Economics Pulse: Construction materials update

The Construction Materials sector has had an eventful 2015 marked by major transactions and the sector’s first initial public offering in over 15 years. Volumes continue to move up modestly as the housing sector continues its slow, but steady, recovery.

Offsetting this good news was the 34th and soon-to-be 35th short-term extension of the federal highway bill. The ongoing series of short-term extensions leaves both the construction sector, states and municipalities in a cloud of uncertainty that has existed since the expiration of SAFETEA-LU in the fall of 2009.

With Federal DOT funding now available until June 2016 and an election year on the horizon, the industry has increasing concern that a long-term bill at adequate funding levels will not be passed. With the ongoing lack of stable federal funding for highways, many states are taking a hard look at alternative methods to raise revenue.

CM Index stock performance

The following charts present the performance of publicly traded construction materials. FMI has created an index of these companies (CM Index) to track performance relative to the broader markets – the Dow Jones Industrial Average (DJIA) and the Standard and Poor’s 500 (S&P 500).

While the index remains behind the broader market over a 10-year period, the CM Index companies have vastly outperformed the broader market since early 2015. The successful IPO of Summit Materials, completion of the Holcim-Lafarge merger and the continued improvement of the residential sector are all factors in the rise to date.

Stock valuations for the top public companies have followed a strong trend line since fall 2008. When the enterprise value to EBITDA ratio rises to today’s levels, it implies that investors believe in the growth story for an industry. Because the stock market is a leading indicator of economic performance, this is a good sign for the materials sector as we look ahead to 2016.

Combined earnings for the CM Index companies have been relatively steady since 2011, due primarily to pressure on price. As volumes increase and plant efficiencies improve, we expect pricing and earnings to improve for the sector.

Operating performance

As illustrated in this article, the last 12 months of the year have seen positive earnings results for companies in the CMI. We expect an uptick for those companies involved in transactions requiring debt financing in their return on equity results, as long as they see positive results from those opportunities. The debt levels in Figure 8 remain a key discussion point among the public companies. Maintaining ratios that satisfy bank covenants is a key capital consideration as the Federal Reserve may begin to increase rates in late 2015 and into 2016.

Market drivers

The outlook for residential construction remains strong, and private sector construction is driving the earnings for materials companies in multiple markets. While consistently improving, the market remains at a fraction of the highs achieved in the mid-2000s as shown in Figure 9.

A federal highway bill remains the most important consideration for the sector. As shown in Figure 10, highway spending has been flat in recent years and is expected to remain that way until a long-term federal highway bill is passed. At the end of July, Congress approved the 34th short-term extension of the SAFETEA-LU bill that expired in the fall of 2009. This extension was until the end of October. Since then, the Department of Transportation has determined it has sufficient funding to meet its obligations through June 2016. This information will likely lead to the 35th short-term extension. Then it is anyone’s guess what will happen in the summer of 2016 during the middle of the election year. The ability to forecast consistent spending and address major road infrastructure issues across the United States would greatly impact the outlook for the sector. However, for now, we are in the same holding pattern we have been in since the fall of 2009.

Cement pricing considerations

Big changes in the cement sector could have implications for ready mixed concrete producers and aggregate suppliers. LafargeHolcim will likely increase cement prices in markets where they are the price leader in order to realize some of the synergies from the merger. In addition, as part of the merger between Holcim and Lafarge, Oldcastle Materials acquired a cement operation in Quebec, Canada, with the ability to influence supply in the Northeast. Summit Materials acquired the Davenport assets of Continental cement, as well as seven terminals along the Mississippi River. Lehigh Hanson announced, via its parent Heidelberg Cement, the acquisition of a stake in Essroc. These events, combined with increased production capacity at the Lafarge Ravena plant and the soon-to-be-open McInnis plant in Canada, will mean major changes in the supply and demand dynamics in the Northeast.

George Reddin is a managing director with FMI Capital Advisors Inc., FMI Corp.’s investment banking subsidiary. He specializes in mergers and acquisitions and financial advisory services. www.fminet.com.