Q1 2016 Economics Pulse: The year ahead

By |  February 26, 2016
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As we begin 2016, we cannot help but look back at what a remarkable year 2015 was for the construction materials industry.

For many companies, 2015 marked their best year of financial performance since the Great Recession. In May, Summit Materials closed the industry’s first initial public offering in more than a decade. The largest deal in our industry’s history, LafargeHolcim, closed in October. A host of other mergers and acquisitions reshuffled the competitive slate in markets across the country.

In addition, Congress and the president finally came together after nearly a decade to pass a long-term federal highway bill, the FAST Act.

While rising interest rates, overheated housing markets, and international political instability provide some uncertainty, the construction materials industry is in a position of strength for the first time since the onset of the Great Recession seven years ago. As we look forward, three factors – new competitive dynamics in the United States; the recovering financial performance of both public firms and smaller, independent players; and the certainty brought by long-term federal highway funding – will make 2016 the best year for U.S.-focused mergers and acquisitions since the Great Recession.

The mega deal era

For two years, merger and acquisition activity in construction materials markets has been heavily dependent on synergies. In other words, buyers have been unwilling to consummate transactions that did not improve the profitability of the target company post-closing.

This has had two primary effects. First, smaller deals that traded were limited primarily to bolt-ons or tuck-ins, while beachhead deal activity (deals in which a buyer enters a new geographic market) all but dried up.

Second, buyers gravitated toward mega deals with larger competitors in an effort to cut overhead costs and strategically reposition assets. As the nearby table indicates, this dynamic resulted in nearly $50 billion in mega deals over the past two years, making 2014 and 2015 the greatest two years of construction materials mergers and acquisitions in history by dollar volume.

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The reasons for the mega merger trend are myriad. Global economic growth coming out of the 2009 recession disappointed. The pre-recession acquisition boom left many acquirers with overleveraged balance sheets and assets that underperformed expectations. With an uphill fight to grow earnings organically, the merging of large companies allowed for substantial cost savings and an opportunity to strategically reposition assets around the globe.

As the trend of the mega deal developed, it also took with it the focus of larger public acquirers. This is for good reason.

The LafargeHolcim merger alone required the strategic analysis, valuation and integration planning of a network of more than 180 cement plants, 1,600 ready-mix plants, 600 aggregate plants and 115,000 employees around the globe. Other mega deals, while comparatively smaller, are no less cumbersome for public companies to execute.

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As a result, deals for smaller, regional independents across the U.S. have been more challenging to execute, and sellers have seen fewer buyers interested in acquisition of their firms.

However, the tide is turning. While the U.S. economy is by no means booming as it was in the early to mid-2000s, it is growing steadily. The emerging economies of Brazil, Russia, India and China, once the focus of investment by large public construction materials firms, are struggling through a period of currency devaluation, political instability and general economic deterioration. The U.S. is now a critical piece of the portfolio for public firms, and the competitive landscape here has shifted dramatically in less than 24 months.

As the dust settles, there can be little doubt that public acquirers will be looking at opportunities to defend their newly shaped competitive positions in the U.S.

A great reshuffling

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The LafargeHolcim merger and Heidelberg/Italcementi deal, along with new cement capacity coming online in Canada and New York, are set to drive a dramatic competitive rebalancing in North America, particularly in the eastern and central United States. Consider the following:

  • The LafargeHolcim merger creates a network of 20 cement plants with more than 33 million metric tons (Mt) of installed production capacity in North America, including 27.9 Mt in the U.S.
  • Newly public Summit Materials has more than doubled its cement production capacity and terminal network along the Mississippi River through the acquisition of the former Lafarge Davenport Cement Plant and seven terminals.
  • Oldcastle Materials has entered the cement market in the Northeast and eastern Canada through the acquisition of the former Holcim cement assets in Ontario and Quebec, Canada, and related terminals.
  • Heidelberg’s acquisition of Essroc includes five cement plants and a network of 18 terminals in the eastern U.S. and a plant in Canada, significantly bolstering Heidelberg’s position in North America (through subsidiary Lehigh Hanson).
  • The McInnis Cement Plant, set to begin production in 2016, will bring an additional 2.5 Mt of waterborne production to the eastern U.S. and Canadian markets.
  • Lafarge’s Ravena plant modernization, which broke ground in April 2014, is set to be completed in mid-2016 and bring with it an incremental 1.1 Mt in capacity to the market.

These developments have enormous competitive implications in downstream markets across the U.S. As seen in Figure 1, more than 20 U.S. cement plants have changed ownership or extended their network of operations as a consequence of the LafargeHolcim or Heidelberg/Italcementi deals. This will drive new competitive dynamics in markets from Maine to Michigan and southward down the Mississippi River to the Gulf Coast states.

These new (and expensive) positions will create a need to defend downstream share in key markets through vertical integration. The fact that two of these firms (Oldcastle and Summit) have historically favored full integration through construction will make it all the more interesting to watch.

Public company performance

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Meanwhile, as the mega deal market has flourished, public construction materials companies have reported their strongest financial performance since the onset of the recession. As a group, FMI’s Construction Materials Index (CMI) companies reported average EBITDA margins in excess of 16.5 percent for the last 12 months (Figure 2), their strongest performance since 2009.

The index’s median net debt to EBITDA declined to 2.65 times in December, the lowest levels since 2007 (Figure 2). FMI’s CMI companies are at their healthiest point since the recession.

Public markets are also favoring CMI companies. FMI’s CMI was up more than 13 percent in 2015, while the Dow Jones Index and S&P 500 were both negative for the year. This dynamic is also at work in the trading multiples of FMI’s CMI, which are at their post-recession high of between 10 and 12 times EBITDA. With higher valuations, healthier balance sheets, and recovering earnings, the CMI companies are primed and ready for additional deal activity.

The FAST Act

The FAST Act signed by President Obama in December, is by no means an industry panacea. However, it does include a slight increase over MAP-21 levels with $230 billion allotted to highways and $60 billion allotted to public transportation projects through 2020. In the wake of numerous reauthorizations, the legislation provides a window of certainty to the industry that it has not had since the passage of SAFETEA-LU in 2005.

This certainty also allows states to plan multi-year transportation projects. As a result, producers’ backlogs will extend in duration, providing greater insight into pricing decisions and future financial performance. Barring a downturn in private markets, we anticipate financial performance will continue to improve in tandem.

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This has important implications for merger and acquisition activity. When buyers have greater confidence in future earnings, they are typically willing to pay higher prices for target companies because perceived risk is lower. Furthermore, with a few years of reasonable earnings behind them, independent sellers are likely to achieve valuations that have not existed in the market for quite some time.

The recovery from the 2009 recession has taken substantially longer than expected. Now, more than seven years after the failure of Lehman Brothers and the onset of the financial crisis, construction materials firms are beginning to recover financially. When combined with a strategic reshuffling in the U.S. and greater insight on future highway spending, we expect 2016 to mark the best year for U.S.-focused mergers and acquisitions since the onset of the Great Recession.

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. www.fminet.com


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