Economics Pulse: Construction materials update

Last year proved to be a year of mixed results for the construction materials sector. Production volumes increased in 2014, but not at the pace that many expected. Sales increased but profit margins struggled to show improvement. Stock prices for the sector’s public companies had an impressive start to the year but lagged the Dow Jones Industrial Average and S&P 500 for the year. The sector benefited from continued increases in both residential and nonresidential construction spending.

At the same time, federal spending on transportation continued its nearly flat trajectory and received only short-term funding commitments. The sector is poised for significant growth; however, that will have to wait until the funding challenges at both the federal and state levels can be resolved.

The Construction Materials Index (CMI) shown here presents the stock performance of the sector’s publicly traded stocks over a 10-year period (Figure 1) and for 2014 (Figure 2). As shown, the sector was one of Wall Street’s darlings during the residential construction boom (2004-2007), far outpacing the performance of the market as a whole. The collapse of residential construction, the expiration of the SAFETEA-LU transportation bill (with no reauthorization in sight) and the overall collapse of the financial markets in the fall of 2008 caused the sector to underperform the overall market.

Figure 2 shows the performance for the CMI in 2014. As shown, the sector had a strong first half of the year when compared to the overall market. The

Martin Marietta and Texas Industries deal announced in January, speculation of the Lafarge and Holcim merger in March and hope for a highway bill all fueled interest in the sector and caused high expectations for 2014. The disappointment in the absence of a meaningful highway bill and the overall market downturn took the wind out of the sails and, consequently, the CMI ended up lagging the markets.

Growth in residential construction and sustainable highway funding drive growth in the construction materials sector. As shown in Figure 3, the overall construction sector had tremendous growth in the years leading up to the collapse of the economy and financial markets with the actual peak being in the 2006-07 timeframe. The construction industry was hit harder than most, but FMI is optimistic about the current recovery.

The impact of the recession was felt on two fronts in the construction materials industry. Consequently, it has experienced a more modest recovery than the construction sector overall. Residential construction took the biggest hit as shown in Figure 4. While residential has improved since hitting bottom between 2010 and 2011 and is forecast to see healthy improvements, it will not return to peak levels any time soon.

At the same time, the highway construction sector ran into problems with reauthorization of SAFETEA-LU, which expired in the fall of 2009. This bill has had short-term extensions subsidized by general fund transfers resulting in flat funding ever since. The dynamics of residential and highway construction have left many producers operating at less-than-optimal capacities.

Figures 6 to 9 present a historic view of volumes of crushed stone, sand and gravel, cement and ready-mixed concrete. Volumes in the construction materials sector dropped by as much as 50 percent from the peak in 2006. On a positive note, shipments have shown year-over-year increases through nine months, and average selling price remained more stable than volume due to product mix related to the nature of the construction activity in recent years relying less on base-type products.

In addition to the residential and highway construction sectors, FMI conducts the Nonresidential Construction Index Scores survey (NRCI), presented in Figure 9, of construction executives that is a leading indicator sentiment in the nonresidential sector. When the indicator is greater than 50, the nonresidential construction industry is expanding; while below 50, it is contracting. Executives are more optimistic than at this same time in 2013, but less than the peak of the index in the second quarter of 2014. For more information on the NRCI visit www.fminet.com/resources.

Figure 10 presents select operating metrics for the public companies in the CMI. As volumes declined, many producers saw both earnings and margins decline as reduced volumes left producers operating inefficiently. Figure 11 presents the composite EBIT and EBITDA for the CMI companies. As shown, the operating performance of the CMI has stabilized as demand has started to increase.

Figure 12 presents market price ratios using Enterprise Value (EV = market value of equity plus debt less cash and cash equivalents) against various metrics. A common market pricing ratio is EV/EBITDA, which is presented in Figure 13. As shown, the median EV/EBITDA for the CMI composite has fluctuated between six and 11 times EBITDA over the last 10 years.

In the fall of 2008, many companies found themselves with significant debt owing to major acquisitions in the prior three to five years. With the collapse of the credit markets and deterioration of earnings, there was great concern about opportunities for debt refinancing and staying within loan covenants. Those that had cash kept it, while those that did not, raised it via divestitures of noncore operations.

Figure 14 presents the composite cash, debt and net debt (total debt less cash) for the CMI companies on a composite basis. Since 2008, companies have focused on balance sheet management by reducing debt and increasing cash.

Figure 15 presents the CMI median leverage ratio of Net Debt/EBITDA. Due to the combination of increased debt (Figure 14) and reduced levels of EBITDA (Figure 11) after the collapse in 2008, leverage ratios increased giving banks great concern. The balance sheet management efforts together with a stabilizing of EBITDA levels helped reduce the leverage for the CMI companies.

Figure 16 presents a summary of select merger and acquisition transactions in the fourth quarter of 2014. Recent years have seen merger and acquisition activity dominated by major corporate divestures as part of the balance-sheet management theme, and small strategic bolt-on transactions. We expect this trend to continue in 2015.

Many of the CMI companies put their M&A plans on hold in recent years as they focused on operational improvement and debt reduction. Others have returned to the market in 2014 with well-defined acquisition programs. Even with the uptick in activity, there exists a pent-up supply of sellers resulting in an interesting outlook for M&A activity in 2015.

The construction materials sector has been challenged since 2008. The positive outlook for the residential sector and overall optimism for the construction industry has many people hopeful for 2015. The big unknown remains highway funding at both the federal and state levels. Regardless of the challenge, CMI companies continue to position themselves for growth with successful efforts in balance-sheet management. There are many reasons to expect improved performance for the sector and increased M&A activity in 2015 and beyond.

Take note

The positive outlook for the residential sector and overall optimism for the construction industry has many hopeful for 2015 and beyond.

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.