FMI: Favorable roads lie ahead

By , and |  June 11, 2018
Photo by Joe McCarthy

Photo by Joe McCarthy

At first blush, the first quarter of 2018 was a poor one for construction materials firms.

FMI’s Construction Materials Index (CMI) declined in the first quarter by more than 13 percent, making it the worst-performing quarter for CMI companies in more than two years.

President Trump’s long-awaited $1.5 trillion infrastructure plan, introduced in February, fell short of meeting analyst expectations. The federal funds rate increased by 25 basis points, while overall market volatility surged.

In summary, there were plenty of reasons to be bearish on the construction materials market following the first quarter.

While market volatility may be a theme for 2018, there is little question that underlying macroeconomic drivers for the construction materials market are sound. As we have discussed previously, the construction materials market in the United States is primarily driven by two subsegments: residential construction, particularly single-family home construction; and infrastructure spending, notably roads, bridges and highways. Both of these segments appear poised for growth.

A housing bubble?

Figure 2 presents the seasonally-adjusted housing inventory from January 1963 through February 2017. The average monthly inventory of homes on the market during this period is 6.1 months. Except for the 2001 recession, which was primarily driven by the dot-com bust, months of housing inventory exceeded 7.0 at least eight months prior to the onset of each recessionary period.

Prior to the onset of the Great Recession, which began in 2007, housing inventories exceeded 7.0 months for more than 11 months before the onset of the recession. As of February 2018, monthly housing inventories sit at 5.9, suggesting there is ample room for the housing market to grow before recessionary pressures begin to mount.

Housing starts show similar dynamics. U.S. seasonally-adjusted monthly home starts have averaged 1,434 per month back through 1959. Housing starts have not exceeded this average figure since June 2007, and as of February 2018 stand at 1,236, again suggesting that supply of housing continues to lag historical averages.

Despite rising interest rates, housing demand remains poised for growth. According to the National Association of Realtors, buyers 36 and younger represent the largest share of homebuyers (34 percent of the market) and 66 percent are first-time homebuyers.

As shown in Figure 3, millennials are quickly reaching a prime home purchasing age, and they greatly outnumber their Generation X predecessors. As millennials enter the homeownership ranks in earnest, demand will likely improve purely based on demographic factors.

Infrastructure spending lags but optimism lingers

While the infrastructure-funding gap in the United States continues to be a key political issue, there is optimism for the construction materials market that a large federal infrastructure package could create meaningful growth drivers for the industry.

Spending levels, however, continue to fall well short of demand. The recently passed fiscal year 2018 federal omnibus spending legislation funded $55.6 billion of spending from the Highway Trust Fund for FAST Act programs. On top of this, the legislation included an additional $3.5 billion in funds for highways and transit projects; tripled funding for the Transportation Investment Generating Economic Recovery (TIGER) program, which is a vestige of the stimulus bill, from $500 million to $1.5 billion; and increased spending on a host of programs aimed at expanding rail programs.

While overall spending will improve as a result of this legislation, there remains ample need for more. The marketplace, however, continues to benefit from the optimism that investors see related to a broader infrastructure package. This optimism is driving both stock market valuations and increased merger and acquisition activity, but it can only last so long without congressional action.

The M&A market continues to show strength

The market for construction materials M&A remained strong in the first quarter of 2018 despite stock market volatility. As discussed previously, FMI’s thesis is that M&A in construction materials markets is driven by three primary factors: the perception of future growth, the availability of capital and strategic need. All three of these factors remain favorable for continued M&A activity.

If stock market valuations decline meaningfully, interest rates continue to rise or exogenous world political events introduce systemic risk to the economy, this may change. For now, we remain bullish on the outlook for construction materials M&A in 2018.

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

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