By Min Tang-Varner
As construction-related companies wrap up an eventful summer season interrupted by hurricanes, flooding, drought, fire, excessive heat, and other natural disasters, we think the modest demand gains driven by the traditional seasonal uptick may not be enough to alleviate the underlying weak work flows these companies are facing. Overcapacity remains stubbornly high, and we still anticipate some further weakness in the near term. The tepid construction environment has led to a record level of unemployment in the industry and unprecedented belt-tightening across the board during the past couple of years. Although most of the industrial sector in the U.S. economy enjoyed at least a couple quarters of upbeat earnings and expanding margins, the engineering and construction industry and building materials companies have been in solid recession territory throughout the year. One of the most troubling indicators is the perceived deterioration in public infrastructure market conditions. The spread between infrastructure work that needs to be done and the availability of public financing remains wide, and sentiment supporting spending has become weaker since the most recent raucous debt-ceiling debate. The reading of one leading indicator -- the Architecture Billing Index--has not been supportive for the industry development six to nine months down the road, consistent with the weakness in sentiment for construction activity.
The Highway Bill has been extended through March 31, 2012. The Highway Trust Fund was created in 1956 as a dedicated funding source for building and maintaining the nation's transportation system with user fees. Prior to the HTF program, the federal government funded highway construction through general funds (general tax receipts, including income taxes and fuel taxes). The dedicated source of HTF funding is fuel taxes, which include the 18.4 cents per gallon gasoline tax and the 24.4 cents per gallon diesel tax. All of the tax rates were last updated in 1997 and have not been indexed for inflation or subject to change since. We're currently operating under the eighth extension of SAFETEA-LU, the highway bill that was signed into law in 2005 and originally was set to expire on September 30, 2009. SAFETEA-LU, which is the guaranteed minimum funding for highway, safety, and public transportation for the 2005-10 period, totals $244.1 billion (averaging $40.67 billion per year). In the past few years, spending levels have actually not been fully supported by fuel taxes, requiring the federal government to transfer money from the general fund every year to make up the difference. In mid-September, Congress extended SAFETEA-LU through March 31, 2012, after much 11th-hour wrangling between the two major political parties. The new short-term extension should give politicians additional time for further negotiation before deciding on a new multiyear bill. However, the gap between the two parties has never been wider, which may mean another round of wrangling or even another extension. The current extension calls for the same level of funding for highway transportation, and the next step is for Congress to appropriate the authorized funds.
Neither proposal for the next highway bill contemplates an increase in fuel taxes. The gap between the Democrat-controlled Senate proposal and the Republican-controlled House proposal is very wide. The Senate is proposing a two-year, $109 billion bill, which essentially maintains the current spending level, but will likely fully deplete the HTF without general fund transfers. The House is proposing a six-year, $230 billion bill, which amounts to roughly $38 billion/year--a whopping 36% below the Senate bill (and 18% below the previous authorization without adjusting for inflation). This proposal would maintain the HTF a nominal surplus and requires no general fund transfers. In our opinion, the Senate bill represents the best-case scenario in the current political environment, albeit for only two years, while the House bill would likely spell some deep trouble for infrastructure contractors and building materials companies. The two-year Senate bill would give Congress and the industry time to develop more creative ways for financing highway construction, which is critical as long as raising fuel taxes remains off the table.
Funding our future transportation system with fuel taxes is a risky proposition due to increased fuel-efficiency requirements and fluctuating fuel demand. Fuel consumption is influenced by a number of factors, including fuel prices, fuel-efficiency standards, and general economic activity. These factors do not bode well for the concept of fixed fuel taxes funding highway construction. And as construction materials (such as steel, aluminum, cement, and wood) increase in price, we are looking at a real loss in purchasing power for infrastructure spending. If there is no change to the funding mechanism, we think this trend will likely result in the number of projects declining precipitously in the long term.
We think the public-private financing model should be greatly expanded to fill up the gaping funding hole. In addressing the pending need to stimulate out of a double-dip recession, the Obama Administration proposed to set up a $105 billion infrastructure bank that leverages federal money with private money for infrastructure projects. We have long championed the idea of a public-private financing model as a great compromise for rebuilding domestic infrastructure projects during the time when government finances are stretched. The public-private model (also known as the public private project, or PPP) uses government money or E&C contractors' equity as a source of seed money and finances the entire project with low-cost private money, then relies on tolls or other user fees to service the loan. The PPP financing model is widely embraced in Europe, Asia, and Canada, but has not been very popular in the domestic U.S. market. However, the I-Bank idea is already in use at a much smaller scale under the Federal Highway Administration, which runs the TIFIA (Transportation Infrastructure Financing and Innovative Act) program. This program provides federal funding by leveraging 10 times with private money to help finance large-scale surface transportation projects. According to the FHA, each federal dollar can provide up to $10 in TIFIA credit, which has a larger multiplier effect than the traditional transportation match of state and federal money. Similar to the Build America Bond program, the federal government can entice state and local governments with low interest rates (which, as of August 19, stood at 3.42% for a 35-year for a TIFIA loan), making it an attractive funding stream for large, long-duration infrastructure projects. We think the I-Bank should broadly open up the access to the public-private funding stream much more than TIFIA, which is reportedly over 12 times subscribed. Companies such as AECOM (ACM), SNC-Lavalin (SNCAF.PL), and Fluor (FLR) are active in project financing related to large-scale projects, and we think if the I-Bank idea is enacted, they will be at the forefront benefiting from this new initiative.