June 16, 2014
By George H. Reddin
At mid-year 2013, the U.S. Geological Survey (USGS) had reported flat results in construction aggregates. While the residential market was showing life, the results had not impacted the sector’s reported volumes; however, by year-end, the sector was showing life. The increased activity and the promise for continued growth sparked a rally in the sectors stock prices in 2014.
Chart 1 presents FMI’s Construction Materials Index (CMI) comprising the results of 13 construction materials companies. The table below the graph presents the performance of the index as compared to the Dow Jones Industrial Average and Standard & Poor’s 500 for various periods.
The CMI was one of the darlings of Wall Street during the residential boom from 2004 to 2007, far outperforming the market as a whole. During this time, there was tremendous M&A activity including strategic bolt-on, new platform, and mega deals. It was also during this time that debt, financing growth, ballooned and cash levels plateaued. Chart 2 and 3 present total debt and cash/short-term investments for the CMI from 2000 through 2013.
The construction materials sector enjoyed the benefits of record growth in the residential market, a strong federal highway program, and healthy state budgets from 2000 through 2007, as shown in Chart 4 and 5.
As we know, things changed in 2008 and the public companies — the CMI companies — experienced sharp drops in their stock price, volumes, and earnings. As shown in Chart 1, the CMI far underperformed the market throughout the last five years and underperformed the market in 2013. The dependence on a decimated residential sector, uncertainty surrounding transportation funding, and unsustainable leverage left the sector out of favor with investors.
The buyers went to the sidelines, leaving the market void of traditional buyers. M&A transactions continued; however, there were fewer deals, and they consisted of only the small strategic acquisitions. There was a big disconnect between buyers and sellers on price as sellers were convinced there would be a return to the “glory” days as they anticipated a traditional V-shaped recovery. At the same time, the buyers were touting the idea of the “new normal.” We were in unchartered territory — an economic recovery, the pace of which nobody in the industry had experienced in their careers. In 2008, everyone knew 2009 would be tough; however, 2010 and beyond had promise. We saw people dust off their notes every year since and repeat this hope for the sector. The market established a bottom with modest gains in 2012 and 2013, and there is cautious optimism for 2014 and beyond.
As residential construction bottomed out and showed improvement in 2012, there was hope; however, the absence of transportation funding at the state and federal level kept expectations in check. Residential improved again in 2013, and the consensus forecast is for strength in this sector for the next few years. The Portland Cement Association’s forecast for cement is very bullish through 2018, as shown in Chart 6.
Additionally, the outlook for overall construction put in place is very encouraging for 2014 as shown in Chart 7.
Federal highway funding has been flat since the expiration of SAFETEA-LU in the fall of 2009 as shown in Chart 5. The current federal transportation bill expires this fall, leaving uncertainty about future funding. There is concern that the political process, and not the need for maintaining the nation’s bridges and roads, will control the debate and result in insufficient funding. At the same time, states are getting creative and increasing funding. At least 10 states including Arkansas, Maine, Maryland, Ohio, Nevada, Pennsylvania, Vermont, Virginia, Wisconsin, and Wyoming have enacted some combination of tax increases, increased fees, or approved bonds as a way to raise funds for transportation spending. These fundraising efforts are only a start and do not solve the funding challenges; however, they represent a step in the right direction that may have influence on the national transportation funding discussion.
Leverage ratios have also improved for the CMI companies with the median net debt/EBITDA ratios approaching pre-recession levels. Cash levels have increased by nearly 47 percent and total debt levels have decreased by approximately 30 percent (see Chart 2 and Chart 3).
All of these trends are good, but necessary, as the CMI companies collective EBITDA and EBIT declined by almost 37 percent and just over 49 percent, respectively, from 2007 to 2013, making things very challenging with debt holders (see Chart 9 and Chart 10). The good news is that margins have ticked up for the CMI and, together with expected overall growth, should result in improved operating performance.
The improved outlook for the construction materials sector and the improved balance sheets of the CMI companies resulted in improved stock prices for the CMI, which has seen a year-to-date increase of 18.4 percent while the market as a whole has been relatively flat (Chart 1).
The improved outlook for the market and the improved balance sheets for the industry’s major buyers should bode well for M&A activity in the sector. We have seen a recent wave of private-equity backed buyers being active in the market. This capital typically invests with a 5- to 10-year horizon, while the CMI companies are long-term investors. This increased interest in private equity capital is another sign of the optimism for the future. After a year of cautious optimism, we expect a more aggressive approach to M&A by the major players in 2014 and beyond.
George H. Reddin is a principal in FMI’s Investment Banking Practice. He can be reached at 919-785-9286 or email@example.com.