Your behavior appears to be a little unusual. Please verify that you are not a bot.


Forecasting the road ahead for construction materials

By and |  June 1, 2020
Photo by Pit & Quarry staff.

A number of construction materials did not miss a beat in the first quarter of 2020. Photo: P&Q Staff

The first quarter of 2020 was a roller coaster for the global economy.

At the start of the year, economic indicators pointed toward steady performance with expected growth. But by March, the global coronavirus (COVID-19) pandemic and shock in the oil markets created significant turbulence across all industries and geographies.

While the construction materials sector fared no differently, first-quarter results for many of the public construction materials companies do not reflect these impacts. For the U.S., the dramatic downturn brought upon by COVID-19 was not felt until mid- to late-March, meaning the majority of customer demand and production was unaffected for the first quarter.

As such, many construction materials firms reported positive results in both top- and bottom-line performance. Strong backlogs coming out of 2019 and steady customer orders helped to bolster revenue.

In addition, decreasing oil prices helped reduce costs and stimulate earnings growth. All reporting public construction materials companies showed first-quarter revenues that either hit or exceeded consensus CapIQ analyst expectations within a 5 percent threshold.

Tale of two markets

The chart shows the quarterly performance of the reporting public construction materials companies. Click to enlarge | Chart: FMI

The chart shows the quarterly performance of the reporting public construction materials companies. Click to enlarge | Chart: FMI

There are generally two metrics that are monitored in order to judge the health and confidence of a market: equity and debt.

For the construction materials space, FMI Capital Advisors utilizes its proprietary Construction Materials Index (CMI) as a lens into the industry-specific equity market. Fluctuations in the CMI can show the general sentiment of investors toward the construction materials space and can be viewed in coordination with trends of the major indices (i.e., S&P 500).

Equity markets are important to monitor for mergers and acquisitions (M&A), as stock price is the currency in which public buyers operate. The debt market for publicly traded companies is often not industry specific.

For the construction materials space, FMI looks at U.S. treasury yields to judge the overall sentiment of the lending sector. We are clearly in uncertain and unusual times, as the messaging from these two markets are currently in contrast.

Equity

The unprecedented severity and contagiousness of COVID-19 resulted in a steep decline in all stocks indices, including the CMI. The temporary “price war” between Russia and Saudi Arabia exacerbated the economic impact of the pandemic, driving further decline. We saw the largest drop occur in March, as the reality of shelter-in-place orders swept the globe.

Since the steep decline, stocks have begun to gradually climb back from their 52-week lows.

Debt

The CMI's (Construction Materials Index) 2020 year-to-date performance compared to the major indices (as of May 29). Click to enlarge | Chart: FMI

The CMI’s (Construction Materials Index) 2020 year-to-date performance compared to the major indices (as of May 29). Click to enlarge | Chart: FMI

The debt (or bond) market does not share the same outlook as its equity counterpart. Ten-year treasury bonds have been hovering around a 0.7 percent yield, which is slightly higher than the all-time low of 0.5 percent.

According to the Wall Street Journal: “The low level of the 10-year yield and its stability suggest that bond investors not only hold a dreary economic outlook, but also are unusually confident in that perspective – a contrast with the optimism that has carried stocks to their highest levels since early March.”

Regardless of the reasoning for the low-interest availability, the result has been an explosion of corporate bond issuance. The construction materials space is not an exception to this trend.

Starting in March, several public construction materials companies took advantage of the low rates by issuing public or private debt – including CRH, HeidelbergCement, Martin Marietta, U.S. Concrete and Vulcan Materials. This debt may provide a silver lining among the clouds of uncertainty.

The leverage that major construction materials companies are gaining from low-interest debt will improve their balance sheet liquidity, arming potential buyers with plenty of “dry powder” for acquisitions once the economy returns to normal.

Funding and the future

Looking ahead, things are murky at best.

We face a time of almost unprecedented uncertainty. We know construction companies are currently facing disruption. According to an Associated General Contractors of America poll, more than 65 percent of surveyed contractors are reporting delays or cancellations of projects as of May 7.

For the construction materials space, the major driver to monitor for future outlook is public funding. With private markets vulnerable to stay-at-home closures, many hoped the economy would be stimulated through public funding. Unfortunately, public funding faces hurdles at both the state and federal levels.

Crisis funding thus far has been based around the concept of triage, deploying capital to mitigate impending economic struggles. Now, funding talks are moving toward the concept of recovery, causing legislators to stumble upon hurdles.

Debate is driving a wedge between officials regarding the best policies and investment methods to deploy. Additionally, as every industry looks to the government for financial support, infrastructure must fight to be heard among a sea of voices.

Federal funding

Federal infrastructure spending measured in billions, dating back to 1992. Click to enlarge | Chart: FMI

Federal infrastructure spending measured in billion of dollars, dating back to 1992. Click to enlarge | Chart: FMI

Even before the pandemic, 2020 was poised to be a complicated year for infrastructure funding.

There are currently three components of federal funding that are being discussed by industry leaders and Congress: a reauthorization of the FAST Act, an additional infrastructure stimulus package and an intermediary stopgap funding to help state Departments of Transportation (DOTs) with recent revenue losses.

The FAST Act is set to expire in September at the end of federal fiscal-year 2020. Industry participants were initially hopeful for another five-year reauthorization. Historically, federal funding packages such as the FAST Act were required to maintain sufficient infrastructure spending across the board. When a comprehensive package is not enacted, spending tends to go flat, setting back development nationwide.

In 2017, the American Society of Civil Engineers gave U.S. infrastructure a D+ rating. Beyond reauthorizing the FAST Act, industry players have been lobbying for an additional stimulus package from the federal government aimed at upgrading infrastructure rather than just maintaining it. Optimism for this package was strong in late 2019 and pre-COVID 2020, as both sides of the political spectrum claimed infrastructure as a high-priority item.

However, in many ways the pandemic has derailed this plan.

Regarding the stopgap funding: State DOTs are running out of money, leading the American Association of State Highway Transportation Officials (AASHTO) to request a $50 billion supplement through the 2021 fiscal year.

Both Democrats and Republicans in Congress met this request with mixed response. The HEROES Act, which was passed narrowly by the House of Representatives, responded to the AASHTO request by offering about $15 billion of supplemental provision to states, ending in September 2020.

Senate Majority Leader Mitch McConnell (R-Kentucky) is concerned that the government overspent in the first stimulus packages and did not get the desired results. Thus, he is hesitant about further funding.

Other legislators are arguing over whether future funding should focus on temporary injections or on more long-term spending efforts such as infrastructure. Overall, there is too much noise to confidently predict what funding will look like.

As of May 29, the most likely outcome for future funding of the FAST Act will take the form of a continuing resolution – rather than a reauthorization. The translation: funding to finance development for another year or possibly two with no clarity on the future.

This type of funding has historically worked against the construction materials industry, as DOTs are unlikely to plan major projects without visibility on how they will pay for them.

If the HEROES act does not pass in the Senate, many think that the government’s ultimate response to the AASHTO request will resemble a supplemental provision rolled into another relief package.

Unfortunately, the information and opinions on funding change daily, giving little visibility for long-term projections. Legislation is difficult to pass under normal circumstances, and the current economic climate adds further complications.

It should be noted that a fourth – but less specific – form of funding for infrastructure has come from the federal general fund in recent years. This funding often provides extra dollars at the budgetary committee’s discretion, representing about a 5 percent increase over FAST Act funding.

Unfortunately, signs for a continued boost in funding seem unlikely in the current environment, as every industry is looking for support from the general fund. As a result, even if a continuing resolution provides future funding at the same level of the current FAST Act, the total money available for infrastructure may be lower without the boost from the general fund.

State funding

For states, the major portion of infrastructure funding comes from state gas taxes. Given the effects of shelter-at-home orders, DOTs across the nation are suffering shortfalls in funding revenue.

States are also quickly running out of money in their own general funds, as unemployment coffers are drained and sales tax revenues are lowered. The economic effects of these declines are expected to trickle down through the rest of the year and beyond.

Still, the impacts of the pandemic on infrastructure seem to vary by state. In Pennsylvania, PennDOT suspended several jobs in April and May, and has even begun canceling contracts that had been previously put out for bid. In contrast, the Florida DOT is taking advantage of empty roads by accelerating more than $2 billion in critical transportation projects.

As funding remains unclear, state DOTs are developing plans to handle the shortfall. Many states, including Maryland, Virginia and Tennessee, have adjusted budgeting to focus away from expansion projects and more toward maintenance and repair. Shelter-in-place orders have significantly reduced daily traffic in major cities, causing many planners to question the need for additional infrastructure development in the face of the massive repair work needed on many highways.

What to watch

There is no way to know for sure how the funding, debt and equity pieces will affect the construction materials space. But we can look at a few possibilities of what the data may suggest.

In order to conserve cash, several public companies have indicated a tightening of capex budgets. Martin Marietta, for example, indicated this in its first-quarter earnings call: “In addition to strengthening our balance sheet through a timely $500 million bond offering in early March, we’ve cut nonessential costs, reduced capital spending for discretionary projects and implemented hiring restrictions. We’re tightening our belts and aligning our capacity with demand consistent with our commitment to being prudent stewards of shareholders’ capital. … We now estimate full-year capital expenditures will be $325 million to $350 million, down from our original guidance of $425 million to $475 million.”

Several other companies have mirrored this sentiment, including Vulcan and U.S. Concrete. As capex spending is lessened, M&A could follow suit. This does not mean a full stop in the acquisition market, but rather a more rigorous evaluation of opportunities from most buyers.

In February 2020, Vulcan commented that it was eying potential acquisition targets, stating that it had “some projects, both large and small” that the company was considering. By early May, though, the tone shifted to a more conservative approach: “In light of the uncertainty created by the pandemic, we are most committed to operating and maintenance capex to protect the value of our franchise, dividends and the overall preservation of our liquidity. From an M&A perspective, our evaluation of opportunities will be even more stringent, and we will remain disciplined in this area.”

An alternative interpretation of the capital restrictions could point to the large “war chests” that public companies are building by reducing capex and taking out large, low-interest loans. This would seem to indicate that as “normal” operations resume, buyers will be poised to take advantage of attractive, synergistic acquisition opportunities.

Next steps

As for when a return to normal will occur, the one thing that seems clear is that no one knows.

California’s school system has already made plans to not reopen in the fall, while other universities have announced plans to reopen earlier than originally scheduled. The chairman of the Federal Reserve and the Secretary of the Treasury have seemingly opposing views on how and when to reopen the U.S. economy.

There is just too much uncertainty for any definitive conclusions. To combat this ambiguity, leaders in the construction materials space are making plans to address a worst-case scenario.

Many industry experts are discussing how the pandemic effects may impact 2021 and beyond. According to a May 15 survey from the Construction Industry Round Table, 69 percent of organizations are more concerned about 2021 revenues than 2020.

All of this information ultimately points to uncertainty, and the lack of clarity into 2021 is increasing. Ambiguity surrounding long-term funding may put a hole in state DOT pipelines, but nothing is guaranteed.

Many companies continue to have outstanding years due to existing healthy backlogs. The construction industry has generally been deemed essential throughout the shutdown, allowing firms to continue to operate even at a reduced rate. While nothing is clear, the continued work has been a silver lining among a global cloudy horizon.

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


Comments are closed