Building and Construction: Value Opportunities in Industrials

by: Alan Brochstein, CFA

Last week, I wrote about one of my favorite segments of the market when I discussed "Betting Big on Small Industrials." I described how my Top 20 Model Portfolio is absolutely stuffed with Small-Cap Industrials. When I wrote last week, we were at 38% Industrials, but we added another name on Friday, bringing the overall exposure now to 41%. As I said then, you don't beat the market by mimicking it. As has been typical since our May 2008 launch, I have moved the model towards parts of the market that are the most attractive. Perhaps this is a little extreme!

This week, I want to focus on a theme underlying my interest: Many of these are beaten up not because they are bad companies, but rather the industry is currently suffering. Patient investors will most likely be rewarded when the environment improves. It may take a while before the actual fundamentals show up in the bottom-line, but, by then, the bargains will be gone. I mentioned Apogee (NASDAQ:APOG) in the post last week, for instance, and it surged this week on news that a leading indicator of commercial construction showed some strength.

I ran a screen for all U.S. stocks in three Industries: Buiding Products, Construction Materials, and Construction and Engineering. Talk about tough times! The 53 names that have market capitalizations in excess of $100mm are down an average of 15% so far in 2010. A few are working, but they seem to have the benefit of being focused overseas. Many of these companies are leveraged to U.S. commercial construction.

To see what looks "cheap" among the 53 names, I ran some additional criteria:

  • EBITDA Margins < 1.2X 5yr Average (Depressed or in-line margins) - this dropped us to 30
  • P/TB < 3 (Value) - this dropped us to 21
  • Net Debt to Capital < 30% - this dropped us to 19

Here are the 19 names that made the list (click to enlarge):

Build and Construct
Several Observations:

  • Similar to the larger universe, the stocks are down hard in 2010 at -12%
  • I ranked them by recent EBITDA margin relative to 5 year average - several are well below average
  • On the other hand, some of these have held margins up despite challenging top-line _-9% y-o-y in last 4 quarters on average
  • No "Materials" companies made the cut (Note: Vulcan (NYSE:VMC) is a prime example of still too expensive, though it seems perhaps washed up)
  • 9 of the 19 trade at <1.5X Tangible Book Value
  • 13 have more cash than debt
  • 14 trade at a Price/Sales ratio below the 5-year median

Since 3 of my 9 Industrial names of the total of 20 names in my Top 20 Model Portfolio are listed above (so 15% of the portfolio), I obviously think that these names are worth investigating. Additionally, I met with management in June at Layne Christensen (NASDAQ:LAYN) and liked what I heard a lot. They have some exciting things going on, but they need to see new construction to improve things in their water infrastructure business. They are the ones who rescued the Chilean miners, by the way. They could also use a boost to natural gas prices. It is in my 100-stock Watchlist. It appears to me, though, to be a good entry, though perhaps early.

The stocks in the model portfolio are Orion Marine (NYSE:ORN), Apogee (APOG) and Insteel (NASDAQ:IIIN). I detailed my view last week on APOG:

A final characteristic is that some of the names may be "late cycle" to some degree. The best example is Apogee, which caters to the commercial construction market (particularly office buildings). Investors are not so interested today in waiting for signs of recovery there, but it seems like the low valuation affords patient investors a low-risk ability to wait for that inevitable improvement.

I have previously shared my views on ORN, which continues to look like it has been a bit too optimistic in the near-term. The pot of gold at the end of the rainbow is the work that they will be doing over the next several years in response to the widening of the Panama Canal. In the near-term, though, they are suffering from some competition from land-based construction companies (bridge work). I admire the company for not caving in on pricing, but it is clearly hurting near-term results. The stock got a nice jump from depressed levels when Obama lifted the moratorium on drilling, but a couple of broker estimate revisions and negative near-term commentary have taken the wind out of its sails. This is a slightly below -average position in the Top 20 Model, and I hope to add more after they report on 11/4.

We just added IIIN after they reported. What a terrible quarter and outlook! This is an excellent company trying to sell ice to Eskimos apparently. The valuation looks compelling to me, but I am a sucker for a contrarian story. I don't think that it will take much sales growth to generate huge earnings gains. I can see the company doing $1 per share when it gets back to $250mm in sales. At $9, and after subtracting net cash of $2.60, this is <7 PE on a number I think that they print in 2012. The stock trades very close to TBV. This is a classic example of sales and earnings plunging and the P/S ratio falling way too much.

I don't know that all 19 of these stocks will work and note that some already are (two are up more than 33% YTD). I would also note that Northwest Pipe (NASDAQ:NWPX) has an apparent accounting issue. I have looked at some of these - Ameron (NYSE:AMN) just announced a one-time dividend and has looked interesting to me. I have looked at Griffon (NYSE:GFF) and concluded that they are likely to sell the company. I wish that I had more time to look into all of these more closely. Let me know your thoughts if you are familiar!

Disclosure: Long APOG, IIIN and ORN in the Top 20 Model Portfolio