Mid-year construction materials review

If the first-half of 2017 for the construction materials industry can be summed up in a word, it’s “uncertainty.” Financial performance and economic conditions continue to improve, but stock prices have begun to reflect decreasing investor confidence (and patience) to promises of federal infrastructure spending.

The good news is that construction materials firms are continuing their recovery from the recession, many of which are now catching up to pre-crisis production levels. 2017 is still poised for a strong second half.

The bad news is that sustained improvement in stock performance and production growth is reliant on the Trump administration’s ability to achieve traction on an infrastructure-spending package.

In total, these dynamics will combine to have a substantial effect on construction materials mergers and acquisitions (M&A).

Furthermore, industry fundamentals suggest the second half of 2017 is poised for a strong finish for the construction materials industry.

The industry’s primary economic drivers of residential, non-residential and highway/infrastructure spending continue to demonstrate promising growth.

On the residential side, while prices alone might indicate the potential for another bubble, housing construction put-in-place remains below its pre-recession peaks. The data suggests there remains ample room for continued growth in the market. FMI is projecting 8 percent growth in residential, 4 percent growth in nonresidential and 1 percent growth in nonbuilding structures in 2017.

First quarter 2017 revenue for FMI’s Construction Materials Index (CMI) companies increased, on average, by 10.3 percent over last year’s first quarter. LTM EBITDA margins averaged 19.0 percent for the first quarter of 2017, maintaining their strongest levels since in nearly a decade.

However, during the first quarter, the U.S. Geological Survey estimated that output of sand and gravel and crushed stone decreased 4 percent and 2 percent, respectively, from the same period in 2016, while cement increased less than 1 percent during the same period.

Despite lower U.S. construction materials volumes from inclement weather and subdued optimism of future infrastructure spending, increased prices in U.S. operations have helped to continue to drive average CMI revenues quarter-over-quarter.

Stock volatility

Sustained improvement in financial performance in the first quarter has not fully translated to sustained CMI stock performance. Stock performance has continued to be volatile around a narrow trading range, which contrasts to the large stock price growth that we witnessed in 2016.

It appears that the jolt companies received from the “Trump Bump” in late 2016 and early 2017 has started its rebound, following increased worries that the Trump administration will be unable to follow through on promises of heightened infrastructure spending.

These concerns have been exacerbated over the past several months as a seemingly unending series of events have hindered voters’ confidence in President Trump’s ability to execute. As we are writing, Republicans in Congress had not passed a revised health care bill, and special counsel had been appointed to investigate Russian influence in the 2016 presidential election.

Additional legislative priorities, such as trade and tax reform, have come under fire and have subsequently been delayed. Finally, Congress continues to battle gridlock as it struggles to raise the country’s debt ceiling by early October.

With so many variables pointing toward a potential delay in Trump’s rollout of infrastructure initiatives, it seems unsurprising that CMI stock performance has not only become tepid, but more volatile. However, earnings growth will continue to influence CMI stock performance, and any notable uptick in investor confidence regarding the Trump administration’s ability to affect policy will likely be reflected in the CMI.

As of July 2017, CMI companies’ median enterprise value to EBITDA sat above 11.5x, the highest level since 2008. Aside from improvement in earnings, the market expects an infrastructure package from the administration and Congress, with the question being when and how much.

CMI companies are trading at strong multiples of earnings, and are therefore returning their focus to small- and mid-sized transactions in the United States. The volume of construction materials M&A so far in 2017 has been notably higher than in recent years, with key strategic buyers actively in the market.

Vulcan Materials and Martin Marietta returned to the market with deals in the first and second quarters, combining for an estimated transaction value of at least $2.5 billion. In May, Vulcan Materials agreed to acquire Aggregates USA, which operates more than 20 locations throughout Georgia, Florida, Tennessee and Virginia.

In June, Martin Marietta announced the acquisition of Bluegrass Materials Co., which has 33 locations across the Mid-Atlantic and Southeast. Other aggregate majors were rumored to be bidders on several of these deals, as well, demonstrating that demand for expansion opportunities is still on the rise.

Since the start of 2017, there have been more than 25 construction materials M&A transactions in the United States and Canada. Given that most public-company CEOs have been enthusiastic about their recent M&A plans, barring any signs of recession, we expect heightened M&A activity to remain a trend for 2017.

Trumping the maze in Washington

With the Highway Trust Fund still headed for insolvency owing to declining vehicle miles traveled and more fuel-efficient vehicles, states are increasingly coming up with their own plans for raising additional transportation revenue.

National concerns about continued deterioration of American infrastructure were partially offset by the passage of the FAST Act in December 2015, which allocated $305 billion to transportation spending over five years. However, as Martin Marietta CEO Ward Nye explains, “We didn’t get more money with the Fast Act, we got more time.”

Construction materials volumes are not reflecting implementation of the FAST Act or other post-election optimism, so there is room for improvement. Although the FAST Act did slightly increase federal allocation of spending to infrastructure, the true benefit of the FAST Act lies in the budgetary predictability it creates for the infrastructure industry.

While the FAST Act will help to grow infrastructure spending and help fund the Highway Trust Fund through 2020, its benefit is primarily short-term and the Highway Trust Fund faces insolvency after 2020. Continued growth in the construction materials industry requires a strong infrastructure stimulus from the Trump administration. Fortunately, a report published by the White House detailing Trump’s 2018 budget still pledges $1 trillion in federal funding for infrastructure initiatives.

Perhaps more interesting is how the administration expects to generate this funding, claiming to target “a combination of new federal funding, incentivized non-federal funding, and newly prioritized and expedited projects.”

Public-private partnerships

Although public-private partnerships are traditionally unpopular in American infrastructure, they’ve become a growing method of transportation stimulus in places such as Canada, Australia and the United Kingdom. Moreover, 34 U.S. states already have legislation in place that allows for the creation of these partnerships.

Should budgetary gridlock in Congress prove too great an obstacle for the Trump administration to fulfill its infrastructure promises, public-private partnerships may provide an alternative means of growing infrastructure expenditures and jump-starting long-term earnings growth for the construction materials industry.

In an even better scenario, should President Trump be successful in obtaining approval for his infrastructure plans, the existing prevalence of private investment capital in the United States may serve to amplify any subsequent benefits.

Budgets aside, Trump has also promised to deregulate and simplify the permitting process for infrastructure projects by rolling back the stringency of the National Environmental Policy Act. In a June 2017 speech, he announced the formation of a task force within the Council on Environmental Quality “to help project managers navigate the bureaucratic maze,” emphasizing the necessity to streamline approval processes for federal, state, and municipal infrastructure projects.

The Trump administration’s continued focus on deregulation and increased funding of federal infrastructure projects, coupled with a Republican-majority Congress that seems eager to make changes, has potential to create a perfect storm at a time when the construction materials industry is already ripe for growth.

If Trump is able to show investors a sign in the right direction, and provided that Congress is ready and able to approve an infrastructure spending bill, we expect the rest of 2017 and 2018 to become an even more active period for construction materials M&A.

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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.