Item 1. Business.
Unless otherwise stated in this Annual Report on Form 10-K, references to “Foundation Building Materials,” “FBM,” “we,” “us,” and “our” refer to Foundation Building Materials, Inc. and its consolidated subsidiaries.
Our Company
We are one of the largest specialty distributors of wallboard, suspended ceiling systems and metal framing in the United States and Canada. We have expanded from a single branch in Southern California in 2011 to more than 175 branches across the United States and Canada as of December 31, 2019, carrying a broad array of more than 30,000 SKUs. Our organic growth initiatives and disciplined acquisition strategy have enabled us to grow rapidly. Our net sales in 2013 were $113.7 million and we reached net sales of over $2.1 billion for the year ended December 31, 2019. Our goal is to be the leading specialty building products distributor by continuing to expand into adjacent and complementary markets.
We have an expansive branch network that serves attractive markets across the United States and Canada. We distribute wallboard, suspended ceiling systems, metal framing and complementary and other products to our customers. We serve as a critical link between our supplier base and a diverse and highly fragmented group of more than 25,000 customers, which are usually contractors who install these products in commercial and residential buildings for both new construction and repair and remodeling projects.
We believe our customers select and trust us because we have the expertise to efficiently and effectively handle and deliver a broad range of product offerings. In addition, we manage the complex logistics required to safely deliver and stock the right products to the appropriate locations at each jobsite. It is critical for our contractor customers to have the correct product when they need it in order to complete their projects on time and on budget. We also provide our customers with technical product expertise, including proper installation techniques for new products. We typically deliver wallboard and other products directly to the floor where it will be installed from the first floor to the penthouse of a major high rise. For suspended ceiling contractors, we carry a wide range of products and have the technical sales expertise to assist our customers in selecting the appropriate suspended ceiling product for their project. Our North American scale gives us the ability to serve contractors and homebuilders that operate across multiple geographic markets. Most of our customer accounts are managed by salespeople and managers who communicate with customers on a regular basis and, as a result, have developed longstanding and trusted relationships.
We have close relationships with our suppliers at the executive, regional and branch levels. We believe we are a distributor of choice for our suppliers due to our scale, nationwide footprint, leading market positions, knowledgeable professionals, high service levels and strong relationships with a broad set of contractor customers. In suspended ceiling systems, we have exclusive distribution relationships in select geographies for certain products. These relationships include contractual exclusivity with Armstrong World Industries, Inc., or Armstrong, a leading manufacturer of suspended ceilings systems in the United States and Canada, and relationship-based exclusivity with USG Corporation, or USG, a leading manufacturer of building products. Armstrong has supported our expansion by renewing our contractual exclusivity or extending our contractual exclusivity into additional territories after we acquired certain companies. This contractual exclusivity makes us the sole distributor carrying Armstrong products in certain markets. We also possess semi-exclusive distribution rights in other markets.
We serve a mix of end markets across the new non-residential construction, new residential construction and non-residential repair and remodel sectors. Our products are used in the new construction and repair and remodel of commercial buildings, single-family homes and multi-family residences. We believe that new non-residential activity and residential housing starts in the United States remain below historical averages, and we expect annual growth to be in the low single digits.
The table below summarizes our major product categories, including percentage of net sales, applications and end markets.
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Our Products
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Wallboard
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Suspended Ceiling Systems
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Metal Framing
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Complementary and Other Products
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% of net sales for the year ended December 31, 2019
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38.0%
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19.2%
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18.2%
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24.6%
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% of net sales for the year ended December 31, 2018
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38.2%
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18.6%
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17.7%
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25.5%
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Applications
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Interior walls and ceilings
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Suspended ceiling systems including suspension grid, ceiling tile, panels and architectural specialties
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Wallboard structural support, typically sold as part of a package with wallboard or suspended ceiling systems
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Safety accessories and fasteners, tools, stucco, insulation and exterior finishing systems
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New Non-Residential
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ü
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ü
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ü
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ü
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Primary End Markets
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New Residential
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ü
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ü
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Non-Residential, Repair and Remodel
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ü
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ü
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ü
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ü
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We were founded in 2011 by our President and Chief Executive Officer Ruben Mendoza, our Chief Financial Officer John Gorey and one of our Regional Vice Presidents, Tom Fischbeck. Mr. Mendoza previously served as Chief Executive Officer of Acoustical Material Services where he oversaw the successful growth of the company before it was acquired by Allied Building Products in 2007. In founding our company, Mr. Mendoza applied a proven, customer-centric operating model that combines strong organic growth with an effective acquisition and integration program across a fragmented industry. In November 2013, we strengthened our management team with the addition of our Chief Operating Officer, Pete Welly, who has over 40 years of experience in our industry. Several members of our management team have spent the majority of their careers in the wallboard and suspended ceiling systems distribution industry. As a result, we have long and close personal relationships with many of the private owners of wallboard and suspended ceiling systems distributors, and our acquisitions generally have been completed on a privately negotiated, non-auction basis. Since 2014, the majority of senior level leaders who have sold us their businesses have elected to stay on as active employees and are often our best references to other business owners considering a sale to us.
On October 9, 2015, 100% of the outstanding equity of FBM Intermediate Holdings LLC was acquired by investment funds, or affiliates of investment funds, advised, managed or controlled by Lone Star Fund IX (U.S.) L.P., which we refer to in this Annual Report on Form 10-K together with certain of its affiliates and associates (excluding us and other companies it owns as a result of its investment activities) as Lone Star, along with certain members of management for approximately $560.0 million.
Our acquisition activity is described in greater detail in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Note 4 to the accompanying consolidated financial statements.
Sale of Mechanical Insulation Segment
On November 1, 2018, we completed the sale of our Mechanical Insulation segment, or the Disposed Business, to SPI LLC, an unrelated third party controlled by Dunes Point Capital and its associated funds, for approximately $122.5 million (subject to certain adjustments). As a result of this sale, FBM operates in one segment. For the year ended December 31, 2018, the Disposed Business met the criteria to be classified as held for sale and presented as a discontinued operation. Accordingly, we reclassified the results of operations and the cash flows of the Disposed Business to discontinued operations in our consolidated statements of operations, statements of financial position, and consolidated statements of cash flows for all periods presented.
Our Competitive Strengths
Market leader with significant size and scale advantages
Our coast-to-coast footprint enables us to distribute our comprehensive product offerings to a large, diverse set of customers and provides us with significant economies of scale that we believe give us cost advantages versus our smaller competitors. As a leading specialty building products distributor, we are able to negotiate volume discounts and preferential pricing terms with our key suppliers. As we continue to grow, we believe we will realize additional cost savings and other benefits from scale. We have also been able to realize procurement discounts on our large fleet of over 2,700 vehicles, and we leverage this fleet to handle the logistical complexities of large scale specialty building products distribution and to further operational cost advantages from economies of scale. Additionally, our local market scale adds route density, which increases our profit margins. We believe our consolidated information technology systems and centralized administrative functions, which are shared nationally across our platform, generate additional operating cost efficiencies.
Proven operating model
We believe that our national operating model, supported by local market expertise, entrepreneurial and customer-centric culture, acquisition and integration expertise and strong national brand has established us as the distributor of choice for leading suppliers and over 25,000 customers across certain construction-related end markets. Our management team originally utilized elements of this operating model while successfully growing prior companies and has applied those elements to our business. Since our inception, we have invested heavily in identifying, recruiting, training and retaining highly dedicated employees. We invest in ongoing talent development and focus on rewarding performance based on profitability goals and sales growth.
Our technology infrastructure and single enterprise resource planning platform, or ERP, allows us to manage our information technology efficiently. We have established a broad, integrated business platform that allows our branch network to leverage a centralized ERP system and other back office support functions to minimize costs, while retaining important and timely decision-making authority at the local level where we conduct business with our customers and can tailor our service and product offerings to their needs. This autonomy at the local level has fostered our entrepreneurial culture, while our national infrastructure support allows employees to focus on customer-first solutions and provides operating cost efficiencies.
Local market excellence
We are a North American company focused on supplying the local building material needs of each geographical area we cover according to climate, building codes, customer preference and other considerations. We believe that we are able to maintain our local market excellence due to our longstanding customer and supplier relationships in local regions, dependable customer service, brand recognition and market-specific product offerings that cater to local trends and preferences. We actively track local and regional construction opportunities for our customers to help drive business for both them and ourselves, and our senior executives complement the local sales efforts by maintaining key relationships with major national and regional accounts. We seek to cultivate an entrepreneurial culture and empower branch managers with the independence and authority to make important business decisions locally under the FBM brand. We believe that this attracts highly dedicated employees who endeavor to provide our customers with local market expertise and dependable customer service that differentiates us from our competition. We strive to be the distributor of choice for our customers in all of the local markets we serve.
Strong customer relationships
We sell to a diverse and highly fragmented base of over 25,000 customers, including commercial, residential and other specialty contractors. In addition to local contractors, we maintain relationships with regional non-residential construction companies and leading national homebuilders. Most customer accounts are serviced by managers and salespeople who communicate regularly with these accounts and have developed meaningful relationships over many years. We believe customer loyalty has been established through our high-quality customer service and technical support, strong logistics capabilities, trade credit offerings, exclusive relationships with key suppliers in critical markets and product expertise across our comprehensive selection of premier products and brands. We are able to safely and efficiently deliver products to our customers at the right time and in the specified location. Based on our customer surveys, contractors often prioritize on-time delivery over price as they consider the negative repercussions that project delays create, particularly increased labor costs. We have an integrated delivery, dispatch and order tracking system that allows us to optimize routes and create efficiencies. Optimization of delivery and dispatch results in lower costs for both delivery and fleet management. Additionally, for many of our products, we facilitate purchasing relationships between suppliers and our highly fragmented customer base by providing technical product knowledge, educating contractors on proper installation techniques for new products, enabling local product availability and extending trade credit.
Longstanding relationships with leading suppliers
We maintain longstanding relationships with a base of over 2,000 suppliers for whom we provide a direct channel to a large, diverse customer base across our national footprint. We are one of the largest customers for several of our top suppliers across the wallboard, suspended ceiling systems and metal framing product categories. We believe suppliers are attracted to our scale, consistent growth, nationwide footprint, leading market positions, knowledgeable professionals, local market expertise, quality customer service and strong relationships with a broad set of contractors. All key supplier relationships are led by our executive management team to foster long-term growth and maximize national pricing programs. We have access to leading brands and maintain exclusive distribution relationships to sell key products, such as suspended ceiling systems, in selected markets. Interior contractors often purchase wallboard and suspended ceiling systems from the same distributor, and our experience suggests carrying a ceilings product line helps to drive sales of wallboard and complementary and other products. We believe that our suppliers view us as a key facilitator to market and grow their businesses. We regularly discuss both acquisitions and greenfield expansion with our key suppliers, who may proactively recommend expansion opportunities to us.
Demonstrated ability to identify, execute and integrate acquisitions
Our management team has built our company from a single branch in 2011 into one of the leading specialty building products distributors in the United States and Canada. Since 2014, we have completed over 35 acquisitions and believe that the large, highly fragmented nature of our market and our reputation throughout the industry provides us access to a robust acquisition pipeline at attractive valuations that will continue to supplement our organic growth. Our acquisitions generally have been initiated through our senior management team’s business relationships developed over their many years in the industry, and we believe we have become an acquiror of choice for owners of specialty building products distribution companies because we offer them the opportunity to gain liquidity while remaining involved in the active management of their businesses going forward. This has led to a substantial pipeline of potential acquisition candidates that management is continuously cultivating. We have dedicated integration leaders who work closely with acquired branch personnel to unify acquisitions under a single brand with a single ERP system. We consolidate our acquired companies’ purchasing into our supplier purchasing programs, which generally have more advantageous terms due to our greater scale. We typically integrate each acquired company into our back office accounting, human resources and information technology systems within 90 days of closing.
Post-acquisition, we transition acquired companies exclusively to the FBM brand, and we have typically achieved additional cost savings from branch consolidations and the elimination of redundant overhead costs. Our acquisitions have historically realized purchasing synergies almost immediately by taking advantage of our volume discounts. Since 2014, many of the owners and senior management of companies that we have acquired have elected to remain employed with us post-acquisition which has proven to be successful to help ensure smooth transitions of the operations of the acquired businesses.
Experienced management team with strong track record of growth
Our management team, including our senior management and vice presidents, collectively have an average of over 25 years of industry experience. Our founder, President and Chief Executive Officer Ruben Mendoza, is an accomplished leader with over 25 years of industry experience. Our Chief Financial Officer John Gorey brings over 30 years of industry experience, our Chief Operating Officer Pete Welly brings over 40 years of industry experience and our Senior Vice President of Sales & Marketing Kirby Thompson has been working in the industry for over 35 years. By fostering an entrepreneurial and customer-centric culture and a proven ability to quickly and effectively integrate acquisitions under a common brand, this team has built FBM from a single branch into one of the leading specialty building products distributors in the United States and Canada.
Our Business Strategy
Our objective is to strengthen our competitive position, achieve profitable growth that exceeds market rates and increase stockholder value through the following key strategies:
Continue to drive organic growth through strategic initiatives
We believe there are significant opportunities to continue to expand our product offerings across all branches, target new customers and increase share with existing customers and grow by selectively opening new branches.
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Expand product offerings across all branches. We believe there is opportunity for additional expansion of our product offerings across our entire network. Our management team continuously identifies opportunities across all our regions for product line expansion. Our goal is to offer our full product suite in as many branches as possible.
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Target new customers and increase share with existing customers. We believe our scale and supplier relationships allow us to more efficiently offer a full suite of products than many of our competitors. We believe these advantages help us win new customers, and we have a proven track record of growing customer relationships and expanding core-products market share. We plan to continue this growth by leveraging our investment in a company-wide customer relationship management system that supports our experienced and driven sales force of more than 250 field sales personnel who develop new customer relationships at the local level. We also believe our product breadth, extensive operating experience, technical knowledge and specialized delivery fleet will allow us to continue to capture new customers and expand our sales to those customers over time. We offer a mobile application that allows our customers to easily access critical information, such as order and delivery status, which we believe will further enhance our customers' relationship with our platform.
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Grow by selectively opening new branches. We believe that significant opportunities exist to continue to expand our geographic footprint by opening new branches that are adjacent to our existing operations. Greenfield branches have each historically required up to $0.9 million in capital expenditures to open and typically generate positive cash flow within one year. On average, our greenfield branches return on invested capital is over 20% by year three. Key steps in the greenfield process include identifying growth markets where current customers or suppliers have identified a market need that we can support, conducting a market assessment, determining branch staffing and sales force, and developing a comprehensive forecast to determine if the location can meet profitability targets. In 2019, we opened four greenfield branches, and in 2020, we plan to open four to six greenfield branches, which includes our most recent greenfield branch in Charleston, South Carolina.
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Continue to expand and strengthen existing relationships with key suppliers
We believe our established relationships with market-leading suppliers serve as a key competitive advantage and support continued volume growth and purchasing power. Our suppliers benefit from our position as a single point of contact to over 25,000 customers and our ability to market and introduce new products efficiently and on a national scale. We maintain exclusive and semi-exclusive distribution rights with certain suppliers in certain key markets. We believe that expanding our relationships with suppliers, whether by adding more exclusive products or expanding exclusivity into new regions, further accelerates our growth. Additionally, our suppliers are critical partners in our growth, and we regularly discuss potential greenfield branches with them, with suppliers sometimes proactively identifying expansion opportunities for us.
Enhance financial performance through improved operational efficiencies
We believe we have the potential for continued operating margin improvement through operational initiatives including optimizing pricing, improving fleet utilization, maximizing working capital efficiency from inventory and accounts receivable management, and implementing strategic procurement processes. In addition, we expect to generate higher operating margins on incremental volume as we leverage our fixed costs across our existing footprint.
We strive to continuously improve our operational efficiency and are currently pursuing a number of initiatives to drive operating margin expansion, including efforts to:
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Monitor critical daily metrics to improve branch efficiencies, including overtime, revenue per truck and revenue per employee;
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Leverage the "Track My Truck" feature on our mobile application to provide real time delivery status for customer deliveries;
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Use our GPS truck-tracking system throughout our business to reduce fleet costs, improve route planning and provide required electronic driver logs;
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Leverage our increased investment in electronic data interchange to improve efficiency for both the purchasing and accounts payable teams; and
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Utilize a centralized customer relationship management system to provide a more comprehensive digital record of customer interactions while also building the sales pipeline by capturing, tracking and reporting on potential projects.
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To further drive operational efficiencies, we unify all of our completed acquisitions under a single brand and a single ERP system. Our information technology systems are scalable and coordinated, which gives us operational efficiencies through the sharing of best practices and information across this common platform. We believe our information technology infrastructure allows for effective, data-driven management and is built to empower local decision-making and enhance visibility across our branch network.
Continue to be a leading industry consolidator
From 2013 through the end of 2019, our management team has identified and closed over 35 acquisitions. We have successfully integrated all of these acquisitions. We believe our national footprint, market leadership, entrepreneurial culture and ability to retain key leadership makes us an attractive buyer. We are selective in identifying acquisition targets and pursue acquisitions that both expand our footprint and generate synergies. We have a dedicated team of professionals to manage the acquisition and integration process, and these professionals have been through several post-closing integrations and have developed a process to maximize the efficiencies in these integrations. Due to the large and highly fragmented nature of our market and our reputation throughout the industry, we believe that we have access to a robust acquisition pipeline at attractive valuations that will continue to supplement our organic growth. We will also consider expansion into complementary specialty distribution markets through acquisitions.
Focus on culture and continuous improvement
We believe that our employees are one of the key drivers of our success, and we intend to continue to recruit, train, promote and retain entrepreneurial and successful people. We believe that we have created a culture where our people feel valued and supported and see that their efforts are instrumental to our continued success. We are focused on providing our employees with regular training and development to improve customer service, workplace safety and job satisfaction. As an example, we have implemented "FBM University" to provide our employees with extensive training and development programs, utilizing new learning management systems and in-person training programs, which we view as essential for new hires and the development of existing employees. We also selected and implemented a new Learning Management System, or LMS, that is user friendly, easily modified, fully compatible with our other existing programs and systems, and cost effective. We invest substantially in leadership training and team building through our annual "Key Leaders Summit" meeting. By improving our employees’ knowledge base and sharing best practices, we are able to empower our people to better serve our customers. In 2019, we introduced our Branch Manager Playbook to provide additional resources to develop our management team.
We incentivize our branch managers and customer-facing, branch-level employees based on branch-level operating income, which we believe leads to improved branch-level performance.
Commitment to safety
Our commitment to safety is one of our core foundational values. New employees participate in a comprehensive onboarding orientation that focuses on safety awareness, risk identification and other essential safety protocols. Training is delivered through a variety of media, including our LMS and classroom settings, so that managers can employ the method that fits our employee’s needs.
Our Products
We are a leading specialty distributor of a diversified mix of building products, including wallboard, suspended ceiling systems, metal framing, and complementary and other products. We are one of the largest wallboard and suspended ceiling systems distributors in the United States and Canada based on our 2019 net sales. We provide customers with comprehensive product offerings, with over 30,000 SKUs. Our product breadth, combined with our commitment to quality customer service, has solidified our position as a supplier of choice. Our diversified product offerings provide exposure to several construction end markets.
Wallboard
We specialize in the distribution of high-quality wallboard used to finish the interior walls and ceilings in residential and commercial construction projects. Wallboard is used in the vast majority of new construction and renovation projects due to its ease of installation and superior performance in providing comfort, fire resistance, thermal and sound insulation, mold and moisture resistance, impact resistance and aesthetic and design elements. It is available in a number of standard lengths, widths and thicknesses with a range of characteristics. Panels with greater thickness provide increased durability and sound insulation. In non-residential construction projects, architectural specifications and building codes provide requirements related to the thickness of the panels and, in some cases, other characteristics, such as fire, mold and moisture resistance. Wallboard is an essential building product, with approximately 11,000 square feet of wallboard used on average in each new home. Given the importance of wallboard to the overall building process, contractors have very precise delivery expectations which are best met by experienced specialty building products distributors with a local presence and specialized equipment. The market is characterized by high manufacturer concentration.
Suspended ceiling systems
Suspended ceiling systems and grid help ensure and enhance the integrity, protection and decorative finishing of interior spaces. Our ceilings product line consists of a higher number of specialized SKUs and less product standardization than our wallboard product line. We believe ceilings product availability often pulls in additional business to our branches, as contractors often look to source additional interior products from a single distributor. The ceilings industry has enjoyed price stability through various cycles. Commoditization risk is limited as customers often seek specific design and aesthetic characteristics unique to their space. The market is characterized by high manufacturer concentration. Ceilings are sold into both non-residential repair and remodel and new non-residential construction markets.
We maintain exclusive distribution rights in certain markets with Armstrong, a leading manufacturer of suspended ceiling systems, in the United States and Canada. Armstrong’s products are highly sought after by designers, contractors, builders and distributors. We have exclusive distribution rights for Armstrong ceilings in multiple markets across seven states and six Canadian provinces and non-exclusive distribution rights with Armstrong in multiple markets across twenty-five states and two other Canadian provinces. Armstrong closely oversees the marketing of its products, and generally grants distribution rights to only one or two companies in a given market. In addition, we have relationship-based exclusivity with USG in select markets in three states and non-exclusive relationships with USG in select markets across three states.
Metal framing
We provide metal framing and other framing products for multiple uses, including interior partitions and load bearing walls. We source our products from local, regional and national manufacturers in accordance with building standards and codes. Commercial contractors typically purchase these materials with wallboard, suspended ceiling systems, insulation and other related building products from us as part of a commercial package. Metal framing pricing was dynamic during 2018 due to tariffs, but pricing became more stable during 2019.
Complementary and other products
We offer complementary and other products, tools and accessories such as wallboard accessories, stucco and finishing systems, safety accessories, fasteners, insulation, doors and roofing products. Certain products are provided on a regional basis to address local preferences. These complementary products allow us to provide a full suite of products across our entire business, enhancing our margins and creating value for our customers.
Wallboard accessories are generally sold as a package in conjunction with wallboard and include most products used for the installation and finishing of wallboard. Key wallboard accessories include joint compounds, trims, tapes and various other accessories.
Customers and Suppliers
Customers
We sell to a diverse and highly fragmented base of over 25,000 customers, including commercial, residential and other specialty contractors. In addition to local contractors, we maintain strong relationships with regional construction companies and leading national homebuilders. Most customer accounts are serviced by managers and salespeople who communicate regularly with these accounts and have developed meaningful relationships built over many years. During the years ended December 31, 2019 and 2018, we have not had any individual customer account that exceeded 10% of net sales.
Suppliers
We maintain longstanding relationships with a base of over 2,000 suppliers, with no single supplier accounting for more than approximately 16% and 15% of our purchases for the years ended December 31, 2019 and 2018, respectively. We are one of the largest customers for several of our top suppliers across wallboard, suspended ceiling systems and metal framing. We believe that suppliers find our scale, nationwide footprint, leading market positions, knowledgeable professionals, local market expertise, quality customer service and strong relationships with a broad set of contractors attractive. We have strong relationships with leading wallboard, suspended ceiling systems and metal framing manufacturers, and we are able to provide them with a direct channel to a large, diverse customer base and a national footprint.
Sales and Marketing
We utilize a sales strategy that enables our sales force to develop strong customer relationships at the local level. The sales effort is managed by sales or branch managers and executed by both inside and field sales teams. Due to the service-oriented and relationship-driven nature of the sales process, it is important to have experienced teams in each local market. To ensure customer expectations are met, our sales teams include both product sales specialists and sales managers who focus on specific products, categories and regions. We also tailor our sales approach to best suit customer needs within each end market. Both the commercial and residential sales processes are largely relationship-driven, although the commercial sales process is also highly technical and requires product knowledge with a sophisticated material delivery plan.
We employ both inside sales and field sales personnel. Inside sales personnel primarily service customers at the branches, by phone or email, while field sales personnel primarily sell to customers face-to-face. These representatives are responsible for driving new customer sales and maintaining, as well as growing, existing customer relationships. Our executives complement the local sales efforts by continuing to maintain key relationships with major national and regional accounts while sharing their significant experience with various sales organizations and reinforcing a customer-centric philosophy. We also coordinate closely with our major suppliers to optimize specific sales strategies. In addition to providing customer relationship support, our executive team also coordinates the go-to-market strategy. Given the importance of strong local relationships, we thoroughly vet the strength of an acquisition target’s long-term customer relationships. Our management views these local relationships and the sales team of any acquired company to be critical to a successful integration.
We also employ various marketing strategies to reach our customers in the most efficient and effective manner. We market our products and services through our website, mobile app, social media, sample kits, targeted advertisements and a range of industry trade shows. Employees are encouraged to participate in industry associations as another point of customer engagement. Certain employees are members and have served as officers and directors of numerous industry associations, including the Association of the Wall and Ceiling Industry, Ceilings & Interior Systems Construction Association, EIFS Industry Members Association and selected other regional associations. Furthermore, we sponsor a number of annual conventions and trade shows. Management believes that some of our most effective marketing is "word-of-mouth" given our reputation for high-quality products, superior customer service, product expertise and stellar delivery performance. We also benefit from the marketing and brand strength of several key suppliers, especially those with whom we hold exclusive or semi-exclusive arrangements.
Employees
As of December 31, 2019, we had more than 3,500 employees, 240 of whom were unionized. We believe we have a strong relationship with our employees, including our unionized employees. We have not experienced a work stoppage, and we currently have no ongoing labor disputes.
Health and Safety
We approach health and safety through an operationally driven safety program utilizing a common approach that encourages the sharing of best practices across the specialty building products distribution industry. Our safety practices have an operational focus, and we work closely with all levels of management on developing and managing our company-wide safety program. We have a strong management commitment to safety from our Chief Executive Officer and Chief Operating Officer to the branch operating level. We have a clearly defined safety structure that includes dedicated Regional Safety Coordinators to drive harmonization of safety protocols across the entire branch network. The Regional Safety Coordinators support branch Safety Champions whose duties are integrated as a shared responsibility within their operations role. Through branch ownership of the safety program, the Safety Champion works with their local management and Regional Safety Coordinator on day-to-day safety issues including incident reporting and investigation, inspections and training needs. Through our internal protocols and safety training programs, we strive to be an industry leader in developing and promoting a strong safety culture. The effort begins immediately with new employees through a comprehensive orientation that focuses on safety awareness, risk identification, hazard communication and other essential safety protocols. We deliver training through a variety of media, including our LMS modules, hands on training and classroom settings. Our employees share the responsibility to work in a manner that safeguards themselves, their coworkers and the communities they serve. We work diligently with our employees and continually advocate adherence to the highest safety standards. Management’s expectations and policy toward safety is clearly communicated and is supported by our "Safety Absolutes," which are key rules that all of our employees are required to follow.
Competition
We compete primarily against other specialty building products distributors, as well as big-box retailers and lumberyards. Among specialty building products distributors, we compete against a small number of large national distributors and many small, local, privately owned distributors. Our remaining competitors are generally smaller regional and local firms, many of which we view as attractive acquisition opportunities. The principal competitive factors in our business include, but are not limited to, availability of materials and supplies; technical product knowledge and expertise; advisory or other service capabilities; timely and comprehensive delivery capabilities; pricing of products; and availability of credit to customers. We have access to certain products on an exclusive or semi-exclusive basis in certain geographical areas.
Backlog
We do not keep a backlog as we do not consider it to be a material part of our operations.
Seasonality
Use and consumption of our products fluctuate due to seasonality. Nearly all of the products we sell are exposed to outdoor elements during delivery or installation. Therefore, seasonal changes and other weather-related conditions, in particular extended rainy and cold weather in the spring and fall and major weather events such as hurricanes, tornadoes, tropical storms and heavy snows, can adversely affect our business and operations. Our shipment levels also follow activity in the construction industry, which typically increases in the more moderate seasons of spring, summer and fall.
Government Regulations
Although we are not engaged in a "regulated industry," we are subject to various federal, state and local government regulations applicable to the business in the jurisdictions in which we operate, including laws and regulations relating to our relationships with our employees, public health and safety, workplace safety, transportation, zoning and fire codes. We believe we are in compliance in all material respects with applicable laws, codes and regulations.
Available Information
Our website address is www.fbmsales.com. Information contained on, or incorporated by reference to, our website does not constitute a part of this Annual Report on Form 10-K or any other filing we make with the SEC. We make available free of charge on our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practical after we file such material with, or furnish it to, the SEC. Certain of these documents may also be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website that contains reports and other information regarding issuers that file electronically with the SEC at www.sec.gov.
We also make available free of charge on our website our Principles of Corporate Governance, our Employee Code of Conduct, our Code of Business Conduct and Ethics for Members of the Board of Directors and the Charters of our audit committee, compensation committee and nominating and corporate governance committee of our Board of Directors.
Item 1A. Risk Factors.
Risks Relating to Our Business and Industry
Our business depends on the construction industry and general business, financial market and economic conditions.
The construction industry is cyclical and significantly affected by changes in general and local economic and real estate conditions, such as employment levels, consumer confidence, demographic trends, housing demand, inflation, deflation, interest rates and credit availability. Changes in these general and local economic conditions or deterioration in the broader economy could negatively impact the level of purchases, capital expenditures and creditworthiness of our direct and indirect customers and suppliers, and, therefore, our margins, earnings, orders and financial condition, results of operations and cash flows. Changes in these economic conditions may affect some of our regions or markets more than others. If adverse conditions affect our larger markets, such as California, Arizona, Indiana, Texas and Florida, they could have a proportionately greater impact on us than on some other companies. In addition, any uncertainty regarding global economic conditions may have an adverse effect on the results of operations and financial condition of us or our customers, distributors and suppliers. A shortage of labor in the construction industry could also have an impact on our financial results.
Our sales depend upon the commercial new construction market and the commercial repair and remodel market.
We cannot predict the duration of the current market conditions or the timing or strength of any future recovery or downturn of commercial construction activity in our markets. Weakness in the commercial construction market and the commercial repair and remodel market would have a material adverse effect on our business, financial condition and operating results. Continued uncertainty about current economic conditions will continue to pose a risk to our businesses that serve the non-residential markets. If participants in these industries postpone spending in response to tighter credit, negative financial news and declines in income or asset values or other factors, this could have a material negative effect on the demand for our products and services, and on our business, financial condition and results of operations.
Homebuilding activity and the mortgage markets affect the demand for products we distribute, which in turn affects our business condition.
The distribution of our products, particularly wallboard, to contractors serving the residential market represents a significant portion of our business. Wallboard demand is highly correlated with housing starts. Housing starts and repair and remodel activity, in turn, are dependent upon a number of factors, including housing demand, housing inventory levels, housing affordability, mortgage and other interest rates, foreclosure rates, geographical shifts in the population and other changes in demographics, the availability of land, local zoning and permitting processes, the availability of construction financing and the health of the economy and mortgage markets. Unfavorable changes in any of these factors, many of which are beyond our control, could adversely affect consumer spending, result in decreased demand for homes and adversely affect our business.
Mortgage financing and commercial credit for smaller homebuilders, as well as for the development of new residential lots, continue to be constrained. If the residential construction industry experiences weakness and a reduction in activity, our business, financial condition and results of operations could be significantly and adversely affected.
Our business relies on private investment and a slower than expected economy may adversely affect our results.
A significant portion of our sales are for projects with non-public owners, such as non-residential builders and home builders who make investments with private funds into their projects. Construction spending is affected by our customers’ ability to finance projects. Residential and nonresidential construction could decline if companies and consumers are unable to finance construction projects or if the economy slows or is stalled, which could result in delays or cancellations of capital projects. If the economy slows, or if housing starts and nonresidential projects do not increase, sales of our products and related services may decline and our financial position, results of operations and liquidity could be materially adversely affected.
The majority of our net sales are credit sales that are made primarily to customers whose ability to pay is dependent, in part, upon the economic strength of the industry and geographical areas in which they operate, and the failure to collect or timely collect monies owed from customers could adversely affect our business.
The majority of our net sales volume is facilitated through the extension of credit to our customers whose ability to pay is dependent, in part, upon the economic strength of the industry in the areas where they operate. We offer credit to customers, either through unsecured credit that is based solely upon the creditworthiness of the customer, or secured credit for materials sold for a specific construction project where we establish a security interest in the material used in the project. The type of credit we offer depends both on the customer's financial strength and the nature of the business in which the customer is involved. End users, contractors and other non-contractor customers sometimes purchase on unsecured credit without the Company having lien rights. If any of our customers are unable to repay credit that we have extended in a timely manner, or at all, our financial condition, operating results and cash flows would be adversely affected. Further, our collection efforts with respect to non-paying or slow-paying customers could negatively impact our customer relations going forward.
Because we depend on certain of our customers to repay extensions of credit, if the financial condition of our customers declines, our credit risk could increase as a result. In a slow economy, there is a likelihood that we will not be able to collect on certain of our accounts receivable from our customers. Significant contraction in the commercial and residential construction markets, coupled with limited credit availability and stricter financial institution underwriting standards, could adversely affect the operations and financial stability of certain of our customers. For example, we experienced payment delays and defaults from some of our customers during the recent economic downturn and subsequent slow recovery. Should one or more of our larger customers declare bankruptcy, it could adversely affect the collectability of our accounts receivable, which would in turn negatively impact our financial condition, results of operations and cash flows.
Within our local markets, we operate in a highly competitive industry and any failure to effectively compete could have a material adverse effect on us.
The United States and Canadian construction industries are highly fragmented with a large number of independent specialty building products distributors in a number of our markets. Additionally, in most markets, we compete against diversified distribution companies, which may be larger and have broader product lines. Competition with competitors that have greater financial resources and are better capitalized than us could lead to lower prices, lower sales volumes, and higher costs in some markets, negatively affecting our financial position, results of operations, and liquidity.
We also compete based on service, quality and range of products. Our competitors may be positioned to provide better service and thereby establish stronger relationships with customers and suppliers. Our competitors may also sell preferred products, develop a more comprehensive product portfolio or have more competitive prices. In addition, certain product manufacturers that sell and distribute their products directly to homebuilders may increase the volume of such direct sales.
There is intense competition in a number of markets in which we operate. If we are unable to compete effectively with our existing competitors or new competitors who enter the markets in which we operate, our financial position, results of operations and liquidity may be adversely affected.
The trend toward consolidation in our industry and broader markets may negatively impact our business.
The trend toward consolidation in our industry and across the building markets sector as a whole could cause markets to become more competitive as greater economies of scale are achieved by distributors that are able to efficiently expand their operations. We believe these factors have led to and could further result in fewer overall distributors operating multiple locations. There can be no assurance that we will be able to continue to execute our acquisition or greenfield branch growth strategy, and any failure to do so may make it more difficult for us to maintain or increase our economies of scales, including the level of incentives we receive from suppliers, and adversely affect our operating margins. Consolidation could also increase the competition for acquisition targets in our industry, resulting in higher acquisition costs and prices.
The success of our business depends, in part, on our ability to execute on our greenfield branch and acquisition strategy.
A significant portion of our historical growth has occurred through acquisitions, and our business plan provides for continued growth through acquisitions. We are presently evaluating, and we expect to continue to evaluate on an ongoing basis, a variety of possible acquisition transactions, including both smaller acquisitions and larger acquisitions that would be material to our business and results of operations. We regularly make, and we expect to continue to make, acquisition proposals, and we may enter into letters of intent for acquisitions. We cannot predict the timing of any contemplated transactions, and there can be no assurances that we will identify suitable acquisition opportunities or, if we do identify such opportunities, that any transaction can be consummated on acceptable terms. In addition, even if we consummate an acquisition, there is no assurance that it will result in enhanced value for our stockholders. Furthermore, a significant change in our business or the economy, an unexpected decrease in our cash flows or any restrictions imposed by our debt may limit our ability to obtain the necessary capital for acquisitions or otherwise impede our ability to complete an acquisition. Our recent growth and our acquisition strategy have placed, and will continue to place, significant demands on our management’s time, which may divert their attention from our business, and may lead to significant due diligence and other expenses regardless of whether we pursue or consummate any acquisition. Failure to identify suitable transaction partners and to consummate transactions on acceptable terms, as well as the commitment of time and resources in connection with such transactions, could have a material adverse effect on our business, financial condition and results of operations.
We also supplement our organic growth through the establishment of greenfield branches. We are generally contemplating several potential locations at any one time, but we cannot guarantee that we will be able to secure the real estate, personnel or financing to open additional greenfield branches. In addition, even if we are able to establish new greenfield branches, there is no guarantee that we will realize the expected value from these decisions.
Our acquisition strategy exposes us to significant risks and additional costs.
Acquisitions also involve risks that the businesses acquired will not perform as expected and that business judgments concerning the value, strengths and weaknesses of acquired businesses will prove incorrect. We may not accurately assess the value, strengths, weaknesses or potential profitability of an acquisition target. We may become liable for certain unforeseen pre-acquisition liabilities of an acquired business, including, among others, tax liabilities, product liabilities, asbestos liabilities, environmental liabilities, pension liabilities and liabilities for employment practices, and these liabilities could be significant. In addition, an acquisition could result in the impairment of customer or vendor relationships or certain acquired assets such as inventory and goodwill. We may also incur costs and inefficiencies to the extent an acquisition expands the industries, products, markets or geographies in which we operate due to our limited exposure to and experience in a given industry, market or region. Large or a number of smaller acquisitions may also require that we incur additional debt to finance the transaction, which could be substantial and impose operational or financial restrictions on our business and result in debt service costs. Acquisitions can also involve post-transaction disputes with the counterparty regarding a number of matters, including purchase price, inventory or other working capital adjustment, environmental liabilities or pension obligations. If any of these risks were to occur, our financial position, results of operations and liquidity may be adversely affected.
Any inability to successfully integrate our recent or future acquisitions could have a material adverse effect on us.
Acquisitions require the integration of acquired companies’ sales and marketing, distribution, purchasing, finance and administrative organizations, as well as exposure to different legal and regulatory regimes in jurisdictions in which we have not previously operated. We may not be able to integrate successfully any business we may acquire or have acquired into our existing business, or may not be able to do so in a timely, efficient and cost-effective manner. Our inability to complete the integration of new businesses in a timely and orderly manner could increase costs and lower profits. Factors affecting the successful integration of acquired businesses include, but are not limited to, the following:
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diverting the attention of our management and that of the acquired business;
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merging or linking different accounting and financial reporting systems and systems of internal controls;
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merging computer, technology and other information networks and systems;
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assimilating personnel, human resources and other administrative departments and potentially contrasting corporate cultures;
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consolidating locations in a timely and efficient manner;
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incurring or guaranteeing additional indebtedness;
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disrupting our relationship with or loss of key customers, suppliers or personnel;
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interfering with, or loss of momentum in, our ongoing business or that of the acquired company; and
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delays or cost-overruns in the integration process.
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Any of our acquisition or other integration-related issues could divert management’s attention and resources from our day-to-day operations, cause significant disruption to our business and lead to substantial additional costs. Our inability to realize the anticipated benefits of an acquisition or to successfully integrate acquired companies, as well as other transaction-related issues, could have a material adverse effect on our business, financial condition and results of operations.
In addition, possible future acquisitions or dispositions may trigger a review by the U.S. Department of Justice, or the DOJ, and the U.S. Federal Trade Commission, or the FTC, under their respective regulatory authority, focusing on the effects on competition, including the size or structure of the relevant markets and the pro-competitive benefits of the transaction. Any delay, prohibition or modification required by regulatory authorities could adversely affect the terms of a proposed acquisition or could require us to modify or abandon an otherwise attractive acquisition opportunity.
An impairment of goodwill could have a material adverse effect on our results of operations.
Acquisitions frequently result in the recording of goodwill and other intangible assets. At December 31, 2019, goodwill represented 35.1% of our total assets. Goodwill is not amortized and is subject to impairment testing at least annually using a qualitative and if necessary, a fair value based approach. The identification and measurement of goodwill impairment may involve the estimation of the fair value of our reporting unit, which is consistent with our operating and reportable segment. The estimate of fair value of the reporting unit is based on the best information available as of the date of the assessment and incorporates management's assumptions about expected future cash flows and other valuation techniques. While we evaluate the recoverability of goodwill at least annually as well as when events or changes in circumstances indicate that the fair value of a reporting unit has more likely than not declined below its carrying value, we cannot accurately predict the amount and timing of any impairment of assets, and, in the future, we may be required to take additional goodwill or other asset impairment charges. Any such non-cash charges would have an adverse effect on our financial results.
The loss of, or a significant decline in business with, one or more of our suppliers, or the development of alternatives to distributors in the supply chain, could adversely affect our business, financial condition, results of operations and cash flows.
Most of our sales are reliant upon maintaining our agreements and other relationships with suppliers of building products including wallboard, suspended ceiling systems and metal framing. Some of these relationships with key suppliers, including Armstrong, provide us with exclusive distribution rights in certain areas while others provide us with access to leading brands in many of our key markets. The loss of distribution rights with any of our key suppliers would have a material adverse impact on our sales and profitability. In addition, many of our suppliers could grant distribution rights in semi-exclusive markets to a competing distributor at any time, which could lead to a loss of market share in these markets, a loss of the share of a customer’s spend related to such products and a reduction in net sales. We cannot assure you that the current level of business with our suppliers can be maintained or that sales and profit will remain at or near current levels.
In addition, our customers could begin purchasing more of their product needs directly from manufacturers, which would result in decreases in our net sales and earnings. Our suppliers could invest in infrastructure to expand their own sales forces and sell more products directly to our customers or could seek out new distribution partners. These changes in the supply chain could adversely affect our financial condition, operating results and cash flows.
If we fail to qualify for supplier rebates or are unable to maintain or adequately renegotiate our rebate arrangements, our results of operations could be materially adversely affected.
Many of our products are purchased pursuant to rebate arrangements that entitle us to receive a rebate based on the volume of our purchases. Some arrangements require us to purchase minimum quantities in certain geographies or product categories and result in higher rebates with increased quantities of purchases. These rebates effectively reduce the costs of our products, and we manage our business to take advantage of these programs. When assessing the desirability of acquisitions, we consider the effects of such acquisitions on our ability to qualify for rebates. Rebate arrangements are subject to renegotiation with our suppliers from time to time. In addition, consolidation of suppliers may result in the reduction or elimination of rebate programs in which we participate. If we are unable to qualify for these rebates, are unable to renew rebate programs on desirable terms or are unable to obtain the expected rebate benefits of our acquisitions, or a supplier materially reduces or stops offering rebates, our costs could materially increase and our gross margins and income could be materially adversely affected.
A material disruption at one of our suppliers’ facilities could prevent us from meeting customer demand, reduce our sales and negatively affect our overall financial results.
Any of the following events could cease or limit operations unexpectedly: fires, floods, earthquakes, hurricanes, on-site or off-site environmental incidents, contagious diseases, or other catastrophes; utility and transportation infrastructure disruptions; labor difficulties; other operational problems; or war, acts of terrorism or other unexpected events. In particular, if the current coronavirus outbreak continues and results in a prolonged period of travel, commercial and other similar restrictions, we could experience supply disruptions. Any downtime or facility damage at our suppliers, including one of the major wallboard suppliers, could prevent us from meeting customer demand for our products or require us to make more expensive purchases from a competing supplier. If our suppliers were to incur significant downtime, our ability to satisfy customer requirements could be impaired, resulting in customers seeking products from other distributors, as well as decreased customer satisfaction and lower sales and operating income. Because we purchase from a limited number of wallboard manufacturing facilities, the effects of any particular shutdown or facility damage could be significant to our operations as a whole and pronounced in the markets near the facility affected.
Weather can materially affect our business and we are subject to seasonality.
Seasonal changes and other weather-related conditions can adversely affect our business and operations through a decline in both the use and production of our products and demand for our services. Adverse weather conditions, such as extended rainy and cold weather in the spring and fall, can reduce demand for our products and reduce sales or render our distribution operations less efficient. Major weather events such as hurricanes, tornadoes, tropical storms, heavy snows and flooding have affected us in the past and could adversely affect future sales.
Construction materials production and shipment levels follow activity in the construction industry, which typically occurs in the spring, summer and fall. Warmer and drier weather during the second and third quarters typically result in higher activity and sales levels during those quarters. The first quarter typically has lower levels of activity due to inclement weather conditions. In particular, the activity level during the second quarter can vary greatly with variations in temperature and precipitation.
Most of our facilities are held under long-term, non-cancelable leases and a substantial number of such properties are leased from the former owners of acquired businesses. The interests of such lessors may be in conflict with our interests and we may be unable to renew leases on favorable terms or at all.
Most of our facilities are leased pursuant to lease agreements that generally are non-cancelable and have initial terms ranging from three to 20 years, with options to renew for specified periods of time. In addition, some facilities are leased from former owners of businesses we have acquired, and our relationships with such lessors could be adversely affected by unrelated business decisions or conflicts arising from such acquisitions. We cannot assure you that we will be able to renew our current or future leases on favorable terms or at all. In addition, if we close or idle a facility, we generally remain committed to perform our obligations under the applicable lease, which include, among other things, payment of the base rent for the balance of the lease term.
Any significant fuel cost increases or shortages in the supply of fuel could disrupt our ability to transport and distribute our products to customers, which could adversely affect our results of operations.
The cost of fuel necessary to deliver products to our customers is largely unpredictable and has a significant effect on our business and results of operations. Prices and availability of petroleum products are subject to political, economic and market factors that are outside our control. Political events in petroleum-producing regions, as well as hurricanes, floods and other weather-related events may cause the price of fuel to increase. A rise in fuel prices could make it unprofitable for us to service certain customers or regions. Significant increases in the cost of fuel or disruptions in the supply of fuel could materially adversely affect our business, sales and results of operations.
Environmental, health and safety laws and regulations and any changes to, or liabilities arising under, such laws and regulations could have a material adverse effect on our financial condition, results of operations and liquidity.
We are subject to a variety of federal, state, provincial and local laws and regulations relating to, among other things: the release or discharge of materials into the environment; the management, use, generation, treatment, processing, handling, storage, transport or disposal of solid and hazardous wastes and materials; and the protection of public and employee health, safety and the environment and data protection and data privacy (including the California Consumer Privacy Act). These laws and regulations impose strict liability in some cases without regard to negligence or fault and expose us to liability for the environmental condition of our currently or formerly owned, leased or operated facilities, and may expose us to liability for the conduct of others or for our actions, even if such actions complied with all applicable laws at the time these actions were taken. These laws and regulations may also expose us to liability for claims of personal injury or property or natural resource damage related to alleged exposure to, or releases of, regulated or hazardous materials. The existence of contamination at properties we own, lease or operate could also result in increased operational costs or restrictions on our ability to use those properties as intended, including for purposes of construction materials distribution. In addition, because our properties are generally situated adjacent to or near industrial companies, our properties may be at an increased risk of having environmental contaminants from other properties spill or migrate onto or otherwise affect our properties.
Despite our compliance efforts, there is an inherent risk of liability in the operation of our business, especially from an environmental standpoint, and, from time to time, we may be in noncompliance with environmental, health and safety laws and regulations. These potential liabilities or non-compliances could have an adverse effect on our operations and profitability. In some instances, we must have government approvals, certificates, permits or licenses in order to conduct our business, which may require us to make significant capital, operating and maintenance expenditures to comply with environmental, health and safety laws and regulations. Our failure to obtain and maintain required approvals, certificates, permits or licenses or to comply with applicable governmental requirements could result in sanctions, including substantial fines or possible revocation of our authority to conduct some or all of our operations. Future changes in law, resulting in stricter laws and regulations, more stringent interpretations of existing laws or regulations or the future discovery of environmental conditions may impose new liabilities on us, reduce operating hours, require additional investment by us in pollution control equipment or impede our ability to open new or expand existing plants or facilities. We have incurred, and may in the future incur, significant capital and operating expenditures to comply with such laws and regulations. The cost of complying with such laws could have a material adverse effect on our financial condition, results of operations and liquidity.
We depend on our senior management, and our business may be adversely impacted if we lose any member of our senior management or are unable to recruit additional management and other personnel.
We are dependent upon the services of our senior management, especially our President and Chief Executive Officer Ruben Mendoza, our Chief Financial Officer John Gorey, our Chief Operating Officer Pete Welly and our Senior Vice President of Sales and Marketing Kirby Thompson. The loss of the services of one or more members of our senior management team could harm our business and future development. Our continued growth also will depend upon our ability to attract and retain additional skilled management personnel. We believe there is a limited number of qualified people in our business and the industry in which we compete. As such, there can be no assurance that we will be able to identify and retain the key personnel that may be necessary to grow our business effectively or successfully implement our growth strategy. If we are unable to attract and retain the requisite personnel as needed in the future, our operating results and growth could suffer.
Employee disputes or employee-related cost increases could disrupt operations of our businesses.
While we believe our relationships with our employees are generally good, a failure to maintain good relationships with our employees could have a material adverse effect on us. A work disruption or stoppage at one of our branches could cause us to lose sales, incur increased costs and adversely affect our ability to meet customers’ needs. As of December 31, 2019, approximately 6.7% of our workforce were members of unions. However, if a larger number of our employees were to unionize, including in the wake of any future legislation that makes it easier for employees to unionize, our business could be negatively affected. We had more than 3,500 employees as of December 31, 2019. Various federal and state labor laws govern our relationships with our employees and affect our operating costs. These laws relate to, among other things, employee classifications as exempt or non-exempt, minimum wage requirements, unemployment tax rates, workers’ compensation rates, overtime, family leave, anti-discrimination laws, safety standards, payroll taxes, citizenship requirements and other wage and benefit requirements. As our employees may be paid at rates that relate to the applicable minimum wage, further increases in the minimum wage could increase our labor costs. In addition, we sometimes must compete for employees with necessary skills and experience or in tight labor markets which can also increase costs. Any such cost increases could have a material adverse effect on our business, financial condition, results of operations and cash flows.
In addition, we compete with other companies for many of our employees, and we invest significant resources to train and motivate our employees to maintain a high level of job satisfaction. If we are unable to effectively retain highly qualified employees in the future, it could adversely impact our operating results.
Our business is cyclical and requires significant working capital to fund operations.
Our business is cyclical and requires that we maintain significant working capital to fund our operations. Our ability to generate sufficient cash flow depends on future performance, which will be subject to general economic conditions, industry cycles and financial, business and other factors affecting our operations, many of which are beyond our control. If we are unable to generate sufficient cash to operate our business and service our outstanding debt and other obligations, we may be required, among other things, to further reduce or delay planned capital or operating expenditures, sell assets or take other measures, including the restructuring of all or a portion of our debt, which may only be available, if at all, on unsatisfactory terms.
We may be unable to effectively manage our inventory and working capital as our sales volume increases or the prices of the products we distribute fluctuate, which could have a material adverse effect on our business, financial condition and results of operations.
We purchase certain products, including wallboard, suspended ceiling systems, metal framing and other specialty building materials, from manufacturers which are then sold and delivered to customers. We must maintain, and have adequate working capital to purchase, sufficient inventory to meet customer demand. Due to the lead times required by our suppliers, we order products in advance of expected sales. As a result, we are required to forecast our sales and make purchasing decisions accordingly. In periods characterized by significant changes in economic growth and activity in the commercial and residential building and home repair and remodel industries, it can be especially difficult to forecast our sales accurately. We must also manage our working capital to fund our inventory purchases. Increases in the market prices of certain building products, such as wallboard, suspended ceiling systems and metal framing, can put negative pressure on our operating cash flows by requiring us to invest more in inventory. In addition, we may not be able to pass along increases in product costs through to our customers, which would put downward pressure on our margins. In the future, if we are unable to effectively manage our inventory and working capital as we attempt to expand our business, our cash flows may be negatively affected, which could have a material adverse effect on our business, financial condition and operating results.
A failure to implement or integrate, or a disruption in, our information technology systems could adversely affect our business and results of operations.
Integration of our acquisitions has required and will continue to require, significant attention from our employees and substantial resources. Among other matters, we are faced with migrating acquired companies’ information related to purchasing, sales, inventory management and rebates to our systems or, in some cases, maintaining multiple systems for a period of time.
As our operations grow in both size and scope, and as we integrate our acquisitions, we will continuously need to improve and upgrade our systems and infrastructure while maintaining the reliability and integrity of our information systems and infrastructure. These and any other upgrades to our systems and information technology, or new technology, now and in the future, will require that our management and resources be diverted from our core business to assist in compliance with those requirements. In addition, we rely upon the capacity, reliability and security of our information technology infrastructure to maintain our existing business.
A disruption resulting from a problem with the implementation, integration or functioning of an important information technology system or a security breach of such a system could have an adverse effect on our business and results of operations.
We could be subject to cybersecurity risks, information technology interruptions, and business continuity risks.
Our information technology and communication systems, as well as those of our third-party providers, store, process and transmit a significant amount of confidential or sensitive information, including the personal information of our employees and other individuals, information relating to our customers and suppliers, as well as our proprietary business, financial, operational and strategic data. We also rely on those systems to manage and support a variety of critical business processes and activities, including supply chain, distribution, sales, billing and customer service. These systems may experience damage or disruption from a number of causes, including power outages, computer and telecommunication failures, computer viruses, malware, ransomware or other destructive software, internal design, manual or usage errors, cyberattacks, terrorism, workplace violence or wrongdoing, catastrophic events, natural disasters and severe weather conditions. We may also be impacted by breaches of our third-party processors. Although no such incidents have had a direct, material impact on us, we are unable to predict the direct or indirect impact of any future incidents to our business.
In addition, numerous and evolving cybersecurity threats, including advanced and persistent cyberattacks, phishing and social engineering schemes, particularly on internet applications, could compromise the confidentiality, availability, and integrity of data in our systems. The protection of our confidential or sensitive information, as well as personal information relating to our employees and other individuals, customers and suppliers, is vitally important to us as the loss, theft, misuse or unauthorized disclosure of such information could lead to significant reputational or competitive harm, cause our suppliers to reconsider their relationships with us, result in litigation, expose us to regulatory proceedings, and subject us to significant liabilities, fines and penalties. The security measures and procedures we, our clients and third-party service providers have in place to protect sensitive data and other information may not be successful or sufficient to counter all data breaches, cyberattacks, or system failures. Although we devote resources to our cybersecurity programs and have implemented security measures to protect our systems and data, and to prevent, detect and respond to data security incidents, there can be no assurance that our efforts will prevent these threats. While we maintain insurance coverage that may, subject to policy terms and conditions, cover certain aspects of the losses and costs associated with cyber-attacks and data incidents, such insurance coverage may be insufficient to cover all losses and would not, in any event, remedy damage to our reputation. In addition, we may face difficulties in recovering any losses from our provider and any losses we recover may be lower than we initially expect.
Because the techniques used to obtain unauthorized access, or to disable or degrade systems change frequently, have become increasingly more complex and sophisticated, and may be difficult to detect for periods of time, we may not anticipate these acts or respond adequately or timely. As these threats continue to evolve and increase, we may be required to devote significant additional resources in order to modify and enhance our security controls and to identify and remediate any security vulnerabilities. As with many other businesses, we have experienced, and are continually at risk of being subject to attacks and incidents.
We are also subject to payment card association rules and obligations under our contracts with payment card processors. Under these rules and obligations, if payment card information is stolen or otherwise compromised, we could be liable to payment card issuers for associated expenses and penalties. In addition, if we fail to follow payment card industry security standards, even if customer information is never compromised, we could incur significant fines or experience a significant increase in payment card transaction costs.
Trade policies could make sourcing product from foreign countries more difficult or more costly.
We source some of our products from outside of the United States. Suppliers that we utilize may rely upon non-domestic products, and therefore, any significant changes to the United States trade policies (and those of other countries in response) may cause a material adverse effect on our ability to procure products from suppliers that source from other countries or significantly increase the costs of obtaining such products, which could result in a material adverse effect on our financial results.
Our foreign operations could have a material adverse effect on us.
We distribute products in Canada, and we are therefore subject to a number of risks specific to Canada and may become subject to risks specific to countries where we complete acquisitions. These risks include social, political and economic instability, unexpected changes in regulatory requirements, tariffs and other trade barriers, currency exchange fluctuations, acts of war or terrorism and import/export requirements. Our financial statements are reported in United States dollars with international transactions being translated into United States dollars. There can be no assurances that any of these factors will not materially impact our production cost or otherwise have a material adverse effect on our business, financial condition and results of operations.
We are exposed to product liability, warranty, casualty, construction defect, contract, tort, employment and other claims and legal proceedings related to our business, the products we distribute, the services we provide and services provided for us by third parties.
In the ordinary course of business, we are subject to various claims and litigation. Any such claims, whether with or without merit, could be time consuming and expensive to defend and could divert management’s attention and resources. The building materials industry has been subject to personal injury and property damage claims arising from alleged exposure to raw materials contained in building products, as well as claims for incidents of catastrophic loss, such as building fires. As a distributor of building materials, we face an inherent risk of exposure to product liability claims in the event that the use of the products we distribute are alleged to have resulted in economic loss, personal injury or property damage or violated environmental, health, safety or other laws. Product liability claims have included and may in the future include allegations of personal injury related to asbestos-containing products, defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product, negligence, strict liability or a breach of warranties.
We are also from time to time subject to casualty, contract, tort and other claims relating to our business, the products we distribute, and the services we provide, either directly or through third parties. If any claim were adversely determined, our financial condition, operating results and cash flows could be adversely affected if we were unable to seek indemnification for such claims or were not adequately insured for such claims. We rely on manufacturers and other suppliers to provide us with the wallboard, suspended ceiling systems, metal framing and other products we sell or distribute. Since we do not have direct control over the quality of such products that are manufactured or supplied to us by third parties, we are particularly vulnerable to risks relating to the quality of such products. In addition, we are exposed to potential claims arising from the conduct of our employees, builders and their subcontractors and third-party installers for which we may be liable. We and they are subject to regulatory requirements and risks applicable to general contractors, which include management of licensing, permitting and quality of third-party installers. If we fail to manage these processes effectively or provide proper oversight of these services, we could suffer lost sales, fines and lawsuits, as well as damage to our reputation, which could adversely affect our business and the results of our operations.
Although we believe we currently maintain suitable and adequate insurance, there can be no assurance that we will be able to maintain such insurance on acceptable terms or that such insurance will provide adequate protection against potential liabilities and the cost of any litigation or other proceeding, even if resolved in our favor, could be substantial. Additionally, we do not carry insurance for all categories of risk that our business may encounter and we also self-insure for certain risks. Any significant uninsured or self-insured liability may require us to pay substantial amounts. There can be no assurance that any current or future claims will not adversely affect our financial position, cash flows or results of operations.
Our operations are subject to special hazards that may cause personal injury or property damage, subjecting us to liabilities and possible losses which may not be covered by insurance.
Operating hazards, such as unloading heavy products, operating large machinery and driving hazards, which are inherent in our business and in some cases outside of our control, can cause personal injury and loss of life, damage to or destruction of property, plant and equipment and environmental damage. We maintain insurance coverage in amounts and against the risks we believe are consistent with industry practice, but this insurance may not be adequate or available to cover all losses or liabilities we may incur in our operations. Our insurance policies are subject to varying levels of deductibles. Losses up to our deductible amounts are accrued based upon our estimates of the ultimate liability for claims incurred and an estimate of claims incurred but not reported. However, liabilities subject to insurance are difficult to estimate due to unknown factors, including the severity of an injury, the determination of our liability in proportion to other parties, the number of incidents not reported and the effectiveness of our safety programs. If we were to experience insurance claims or costs above our estimates, we might also be required to use working capital to satisfy these claims rather than using working capital to maintain or expand our operations.
Our business may be subject to additional obligations to collect and remit sales, use and other taxes and we may be subject to tax liabilities for past sales.
State, local, foreign and provincial taxing jurisdictions have differing rules and regulations governing sales, use and other taxes and these rules and regulations are subject to varying interpretations that may change over time. It is possible that we could incur additional liabilities that exceed our estimates and we could assume tax liabilities through our acquisitions. Other tax authorities could still assert that we are obligated to collect additional amounts as tax from our customers and remit those taxes to those authorities. We could also be subject to audits with respect to state, local, foreign and provincial jurisdictions for which we have not accrued tax liabilities. A successful assertion that we should be collecting additional sales, use or other taxes on our services in jurisdictions where we have not historically done so and do not accrue for taxes could result in substantial tax liabilities for past sales, discourage customers from purchasing our products or otherwise adversely affect our business and results of operations.
Risks Relating to Our Indebtedness
Our leverage could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk, give creditors secured claims to any collateral securing the debt, and restrict us from making certain strategic decisions.
On August 13, 2018, FBM Alpha LLC (formerly known as LSF9 Cypress Parent, LLC), or Alpha, its wholly owned direct subsidiary Foundation Building Materials Holding Company LLC (formerly known as FBM Beta LLC and LSF9 Cypress Holdings, LLC), or Holdco, as the lead borrower, the additional U.S. borrowers party thereto from time to time, the Canadian borrowers party thereto from time to time, or collectively, the ABL Borrowers, the lenders party thereto from time to time, Bank of America, N.A., as administrative agent and collateral agent, or the ABL Agent, and the other agents party thereto, entered into the ABL Credit Agreement, or the 2018 ABL Credit Agreement, including the exhibits and schedules thereto, collectively, the 2018 Revolving Credit Facility. On August 13, 2018, we also entered into a credit agreement by and among Alpha, Holdco, Royal Bank of Canada, as administrative agent and collateral agent, and the lenders party thereto, or the 2018 Term Loan Facility.
Our business is leveraged. As of December 31, 2019, the aggregate principal amount of our credit facility-related debt was approximately $534.5 million, which was comprised of $89.0 million under the 2018 Revolving Credit Facility, and $445.5 million under the 2018 Term Loan Facility. Additionally, we may borrow additional funds under our 2018 Revolving Credit Facility, and increase the borrowing capacity thereunder. We may also seek to refinance our credit facilities or borrow additional amounts under new credit arrangements.
Our degree of debt leverage could have important consequences for you, including:
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making it more difficult for us to make payments on our existing indebtedness;
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increasing our vulnerability to general economic and industry conditions;
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requiring a substantial portion of cash flow from operations to be dedicated to the payment of principal and interest on our indebtedness, thereby reducing our ability to use our cash flow to fund our operations, capital expenditures and future business opportunities;
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exposing us to the risk of increased interest rates on our borrowings under our 2018 Revolving Credit Facility, which is at variable rates of interest;
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restricting us from making certain strategic decisions due to operational covenants;
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causing us to incur expenses relating to the hedging of our variable interest rate exposure;
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limiting our ability to obtain additional financing for working capital, capital expenditures, debt service requirements, acquisitions and general corporate or other purposes; and
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limiting our ability to adjust to changing market conditions and placing us at a competitive disadvantage compared to our competitors who are less leveraged.
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Our ability to make payments on debt, to repay existing indebtedness when due and to fund operations and significant planned capital expenditures will depend on our ability to generate cash in the future. Our ability to produce cash from operations is, and will be, subject to a number of risks, including those described in this Annual Report on Form 10-K.
Borrowings under our 2018 Revolving Credit Facility are at variable rates of interest and allow certain borrowings in Canadian dollars, which may expose us to interest rate and currency risk. If interest rates increase, our debt service obligations on the variable rate indebtedness will increase even though the amount borrowed will remain the same, and our net income and cash flows, including cash available for servicing our indebtedness, will correspondingly decrease.
Additional financing, if required, may not be available on commercially reasonable terms, if at all. In addition, our ability to borrow under our 2018 Revolving Credit Facility is subject to our ability to satisfy significant conditions.
Despite our current level of indebtedness, we and our subsidiaries may incur more debt.
We and our subsidiaries may incur significant additional indebtedness in the future. For example, we expect to incur additional indebtedness in connection with future acquisitions. Although the 2018 Revolving Credit Facility contains restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of qualifications and exceptions, and the additional indebtedness incurred in compliance with (or as a result of waiver of) these restrictions could be substantial. These restrictions also do not prevent us from incurring obligations that do not constitute indebtedness. In addition, as of December 31, 2019, our 2018 Revolving Credit Facility provided for an unused commitment of $286.0 million (without giving effect to any outstanding letters of credit, and subject to borrowing base limitations).
We will require a significant amount of cash to service our indebtedness. The ability to generate cash or refinance our indebtedness as it becomes due depends on many factors, some of which are beyond our control.
Our ability to make scheduled payments on, or to refinance our respective obligations under, our indebtedness, and to fund planned capital expenditures and other corporate expenses will depend on our future operating performance and on economic, financial, competitive, legislative, regulatory and other factors, many of which are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations, that currently anticipated cost savings and operating improvements will be realized or that future borrowings will be available to us in an amount sufficient to enable us to satisfy our respective obligations under our indebtedness or to fund our other needs. In order for us to satisfy our obligations under our indebtedness and fund planned capital expenditures, we must continue to execute our business strategy. If we are unable to do so, we may need to reduce or delay our planned capital expenditures or refinance all or a portion of our indebtedness on or before maturity. Significant delays in our planned capital expenditures may materially and adversely affect our ability to execute our strategic plans. In addition, we cannot assure you that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all.
Our tax receivable agreement, or TRA, requires that, after Lone Star, our majority stockholder, no longer controls us, any senior debt document that refinances or replaces our existing indebtedness permit our subsidiaries to pay dividends to us, without any conditions, to the extent required for us to make payments under the TRA, unless Lone Star otherwise consents. At the time of any such refinancing, it may not be possible to include this term in such senior debt documents, and as a result, we may need Lone Star’s consent to complete such refinancing.
The 2018 Revolving Credit Facility restricts our ability and the ability of most of our subsidiaries to engage in some business and financial transactions.
The 2018 Revolving Credit Facility contains a number of covenants that among other things, limit our ability and the ability of our restricted subsidiaries to:
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incur additional indebtedness or guarantees;
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create liens on assets;
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change our fiscal year;
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enter into sale and leaseback transactions;
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engage in mergers or consolidations;
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incur additional liens;
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pay dividends and make other restricted payments;
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make investments, loans or advances;
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repay subordinated indebtedness;
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• make certain acquisitions;
• engage in certain transactions with affiliates;
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change our lines of business;
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restrict distributions by our restricted subsidiaries;
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amend or otherwise modify organizational documents or certain debt agreements; and
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manage cash and other assets in our deposit accounts and securities accounts.
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In addition, the 2018 Revolving Credit Facility requires us to maintain a minimum fixed charge coverage ratio. The 2018 Revolving Credit Facility also contains certain customary representations and warranties, affirmative covenants and events of default (including, among others, an event of default upon a change of control). If an event of default occurs, the lenders under the 2018 Revolving Credit Facility will be entitled to take various actions, including the acceleration of amounts due under our 2018 Revolving Credit Facility and all actions permitted to be taken by a secured creditor.
Any future debt that we incur may contain additional negative covenants and financial maintenance covenants. These restrictions could limit our ability to obtain debt financing, repurchase stock, refinance or pay principal on our outstanding debt, complete acquisitions, execute our strategic plans, or react to changes in our operating environment or the economy.
Our failure to comply with obligations under the 2018 Revolving Credit Facility, the 2018 Term Loan Facility or the agreements governing any other indebtedness we may enter into in the future, may result in an event of default under the applicable agreement. A default, if not cured or waived, may permit acceleration of some or all of our indebtedness. We cannot be certain that we will be able to remedy any defaults. If our indebtedness is accelerated, we cannot be certain that we will have sufficient funds available to pay the accelerated indebtedness or that we will have the ability to refinance the accelerated indebtedness on terms favorable to us or at all.
Risks Related to Ownership of Our Common Stock
The market price of our common stock has been highly volatile and subject to wide fluctuations, which could cause the value of your investment to decline. The price of our common stock could decline substantially and, as a result, you may not be able to sell shares at or above the price you paid for them.
Some of the factors that could negatively affect or result in fluctuations in the market price of our common stock include:
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actual or anticipated variations in our quarterly operating results;
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changes in market valuations of similar companies;
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changes in the markets in which we operate or speculation that changes may occur;
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additions or departures of key personnel;
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actions by our significant stockholders, including the sale by Lone Star of any of its shares of our common stock;
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speculation in the press or investment community about our business or industry;
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general market, economic and political conditions, including an economic slowdown;
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changes in interest rates or perceptions that changes could occur;
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our operating performance and the performance of other similar companies;
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our ability to accurately project future results and our ability to achieve those and other industry and analyst forecasts; and
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new legislation or other regulatory developments that adversely affect us, our markets or our industry.
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Furthermore, in recent years, the stock market has experienced significant price and volume fluctuations. This volatility has had a significant impact on the market price of securities issued by many companies, including companies in our industry, and often occurs without regard to the operating performance of the affected companies. Therefore, factors that have little or nothing to do with us could cause the price of our common stock to fluctuate, and these fluctuations or any fluctuations related to our company could cause the market price of our common stock to decline materially.
As a “smaller reporting company,” we may avail ourselves of reduced disclosure requirements, which may make our common stock less attractive to investors.
As of June 30, 2018, we qualified as a "smaller reporting company" under applicable SEC rules and regulations. As a "smaller reporting company," we have relied on exemptions from certain disclosure requirements that are applicable to other public companies. These exemptions include reduced financial disclosure and reduced disclosure obligations regarding executive compensation. As of June 30, 2019, we no longer qualified as a smaller reporting company; however, we are allowed to use such status for our filings through our annual report for 2019.
Our internal control over financial reporting may not be effective and our independent registered public accounting firm may not be able to certify as to their effectiveness, which could have a significant and adverse effect on our business and reputation.
As a public company, we are required to comply with the SEC’s rules, implementing Sections 302 and 404 of the Sarbanes-Oxley Act, which require management to certify financial and other information in our quarterly and annual reports and provide an annual management report on the effectiveness of control over financial reporting. At such time, our independent registered public accounting firm may issue a report that is adverse in the event that it is not satisfied with the level at which our internal control over financial reporting is documented, designed or operating.
To continue to comply with the requirements of being a public company, we may need to undertake various actions, such as implementing additional internal controls and procedures and hiring additional accounting or internal audit staff. Testing and maintaining internal control can divert our management’s attention from other matters that are important to the operation of our business. If we identify material weaknesses in our internal control over financial reporting or are unable to comply with the requirements of Section 404 of the Sarbanes-Oxley Act or assert that our internal control over financial reporting is effective, or if our independent registered public accounting firm is unable to express an opinion as to the effectiveness of our internal control over financial reporting, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our common stock could be negatively affected, and we could become subject to investigations by the SEC or other regulatory authorities, which could require additional financial and management resources.
The coverage of our business or our common stock by securities or industry analysts or the absence thereof could adversely affect our stock price and trading volume.
The trading market for our common stock is influenced in part by the research and other reports that industry or securities analysts may publish about us or our business or industry. We currently have, but may not be able to continue, research coverage by industry or financial analysts. If analysts do not continue coverage of us, the trading price and volume of our stock would likely be negatively impacted. Even if analyst coverage continues, if one or more analysts who do cover us downgrades our stock, or if they issue other unfavorable commentary about us or our industry or inaccurate research, our stock price would likely decline. Furthermore, if one or more of these analysts cease coverage or fail to regularly publish reports on us, we could lose visibility in the financial markets. Any of the foregoing would likely cause our stock price and trading volume to decline.
Lone Star may have conflicts of interest with other stockholders and may limit our minority stockholders' ability to influence corporate matters.
Lone Star beneficially owns approximately 52.5% of our outstanding common stock. As a result of this concentration of stock ownership, Lone Star acting on its own has sufficient voting power to effectively control all matters submitted to our stockholders for approval, including director elections and proposed amendments to our bylaws or certificate of incorporation. Currently, six of the nine members of our board of directors are employees or affiliates of Lone Star.
In addition, this concentration of ownership may delay or prevent a merger, consolidation or other business combination or change in control of our company and make some transactions that might otherwise give our stockholders the opportunity to realize a premium over the then-prevailing market price of our common stock more difficult or impossible without the support of Lone Star. Because we have opted out of Section 203 of the Delaware General Corporation Law, or the DGCL, regulating certain business combinations with interested stockholders, Lone Star may transfer control of us to a third party, which may limit the price that investors are willing to pay in the future for shares of our common stock. Lone Star could transfer control of us to a third party by transferring its common stock, which would not require the approval of our board of directors or other stockholders. The interests of Lone Star may not always coincide with our interests as a company or the interests of other stockholders. Accordingly, Lone Star could cause us to enter into transactions or agreements of which our other stockholders would not approve or make decisions with which our other stockholders would disagree. This concentration of ownership may also adversely affect our share price.
Lone Star is in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us, although it does not currently hold any such interests. Lone Star may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. In recognition that principals, members, directors, managers, partners, stockholders, officers, employees, consultants and other representatives of Lone Star and its affiliates and investment funds may serve as our directors or officers, our amended and restated certificate of incorporation provides, among other things, that none of Lone Star or any principal, member, director, manager, partner, stockholder, officer, employee or other representative of Lone Star has any duty to refrain from engaging directly or indirectly in the same or similar business activities or lines of business that we do. In the event that any of these persons or entities acquires knowledge of a potential transaction or matter which may be a corporate opportunity for itself and us, we will not have any expectancy in such corporate opportunity, and these persons and entities will not have any duty to communicate or offer such corporate opportunity to us and may pursue or acquire such corporate opportunity for themselves or direct such opportunity to another person. These potential conflicts of interest could have a material adverse effect on our business, financial condition and results of operations if, among other things, attractive corporate opportunities are allocated by Lone Star to themselves or their other affiliates.
Lone Star may also have conflicts of interest with us and our stockholders as a result of its status as a party to the TRA in connection with our initial public offering in February 2017, or the IPO. For example, the TRA entered into with Lone Star at the time of the IPO gives us the right to terminate the TRA with approval of a majority of our independent directors and with Lone Star’s consent by making a payment equal to the present value of future payments under the TRA (based on certain assumptions and deemed events in the agreement, including those relating to our and our subsidiaries’ future taxable income). Lone Star may determine to withhold its consent to terminate the TRA at a time when such a termination would be favorable to us and the other stockholders or Lone Star may elect to terminate the TRA upon certain changes of control or at any time following the fifteenth anniversary of our IPO at a time when such a termination would not be favorable to us and the other stockholders. Furthermore, the TRA prohibits us from settling any tax audit without Lone Star’s consent (not to be unreasonably withheld, conditioned or delayed) if the outcome of the audit is reasonably expected to affect Lone Star’s rights under the TRA. Therefore, Lone Star may determine to withhold consent to a settlement that reduces the payments Lone Star will receive under the TRA, even though the settlement might be favorable to us and our stockholders.
We are required to pay Lone Star for certain tax benefits, and these amounts are expected to be material.
We have entered into a TRA with Lone Star that provides for the payment by us to Lone Star of 90% of the amount of cash savings, if any, in United States federal, state, local and non-U.S. income tax that we and our subsidiaries realize (or in some circumstances are deemed to realize) as a result of the utilization of certain tax benefits, together with interest accrued at a rate of the London Interbank Offered Rate, or LIBOR, plus 300 basis points from the date the applicable tax return is due (without extension) until paid. These tax benefits, or collectively the Covered Tax Benefits, include: (a) all depreciation and amortization deductions, and any offset to taxable income and gain or increase to taxable loss, resulting from the tax basis that we had in our assets as of the time of our IPO, (b) the utilization of our and our subsidiaries’ net operating losses and tax credits, if any, attributable to periods prior to our IPO, (c) deductions in respect of payments made, funded or reimbursed by Lone Star under the LSF9 Cypress Parent, LLC Long Term Incentive Plan, or LTIP, (d) deductions in respect of transaction expenses attributable to certain acquisitions made by us prior to our IPO, (e) deductions in respect of the debt issuance costs and original issue discount associated with certain of our financing agreements, and (f) deductions in respect of expenses related to our IPO and (g) certain other tax benefits attributable to payments made under the TRA.
We expect that the payments we make under the TRA could be substantial. Assuming no material changes in the relevant tax law and that we and our subsidiaries earn sufficient income to realize the full tax benefits subject to the TRA, we currently estimate that future payments under the agreement will aggregate to $117.4 million. This amount excludes any payments that may be made to Lone Star under the TRA as a result of tax benefits recognized in connection with payments under the LTIP and, thus, the actual payments we ultimately are required to make under the TRA could be greater, potentially materially greater, than these amounts. These payment obligations are our obligations and are not obligations of any of our subsidiaries. Furthermore, these payment obligations are not conditioned upon Lone Star maintaining a continued direct or indirect ownership interest in us. The actual utilization of Covered Tax Benefits, as well as the timing of any payments under the TRA, will vary depending upon a number of factors, including the amount, character and timing of our and our subsidiaries’ taxable income in the future.
We will not be reimbursed for any payments made to Lone Star under the TRA in the event that the tax benefits are disallowed.
Lone Star will not reimburse us for any payments previously made under the TRA if such benefits are subsequently disallowed upon a successful challenge by the Internal Revenue Service, although future payments under the agreement would be adjusted to the extent possible to reflect the result of such disallowance. As a result, in certain circumstances, payments could be made under the TRA in excess of our cash tax savings if any, from the Covered Tax Benefits, and we may not be able to recoup those payments, which could adversely affect our liquidity.
In certain cases, payments made by us under the TRA may be accelerated and/or significantly exceed the actual benefits we realize in respect of the Covered Tax Benefits.
The term of the TRA will continue until all Covered Tax Benefits have been utilized or expired, unless we exercise our right to terminate the agreement with approval of a majority of our independent directors and with Lone Star’s consent, we breach any of our material obligations under the agreement, certain credit events occur with respect to us, Lone Star elects to terminate the TRA upon certain changes of control or Lone Star exercises its right after the fifteenth anniversary of our IPO to terminate the TRA, in any of which cases we will be required to make an accelerated payment to Lone Star equal to the present value of future payments under the TRA. Such payment would be based on certain assumptions, including the assumption that we have sufficient taxable income and tax liability to fully utilize all Covered Tax Benefits. The TRA also provides that upon certain changes of control, in the event that Lone Star does not elect to terminate the TRA, our (or our successor’s) payments under the TRA for each taxable year after any such event would be based on certain valuation assumptions, including the assumption that we and our subsidiaries have sufficient taxable income to fully utilize the Covered Tax Benefits. Accordingly, payments under the TRA may be made years in advance of the actual realization, if any, of the anticipated future tax benefits and may be significantly greater than the benefits we realize in respect of the Covered Tax Benefits.
Even if the payments under the TRA are not accelerated as described above, such payments may be significantly greater than the benefits we realize in respect of the Covered Tax Benefits, due to the manner in which payments are calculated under the TRA. For example, for purposes of calculating the payments to be made to Lone Star:
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it is assumed that we will pay state and local taxes at a rate of 5%, even though our actual effective state and local tax rate may be materially lower;
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tax benefits existing at the time of our IPO are deemed to be utilized before any post-closing/after-acquired tax benefits and, as a result, we could be required to make payments to Lone Star for a particular tax year even if our tax liability for such year would have been materially reduced or eliminated by reason of our utilization of the post-IPO/after-acquired tax benefits;
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a non-taxable transfer of assets by us to a non-consolidated entity is treated under the TRA as a taxable sale at fair market value and, as a result, we could be required to make payments to Lone Star even though such non-taxable transfer would not generate any actual tax benefits to us or our non-consolidated entity; and
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a taxable sale or other taxable transfer of subsidiary's stock by us is (in cases where the subsidiary’s tax basis in its assets exceeds our tax basis in the subsidiary’s stock) treated under the TRA as a taxable sale of the subsidiary’s assets and, as a result, we could be required to make payments to Lone Star that materially exceed the actual tax benefit we realize from such stock sale.
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Because of the foregoing, our obligations under the TRA could have a substantial negative impact on our liquidity and could have the effect of delaying, deferring or preventing certain mergers, asset sales, other forms of business combinations or other changes of control.
Certain provisions of the TRA limit our ability to incur additional indebtedness, which could adversely affect our business and growth strategy.
For so long as the TRA remains outstanding, without the prior written consent of Lone Star (not to be unreasonably withheld, conditioned or delayed), we are restricted from (a) entering into any agreement or amendment, after Lone Star ceases to control us, that would materially restrict (or in the case of amendments, further restrict beyond the restrictions in our existing financing agreements) our ability to make payments under the TRA, or (b) unless permitted by the terms of the 2018 ABL Credit Agreement or any replacement senior debt document to the extent that the terms thereof are no less restrictive in this regard than the 2018 Term Loan Facility and the 2018 ABL Credit Agreement, incurring debt that would cause our consolidated total leverage ratio (the ratio of consolidated total indebtedness for borrowed money less balance sheet cash to consolidated EBITDA) to exceed 6.00 to 1.00. In addition, we are prohibited under the TRA from replacing our existing financing agreements with any senior debt document that does not permit our subsidiaries to make dividends to us to the extent necessary to make the payments under the TRA, without conditions, unless Lone Star otherwise consents. These restrictions on the incurrence of debt could adversely affect our business, including by preventing us from pursuing an acquisition or other strategic transaction that we believe is in the best interests of our company and our stockholders, thereby impeding our growth strategy. Lone Star has no fiduciary duties to us when deciding whether to enforce these covenants under the TRA. Moreover, these restrictions on amending or refinancing our existing indebtedness could result in a requirement to obtain Lone Star’s consent for any such amendment or refinancing. Furthermore, the provision in the TRA that requires that we make an accelerated payment to Lone Star equal to the present value of all future payments due under the TRA if we breach any of our material obligations under the agreement or certain credit events occur with respect to us, might make it harder for us to obtain financing from third party lenders on favorable terms.
We would be required to make tax gross-up payments to Lone Star if we consummate a corporate inversion or similar transaction that causes payments under the TRA to be subject to withholding taxes.
If we were to consummate a change of control transaction that causes us (or our successor) to become a non-U.S. person (e.g., a corporate inversion transaction), and such transaction causes payments under the TRA to become subject to withholding taxes, we would be required under the TRA to make tax gross-up payments to Lone Star in respect of such withholding taxes in amounts that may exceed the tax savings realized by us from the Covered Tax Benefits. Any such tax gross-up payments could have a negative impact on our liquidity and our ability to finance our growth.
We are a controlled company within the meaning of the New York Stock Exchange rules and, as a result, qualify for, and intend to continue relying on, exemptions from certain corporate governance requirements.
Lone Star controls a majority of the voting power of our outstanding common stock. As a result, we are a controlled company within the meaning of the corporate governance standards of the New York Stock Exchange, or the NYSE. Under the NYSE rules, a company of which more than 50% of the voting power is held by a person or group is a controlled company and need not comply with certain requirements, including the requirement that a majority of the board of directors consists of independent directors and the requirements that the compensation and nominating and corporate governance committees be composed entirely of independent directors. We are utilizing and, for so long as Lone Star controls a majority of the voting power of our outstanding common stock, we intend to utilize these exemptions. As a result, among other things, we do not have a majority of independent directors and our compensation and nominating and corporate governance committees do not consist entirely of independent directors. Accordingly, our stockholders will not have the same protections afforded to stockholders of companies that are subject to all of the NYSE corporate governance requirements.
Future sales of our common stock in the public market could cause our stock price to fall.
Lone Star beneficially owns approximately 52.5% of our outstanding shares of common stock. All shares held by our affiliates are eligible for resale in the public market, subject to applicable securities laws, including the Securities Act. We registered Lone Star's shares pursuant to a registration statement in 2019 on Form S-3. Lone Star is an affiliate of ours based on its share ownership and representation on our Board. Any sale by Lone Star or other affiliates or any perception in the public markets that such a transaction may occur could cause the market price of our common stock to decline materially.
We have filed a registration statement on Form S-8 under the Securities Act registering shares under our stock incentive plan. Subject to the terms of the awards pursuant to which these shares may be granted and except for shares held by affiliates who will be subject to the resale restrictions described above, the shares issued pursuant to our stock incentive plan will be available for sale in the public market immediately after vesting of the applicable award.
We have no present intention to pay dividends on our common stock.
We have no present intention to pay dividends on our common stock. Any determination to pay dividends to holders of our common stock will be at the discretion of our board of directors and will depend upon many factors, including our financial condition, results of operations, projections, liquidity, earnings, legal requirements, restrictions in our credit facilities and agreements governing any other indebtedness we may enter into and other factors that our board of directors deems relevant. Accordingly, holders of our common stock may need to sell their shares to realize a return on their investment, and may not be able to sell their shares at or above the price paid for them.
Provisions of our amended and restated governing documents, Delaware law and other documents could discourage, delay or prevent a merger or acquisition at a premium price.
Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. For example, our certificate of incorporation and bylaws include provisions that:
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permit us to issue, without stockholder approval, preferred stock in one or more series and, with respect to each series, fix the number of shares constituting the series and the designation of the series, the voting powers, if any, of the shares of the series and the preferences and other special rights, if any, and any qualifications, limitations or restrictions, of the shares of the series;
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prevent stockholders from calling special meetings;
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restrict the ability of stockholders to act by written consent after such time as Lone Star owns less than a majority of our common stock;
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limit the ability of stockholders to amend our certificate of incorporation and bylaws;
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require advance notice for nominations for election to the board of directors and for stockholder proposals;
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do not permit cumulative voting in the election of our directors, which means that the holders of a majority of our common stock may elect all of the directors standing for election; and
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establish a classified board of directors with staggered three-year terms.
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These provisions may discourage, delay or prevent a merger or acquisition of our company, including a transaction in which the acquiror may offer a premium price for our common stock.
Our amended and restated certificate of incorporation includes an exclusive forum clause, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us.
Our amended and restated certificate of incorporation provides that, unless we consent in writing to the selection of an alternative forum, the sole and exclusive forum for any stockholder (including any beneficial owner) to bring (a) any derivative action or proceeding brought on our behalf, (b) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers or employees to us or to our stockholders, (c) any action asserting a claim arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws or (d) any action asserting a claim governed by the internal affairs doctrine, will be a state court located within the State of Delaware (or, if no state court located within the State of Delaware has jurisdiction, the federal district court for the District of Delaware); in all cases subject to such court having personal jurisdiction over the indispensable parties named as defendants. Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock is deemed to have notice of and consented to the foregoing provisions. The exclusive forum clause may limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us. It is also possible that, notwithstanding such exclusive forum clause, a court could rule that such a provision is inapplicable or unenforceable.
We may be at increased risk of securities class action litigation.
In the past, securities class action litigation has been instituted against companies following periods of volatility in the overall market and in the price of a company’s securities. We believe this risk may be particularly relevant to us as we have recently and in past years experienced significant stock price volatility. If we face such litigation, it could result in substantial costs and a diversion of management’s attention and resources, which could harm our business, financial condition and results of operations. Our stock price volatility and the change in our market capitalization during the past year may also result in higher expenses associated with our directors’ and officers’ liability insurance program.