Builders FirstSource, Inc. - Quarter Report: 2018 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended September 30, 2018

OR

For the transition period from                 to                

Commission File Number 0-51357

BUILDERS FIRSTSOURCE, INC.

(Exact name of registrant as specified in its charter)

(214) 880-3500

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).     Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

The number of shares of the issuer’s common stock, par value $0.01, outstanding as of October 30, 2018 was 114,724,995.

BUILDERS FIRSTSOURCE, INC.

Index to Form 10-Q

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PART I  — FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

BUILDERS FIRSTSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME  

The accompanying notes are an integral part of these condensed consolidated financial statements.

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BUILDERS FIRSTSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEET

The accompanying notes are an integral part of these condensed consolidated financial statements.

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BUILDERS FIRSTSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Supplemental disclosure of non-cash activities

For the nine months ended September 30, 2018 and 2017, the Company retired assets subject to lease finance obligations of $0.6 million and $15.0 million and extinguished the related lease finance obligation of $0.7 million and $12.9 million, respectively.

The Company purchased equipment which was financed through capital lease obligations of $9.0 million and $14.2 million in the nine months ended September 30, 2018 and 2017, respectively. In addition, purchases of property, plant and equipment included in accounts payable were $2.5 million and $1.0 million for the nine months ended September 30, 2018 and 2017, respectively.

The accompanying notes are an integral part of these condensed consolidated financial statements.

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BUILDERS FIRSTSOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

The accompanying notes are an integral part of these condensed consolidated financial statements.

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BUILDERS FIRSTSOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Basis of Presentation

Builders FirstSource, Inc., a Delaware corporation formed in 1998, is a leading supplier and manufacturer of building materials, manufactured components and construction services to professional homebuilders, sub-contractors, remodelers and consumers.  The Company operates 403 locations in 40 states across the United States. In this quarterly report, references to the “Company,” “we,” “our,” “ours” or “us” refer to Builders FirstSource, Inc. and its consolidated subsidiaries unless otherwise stated or the context otherwise requires.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all recurring adjustments and normal accruals necessary for a fair statement of the Company’s financial position, results of operations and cash flows for the dates and periods presented. Results for interim periods are not necessarily indicative of the results to be expected during the remainder of the current year or for any future period. Intercompany transactions are eliminated in consolidation.

The condensed consolidated balance sheet as of December 31, 2017 is derived from the audited consolidated financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America. This condensed consolidated balance sheet as of December 31, 2017 and the unaudited condensed consolidated financial statements included herein should be read in conjunction with the more detailed audited consolidated financial statements for the year ended December 31, 2017 included in our most recent annual report on Form 10-K. Accounting policies used in the preparation of these unaudited condensed consolidated financial statements are consistent with the accounting policies described in the Notes to Consolidated Financial Statements included in our Form 10-K.

Recent Accounting Pronouncements

In August 2018, the Financial Accounting Standards Board (“FASB”) issued an update to the existing guidance under the Intangibles-Goodwill and Other topic of the Accounting Standards Codification (“Codification”) which aligns the requirements for capitalizing implementation costs of a cloud computing arrangement service contract with the requirements for capitalizing implementation costs incurred for an internal-use software license. This update is effective for public companies for annual and interim periods beginning after December 15, 2019, with early adoption permitted. This guidance permits either prospective or retrospective adoption. In the third quarter of 2018, we elected to adopt this guidance on a prospective basis. As such, implementation costs related to cloud computing arrangements will now be capitalized and amortized on a straight-line basis over the term of the associated agreement. The adoption of this guidance did not have a material impact on our financial statements.    

In May 2017, the FASB issued an update to the existing guidance under the Compensation-Stock Compensation topic of the Codification to clarify when modification accounting would be applied for a change to the terms or conditions of a share-based award. Under this new guidance modification accounting is required only if the fair value, the vesting conditions, or the classification of the award changes as a result of the change in terms or conditions. This guidance was required to be adopted on a prospective basis for annual periods beginning on or after December 15, 2017. As such, the Company adopted this guidance on January 1, 2018. The adoption of this guidance did not have an impact on our financial statements.

In January 2017, the FASB issued an update to the existing guidance under the Business Combinations topic of the Codification. This update revises the definition of a business. Under this guidance when substantially all of the assets acquired are concentrated in a single asset (or group of similar assets) the assets acquired would not be considered a business. If this initial screen is met, the need for further assessment is eliminated. If this screen is not met, in order to be considered a business an acquisition would have to include an input and a substantive process that together significantly contribute to the ability to create outputs. This update was required to be adopted by public companies on a prospective basis for annual and interim reporting periods beginning after December 15, 2017. As such, the Company adopted this guidance on January 1, 2018. The adoption of this guidance did not have an impact on our financial statements.

In June 2016, the FASB issued an update to existing guidance under the Investments topic of the Codification. This update introduces a new impairment model for financial assets, known as the current expected credit losses (“CECL”) model that is based on expected losses rather than incurred losses. The CECL model requires an entity to estimate credit losses on financial assets, including trade accounts receivable, based on historical information, current information and reasonable and supportable forecasts. Under this guidance companies will record an allowance through earnings for expected credit losses upon initial recognition of the financial asset. The aspects of this guidance applicable to us will be required to be adopted on a modified retrospective basis. This update is

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effective for public companies for annual and interim periods beginning after December 15, 2019, with early adoption permitted for annual and interim periods beginning after December 15, 2018.  While we are still evaluating the impact of this guidance on our financial statements we do not currently expect it to have a material impact.

In February 2016, the FASB issued an update to the existing guidance under the Leases topic of the Codification. Under the new guidance, lessees will be required to recognize the following for all leases, with the exception of short-term leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. This update is effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with early adoption permitted.

The Company intends to adopt this guidance on January 1, 2019 by applying the transition provisions on a modified retrospective basis as of the effective date. As such, comparative periods will not be restated and will continue to be reported under current guidance.  We also intend to elect certain of the transition practical expedients permitted under this new guidance, including the package of practical expedients whereby we will not be required to: i) reassess whether any expired or existing contracts are or contain leases, ii) reassess the lease classification of existing leases and iii)  reassess initial direct costs for any existing leases.

The Company has a significant number of leases, primarily related to real estate and rolling stock, which are primarily accounted for as operating leases under existing guidance. While we are currently evaluating the impact of this new guidance on our financial statements, we are expecting a significant impact to our balance sheet upon adoption related to the establishment of lease liabilities and the corresponding right-of-use assets. We are also currently assessing and updating our business processes, systems and controls to ensure compliance with the accounting and disclosure requirements of the new standard upon adoption.

Through the issuance of a series of updates, the FASB modified the guidance under the Revenue Recognition topic of the Codification which provided for a comprehensive new revenue recognition model requiring a company to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Under previous guidance, we recognized sales from contracts with service elements on the completed contract method when these contracts were completed within 30 days. The remaining contracts with service elements were recognized under the percentage of completion method.  

On January 1, 2018 we adopted this guidance on a modified retrospective basis for contracts which were not completed as of January 1, 2018. Under this updated guidance, revenue related to our contracts with service elements is now recognized over time based on the extent of progress towards completion of the performance obligation because of continuous transfer of control to the customer. We have assessed and updated our business processes, systems and controls to ensure compliance with the recognition and disclosure requirements of the new standard.

Results for periods beginning on or after January 1, 2018 are presented in accordance with this new guidance. Results for prior periods have not been adjusted and continue to be presented under previous guidance. Upon adoption, the Company recognized a $2.0 million ($1.5 million net of taxes) impact to the beginning balance of our accumulated deficit through a cumulative effect adjustment related to the unrecognized portion of contracts previously accounted for under the completed contract method of revenue recognition.

2. Revenue

We recognize revenue as performance obligations are satisfied by transferring control of a promised good or service to a customer in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. We generally classify our revenues into two types: (i) distribution sales; or (ii) sales related to contracts with service elements.  Sales related to contracts with service elements represents less than 10% of the Company’s net sales for each period presented.

Distribution sales typically consist of the sale of building products we manufacture and the resale of purchased building products. We recognize revenue related to distribution sales at a point in time upon delivery of the ordered goods to our customers. Payment terms related to distribution sales are not significant as payment is generally received shortly after the point of sale.

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Our contracts with service elements primarily relate to installation and construction services. We evaluate whether multiple contracts should be combined and accounted for as a single contract and whether a single or combined contract should be accounted for as a single performance obligation or multiple performance obligations. If a contract is separated into more than one performance obligation, we allocate the transaction price to each performance obligation generally based on observable standalone selling prices of the underlying goods or services. Revenue related to contracts with service elements is generally recognized over time based on the extent of progress towards completion of the performance obligation because of continuous transfer of control to the customer. We consider costs incurred to be indicative of goods and services delivered to the customer. As such, we use a cost based input method to recognize revenue on our contracts with service elements as it best depicts the transfer of assets to our customers. Payment terms related to sales for contracts with service elements are specific to each customer and contract. However, they are considered to be short-term in nature as payments are normally received either throughout the life of the contract or shortly after the contract is complete.

Contract costs include all direct material and labor, equipment costs and those indirect costs related to contract performance. Provisions for estimated losses on uncompleted contracts are recognized in the period in which such losses are determinable. Prepayments for materials or services are deferred until such materials have been delivered or services have been provided. All sales recognized are net of allowances for discounts and estimated returns, based on historical experience. The Company records sales incentives provided to customers as a reduction of revenue. We present all sales tax on a net basis in our consolidated financial statements.

Costs to obtain contracts are expensed as incurred as our contracts are typically completed in one year or less, and where applicable, we generally would incur these costs whether or not we ultimately obtain the contract. We do not disclose the value of our remaining performance obligations on uncompleted contracts as our contracts generally have a duration of one year or less.

The following table disaggregates our sales by product category (in thousands):

Information regarding disaggregation of sales by segment is discussed in Note 8 to the condensed consolidated financial statements.

The timing of revenue recognition, billings and cash collections results in accounts receivable, unbilled receivables, contract assets and contract liabilities. Contract asset balances were not significant as of September 30, 2018 or December 31, 2017. Contract liabilities consist of deferred revenue and customer advances and deposits. Contract liability balances are included in accrued liabilities on our consolidated balance sheet and were $47.4 million and $37.2 million as of September 30, 2018 and December 31, 2017, respectively.

3. Net Income per Common Share

Net income per common share (“EPS”) is calculated in accordance with the Earnings per Share topic of the Codification, which requires the presentation of basic and diluted EPS. Basic EPS is computed using the weighted average number of common shares outstanding during the period. Diluted EPS is computed using the weighted average number of common shares outstanding during the period, plus the dilutive effect of potential common shares.

For the purpose of computing diluted EPS, weighted average shares outstanding have been adjusted for common shares underlying 1.5 million options and 2.1 million restricted stock units (“RSUs”) outstanding as of September 30, 2018. Weighted average shares outstanding have been adjusted for common shares underlying 2.7 million options and 2.2 million RSUs outstanding as of September 30, 2017.

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The table below presents a reconciliation of weighted average common shares used in the calculation of basic and diluted EPS (in thousands):  

4. Debt

Long-term debt and lease obligations consisted of the following (in thousands):

Fair Value

As of September 30, 2018 and December 31, 2017 the Company does not have any financial instruments which are measured at fair value on a recurring basis. We have elected to report the value of our 5.625% senior secured notes due 2024 (“2024 notes”), senior secured term loan facility due 2024 (“2024 term loan”) and $900.0 million revolving credit facility (“2022 facility”) at amortized cost. The fair values of the 2024 notes and the 2024 term loan at September 30, 2018 were approximately $722.5 million and $460.4 million, respectively, and were determined using Level 2 inputs based on market prices. The carrying value of the 2022 facility at September 30, 2018 approximates fair value as the rates are comparable to those at which we could currently borrow under similar terms, are variable and incorporate a measure of our credit risk. As such, the fair value of the 2022 facility was also classified as Level 2 in the hierarchy.

We were not in violation of any covenants or restrictions imposed by any of our debt agreements at September 30, 2018.

5. Employee Stock-Based Compensation

Time Based Restricted Stock Unit Grants

In the first nine months of 2018, our board of directors granted 461,000 RSUs to employees and eligible directors under our 2014 Incentive Plan for which vesting is based solely on continuous employment over the requisite service period. 269,000 of the RSUs vest at 33% per year at each anniversary of the grant date over the next three years, 74,000 RSUs cliff vest on the third anniversary of the grant date, 64,000 of the RSUs cliff vest on the fourth anniversary of the grant date and 54,000 of the RSUs cliff vest on the first anniversary of the grant date. The weighted average grant date fair value for these RSUs was $20.33 per unit, which was based on the closing stock price on the grant date.

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Performance and Service Condition Based Restricted Stock Unit Grants

In the first nine months of 2018, our board of directors granted 135,000 RSUs to employees under our 2014 Incentive Plan, that vest if the compound annual growth rate of the Company’s total sales in 2020 over 2017 exceeds a composite annual growth rate based on single-family housing starts, multi-family housing starts, and growth in repair and remodeling sales over the same period. Assuming continued employment and if the performance vesting condition is achieved, these awards will cliff vest on the third anniversary of the grant date. The weighted average grant date fair value for these RSUs was $21.19 per unit, which was based on the closing stock price on the grant date.

Market and Service Condition Based Restricted Stock Unit Grants

In the first nine months of 2018, our board of directors granted 135,000 RSUs to employees under our 2014 Incentive Plan for which vesting is contingent upon the Company’s total shareholder return being equal to or exceeding 75% of the median total shareholder return of the Company’s peer group if the median return of the Company’s peer group is positive, or being equal to or better than 125% of the median total shareholder return if the median return of the Company’s peer group is negative. In each case, the measurement will take place over a three year period. Assuming continued employment and if the market vesting condition is met, these awards will cliff vest on the third anniversary of the grant date. The actual number of shares of common stock that may be earned ranges from zero to a maximum of 150% of the RSUs granted.  The average grant date fair value for these RSUs was $22.57 per unit, which was determined using the Monte Carlo simulation model using the following assumptions:

The expected volatilities and correlation are based on the historical daily returns of our common stock and the common stocks of the constituents of the Company’s peer group over the most recent period equal to the measurement period. The expected dividend yield is based on our history of not paying regular dividends in the past and our current intention to not pay regular dividends in the foreseeable future. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant and has a term equal to the measurement period.

6. Income Taxes

A reconciliation of the statutory federal income tax rate to our effective rate for continuing operations is provided below:

We base our estimate of deferred tax assets and liabilities on current tax laws and rates. In certain cases, we also base our estimate on business plan forecasts and other expectations about future outcomes. Changes in existing tax laws or rates could affect our actual tax results, and future business results may affect the amount of our deferred tax liabilities or the valuation of our deferred tax assets over time. Due to uncertainties in the estimation process, particularly with respect to changes in facts and circumstances in future reporting periods, as well as the residential homebuilding industry’s cyclicality and sensitivity to changes in economic conditions, it is possible that actual results could differ from the estimates used in previous analyses.  

Accounting for deferred taxes is based upon estimates of future results. Differences between the anticipated and actual outcomes of these future results could have a material impact on our consolidated results of operations or financial position.

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7. Commitments and Contingencies

The Company has a number of known and threatened construction defect legal claims.  While these claims are generally covered under the Company’s existing insurance programs to the extent any loss exceeds the deductible, there is a reasonable possibility of loss that is not able to be estimated at this time because (i) many of the proceedings are in the discovery stage, (ii) the outcome of future litigation is uncertain, and/or (iii) the complex nature of the claims.  Although the Company cannot estimate a reasonable range of loss based on currently available information, the resolution of these matters could have a material adverse effect on the Company's financial position, results of operations or cash flows.

In addition, we are involved in various other claims and lawsuits incidental to the conduct of our business in the ordinary course. We carry insurance coverage in such amounts in excess of our self-insured retention as we believe to be reasonable under the circumstances and that may or may not cover any or all of our liabilities in respect of such claims and lawsuits. Although the ultimate disposition of these other proceedings cannot be predicted with certainty, management believes the outcome of any such claims that are pending or threatened, either individually or on a combined basis, will not have a material adverse effect on our consolidated financial position, cash flows or results of operations.  However, there can be no assurances that future adverse judgments and costs would not be material to our results of operations or liquidity for a particular period.

8. Segment Information

We offer an integrated solution to our customers providing manufacturing, supply, and installation of a full range of structural and related building products.  We provide a wide variety of building products and services directly to homebuilder customers. We manufacture floor trusses, roof trusses, wall panels, stairs, millwork, windows, and doors. We also provide a full range of construction services. These product and service offerings are distributed across 403 locations operating in 40 states across the United States, which are organized into nine geographical regions.  Centralized financial and operational oversight, including resource allocation and assessment of performance on an income (loss) before income taxes basis, is performed by our CEO, whom we have determined to be our chief operating decision maker (“CODM”).    

The Company has nine operating segments aligned with its nine geographical regions (Regions 1 through 9). While all of our operating segments have products, distribution methods and customers of a similar nature, certain of our operating segments have been aggregated due to also containing similar economic characteristics, resulting in the following composition of reportable segments:

In addition to our reportable segments, our consolidated results include corporate overhead, other various operating activities that are not internally allocated to a geographical region nor separately reported as a single unit to the CODM, and certain reconciling items primarily related to allocations of corporate overhead and rent expense, which have collectively been presented as “All Other”.  The accounting policies of the segments are consistent with those referenced in Note 1, except for noted reconciling items.  

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The following tables present Net sales, income before income taxes and certain other measures for the reportable segments, reconciled to total consolidated operations, for the periods indicated (in thousands):

Asset information by segment is not reported internally or otherwise reviewed by the CODM nor does the Company earn revenues or have long-lived assets located in foreign countries.   

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9. Related Party Transactions

Transactions between the Company and related parties occur in the ordinary course of business. Certain members of the Company’s board of directors serve on the board of directors for one of our suppliers, PGT, Inc.  Further, the Company has entered into certain leases of land and buildings with certain employees or non-affiliate stockholders. However, the Company carefully monitors and assesses related party relationships. Management does not believe that any of its transactions with related parties had a material impact on the Company’s results for the three and nine months ended September 30, 2018 or 2017.

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Item  2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes thereto for the year ended December 31, 2017 included in our most recent annual report on Form 10-K. The following discussion and analysis should also be read in conjunction with the unaudited condensed consolidated financial statements appearing elsewhere in this report. In this quarterly report on Form 10-Q, references to the “company,” “we,” “our,” “ours” or “us” refer to Builders FirstSource, Inc. and its consolidated subsidiaries unless otherwise stated or the context otherwise requires.

Cautionary Statement

Statements in this report and the schedules hereto that are not purely historical facts or that necessarily depend upon future events, including statements about expected market share gains, forecasted financial performance or other statements about anticipations, beliefs, expectations, hopes, intentions or strategies for the future, may be forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended.  Readers are cautioned not to place undue reliance on forward-looking statements. In addition, oral statements made by our directors, officers and employees to the investor and analyst communities, media representatives and others, depending upon their nature, may also constitute forward-looking statements. All forward-looking statements are based upon currently available information and the Company’s current assumptions, expectations and projections about future events.  Forward-looking statements are by nature inherently uncertain, and actual results or events may differ materially from the results or events described in the forward-looking statements as a result of many factors.  The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Any forward-looking statements involve risks and uncertainties, many of which are beyond the Company’s control or may be currently unknown to the Company, that could cause actual events or results to differ materially from the events or results described in the forward-looking statements, including risks or uncertainties related to the Company’s growth strategies, including gaining market share, or the Company’s revenues and operating results being highly dependent on, among other things, the homebuilding industry, lumber prices and the economy.  The Company may not succeed in addressing these and other risks.  Further information regarding factors that could affect our financial and other results can be found in the risk factors section of the Company’s most recent annual report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) and may also be described from time to time in the other reports the Company files with the SEC.  Consequently, all forward-looking statements in this report are qualified by the factors, risks and uncertainties contained therein.

COMPANY OVERVIEW

We are a leading supplier and manufacturer of building materials, manufactured components and construction services to professional contractors, sub-contractors and consumers. The Company operates 403 locations in 40 states across the United States. Given the span and depth of our geographical reach, our locations are organized into nine geographical regions (Regions 1 through 9), which are also our operating segments, and these are further aggregated into four reportable segments: Northeast, Southeast, South and West. All of our segments have similar customers, products and services, and distribution methods. Our financial statements contain additional information regarding segment performance which is discussed in Note 8 to the condensed consolidated financial statements included in Item 1 of this quarterly report on Form 10-Q.

We offer an integrated solution to our customers providing manufacturing, supply and installation of a full range of structural and related building products. Our manufactured products include our factory-built roof and floor trusses, wall panels and stairs, vinyl windows, custom millwork and trim, as well as engineered wood that we design, cut, and assemble for each home. We also assemble interior and exterior doors into pre-hung units. Additionally, we supply our customers with a broad offering of professional grade building products not manufactured by us, such as dimensional lumber and lumber sheet goods and various window, door and millwork lines. Our full range of construction-related services includes professional installation, turn-key framing and shell construction, and spans all our product categories.

We group our building products into six product categories:

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Our operating results are dependent on the following trends, events and uncertainties, some of which are beyond our control:

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CURRENT OPERATING CONDITIONS AND OUTLOOK

Though the level of housing starts remains below the historical average, the homebuilding industry has shown improvement since 2011. For the third quarter of 2018, actual U.S. total housing starts were 330,600, a 3.5% increase compared to the third quarter of 2017. Actual U.S. single-family starts were 235,600 in the third quarter of 2018, a 2.4% increase compared to the same quarter a year ago. For the nine months ended September 30, 2018, actual U.S. total housing starts were 972,200, a 6.4% increase compared to the nine months ended September 30, 2017. Actual U.S. single-family starts were 687,700 in the first nine months of 2018, a 6.0% increase compared to the same period a year ago.  While the housing industry has strengthened over the past few years, the limited availability of credit to smaller homebuilders and potential homebuyers, the high cost of land development in many major metropolitan areas and the high demand for a limited supply of skilled construction labor, among other factors, have hampered a stronger recovery. A composite of third party sources, including the NAHB, are forecasting 1,278,000 U.S. total housing starts and 891,000 U.S single family housing starts for 2018, which are increases of 6.2% and 5.0%, respectively, from 2017. In addition, the Home Improvement Research Institute (“HIRI”) is forecasting sales in the professional repair and remodel end market to increase approximately 9.9%, inclusive of commodity price inflation, in 2018 compared to 2017.

Our net sales for the third quarter of 2018 were up 12.7% over the same period last year. We estimate that 11.2% of this increase is attributable to the impact of commodity price inflation on sales during the third quarter of 2018 compared to the third quarter of 2017.  Increases in single-family and multi-family sales volume were partially offset by declines in the repair and remodel/other end market. Our gross margin percentage increased by 0.3% during the third quarter of 2018 compared to the third quarter of 2017, primarily due to the sharp decline in commodity costs during the third quarter of 2018 relative to our customer pricing. We continue to invest in our business to improve our operating efficiency, which, along with operating leverage and disciplined cost management, has allowed us to better leverage our operating costs against changes in net sales. Our selling, general and administrative expenses, as a percentage of net sales, were 18.9% in the third quarter of 2018, a 0.8% decrease from 19.7% in the third quarter of 2017. This decrease in selling, general and administrative expenses, as a percentage of net sales on a year over year basis, was primarily driven by cost leverage as well as continued cost management.

While the rate of market growth has recently eased we still believe the long-term outlook for the housing industry is positive due to growth in the underlying demographics. We feel we are well-positioned to take advantage of the construction activity in our markets and to increase our market share, which may include strategic acquisitions or investments in organic growth opportunities. We will continue to focus on working capital by closely monitoring the credit exposure of our customers and by working with our vendors to improve our payment terms and pricing on our products. We strive to achieve the appropriate balance of short-term expense control while maintaining the expertise and capacity to grow the business as market conditions improve. In addition, debt reduction will continue to be a key area of focus for the Company.

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SEASONALITY AND OTHER FACTORS

Our first and fourth quarters have historically been, and are generally expected to continue to be, adversely affected by weather causing reduced construction activity during these quarters. In addition, quarterly results historically have reflected, and are expected to continue to reflect, fluctuations from period to period arising from the following:

The composition and level of working capital typically change during periods of increasing sales as we carry more inventory and receivables. Working capital levels typically increase in the first and second quarters of the year in anticipation of higher sales during the peak residential construction season. These increases have in the past resulted in negative operating cash flows during this peak season, which historically have been financed through available cash and borrowing availability under credit facilities. Collection of receivables and reduction in inventory levels following the peak building and construction season have in the past positively impacted cash flow and resulted in seasonal debt reduction, primarily in the fourth quarter.

RESULTS OF OPERATIONS

The following table sets forth, for the three and nine months ended September 30, 2018 and 2017, the percentage relationship to net sales of certain costs, expenses and income items:

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Three Months Ended September 30, 2018 Compared with the Three Months Ended September 30, 2017

Net Sales. Net sales for the three months ended September 30, 2018 were $2,118.5 million, a 12.7% increase over net sales of $1,878.9 million for the three months ended September 30, 2017. We estimate that 11.2% of this increase is attributable to the impact of commodity price inflation on sales during the third quarter of 2018 compared to the third quarter of 2017. Single-family and multi-family sales volume growth in the third quarter of 2018 was partially offset by declines in the repair and remodel/other end markets. 

The following table shows net sales classified by product category (dollars in millions):

The impact of commodity price inflation in the third quarter of 2018 resulted in the sales growth of our lumber and lumber sheet goods and manufactured products categories exceeding the sales growth of our other product categories.

Gross Margin. Gross margin increased $63.5 million to $522.8 million. Our gross margin percentage increased to 24.7% in the third quarter of 2018 from 24.4% in the third quarter of 2017, a 0.3% increase. Our gross margin percentage increased primarily due to the sharp decline in commodity costs during the third quarter of 2018 relative to our customer pricing.

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased $30.4 million, or 8.2%. Largely due to our increase in sales, our salaries and benefits expense was $267.6 million, an increase of $28.6 million from the third quarter of 2017. In addition, our fuel expense increased of $2.9 million in the third quarter of 2018 compared to the third quarter of 2017.

As a percentage of net sales, selling, general and administrative expenses decreased to 18.9% in the third quarter of 2018 from 19.7% in the third quarter of 2017, a 0.8% decrease. This improvement was primarily driven by cost leverage as well as continued cost management.

Interest Expense, Net. Interest expense was $29.1 million in the third quarter of 2018, a decrease of $4.7 million from the third quarter of 2017. This decrease, which is largely attributable to the positive results of our debt transactions executed in fiscal year 2017, was partially offset by increased interest expense on our variable rate debt instruments due to increased market interest rates in the third quarter of 2018 compared to the third quarter of 2017.

Income Tax Expense. We recorded income tax expense of $19.4 million and $15.1 million in the third quarters of 2018 and 2017, respectively. Our effective tax rate was 20.9% in the third quarter of 2018, largely due to the Tax Cut and Jobs Act (“the 2017 Tax Act”), compared to 27.5% in the third quarter of 2017.

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Nine Months Ended September 30, 2018 Compared with the Nine Months Ended September 30, 2017

Net Sales. Net sales for the nine months ended September 30, 2018 were $5,908.8 million, a 12.4% increase over net sales of $5,255.3 million for the nine months ended September 30, 2017. We estimate that 9.9% of this increase is attributable to the impact of commodity price inflation on sales during the first nine months of 2018 compared to the first nine months of 2017. Single-family and repair and remodel/other end market sales volume growth in the first nine months of 2018 was partially offset by declines in multi-family. 

The following table shows net sales classified by product category (dollars in millions):

The impact of commodity price inflation in the first nine months of 2018 resulted in the sales growth of our lumber and lumber sheet goods categories exceeding the sales growth of our other product categories. The decrease in net sales in our gypsum, roofing & insulation category was largely associated with declines in multi-family and light commercial sales in the first nine months of 2018 compared to the first nine months of 2017.

Gross Margin. Gross margin increased $134.0 million to $1,430.2 million. Our gross margin percentage decreased to 24.2% in the first nine months of 2018 from 24.7% in the first nine months of 2017, a 0.5% decrease. Our gross margin percentage decreased primarily due to the impact of commodity price inflation during the nine months ended September 30, 2018 relative to our customer pricing commitments.

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased $75.8 million, or 7.0%. Largely due to our increase in sales, our salaries and benefits expense was $758.2 million, an increase of $62.1 million from the first nine months of 2017, and our fuel expense increased $8.4 million. In addition, office general and administrative expense increased $3.1 million, bad debt expense increased $1.8 million and occupancy expense increased $0.9 million. Further, we recognized a $4.4 million loss on the disposal of assets in the first nine months of 2017.

As a percentage of net sales, selling, general and administrative expenses decreased to 19.5% in the first nine months of 2018 from 20.5% in the first nine months of 2017, a 1.0% decrease. This improvement was primarily driven by cost leverage as well as continued cost management.

Interest Expense, Net. Interest expense was $84.8 million for the nine months ended September 30, 2018, a decrease of $18.9 million compared to the nine months ended September 30, 2017. This decrease, which is largely attributable to the positive results of our debt transactions executed in fiscal year 2017, was partially offset by increased interest expense on our variable rate debt instruments due to increased market interest rates in the first nine months of 2018 compared to the first nine months of 2017. Additionally, interest expense for the nine months ended September 30, 2017 included one-time charges of $2.4 million related to the debt financing transactions executed in that period.

Income Tax Expense. We recorded income tax expense of $40.5 million and $35.1 million for the nine months ended September 30, 2018 and 2017, respectively. Our effective tax rate was 20.9% for the nine months ended September 30, 2018, largely due to the 2017 Tax Act, compared to 30.1% for the nine months ended September 30, 2017.

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Results by Reportable Segment

The following tables show net sales and income before income taxes by reportable segment excluding the “All Other” caption as shown in Note 8 to the condensed consolidated financial statements included in Item 1 of this quarterly report on Form 10-Q (dollars in thousands):

We have four reportable segments based on an aggregation of the geographic regions in which we operate. While there is some geographic similarity between our reportable segments and the regions as defined by the U.S. Census Bureau, our reportable segments do not necessarily fully align with any single U.S. Census Bureau region.  

According to the U.S. Census Bureau, actual single-family housing starts in the third quarter of 2018 increased 7.1%, 1.1% and 8.2% in the Midwest, South and West regions, respectively, compared to the third quarter of 2017. However, single-family housing starts decreased 13.1% in the Northeast region over the same period. For the third quarter of 2018, we achieved increased net sales and profitability across all of our reportable segments.

According to the U.S. Census Bureau, actual single-family housing starts for the nine months ended September 30, 2018 increased 0.2%, 4.9% and 14.7% in the Northeast, South and West regions, respectively, compared to the nine months ended September 30, 2017. However, single-family housing starts decreased 1.0% in the Midwest region over the same period. For the first nine months of 2018, we achieved increased net sales and profitability in our Southeast, South and West reportable segments. While we also achieved increased net sales in our Northeast reportable segment, profitability for that segment declined largely due to the impact of commodity price inflation relative to our costs.

LIQUIDITY AND CAPITAL RESOURCES

Our primary capital requirements are to fund working capital needs and operating expenses, meet required interest and principal payments, and to fund capital expenditures and potential future growth opportunities. Our capital resources at September 30, 2018 consist of cash on hand and borrowing availability under our 2022 facility.

Our 2022 facility will be primarily used for working capital, general corporate purposes, and funding growth opportunities. In addition, we may use the 2022 facility to facilitate debt consolidation. Availability under the 2022 facility is determined by a borrowing base. Our borrowing base consists of trade accounts receivable, inventory, other receivables which include progress billings and credit card receivables, and qualified cash that all meet specific criteria contained within the credit agreement, minus agent specified reserves. Net excess borrowing availability is equal to the maximum borrowing amount minus outstanding borrowings and letters of credit.

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The following table shows our borrowing base and excess availability as of September 30, 2018 and December 31, 2017 (in millions):

As of September 30, 2018, we had $404.0 million in outstanding borrowings under our 2022 facility and our net excess borrowing availability was $413.8 million after being reduced by outstanding letters of credit of approximately $82.2 million. Excess availability must equal or exceed a minimum specified amount, currently $90.0 million, or we are required to meet a fixed charge coverage ratio of 1:00 to 1:00. We were not in violation of any covenants or restrictions imposed by any of our debt agreements at September 30, 2018.

Liquidity

Our liquidity at September 30, 2018 was $448.2 million, which consists of net borrowing availability under the 2022 facility and cash on hand.

We have substantial indebtedness following our recent historical acquisitions, which increased our interest expense and could have the effect of, among other things, reducing our flexibility to respond to changing business and economic conditions. From time to time, based on market conditions and other factors and subject to compliance with applicable laws and regulations, the Company may repurchase or call the 2024 notes, repay debt, or otherwise enter into transactions regarding its capital structure.

Should the current industry conditions deteriorate or we pursue additional growth opportunities, we may be required to raise additional funds through the sale of capital stock or debt in the public capital markets or in privately negotiated transactions. There can be no assurance that any of these financing options would be available on favorable terms, if at all. Alternatives to help supplement our liquidity position could include, but are not limited to, idling or permanently closing additional facilities, adjusting our headcount in response to current business conditions, attempts to renegotiate leases, managing our working capital and/or divesting of non-core businesses. There are no assurances that these steps would prove successful or materially improve our liquidity position.

Consolidated Cash Flows

Cash provided by operating activities was $9.5 million for the nine months ended September 30, 2018 compared to cash used in operating activities of $7.6 million for the nine months ended September 30, 2017. The increase in cash provided by operating activities is largely due to increased sales and profitability during the nine months ended September 30, 2018 compared to the prior year. In addition, cash interest payments for the first nine months of 2018 decreased $29.2 million compared to the first nine months of 2017. However, the increase in cash provided by operating activities was mostly offset by the working capital increase of $266.5 million in 2018 exceeding the working capital increase of $212.9 million in 2017.  This change in working capital was primarily due to the timing of both inventory purchases and cash paid to vendors during the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017.

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Cash used in investing activities was $76.8 million and $43.3 million for the nine months ended September 30, 2018 and 2017, respectively. The change is primarily due to an increase in capital expenditures in the first nine months of 2018 compared to the first nine months of 2017. The increase in capital expenditures in 2018 largely relates to facility improvements and the purchase of machinery and rolling stock to support sales growth.

Cash provided by financing activities was $44.2 million and $45.7 million for the nine months ended September 30, 2018 and 2017, respectively. Our net borrowing activity under our long-term debt arrangements for the first nine months of 2018 was largely unchanged from the first nine months of 2017. The decrease in cash provided by financing activities is primarily due to a $2.4 million increase in repurchases of common stock related to restricted stock tendered in order to meet minimum withholding tax requirements for shares vested and a $2.2 million decrease in cash received from employee option exercises in 2018 compared to 2017. These decreases were partially offset by $2.8 million in payments of debt issuance costs in 2017.

RECENT ACCOUNTING PRONOUNCEMENTS

Information regarding recent accounting pronouncements is discussed in Note 1 to the condensed consolidated financial statements included in Item 1 of this quarterly report on Form 10-Q.

Item  3. Quantitative and Qualitative Disclosures About Market Risk

We may experience changes in interest expense if changes in our debt occur. Changes in market interest rates could also affect our interest expense. Our 2024 notes bear interest at a fixed rate, therefore, our interest expense related to these notes would not be affected by an increase in market interest rates. Borrowings under the 2022 facility and the 2024 term loan bear interest at either a base rate or eurodollar rate, plus, in each case, an applicable margin. A 1.0% increase in interest rates on the 2022 facility would result in approximately $4.0 million in additional interest expense annually as we had $404.0 million in outstanding borrowings as of September 30, 2018. The 2022 facility also assesses variable commitment and outstanding letter of credit fees based on quarterly average loan utilization. A 1.0% increase in interest rates on the 2024 term loan would result in approximately $4.6 million in additional interest expense annually as of September 30, 2018.

We purchase certain materials, including lumber products, which are then sold to customers as well as used as direct production inputs for our manufactured products that we deliver. Short-term changes in the cost of these materials and the related in-bound freight costs, some of which are subject to significant fluctuations, are sometimes, but not always, passed on to our customers. Delays in our ability to pass on material price increases to our customers can adversely impact our operating results.

Item 4. Controls and Procedures

Disclosure Controls Evaluation and Related CEO and CFO Certifications. Our management, with the participation of our principal executive officer (“CEO”) and principal financial officer (“CFO”), conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this quarterly report.

Certifications of our CEO and our CFO, which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (“Exchange Act”), are attached as exhibits to this quarterly report. This “Controls and Procedures” section includes the information concerning the controls evaluation referred to in the certifications, and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.

Limitations on the Effectiveness of Controls. We do not expect that our disclosure controls and procedures will prevent all errors and all fraud. A system of controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the system are met. Because of the limitations in all such systems, no evaluation can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Furthermore, the design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how unlikely. Because of these inherent limitations in a cost-effective system of controls and procedures, misstatements or omissions due to error or fraud may occur and not be detected.

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Scope of the Controls Evaluation. The evaluation of our disclosure controls and procedures included a review of their objectives and design, and the effect of the controls and procedures on the information generated for use in this quarterly report. In the course of the evaluation, we sought to identify whether we had any data errors, control problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken if needed. This type of evaluation is performed on a quarterly basis so that conclusions concerning the effectiveness of our disclosure controls and procedures can be reported in our quarterly reports on Form 10-Q. Many of the components of our disclosure controls and procedures are also evaluated by our internal audit department, our legal department and by personnel in our finance organization. The overall goals of these various evaluation activities are to monitor our disclosure controls and procedures on an ongoing basis, and to maintain them as dynamic systems that change as conditions warrant.

Conclusions regarding Disclosure Controls. Based on the required evaluation of our disclosure controls and procedures, our CEO and CFO have concluded that, as of September 30, 2018, we maintain disclosure controls and procedures that are effective in providing reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting. During the period covered by this report, there have been no changes in our internal control over financial reporting identified in connection with the evaluation described above that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II  — OTHER INFORMATION

Item 1. Legal Proceedings

The Company has a number of known and threatened construction defect legal claims. While these claims are generally covered under the Company’s existing insurance programs to the extent any loss exceeds the deductible, there is a reasonable possibility of loss that is not able to be estimated at this time because (i) many of the proceedings are in the discovery stage, (ii) the outcome of future litigation is uncertain, and/or (iii) the complex nature of the claims.  Although the Company cannot estimate a reasonable range of loss based on currently available information, the resolution of these matters could have a material adverse effect on the Company's financial position, results of operations or cash flows.

In addition, we are involved in various other claims and lawsuits incidental to the conduct of our business in the ordinary course. We carry insurance coverage in such amounts in excess of our self-insured retention as we believe to be reasonable under the circumstances and that may or may not cover any or all of our liabilities in respect of such claims and lawsuits. Although the ultimate disposition of these other proceedings cannot be predicted with certainty, management believes the outcome of any such claims that are pending or threatened, either individually or on a combined basis, will not have a material adverse effect on our consolidated financial position, cash flows or results of operations.  However, there can be no assurances that future adverse judgments and costs would not be material to our results of operations or liquidity for a particular period.

Although our business and facilities are subject to federal, state and local environmental regulation, environmental regulation does not have a material impact on our operations. We believe that our facilities are in material compliance with such laws and regulations. As owners and lessees of real property, we can be held liable for the investigation or remediation of contamination on such properties, in some circumstances without regard to whether we knew of or were responsible for such contamination. Our current expenditures with respect to environmental investigation and remediation at our facilities are minimal, although no assurance can be provided that more significant remediation may not be required in the future as a result of spills or releases of petroleum products or hazardous substances or the discovery of unknown environmental conditions.

Item  1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part 1, “Item 1A. Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2017, which could materially affect our business, financial condition or future results. The risks described in our annual report on Form 10-K are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results

Item  2. Unregistered Sales of Equity Securities and Use of Proceeds

Unregistered Sales of Equity Securities

(a)  None

Use of Proceeds

(b) Not applicable

Company Stock Repurchases

(c) None

Item 3. Defaults Upon Senior Securities

(a) None

(b) None

Item 4. Mine Safety Disclosures

Not applicable.

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Item 5. Other Information

(a) None

(b) None

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Item 6.  Exhibits