company has had little to no debt on the balance sheet until the recent acquisition of ETANCO, there isn't much to say in this regard. The balance sheet is as good as it gets. I like to graph FCF after dividends, share buybacks, and acquisitions (Figure 8). If I see positive green bars, I feel like I have nothing to worry about. There is no funny business, no financial engineering, and cash is rolling in. I want to be an owner of such businesses. We see two spikes in the year-over-year (YOY) debt line in Figure 8. The first is a non-issue since debt goes from non-existent to $35 million. A closer look at the 2020 10-K reveals that this amount is related to Operating Lease Liabilities, not actual interest-bearing liabilities (my data provider lumps operating leases with total debt). The second spike and the "massive" red bar is the money the company borrowed to acquire ETANCO. A nearly 2000% jump in debt sounds worse than it is because, once again, it compares to negligible debt levels.

Figure 8: Simpson Manufacturing Free Cash Flow After Dividends, Buybacks and Acquisitions (Author)

Figure 8: Simpson Manufacturing Free Cash Flow After Dividends, Buybacks and Acquisitions (Author)

Even after the ETANCO deal, debt is now at 1.45X EBITDA, a very conservative leverage level by any standard. Currently, the Interest Coverage Ratio is a healthy 52.7, the Current Ratio is 3.3, and the Acid-Test Ratio is 1.71 (Figure 9). A global meltdown must occur before SSD runs into liquidity problems.

Figure 9: Simpson Manufacturing Liquidity (Author)

Figure 9: Simpson Manufacturing Liquidity (Author)

A variation of the graph I mentioned in the previous section shows the dividends and buybacks (Figure 10). Simpson Manufacturing does both. The dividend yield is nothing to write home about at 1.15%, but dividend investors will be happy to know that it has grown at a rate of 6.13% per year over the last five years (Figure 11). Buybacks are not at the insane levels of companies like Home Depot (HD) or AutoZone (AZO), but shareholders still have the warm feeling of having their ownership grow without the need to buy more shares. Unlike HD or AZO, SSD does buybacks without going into negative equity. They do it responsibly, even during times when debt is cheap, and can thus be used to put a little makeup on those EPS numbers to please Wall Street during earnings season. The dividend and buybacks are sweeteners that are unlikely to go away when the company targets 35% of FCF as their limit for capital return to shareholders. There is no trap here. The focus is still on growth.

Figure 10: Simpson Manufacturing Buybacks, Profitability And Equity (Author) Figure 11: Simpson Manufacturing Dividend Growth (Author)

Figure 10: Simpson Manufacturing Buybacks, Profitability And Equity (Author)

Figure 11: Simpson Manufacturing Dividend Growth (Author)

SSD stock is no Treasury Bill. It's not risk-free. Although Simpson Manufacturing states that their products are not as tightly correlated with housing starts as lumber or other products, the truth is, if the economy and construction decelerate, revenue will suffer. Like any other company, there is no immunity to macroeconomic events. The talk in the street is all about inflation, interest rates, and supply chain constraints. All of these affect Simpson's profitability. As I pointed out earlier, sales growth in the TTM period is primarily the result of price increases in 2021. If anything, this could be a warning sign of things to come. But... the future is uncertain, and if knowing the future is necessary for one to invest, one never will. Quoting Howard Marks, "whenever we're not in a recession, we're heading towards one" - Howard Marks, I Beg To Differ. Therefore, I don't weigh these risks heavily. They are there, but there is nothing I can do to mitigate them.

A risk worth considering is the admission that the company has a few large customers. It's always better when no single customer is responsible for a significant portion of revenue. Still, I think this risk is mitigated by the quality of both Simpson's products and customer care/support.

At this point, I think it's clear that I am bullish on Simpson Manufacturing's future. But being bullish is not enough to invest. Although I believe that fair value calculations have a high degree of subjectivity built in, I will attempt to justify my investment and, in the process, put my valuation out there in the open for criticism, if there is any. Even though the company has strong free cash flows, I will base my valuation on earnings instead. My reason for doing so is the fact that PE has shown less variability in the last ten years (Figure 12). The price to free cash flow ratio (P/FCF), the red line in Figure 12, has spiked several times between 2012 and 2022, pushing the average higher and distorting the historical multiple. Because I will use an exit multiple for my terminal value calculation, I want one that I know has been less volatile. Both PE and EV/EBITDA are more stable for that purpose.

Figure 12: Simpson Manufacturing Stock Price and Multiples History (Author)

Figure 12: Simpson Manufacturing Stock Price and Multiples History (Author)

I use a simple discount model where the present value of future earnings is adjusted for net debt. My starting point is a 10-year and a 5-year PE distribution. I take weekly stock closing prices over those periods and divide them by the corresponding fiscal year's EPS. This gives me an idea of the characteristic multiple for the company I am looking at, in essence, what the market thinks of the company in terms of valuation.

I then find the 95% Confidence Interval for the multiple and test for the difference of means between the TTM PE and the historical PE. This first approach tells me immediately whether the company is trading above or below historical multiples. In Figure 13, the red cells for the p-Value in the ten and 5-year periods indicate precisely that. The TTM PE of 14.51 is clearly below the 10-year (25.11) and 5-year (20.89) PE multiples. This one is quite obvious, and there is no need for statistics.

Figure 13: Simpson Manufacturing Fair Value (Author)

Figure 13: Simpson Manufacturing Fair Value (Author)

My goal is not to be precise with my fair value calculation. Instead, I aim to establish a baseline where I am confident that I am not dead wrong regarding downside risk. One way to guarantee that is haircutting the exit multiple. Although the company's historical PE has been above 20, regardless of whether we look at the ten or 5-year periods, I am assuming an exit multiple of just 15 in both scenarios, which I consider pretty conservative in light of the growth that the company has experienced. Despite not being very well covered by analysts, four firms are following SSD. One of those firms, Sidoti & Co., estimates the EPS CAGR for the next five years at 5%. This figure is way lower than recent historical growth would suggest, but I used this value nonetheless for my 5-year projection, as shown in Figure 13. For my 10-year forecast, I bumped that growth to 10%, which is still lower than recent historical trends. If there is indeed economic turmoil ahead of us, I am optimistic that recovery will ensue, as it always does.

For the discount rate, I am using 9%. This rate is the cost of equity calculated by adding the risk-free rate to the beta-adjusted Equity Risk Premium of 5.10% calculated by Aswath Damodaran. And these are all the assumptions that get me to a fair value of $160 per share if I project earnings out ten years or $98 if my projections extend only five years into the future. Because I can currently buy as many shares as I please at $90, Simpson Manufacturing is a strong buy for me.

The excellent track record for growth and shareholder value creation, the rock-solid balance sheet, and a share price that I believe to be below fair value make Simpson Manufacturing a very attractive investment. Investors looking to go off the beaten path and who want to play a different game in hopes of finding an outperforming stock should put SSD on their shortlist and conduct their research on the company.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of SSD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.