By Elizabeth Collins
Although rock salt miner Compass Minerals (CMP) and aggregates producers Martin Marietta (MLM) and Vulcan Materials (VMC) sell different commodities, these three basic materials firms share an important characteristic. The commodities they produce have low value/weight ratios -- rock salt generally sells for around $50 per ton and aggregates fetch only $10 per ton -- so producers located closer to customers have a great cost advantage over far-flung competitors. As such, we've seen relatively small changes in prices for rock salt and aggregates despite some wild swings in demand. Along with some other favorable characteristics, we think the low value/weight ratio contributes to a wide economic moat for each company, and all three appear undervalued to us. Compass Minerals' near-term profits have been hurt by back-to-back low-snowfall winters, but earnings should grow long-term, assuming normal weather, as the company expands its specialty fertilizer production capacity. Both Martin Marietta and Vulcan Materials have suffered from a serious multiyear downturn in construction activity, but they've cut costs greatly and pricing should continue to be strong, giving both companies tremendous leverage to an expected upturn in demand.
Rock salt and aggregates prices stay relatively steady even when demand declines precipitously. While rock salt and aggregates are undifferentiated commodities, Compass Minerals’, Martin Marietta’s, and Vulcan Materials' prices haven't suffered as one would expect during periods of weak demand. As you can see in the data below, even when Compass' volumes suffered from low snowfall in 2006, 2009, and 2012, the company's average realized selling prices remained steady. And even when Martin Marietta and Vulcan suffered from a disastrous multiyear downturn in construction activity after 2005, prices remained relatively strong and actually ended much higher in 2012 than they had been in 2005, despite no drastic increase in cash costs.
Volume and Nominal Price Changes
Source: Company filings
For Compass Minerals' deicing salt business, while volumes can swing wildly from year to year based on the severity of winter weather, salt prices remain relatively stable. Shipping costs make up a significant portion of total delivered costs, so markets tend to be very regional. Low-priced imports are unlikely because far-flung producers can't overcome high shipping costs. Most cities, counties, and states secure their winter salt supply through a contract bid system. Each government entity issues a Request for Quotation, and salt companies submit those in blind, sealed bids. All bids are made public on the bid-open date, and the contract is awarded to the lowest bidder. Most U.S. customers guarantee a minimum purchase volume and require a maximum volume delivery (typically 80%-120%). As a result of this system, prices will not change during the winter. We've seen a weak winter result in flat pricing in the subsequent summer as customers reduced their bid volumes because they had leftover inventory; likewise, pricing gains have been as high as 8% in a bidding season after an especially harsh winter.
For Martin Marietta and Vulcan Materials, the average selling price of roughly $10 results in highly localized markets, as it doesn't make sense to ship aggregates much longer than 45 minutes by truck. This low value/weight ratio for aggregates results in high barriers to imports (absent efficient water or rail transportation options). Further, quarries are dusty, noisy operations, so neighbors are unlikely to take kindly to new quarry operations in their area, making permitting a new quarry a significant endeavor.
Besides strong pricing, these companies benefit from other favorable characteristics. Compass Minerals is a low-cost producer of both highway deicing salt and sulfate of potash specialty fertilizer. And the characteristics of aggregates production lend themselves to more operating flexibility for Martin Marietta and Vulcan Materials than is the case with most other commodities.
Compass Minerals' Goderich, Ontario, rock salt mine is the largest in the world. The deposits are 100 feet thick, compared with most regional competitors' mines, which access deposits 20-30 feet thick. This allows Compass to use more efficient mining techniques and to get more salt for each foot of advance. Goderich is located on a deep-water port that can accept the largest ships on the Great Lakes, which gives Compass a shipping cost advantage. In 2010 Compass completed a $70 million project to expand the annual capacity of Goderich to 9.0 million tons from 7.5 million tons. This will give Compass the opportunity to capture more than its share of organic market growth as well as opportunistic spot sales when winters are especially harsh. The Winsford rock salt mine in Cheshire is the largest in the United Kingdom. Its size enables efficient mining, and the mine's stability and closeness to the surface allow for alternative uses of unutilized caverns. Compass uses these caverns for its document storage and hazardous waste management businesses, effectively lowering the cost of rock salt mining at Winsford. Compass' energy-efficient Great Salt Lake solar evaporation facility gives the firm an edge in the production of sulfate of potash, or SOP, specialty fertilizer. Its plant is one of only three all-natural solar SOP plants in the world -- the others are in Chile and China. Compass' solar evaporation method gives it a significant cost advantage relative to the chemical-process SOP producers that must purchase MOP and sulfuric acid.
The nature of aggregates production gives Martin Marietta and Vulcan Materials much more flexibility to vary production than manufacturers of, say, chemicals, steel, refined oil products, or cement. Quarry operations are relatively simple and involve drilling and blasting rock, loading and hauling using excavators and trucks, crushing, and screening. It's a mechanical process, rather than one that involves the transfer of heat or chemical reactions. Therefore, quarry operators can very easily scale production in response to weak demand without massive fixed-cost deleveraging. The benefits of this flexibility are twofold. First, aggregates producers have less incentive to be ultra-aggressive on pricing in order to fully utilize capacity. Second, when demand is weak, cash profit margins suffer less than those of commodity producers with more operating leverage.
Of these three wide-moat companies, Vulcan Materials appears the most undervalued to us. Vulcan Materials’ earnings look set to grow significantly in the next several years. With the passage of the highway bill in mid-2012 and the recent uptick in residential construction (although from an extremely low base), the outlook for aggregates demand is brighter than it has been for several years. During the downturn, Vulcan Materials worked hard to lower operating costs and maintain pricing power. Many of these efforts seem to have been successful. As construction activity and sales volumes gradually improve, the lower costs and higher prices should have a powerful impact on profits. We expect profit margins to eventually improve considerably from their currently depressed levels. Our view that demand will improve is supported by our thesis that housing construction will ultimately recover thanks to strong expected population growth in Vulcan Materials’ key markets, although not to peak 2005-06 levels in any sustainable fashion.
Our fair value estimate for Vulcan Materials is based on the assumption of an eventual return to more normal circumstances. We assume that aggregates sales volume eventually will recover to about 225 million tons within the five-year explicit forecast period of our discounted cash flow model. This figure compares with a sales level of 141 million tons in 2012 and the 255 million tons reached in 2006 before the Florida Rock acquisition. We also assume that Vulcan's gross margin will improve to 28%, compared with 13% in 2012, on the back of assumed future price increases in aggregates and some leverage over fixed costs (mostly depreciation, depletion, and amortization) as volume recovers.
Vulcan Materials’ overpriced, ill-timed acquisition of Florida Rock leaves it with the weakest balance sheet. Compass Minerals' strong earnings in recent years have it in much stronger financial health. And Martin Marietta's avoidance of a large acquisition in 2006-08 leaves it in much better shape than its building materials peers.
Vulcan currently is in weak financial health. Before the acquisition of Florida Rock in 2007, Vulcan sported a modest and manageable debt load of roughly $522 million. Debt/capital hovered around 20% and debt/EBITDA was comfortably below 1.0 times. At the time, management (and, arguably, investors) thought Vulcan was underleveraged. With hindsight, we know that mid-2006 marked the peak of construction activity. Vulcan's ill-timed purchase of Florida Rock increased its total debt burden to $3.7 billion. Since the acquisition, debt/capital has floated around 40%-50%, and debt/EBITDA has surged from roughly 3.7 times post-deal to more than 6 times today as earnings have plummeted along with construction activity. During the downturn, Vulcan took some measures to strengthen its balance sheet. The company issued more than $600 million worth of common stock and cut the annualized dividend to $0.04 per share from $1.96. Annual capital expenditures have been slashed from nearly $500 million in 2007 to an expected $150 million in 2013. Somewhat surprisingly -- given Vulcan's leverage and industry -- the company does not have a debt/EBITDA covenant. However, total debt as a percentage of total capitalization must remain below 65%, which seems manageable to us, absent a write-down of goodwill (which stands at $3.1 billion). Management's long-term target for debt/capital is 35%-40%.
In comparison, Compass Minerals and Martin Marietta are in much better financial health. Compass Minerals ended 2012 with $482 million in debt and $100 million in cash. Balance sheet leverage has declined in recent years thanks to strong earnings in 2008 and 2009, which enabled Compass to cut its debt load by about $100 million. Debt/EBITDA averaged about 1.8 times in 2008 through 2012 versus roughly 3.5 in 2006-07. Interest coverage also improved to an average 11 times in 2008-12 from a modest 3.2 in 2006-07.
Meanwhile, Martin Marietta's reluctance to engage in large, high-priced, and highly leveraged acquisitions at the peak of the last cycle means that today the company is operating with a much healthier balance sheet than many of its building materials peers. Compared with firms outside the industry, however, Martin Marietta is operating with a meaningful amount of financial leverage, given the downturn in profitability. Martin Marietta's gross debt/EBITDA was 3.2 times at the end of 2012. The company's covenants were temporarily loosened to allow for the acquisition of assets in Colorado, with leverage not to exceed 3.75 times at Dec. 31, 2012. This limit returns to 3.5 times on Sept. 30, 2013. Barring unforeseen weather events, we think Martin Marietta's leverage will fall short of this maximum.
Compass Minerals is led by exemplary stewards of shareholder capital, in our view. As Compass Minerals' earnings improve, its managers will have more cash at their disposal, but we think investors should not be too concerned about the potential for future dilutive actions given the company's strong track record. Fortunately for shareholders, Compass Minerals' investments over the past several years have only enhanced its existing strengths. The company bought a document storage business that leverages unutilized storage capacity at its U.K. salt mine and has invested in specialty fertilizer production at the Goderich salt mine in Ontario and the Great Salt Lake solar evaporation facility. In 2011, Compass acquired Big Quill Resources, a fellow SOP producer, for an attractive valuation. The company continues to work on an expansion at its Great Salt Lake facility, a high-return investment proposition, by our calculations. We think the managers have taken a company with attractive assets and actually enhanced its competitive advantages, as indicated by our wide moat and positive moat trend ratings on the company. It's too soon to tell if new CEO Francis Malecha will deviate from Compass Minerals' past successful strategy. But so far, Malecha has made encouraging remarks. We'll keep a close eye on the situation, and review our stewardship rating if Malecha's next moves deviate too far from the company's past successful strategies.
We rate Vulcan Materials' management team as poor stewards of shareholder capital. Donald James has served as CEO since 1996 and chairman since 1997. He started working for Vulcan in 1992 after a career with a Birmingham law firm. Major moves during James' tenure include the 1999 acquisition of CalMat (California's largest aggregates producer), the 2005 divestiture of the chemical business, and the 2007 acquisition of Florida Rock. We admit that we're operating with the benefit of hindsight, and it's true that few foresaw the depths that the current downturn in construction activity would plumb, but it's still the case that Vulcan's purchase of Florida Rock was poorly timed, overpriced, and overleveraged. Vulcan announced the Florida Rock deal in 2007, paying a 45% premium and an EV/TTM EBITDA multiple of about 11 times. Since then, Vulcan's stock price has suffered and the company has had to issue equity, cut the dividend, and reduce capital expenditures to shore up its balance sheet.
Since Martin Marietta avoided the mistakes that many of its peers made, we give its management team a standard stewardship rating. Stephen Zelnak has been chairman of the board since 1997, and he served as CEO from 1993 to 2009. Howard Nye is the current CEO, having joined Martin Marietta in 2006 after working for Hanson Aggregates North America, which was ultimately acquired by HeidelbergCement (OTCPK:HLBZF). We think Martin Marietta's leaders deserve credit for staying away from the highly leveraged acquisitions -- consummated at high multiples on peak earnings -- that brought many of its building materials peers to their knees during the downturn in construction activity. Vulcan Materials, HeidelbergCement, Lafarge (GM:LFGEF), and CEMEX (CX) all caught the bug, leaving Martin Marietta in the small minority with Holcim in exercising restraint.
The biggest risks to our Compass Minerals thesis are lower SOP prices and weak demand and sales volumes for highway deicing salt. In a low-SOP-price and low-salt-demand scenario, we think Compass Minerals' shares would be worth only $68 each. SOP prices should track muriate of potash, or MOP, prices. SOP is a substitute for MOP, and MOP is a feedstock for the world's highest-cost SOP producers. Therefore, MOP prices are the key determinant of SOP prices. Producers of potash benefit from an industry oligopoly, which we think will allow potash prices to remain well above marginal costs of production over the long term. The prospects for new entrants to materially penetrate the market are fairly low, with BHP Billiton (BHP) as the most notable possibility. If this mining giant is able to bring meaningful production to market -- or acquire a large incumbent -- the company could put downward pressure on potash prices by operating at full capacity without regard to market conditions. That said, major greenfield development projects still have hurdles to cross, with large projects currently scheduled for the back half of the decade.
The biggest risk to our theses for Martin Marietta and Vulcan Materials is lower demand for aggregates than what we envision. Both companies have seen a precipitous decline in sales volumes since the last peak. If volumes don't recover to the level that we expect, the companies' shares won't appreciate as we expect them to. Our low-case scenario for each company takes a 20% haircut to our base-case volume projections. Our low-case fair value estimate for Martin Marietta is $78 per share, and for Vulcan Materials it's $42 per share. We think it's unlikely the two companies will face minimal demand growth over the next five years, which is what our low-case scenarios imply. Demographic trends bode well for a recovery in residential construction activity, and indicators have improved for commercial construction activity.