Dear Directors of Simpson Manufacturing,
Funds affiliated with Iron Compass LLC ("Iron Compass" or "we") currently own shares of Simpson Manufacturing ("Simpson" or the "Company"). We appreciate the time that executive management and Peter Louras, Chairman of the Board of Simpson (the "Board"), have spent with us over the past nine months and enjoyed seeing many of you at the shareholder meeting. Peter has indicated that the analysis and potential paths forward we presented to him on April 19 have been shared with all of the members of the Board. These efforts were intended as the beginning of a dialogue, and as a result, we were disappointed to learn that the Board has chosen not to meet with us. Simpson's problems extend beyond the compensation-related feedback that it has received from proxy advisors. As you know, we have deep concern about Simpson's strategy, the Board's oversight of the Company, and our assessment of the value destruction shareholders are suffering as a result. In light of the need for significant, immediate change we are compelled to explore all of our alternatives. We believe that the Company can create more than $21 per share of value, representing more than a 50% gain relative to the current stock price. To that end, we have identified the following three "Steps for Value Creation," which could create significant value today and restore Simpson to being a focused, high return on capital enterprise that can attractively compound equity value over the long-term:
- Sell the Company's commercial construction and truss plate businesses and reduce selling, general and administrative expenses ("SG&A") to historical levels;
- Restructure the balance sheet to optimize cost of capital by incurring modest debt and tightening working capital management; and
- Return capital to shareholders using domestic cash on hand as well as proceeds from the aforementioned business sales, debt incurrence, and inventory improvements. We estimate that the company could pay out more than 40% of the current stock price as a special dividend.
These steps could return the Company to the organization that Barclay Simpson built so successfully, and which we so admire. The Company's wood connector and fasteners business is the envy of the building products industry. Over fifty years, the Company built wide moats around these franchises and made Simpson's products truly critical to the American residential construction industry. We believe this is as true today as ever, yet as housing starts have doubled over the last six years we have been continually surprised at the Company's lack of operating leverage and cash flow generation. A company that used to generate some of the highest returns on capital in the industry has seen that metric stuck below 10%. This has resulted in share price growth that has lagged behind various construction industry exchange-traded funds (XHB, ITB) by more than 50% over the five years ended June 30, 2016. Simpson, a gem of a business that traditionally traded at a substantial premium to its peers, now trades at a lower multiple of adjusted EBITDA than many lower margin, lower return on capital building product manufacturers.
Due Diligence Review
Over the last two years, we have conducted deep due diligence on Simpson's business. We have engaged third party experts in the residential and commercial construction industries. We have interviewed builders, architects, distributors, commercial engineers, truss designers and a range of competitors. We have attended numerous trade shows and software product demonstrations. Our April 19 analysis describes the conclusions in detail, but at a high level, the problems facing Simpson can be stated quite simply: runaway overhead spending + weak capital management = poor return on capital.
Runaway overhead spending: In 2006, Simpson (excluding Dura-Vent) spent 22% of revenue on SG&A, more than most other building or highly engineered industrial products companies that we track. By 2015, SG&A had risen to 31% of revenue – a 900 basis point increase, representing $75 million per year. Management claims to be investing for growth but has never provided metrics or delivered operating results that appear to justify this explosion in cost relative to the more cost effective growth spending that the Company historically pursued.
Weak capital management: We believe that shareholder equity has been eroded by the more than $190 million spent on acquisitions (excluding post-closing operating losses and capital expenditures) since the beginning of 2008. Companies that were bought and then shuttered, like Liebig and Keymark, were obvious value destroyers. However, our analysis suggests that other deals, including Automatic Stamping and S&P Clever, have produced negative returns if overheard costs are fully allocated and goodwill were ultimately to be impaired. We note that PricewaterhouseCoopers, the Company's longtime auditor until 2015, had identified a material weakness in the Company's process and controls related to valuing goodwill and testing for impairments in their 2013 audit. The Company has also diluted equity returns through its capitalization. Instead of carrying more than $230 million of net cash, the Company could use modest leverage to replace expensive equity with long-term, covenant light debt at a low single digit cost of capital.
We trace these problems back to a strategy change made during the financial crisis. For decades prior to this, Barclay Simpson led the Company to ever-increasing profitability and the creation of an American success story for employees, shareholders and customers. In the midst of the housing collapse, he changed strategy to prioritize diversification and reducing dependence on North American residential construction. Since that time, management and the Board have been executing this new strategy. However, after a decade of severe underperformance, the diversification strategy must be re-evaluated. Management explains that Simpson's margins have dropped because the Company is more complex today than it has been historically. However, it seems as though the next logical question has not been considered: Is this more complex, lower margin business better? Barclay frequently told investors about his goal of increasing operating profit per employee every year. He recognized that revenue growth alone was not enough, but that cost and profit discipline had to come with it. We believe that discipline has been lost. Shareholders have waited patiently for almost seven years; we could now make changes to get that discipline back.
Potential Steps for Value Creation
1) Sell the commercial construction and truss plate businesses. As explained in our April 19 analysis, we estimate that the Company may lose $39 million per year across the commercial construction and truss plate business lines. Selling them could immediately boost profitability, generate cash proceeds, and potentially generate tax losses. We estimate this could create more than $625 million of shareholder value, or more than $13 per share.
Commercial construction businesses: Despite almost a decade of investment, we estimate that Simpson's commercial construction businesses may have never generated a material annual operating profit, the losses have widened over time, and their organic revenue growth represents a drag on the Company's overall organic growth rate. While it is possible for commercial construction businesses to generate high gross margins, they are expensive to build and have limited synergies with Simpson's residential operations. The commercial market has a different set of customer constituents including contractors, distributors, and engineers, requiring a duplicative (and expensive) go-to-market cost structure. This is further complicated by Simpson's smaller scale vs. large incumbent competitors with established brand names and product track records. Arguably, the industry is structurally less favorable; limited opportunities exist for the propriety specifications that Simpson enjoys in the residential market, and code approval processes are often unpredictable, resulting in engineering cost overruns and budgeting difficulty. Simpson's commercial product lines are likely to be worth far more to larger players already in the market who can leverage their long-standing customer relationships and overhead scale.
Truss plate business: After four years and an estimated $80 million spent on acquisitions, research, and business development, Simpson still lacks a truss design software product that can compete for much of the market. We believe that Simpson cannot earn an attractive return on capital, even if a product is successfully launched, due to high barriers to entering this business. Managing software development requires a wildly different skill set than managing Simpson's core business. Finding good software engineers, overseeing their work, and managing costs is challenging for executives with manufacturing backgrounds. Even after a product is launched, continued annual investment likely would be required to keep the platform competitive with MiTek – some industry participants suggest that they may invest over $20 million each year. All of this hard work leads to the most difficult part: actually winning customers. Truss manufacturers use software to run their daily operations, making any change difficult and risky. At best this means a very long sales cycle, and more commonly it will mean rejection.
Simpson's travails in building its truss software are well known to the market. We have heard a stream of negative commentary from consultants, customers and competitors involving: i) Simpson's decision to outsource software development to Keymark; ii) Simpson's decision to buy Keymark when the work wasn't progressing fast enough; iii) Simpson's heavy investment in Keymark followed by a decision to scuttle the software and restart development; iv) high churn among employees; and v) potentially limited appeal of the Company's 2015 product release because it lacks a graphical interface. At Simpson's invitation, we attended a customer demonstration in October 2015. The Company's sales team conceded that the product couldn't meet the customer's needs now, and the goal for the next year was to "get closer."
The original decision to buy Automatic Stamping and compete with MiTek in its truss market might have been a defensive tactic. MiTek had just bought USP and begun competing in Simpson's core market. If this was part of the original premise, we now have enough data to reject it. MiTek has owned USP for four years, Simpson has largely maintained its market position, and MiTek has behaved rationally. Even if MiTek were challenging Simpson more aggressively and Simpson had a viable truss software platform, heavy doubt would remain as to whether Simpson could credibly threaten MiTek's truss business given its market leadership and strong product offering. More likely, Simpson might pick off a few truss customers from MiTek's weaker competitors. While building a truss plate business may not be the right strategy for Simpson, the software developed to date could have value to a strategic or financial acquirer.
For both the commercial construction and truss plate businesses, the Company could engage a financial advisor to explore strategic alternatives.
2) Restructure the balance sheet. Over the last two years, Simpson has held more than $240 million of net cash on average. Since 2007, the net cash balance hasn't dropped below $150 million. We posit that managing shareholder capital in this manner is not conservative, it is irresponsible. Whether the cost of equity is 12%, 15%, or 20%+, these cash balances come at a tremendous cost to shareholders. The Company could borrow $500 million, which represents approximately ~3x adjusted EBITDA, or ~2.5x net of the foreign cash. These leverage multiples are substantially lower when dividing by EBITDA pro forma for the elimination of the losses relating to the commercial construction and truss plate businesses. Such financing is easily and cheaply available; we estimate the after tax interest rate might be 2-3%. Debt proceeds, combined with existing domestic balance sheet cash, could be used to fund a special dividend as discussed below. We believe this modest level of debt does not create a material risk to equity holders or other Simpson constituents due to the resilience of the business. Even in 2010, a year with fewer than 600,000 housing starts, Simpson generated more than $100 million of adjusted EBITDA and $60 million of free cash flow. The debt could be raised with covenant-light terms that provide for wide operating flexibility. The Company could maintain an undrawn revolver for incremental liquidity, and a bank facility could be pre-payable in the event that a larger strategic opportunity presented itself.
Inventory represents another area where Simpson could unlock value from its balance sheet. Simpson turns its inventory approximately twice per year, a far lower velocity than any other building products or industrials business that we track. Having a broad range of SKUs available for builders on demand is a key part of Simpson's sales pitch, but the Company has fallen behind its own standards. Current inventory turns are over 20% below the Company's 2006 level. Approximately 40% of inventory is raw material, representing months of commodity rolled steel. Vice Chairman and former CEO Tom Fitzmeyers has told investors that the Company could operate with $50 million less in inventory. We believe that the opportunity may be much larger, but Tom's figure alone equates to over $1 per share of equity value.
3) Return capital to shareholders via special dividend. Based on our analysis and assuming completion of the aforementioned steps, Simpson could return $16 to $18 per share of capital to shareholders. The sources of funds could be existing domestic cash, the proceeds from selling non-core businesses, release of cash from reducing inventory, and the debt financing. Given the magnitude of capital to be distributed and the benefits of effecting this recapitalization rapidly, a special dividend could be the optimal method. The Company's current approach of small, sporadic stock buybacks and a modest quarterly dividend would take far too long to complete the task. Furthermore, it would avoid any debates as to the right price to pay for stock in a buyback – a subject with which the Board has struggled historically.
Post-dividend, Simpson's newly efficient capital structure could allow shareholders to compound value at materially improved rates of return. Concurrent with paying the special dividend, the Company could adopt and communicate a clear capital allocation framework with specific hurdle rates and targets. Reintroducing Simpson to the market as a focused and disciplined allocator of capital could result in a material upward revision in the company's EBITDA trading multiple. If investors once again valued the business at what we believe to be a historical premium of ~2x EBITDA vs. comparable companies, that could add over $350 million of equity value, or $7 per share.
Next Steps for Change
It is extremely challenging for any organization to examine itself critically and implement changes without a real "change agent." As we have told Peter and Karen Colonias, President and CEO of the Company, Simpson's Board could obtain fresh perspectives from new Directors with the following specific qualifications: i) investment experience to evaluate strategic alternatives; ii) capital markets expertise to execute a recapitalization and implement a disciplined capital allocation strategy; and iii) willingness to dig deeply into the details of different products and end-markets, well beyond what is presented in a summary board book. A first step in Simpson's value creation process could be to appoint three new Board members. We are aware of several qualified, independent candidates who have the requisite skills, are eager to take on the role, and likely would receive a favorable reaction from other shareholders. The current Board members, if they already recognize that Simpson faces cultural barriers to change, likely would welcome new members to the Board.
With the new members of the Board in place, the Board could engage a nationally-recognized consulting firm to evaluate the standalone profitability for the non-core businesses, properly allocating overhead costs across different products and end-markets. This could include a comprehensive head-by-head comparison of today's SG&A structure versus 2006. In our experience, external analytical resources are often needed to re-evaluate data collection and presentation, especially when the goal involves evaluating material operational change.
Other shareholders may share many, if not all, of these views. Based upon recent votes, one could conclude that many shareholders are unhappy with the Company's affairs. At the most recent shareholder meeting, nearly 29% of the shares voted against or abstained from the chairman's uncontested re-election. 48% of the shares voted against or abstained from approving the executive compensation plan. These negative results came on the heels of Company representatives' reaching out to the majority of the shareholder base to assuage concerns about executive pay and governance. In addition to these issues, these votes may reflect deeper dissatisfaction with this Board's oversight and the Company's performance.
To us, the compensation framework is problematic, but not because of the dollars in question, as we want for executive management to be very well paid for creating shareholder value. Rather, the Company's compensation framework and its execution suggest that the Board is not critically evaluating the operating performance nor considering incentives based upon the realities of the business. Simpson's quarterly cash profit sharing system may have functioned adequately when a substantial owner of the business – Barclay Simpson – established and held executive management accountable to long and short-term goals for shareholder value creation. However, we believe that this framework no longer functions properly. As disclosed in the most recent proxy, the Board set the 2016 annual operating profit target for executive cash profit sharing 5.5% below the actual operating profit achieved in 2015. This cannot be explained by temporary weather fluctuations or other factors. In fact, annual proxies show that for every year of the housing market recovery (2011-2015) the Board has set the target operating profit below the actual amount achieved in the prior year. For a growth business experiencing a rapid cyclical recovery, this creates an alarming lack of accountability and essentially rewards underperformance. The problem was further highlighted when Q1 2016 financial results were announced. Management attributed revenue growth primarily to excellent weather conditions. Yet, SG&A operating leverage was limited by the nearly $2 million in increased general and administrative cash profit sharing expense. It appears as though executives were paid significantly higher cash bonuses based upon those weather-driven results.
Taken together and viewed over a period of years, these compensation practices seem to reflect a lack of oversight by the Board, which appears to have resulted in the recent, highly public criticism of the Company's executive compensation practices. A push and pull between Directors and executive management involving bonus targets and many other topics should be expected; however, a functioning Board has to be able to make difficult decisions, sometimes even over the objections of management.
Other Simpson shareholders likely share the concerns we have articulated here; executive management has acknowledged to us that the Company has a shareholder relations problem. We write to you today in an attempt to help Simpson overcome its current challenges and improve the Company for all stakeholders. Please accept this letter in that spirit. The Board, consistent with the duty it owes to Company shareholders, could take immediate, comprehensive action to avoid the Company's continued underperformance.
Thank you for your consideration and we look forward to your prompt reply.
Matthew Kupersmith & James Hegyi
About Iron Compass
Iron Compass endeavors to be a long term owner of 'classically great' businesses. These are companies we believe have a distinct competitive advantage that allows them to generate high returns on invested capital, stable cash flow, and growth over the long term. The greatest businesses seek to outperform contemporaneously in both operations and capital management.
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SOURCE Iron Compass LLC