Competitive changes in the aggregate industry

Can there be any doubt now that the construction materials market is in a period of profound competitive change?

Over the course of the past four years, more than $50 billion has changed hands through mergers and acquisitions. The acquisition of Ash Grove Cement by CRH is only the latest in a string of megamergers that will disrupt the U.S. market for decades to come.

We remember the good old days – back in 2013 – when a cast of 10 players produced more than 78 percent of total U.S. cement volumes. Since 2013, five of those 10 companies – Lafarge, Holcim, Essroc, Ash Grove and TXI – are now either merged or part of another entity.

Two fully vertically integrated firms – not to mention serial acquirers in CRH and Summit Materials – have also entered the cement market in the United States. In less than four years, the market has been turned on its head, becoming both substantially more concentrated and vertically integrated in nature.

With the announcement of the CRH-Ash Grove deal in the third quarter, the market for mergers and acquisitions in the construction materials market is reaching highs not seen since 2007. However, the implications of the CRH-Ash Grove transaction in the wake of the wave of megamergers that began in 2014 will likely make this current cycle one of the most robust construction materials M&A environments in our lifetimes.

Mergers and acquisitions are difficult and expensive. However, there are three primary factors that will make strategic investors jump at the opportunity to acquire: the first is the perception of future growth; the second is the availability of capital; and the third and most powerful is strategic need.

Today, all three are at an apex, creating a clear window of opportunity for both buyers and sellers.

Market fundamentals are strong – for now

The effects of the Great Recession on the construction sector are well known. Overall, construction spending fell 37 percent from a peak of $1.2 trillion in February 2006. Since then, the recovery has been strong.

Since late 2011, construction spending has increased at double-digit, year-over-year growth rates. And most forecasts remain strong through 2019.

While the rate of growth has moderated in 2017, there are a number of reasons to be optimistic about near-term growth: states have begun funding infrastructure in earnest, and the federal government continues to discuss an infrastructure package that could add an additional $1 trillion in funding.

As a percentage of GDP, construction remains at an all-time low, a trend that is unlikely to continue for long. The housing market continues to rebound from Great Recession lows, with low interest rates and limited supplies driving new construction in markets across the nation.

There are risks, though. Some forecasters, most notably the Portland Cement Association, are forecasting a downturn in the market beginning in 2021. While still four years out, investors know growth cannot continue indefinitely.

But for now, buyers can defend a thesis for continued investment in the United States.

Capital is cheap and abundant

How long has cheap money persisted in the U.S.? Consider the following: The average 30-year fixed rate mortgage has not exceeded 6.0 percent since November 2008 and has not exceeded 7.0 percent since April 2002. The United States has had the longest run of low interest rates in history.

In this environment, yield has been very difficult to find. Retirees seeking income from investments have little option to invest in higher-risk assets. As a result, more capital has flowed into the stock market, increasing valuations. The net effect is a very positive environment for those who wish to acquire companies.

Figure 1 presents the constituents of FMI’s Construction Materials Index (CMI) Enterprise Value to EBITDA Ratio. This ratio is a proxy for how the market is valuing the earnings of the constituent companies.

CMI firms are trading around 10-year highs, in excess of 12.0 EBITDA on average. As we have discussed in prior articles, this creates a tremendous incentive for strategic buyers to do deals, as additional earnings derived from acquisitions completed at lower multiples have a compounded effect on the company’s stock price.

Strategic needs are paramount

While capital is available and the market outlook is favorable, what is driving many transactions in today’s market is the strategic realignment that was spurred by the LafargeHolcim merger.

More than two years following the announcement of the deal, the fallout is far from complete. As we discussed in this column one year ago, the merger of LafargeHolcim and the acquisition of Italcementi by Heidelberg drove new competitive pressures primarily in the eastern U.S., where more than two dozen cement plants saw new or merged ownership positions.

However, one of the more notable outcomes of the LafargeHolcim merger was the entry of CRH into U.S. cement markets and the expansion of Summit Materials’ small, but meaningful presence in cement markets in the Midwest.

As a requirement of its merger, LafargeHolcim was required to divest four cement plants and 14 cement terminals in the U.S. and Canada. CRH purchased the Trident Cement Plant in Montana, the Joliette Cement Plant in Quebec, Canada, the Mississauga Cement Plant in Ontario, Canada, and seven terminals. Summit Materials acquired the Davenport, Iowa, cement plant and seven terminals, a strong strategic fit with the company’s 2010 acquisition of Continental Cement.

These acquisitions gave both CRH and Summit a foothold in U.S. cement markets. These positions were also highly profitable. Cement has quickly become Summit’s highest-margin business, producing more than 30 percent of the company’s total adjusted EBITDA in 2016 and also represented the company’s strongest performing segments, with operating margins of more than 29 percent.

New competitive dynamics also emerged. Two dozen cement plants in the eastern U.S. were under new ownership, a new cement plant (McInnis) was being built in eastern Canada, and as a result, every cement player in the U.S. found themselves with new competitive positions. CRH’s entry into Montana presented Ash Grove with the unique challenge of being in competition with its largest customer.

Thus, it came as no surprise that Ash Grove announced its sale to CRH in September, and that Summit made a run at topping CRH’s offer. The winner of the deal would be a fully integrated player, from cement through construction, with a national presence, strong operational leverage and enormous strategic advantage.

In the end, Summit’s balance sheet simply was not large enough.

The outlook for construction markets in the United States remains favorable. Capital is cheap, and the CRH-Ash Grove transaction once again disrupts the competitive dynamics at play in construction materials markets.

As a result, we expect M&A markets to remain strong in 2018, particularly for downstream ready-mix and aggregate businesses, as well as for the smaller cement players that have not yet hitched their fortunes to a megamerger.

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George Reddin, managing director, and Scott Duncan, director, are with FMI Capital Advisors Inc., FMI Corp.’s investment banking subsidiary. They specialize in mergers and acquisitions and financial advisory services.