New dynamics at play for the aggregate industry

2018 was the strongest year in a decade for construction materials firms.

Demand continues to be strong, and pricing in most markets increased. Macro-drivers like infrastructure spending, residential spending and home prices all showed resilience in what is now the 10th year of recovery since the Great Recession.

At the same time, a number of markets around the country were hit by unusually inclement weather, resulting in a significant amount of work being pushed into 2019. Early third-quarter earnings reports for publicly traded companies in the construction materials sector are showing strong revenue and profitability.

Much of the strength in the market can be attributed to improvements in single-family residential spending, up around 7 percent year-over-year and up more than 20 percent over the last three years. While the panacea of an infrastructure bill has yet to emerge from Congress (and will likely not develop before the next presidential election), infrastructure spending is improving, as 31 states have approved initiatives to bridge the ever-growing infrastructure gap since 2012.

These dynamics, coupled with the enhanced benefits from new tax legislation (i.e., bonus depreciation), have driven not only improvements in revenues and profitability, but also made 2018 a strong year for mergers and acquisitions. Strong financial results and favorable industry trends have combined to keep transaction activity robust across the industry and valuations strong.

2019 forecast

Looking ahead, most economists expect growth to be moderate. The forecasted growth for single-family residential construction is slowing, as interest rates increase. This, combined with higher overall housing prices, may exclude some homebuyers from the marketplace.

As of mid-October, the average 30-year fixed-rate mortgage reached 4.9 percent in the United States – its highest level in more than seven years. Housing inventories, as reported by the U.S. Department of Housing & Urban Development, reached 7.1 months in September, also their highest level in seven years.

FMI is forecasting about 5 percent growth in single-family residential construction spending in 2019 and about 4 percent growth in 2020. This represents a decline in growth rate versus 2016 and 2017, when single-family residential grew at 9.6 percent and 11.3 percent, respectively. Overall, the market for single-family residential construction, a critical input for growth in the construction materials space, appears to be moderating with room to run.

Infrastructure spending, while strengthening due to increasing state funding initiatives, will face another funding battle in Congress when the FAST Act expires in 2020. While the U.S. is unlikely to see a dramatic reduction in federal infrastructure dollars post-FAST Act, the ability of Congress and the White House to agree on infrastructure programs prior to the 2020 election is unlikely.

The likelihood of legislation supporting infrastructure funding is further hindered by the presence of an unusually high deficit during an otherwise strong economy. Without confidence in the reauthorization of a federal highway bill, investors will be increasingly hesitant to make long-term investments driven by infrastructure markets.

While these metrics suggest growth rates may begin to slow, investors have already cooled to construction materials stocks. Since Jan. 1, 2018, the Construction Materials Index (CMI) has dropped by more than 27 percent, compared to a 1.8 percent increase for the Dow Jones and a 1.0 percent increase for the S&P 500.

Since the 2016 election and the “Trump bump” that emerged two years ago, CMI stocks have fallen by more than 21 percent. Investor optimism for the sector has undoubtedly faltered, which will likely begin to influence the behavior of public companies in 2019.

Underlying investor sentiment is driven by two primary concerns, the first of which is macro in nature. As described, the outlooks for housing and infrastructure spending, while stable, do not portend meaningful growth improvements. The second and potentially more nefarious concern is cost pressure. In late October, LafargeHolcim increased its sales forecast for 2019 but reduced profit forecasts, citing steep cost inflation as the culprit. HeidelbergCement reported similar trends in its forecast for the remainder of 2018.

While energy costs are the primary driver of cost inflation, wage inflation is also likely to create cost pressures. In September, for example, U.S. annual wage growth reached a nine-year high of 2.9 percent.

Should cost pressures begin to emerge, the squeeze in operating margins will place pressure on management teams to both increase prices and cut costs – difficult objectives when market growth is slowing and when labor, one of the larger expenses on construction materials companies’ income statement, is in increasingly short supply.

What it all means

In short, the data indicates the beginning of the late cycle for growth in construction materials markets.

While a recession is possible within the next few years, there is equal likelihood that the economy will continue to grow, but at a lower rate than was seen coming out of the Great Recession. Inflationary cost pressures may also mount, weighing on bottom-line profits for companies that do not have the ability to push prices higher.

These late-cycle dynamics will undoubtedly change the way larger firms approach capital investments, particularly mergers and acquisitions. These changes will likely include the following:

• Investment costs will increase, driving more scrutiny in investment decisions. The cost of capital (both debt and equity) is likely to increase in 2019 if interest rates rise. This will, in turn, force companies to be more rigorous in their capital investment decisions and focus on quality transactions with meaningful synergies and strategic value. Increased capital costs may also have the effect of decreasing valuation multiples in some markets. Rising interest rates are specifically troublesome to highly leveraged companies, as refinancing becomes less of a viable option.
• “A flight to quality” among strategic buyers. Nearly all strategic buyers prefer markets with strong barriers to entry, fewer independent competitors and high expectations for growth. These highly defensible, well-structured markets allow companies a greater opportunity to improve market pricing and defend market share. Larger firms will increasingly spend their investment dollars within these markets through bolt-on transactions.
• Conversely, a “flight from risk” among larger companies. More poorly structured and less-defensible markets, particularly those in lower-growth areas, will likely be targets of more divestment initiatives among larger firms. As a result, we are likely to see an increase in swap activity among larger companies, though recent tax legislation may alter the structure and attractiveness of those transaction structures.

Overall, FMI expects the market to remain active in 2019, largely due to sustained profitability and the demographic realities at play (i.e., many construction materials firms are owned by baby boomers). Still, we expect buyers to become increasingly focused on defending and consolidating core markets while growing skeptical on more risky platform transactions.
Buyers will become increasingly strategic in their transaction activity as the market enters the latter portions of this economic cycle.

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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.