Depot makes a splash

The LBM channel doesn’t make headlines very often, so it was kind of a big deal the other week when Home Depot executed a perfect cannonball into the pro end of the pool.

On March 28th, Depot announced its purchase of McKinney, Texas-based SRS Distribution for $18.25 billion. SRS is the second-largest U.S. roofing/siding one-stepper behind ABC Supply: $9.8 billion in 2023 revenue from 767 branches in 47 states according to Craig Webb at Webb Analytics.

SRS is “the latest and largest sign of (Depot’s) ambitions to drive sales by winning more business from contractors,” says CNBC. SRS would certainly do the trick on that score. According to HBS Dealer’s annual rankings, 99% of its revenue comes from contractors.

The timing was good, too. On LinkedIn, Zonda’s Todd Tomalak noted that the acquisition occurred just as “big box retailers are facing an unwind of ‘middle-income remodels’ through 1H 2024.”

Depot’s revenue was down 3% in 2023, a sure sign that the home improvement market is stumbling. According to the Harvard Joint Center for Housing Studies’ Leading Indicator of Remodeling Activity, homeowner improvement and repair activity has fallen 5.3% since Q3 2023, the first decline in more than a decade.

The Joint Center believes the market will bottom out this year at about 8% below its Q3 2023 peak, then start to recover in 2025. But the problem runs deeper than that. Big box home improvement retailers have achieved near-saturation in North America—plus, an aging population suggests a long-term decline in DIY activity.

So it makes sense that Depot would be looking “beyond its do-it-yourself roots to revive growth,” as Bloomberg put it. But while that may be news to the media, it hardly qualifies as news within the LBM channel. Home Depot has been chasing contractors for most of its 46-year existence.

In the 1990s, a program called Home Depot Direct was a short-lived attempt to sell framing packages to home builders from its big box stores. Home Depot Expo was a selection showroom for contractors’ clients. It hung around until 2009, but never came close to the nationwide chain Depot had planned.

In the early 2000s, Depot caught the M&A bug and began assembling a mashup of businesses under the HD Supply banner: MRO, waterworks, electrical and utilities supply, home decor and interior design, industrial tools and accessories, concrete forming systems—and even lumberyards and truss plants (Williams Bros., Cox, Forest Products). It also picked up California-based Contractors’ Warehouse and made at least one attempt to field an outside sales force at its big box stores.

Depot sold HD Supply to a group of PE firms in 2007. They stripped it to its MRO roots and took it public in 2013, then Depot bought it back in 2020. Around the same time, Depot also opened bulk material distribution centers in a handful of major metros and once again started selling framing packages to home builders.

In other words, SRS is no outlier—this is what Home Depot does. Right now the industry is all abuzz trying to figure out the strategy behind the purchase. But there is another mystery that might be equally relevant.

SRS Distribution was launched in 2008 by a group of execs from Cameron Ashley and Shelter Distribution. SRS is essentially an acquisition machine: It buys well-managed local roofing suppliers, keeps the management team intact, and lets them manage their markets under their own brand name while SRS provides capital plus administrative and purchasing support.

According to Webb Analytics, SRS finished its first year with 18 locations and $120 million in revenue. Roughly two-thirds of today’s $9.8 billion is roofing supply. The other third is split between pool supply and landscaping divisions acquired not long after the pandemic.

In 2013, just as the global M&A wave was morphing into a tsunami, SRS flipped a majority stake to Boston-based PE firm Berkshire Partners. In turn, Berkshire sold a majority stake to L.A.-based Leonard Green & Partners in 2018.

SRS is privately-held so there isn’t a lot of data beyond trade magazine rankings and the presentation Depot made to investors when it announced the purchase. But its closest direct competitor, Beacon Roofing Supply, is publicly-held so it might be worth comparing the two.

In terms of revenue, they’re virtually twins—both just shy of $1 billion and both a little less than half the size of the No. 1 roofing one-stepper, ABC Supply. According to Depot’s presentation, SRS’s 2023 adjusted EBITDA was about $1.1 billion, which works out to a little over 11%. Beacon claimed 10.2% adjusted EBITDA last year.

The not-fantasy numbers are close, too. Beacon’s net margin in 2023 was 4.8%. Webb Analytics says TD Cowen estimates SRS’s net at 5.3%. For reference, Home Depot’s net margin before taxes in 2023 was 13.1%.

There are also a couple of significant differences between the two. Beacon’s 533 branch locations generated an average of $17.1 million per unit in 2023, not far behind ABC Supply’s $20.4 million per unit. SRS averaged just $12.8 million per branch location.

The other significant spread is in revenue growth per branch. From 2018 to 2023, Beacon’s average revenue per unit rose from $7.4 million (HBS Dealer rankings) to $17.1 million (Q4 2023 investor presentation), a 130.7% increase. By comparison, ABC’s revenue per unit rose 19.6% while SRS was up 17%. Crude oil prices rose 18% during the same period.

Everyone is asking why Depot wanted SRS. The official answer, courtesy of EVP Richard McPhail, is that “SRS is opening up a new customer for us.” Depot has pointed out repeatedly that SRS increases its “total addressable market” (TAM in corporate-speak) by $50 billion.

That’s fine, albeit not as impressive as it looks in context. Depot estimates its pre-acquisition TAM at about $1 trillion, so $50 billion only adds 5%.

Analysts have opinions, too. As reported by Webb Analytics, some believe Depot wanted SRS for its ability to help the retailer improve its contractor services. Depot claims 50% of its revenue comes from contractors, but admits that most of them use it as a convenience store. It wants to be a primary supplier

Others point out that SRS gives Depot a new weapon vs. Amazon. Manufacturers frequently have dedicated product lines for big box retailers while reserving other lines for sale through construction suppliers—and Amazon, either directly or via those suppliers. SRS gives Depot access to those product lines.

Still others say Depot wanted SRS for the internal systems it uses to manage its branch locations. That makes sense, too. Chain operators frequently struggle with the degree of local decision-making required in construction supply. If SRS has developed tools to effectively monitor and manage branch-level autonomy, that may well have been a strong selling point with Depot.

Something certainly was. $18.25 billion for a company that earned $1.1 billion EBITDA (adjusted at that) pencils out to over 16 times earnings. Sources familiar with the deal say Depot paid a 16.1x multiple.

For an independent LBM, 5x or 6x is common and 8x is creeping up on top dollar. Chains are valued higher because of their size, and it’s true that strategic buyers are often willing to pay more than PE investors looking for a quick flip. But 16x seems excessive.

Builders FirstSource is currently valued at only about 10x EBITDA and it blew the doors off SRS in 2023: 11.6% net before taxes and 17.0% adjusted EBITDA. Across the entire U.S. economy—including high-margin sectors like banking and tech—the average purchase multiple last year was 10.8x according to Bain & Company’s latest annual Global Private Equity Report.

It would be interesting to know why Depot wanted SRS. But the real mystery may be why it wanted SRS so badly that it was willing to pay a 40% to 50% premium. At least by all the visible evidence, SRS is strictly a middle-of-the-road performer.

It would make sense if Depot is feeling pressure from investors to show something for its efforts in the contractor market. Its big boxes are at or near saturation, and DIY is declining as Boomers and GenXers age. MRO might not be a growth market, either. Office vacancies are at an all-time record high due to what is most likely a permanent shift toward remote work.

On the other hand, both new residential construction and remodeling are poised for an unprecedented period of growth. The U.S. is underbuilt to the tune of 4 to 6 million housing units depending on who you ask. Even if we could build 2.5 million new homes per year—which we can’t, at least not yet—it would take a solid decade and probably more to catch up to demand.

In R&R, the median U.S. home is now 42 years old—i.e., ripe for repairs. Moreover, fully one-third of the country’s 83.6 million mortgage holders are sitting on sub-3% loans. They’re naturally reluctant to give up those rates, but their needs will change over time. If they won’t move, the other option is to remodel.

SRS puts Depot smack in the path of both trends so there’s no question that the acquisition was a good move for Depot. For everyone else, the issue is whether this will shake up the competitive landscape at all. Setting aside the headaches it might cause for manufacturers, the answer is probably no.

Home Depot is obviously a formidable competitor. Like Wal-Mart and Costco, it developed a store format that hit the jackpot in the late 20th century. Throughout the 1980s and 90s, it swatted aside other big box home improvement retailers and drove local home centers out of the consumer side of the LBM market.

According to HBS Dealer’s 2023 Top 150 Leaderboard, building material retailers (NAICS 4441) generated total sales of $445.8 billion in 2022. Depot’s 2022 revenue was $157.4 billion, or 35.3% market share. That’s true consolidation, but it works for a reason.

In retailing, a single store format that can be replicated across multiple markets is critical because it creates economies of scale and synergies that give large players an advantage. That’s why a Home Depot is a Home Depot whether it’s in Portland, Ore. or Portland, Maine.

Construction supply is different. Building codes, construction practices, and even materials may vary from market to market. How much depends on the phase—e.g., there are more variables in shell construction than in roofing supply. But to one degree or another, every supplier’s offering needs to be tailored to the quirks of each individual market.

That levels the playing field between chains and independents: It limits economies of scale and rewards local decision-making authority. Independents compete by maximizing responsiveness. Chain operators compete by striking a careful balance between centralization and local autonomy, to get the greatest possible advantage from size without undermining responsiveness.

Every chain operator defines the balance differently—BFS, US LBM, Kodiak, and 84 Lumber each have their own ideas. If they get it right, they can hold their own against independents and occasionally even outperform many of them. BFS’s 11.6% net margin in 2023 probably puts it in the top 10% of LBMs with manufacturing.

But even that isn’t enough to muscle local competitors out of the market like Depot did in home improvement retailing 30 years ago. Good construction suppliers are too deeply integrated into their customers’ operations. You might be able to pry them loose temporarily with lowball pricing—builders do like free money—but as soon as the spigot closes, they’ll jump back to the supplier who provides the best support.

That’s why we don’t have consolidation in construction supply. Instead, we have roll-up consolidation. Nobody puts anybody out of business. If you want to capture a competitor’s market share, the only way to do it is to buy the company.

In that environment, it makes no difference who owns whom. Home Depot can’t run SRS’s portfolio companies much differently than they ran themselves before SRS bought them. It’d be no surprise to find that most customers aren’t even aware that their local supplier is owned by someone else. With SRS that was no accident. It remains to be seen what Depot will do.

One way or another, the question is whether Depot will find the right balance between synergy and autonomy. If so, nothing will change. If not, chances are ABC Supply and Beacon will be happy campers.

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