FourBridges’ Managing Directors Andy Stockett and Ralph Montgomery sat down with Kathryn Thompson, founding partner and CEO of the Thompson Research Group, to talk about the outlook for the building products and industrial services industries in 2023. TRG is an equity research and advisory firm that focuses on the construction and industrial value chain — anything related to residential, non-residential, or commercial construction.

Since our last conversation with Kathryn back in August 2022, there have been interesting shifts in the economy, and we were interested in Kathryn’s perspective on the future of the building products and industrial services arena, especially as it relates to M&A.

Read a transcript of our conversation with Kathryn below, or watch the full interview here:

Economic Outlook 

Andy Stockett: Here’s some economic data to kick things off. I think our last interview with you was on August 22nd, and at that point in time, the Fed funds rate had skyrocketed from 25 basis points in March 2022 to around 3.25 in August, which now stands at 4.5 to 4.75. 

The Dow Jones industrial average hit a 12-month low back in February of last year at about 28,000. It’s now, after a couple of down days, around 32,000. The 30-year Freddie Mac mortgage was at 3.92 in February of ‘22. It hit as high as 7.08 in October and was recently at 6.32.

A little bit closer to the world that Ralph and I live in, lower middle market M&A activity saw a big dip in transaction activity in Q4, according to GF data. So a lot of interesting economic statistics that obviously play into your world and ours, and we’d love to hear your perspective on what happened during that period and where we may be trending.

Kathryn Thompson: When we spoke in August, the clouds were gathering. And candidly, from our perspective, we were feeling pretty lousy about the world starting in July and definitely by August. But you had to put a chipper face on for things. 

It sounds counterintuitive, I know, because the market is getting incredibly beaten up right now, but we actually are a little bit relieved because some of the concerns and the data are working their way out.

If we look at some of the things that have happened since then, the first and the most obvious one is the impact of rate hikes on residential housing starts. We’re right in the middle of public company quarterly earnings, with several big companies this week report earnings, and really pretty much the consensus has shown double digit declines in the residential end market. 

But the question is, what’s the magnitude? Is it going to be down 10%, or is it going to be down 30%? And I think when you look at that residential end market, the biggest difference now versus when we first talked is you’re going to see much greater variances in regions in terms of performance. And that’s going to really be across the value chain, but in particular, for residential. 

On non-residential construction, some things have changed and some haven’t. What has changed is really more anticipation in that light non-residential construction piece that is tied to follow on from new residential construction. Historically it follows between nine to 12 months, but given our new world, it’s going to be closer to 12 to 18 months out. So the thought is that by the end of ‘23 on light non-residential construction, you’re going to see a slowdown. There’s anticipation for that. Beacon Roofing, in fact, talked about just that yesterday afternoon after the market closed. They haven’t seen it yet, but they certainly are forecasting that for ‘23. 

What is unchanged, however, for the commercial side is the industrial construction side, which feeds into a big trend that we talked about this summer that remains unchanged, which is that population shift to the southern U.S.

That big Oracle campus announced for Nashville, it’s still going to be built. The big projects, like the Tesla plant outside of Austin, are still being built. So you have these really huge projects that are not only 12 months or even 18 months old, often two to three year projects are going to continue and that’s going to somewhat offset other negative factors.

The bright spot and the only thing that has remained really unchanged is our view on public construction. As we go into ‘23, we’re starting to see some of the dollars flow through, but it’s bolstered by IIJA (Infrastructure Investment and Jobs Act) dollars flowing through, as well as from the CARES act. But really a lot of it’s coming from pretty healthy state DOT budgets.

I think what’s different with IIJA dollars versus, let’s say, if we go back to the Great Recession and the stimulus dollars that came through there, those were shovel-ready. These funds are for large multi-year projects. Using Texas DOT as a good example, in the past, having, say, a half a billion monthly letting was sort of the norm even after some big funding. They’re now looking at, essentially, almost doubling that. So that gives a lot of visibility.

Just kind of wrapping it all up, I always like to end on the public construction part, simply because every new road you build helps to promote private construction. So in short, we don’t feel as badly as we did going into the Great Recession. We know it’s a tough road ahead, but the mid-to-longer term view is actually pretty good. 

And I think that the final point is, you’re going to see more have and have nots in ‘23 than you did before. What I mean by that is, in ‘22 and ‘21, everyone was getting pricey. In ‘23, you will have some categories that get pricey or some regions that get pricey and others that don’t.

Sectors to Watch 

Ralph Montgomery: To follow up on that, we had some success earlier in the year, certainly in a couple of sub-sectors, with a disaster recovery company, home goods, and a group of lighting gallery stores.

We certainly saw in the fourth quarter, as we were talking about, where things got a little bit bumpy. Things got constricted from a middle market standpoint across the board and certainly in home goods and building products in particular, but it was very regional as you were just pointing out. I think we felt like in many cases, our deals were a little bit insulated from that.

Are there any particular sectors that you are looking at right now that you like?

Kathryn Thompson: Yeah, there’d be two ways to think about it. One, anything that’s heavy construction going towards infrastructure, we’re going to be more positively biased. That could be like crushed rock companies, road builders, or anything infrastructure, that’s going to be one category.

More on the residential side, they say, “well, is it all terrible?” Probably not, because here’s the deal. New residential construction is going to be murky until there is some visibility for stabilization rates. I mean, that is unchanged. So with that backdrop, I think what you’re going to see is more home renovation. There’s a greater bias to say, okay, I’m not going to buy that new home. I’m just going to add on, I’m going to add that office or add that bathroom as opposed to going out and buying a new home.

If you look at the Home Depot results, the stock got whacked. However, the results really weren’t that bad if you really were to kind of dig into it, and what we’re gleaning through results is that some of the more pro sales actually had positive comps. That kind of feeds and supports that renovation area. 

And final point, you’ve got to look at where inventories are in the field and how is that going to improve. I think realistically, roofing has a little bit more to go. If you think about Beacon, they’re guiding for up 2% to 4% on the top line with that basically flat-ish pricing, which essentially assumes that you’ve got some volume growth. That’s not a bad place to be. If you have the rest of the world going to be down double digits, having some more nondiscretionary type products like roofing is not a bad place to park some money.

In the M&A market in particular, do you have a perspective on strategic buyers right now versus the private equity community? Where do you see that going?

Kathryn Thompson: For us, we’ve got two sides of our business. With Beacon and Home Depot, that’s more of our equity research side, where we give a review of publicly traded companies and how they’re doing in the market. 

But our consulting and advisory side of the business gives us a great kind of tip-of-the-spear view of what’s coming in the future. Because often what will happen is, we’ll have companies – whether they’re private equity, public companies, or private companies – come to us for different ways of thinking about growth initiatives. It may be about a transaction that’s happening right now, or it could be like, “listen, we’re thinking about doing something 12 months from now.”

And things were very quiet in our business from early summer up until about November — and then a spigot opened up.

Ranging from the non-residential end market to residential to even kind of on the heavy side, we’re starting to see a pickup and activity for TRG consulting and advisory services around specific growth initiatives. So it may not happen in the next month or two, but people that have strong balance sheets and a vision are doing work now.

The Effects of Reshoring 

Andy Stockett: Kathryn, in a sub-sector of the industrial value chain sector and construction, we’ve closed a deal recently for IER Electrical out of Houston, which made control panels and switchgear. 

And despite kind of a bumpy M&A market in the fall, we were able to get that one over the transom, primarily benefiting from the onshoring or reshoring of a lot of manufacturing as well as the pressure that’s being put on the electrical grid through the proliferation of electric vehicles. 

Do you have any thoughts on sub-sectors of the industrial value chain? 

Kathryn Thompson: On the reshoring bit, it’s going to be a slow ship to turn, but that ship is turning and it’s definitely coming our way in the US. We’ve seen some pretty specific examples of that, things that we never thought we would see. 

The flooring industries are really great examples. In the subcategory of LVT (luxury vanity tile), the vast, vast majority had been manufactured in China. It’s just where the intellectual property was created. The US created the concept of carpet. China created the concept of LVT. For the first time, we’re seeing Chinese companies setting up operations in the US, and that is a direct result of changes in thinking about reshoring. There are other categories, like we’ve seen this in the composite industries. I don’t know if you’ll see a complete reversal, but it’s certainly a trend that is building and that we see will continue.

On lighting, I know that there are a lot of headlines for ESG (Environmental, Social, and Governance). But when ESG meets real dollar savings, that’s where the rubber hits the road. So for certain categories that feed into tangible savings and also check the ESG box, those should do well. I think that the lighting example you gave is a really good example of that.

Private Equity vs. Strategics

Ralph Montgomery: A lot of our buyers tend to be in that private equity community. It’s great news about the strategics and their activity picking up, and I’m going to assume that most of them are still pretty cash heavy – and tell me if you think I’m wrong on that – so the rate hikes don’t affect them as much in terms of what they’re looking for.

Kathryn Thompson: Perhaps, particularly in the middle market.

Going forward in 2023, from an M&A perspective, do you think we’ll see a less competitive environment out there? 

Ralph Montgomery: Do you think that people are going to stay on the sidelines and wait things out until the back half of the year? Or do you think that some of the strategics will come in and maybe be a little more aggressive? 

Kathryn Thompson: It’s a great question, and I can see a lot of different scenarios playing out. Right now, I think the strategics realize that private equity is on their heels right now.

The ability to access capital and just how many you have to have in a syndicate to even get the numbers to work is simply herding cats, it’s not really easy and not very effective. I think from a perspective of strategics, they recognize that window.

Point number two, they’re just certainly going to be certain industries and certain business models that are much better positioned now. If they’re not as capital intensive, they have strong free cash flow metrics, and if they also have a clean balance sheet, they will take advantage of this right now. When they’re just doing the basic math of the returns, they couldn’t be as competitive in previous years because of the bid up from private equity.

Now, there’s still a lot of dollars in private equity, there’s still a lot of dry powder. But I think there are just some companies and some industries that are more asset-light, strong free cash flow generators that don’t have a huge amount of capital needs. I think those are industries that are going to do well.

And then finally, in the year of haves and have-nots, I think that balance sheets are going to be a huge differentiator this year in terms of who can and can’t do things. I know this doesn’t seem like a lot, but if you’re above three-times levered, they’re going to be working that down to two. That’s kind of our perspective.

Andy Stockett: Great. Well, Kathryn, thank you for spending time with us this morning. We’ll see what develops as the year goes on and we’ll look forward to catching up with you again.