VMC MATERIALS IS A SUPERIOR 10 YEAR "BUY & HOLD"
Since the 2008 financial crisis and the original fiscal stimulus package, most subsequent economic policy has come from Central Banks via interest rate reductions and QE policies. Fiscal stimulus has been a drag. We have slogged through 10 years of real GDP growth of roughly 2%. Monetary policy seems to be "out of bullets" and perhaps monetary models are not accurate when a society has aging demographics. Central Bank leaders repeatedly have requested "Fiscal" help.
"Infrastructure" investment is gaining as a socially and politically acceptable form of investment. The Parties agree that our Nation's infrastructure is aged and lagging. All agree that this fact worsens competitiveness. All agree that Infrastructure investment drives high paying middle class and blue collar jobs. Candidates Clinton, Trump and Sanders propose large spending programs. Last year to much surprise, a major infrastructure finance bill passed Congress on a bipartisan vote. This year 26 states are aggressively accelerating state spending. The Federal and State governments and the major political candidates as well as the voters are all demonstrating a strong willingness to fund a sustained commitment to investing in the infrastructure of our country.
The period 2016 - 2026 will be a time when the United States chooses to invest in itself. It will be the Infrastructure Era. Aggregates - crushed stone - are literally the foundation of the Infrastructure Era. Despite some modest recovery since mid 2011, aggregate consumption of about 180 million tons in the US remains at just above 55% of prior early 2000s cycle peak of about 300 million tons and well below "normal" consumption of 255 million tons. The major consumers of aggregates - housing, public and private construction - all remain well below trend.
After years of frustration and poorly designed funding, in late 2015 a long-term, fully-funded highway bill became law. The "FAST" (Fixing America's Surface Transportation) Act is one of few bi-partisan policies. FAST gives states the certainty and visibility that they have long needed to plan, design and build highway projects. As a result, at the state level, Goldman Sachs has identified a major inflection in state highway spending, with 2016 budgets now expected to rise by 7%. This inflection is likely the beginning of a decade of better spending.
In Infrastructure Era, Aggregates become the compelling asset to own. VMC Materials is the near pure play public aggregates company.
A link to a discussion on infrastructure is attached as an addendum at the end of this presentation.
VMC is the largest pure play aggregates company in the US. Aggregates are used in public and private infrastructure, non-residential and residential construction. Business volumes in aggregates are strongly impacted by construction activity which is cyclical. However, given that aggregates are high weight:value commodity, transportation costs prevent an outside player from economically importing aggregates into the local market. Therefore, competition is very limited, and local markets tend to consolidate to 2-3 players.
Each local market becomes a quasi monopoly with significant pricing power. VMC's prices actually went UP during the 2005 - 2009 construction recession even though unit volumes went down about 50%. Aggregates is a high barriers to entry; quasi monopoly business with pricing power and incremental margins of 60%. VMC has a 15 Billion+ ton reserve base (75+ years) located in states which will represent nearly 80% of all net projected US population growth over the next decade.
Assuming 6% pricing and 5% unit growth compounded over 10 years at an incremental margin of 60%, VMC EPS will compound from roughly $4 in 2016 to nearly $30 in 2026. The business will generate approximately $16 Billion of cash on a cumulative basis as compared to a current enterprise value of about $17 Billion. The business would still have 65+ years of reserves "for free." At "normal" demand and prices, VMC believes that the reserve base has a theoretical gross margin dollar potential of approximately $135 Billion. In short, VMC is a very valuable asset.
These estimates simply put the Aggregate industry back on a "normal" long term demand & pricing curve and apply incremental margins. These estimates do not get the industry back to past prior peak unit volumes and would not truly capture a Trillion $ fiscal stimulus package. It is the power of pricing power compounding at the incremental margin.
Source: Company IR website
1. INDUSTRY & MARKET OVERVIEW
Nearly all Aggregate markets are local. Pricing is set locally. Generally 2-4 players compete. Originally, the businesses were family owned, and the industry structure remains fragmented. Larger players seek to buy smaller players in local markets in order to consolidate and control pricing. Larger players will buy bigger private players to gain entry into new markets perceived to offer good demographics. "Good" markets are dictated by growth dynamics related to net population and business migration as well as the State support of Highway construction. Geology ranges markedly.
Source: Barclay's Research Report
There are limited substitutes for quality aggregates. Recycled concrete and asphalt have certain applications as a lower-cost alternative to virgin aggregates. However, due to technical specifications many types of construction projects cannot be served by recycled concrete, but require the use of virgin aggregates to meet specifications and performance-based criteria for durability, strength and other qualities.
Source: Company IR website
VMC serves both the public and the private sectors. Public sector construction activity has historically been more stable and less cyclical than privately-funded construction, and generally requires more aggregates per dollar of construction spending. Private sector construction (primarily residential and nonresidential buildings) typically is more affected by general economic cycles than publicly funded projects (particularly highways, roads and bridges), which tend to receive more consistent levels of funding throughout economic cycles.
PUBLIC SECTOR CONSTRUCTION Public sector construction includes spending by federal, state, and local governments for highways, bridges, buildings and airports as well as other infrastructure construction for sewer and waste disposal systems, water supply systems, dams, reservoirs and other public construction projects. Construction for power plants and other utilities is funded from both public and private sources. In 2015, publicly funded construction accounted for approximately 49% of VMC total aggregates shipments.
PUBLIC SECTOR FUNDING: Generally, public sector construction spending is more stable than private sector construction because public sector spending is less sensitive to interest rates and has historically been supported by multi-year legislation and programs. Some 35% of transportation projects are federally-funded, with special emphasis given to the largest and most complex projects. The long-term nature of such legislation is important because it provides state departments of transportation with the ability to plan and execute long-range, complex highway projects. Federal highway spending is governed by multi-year authorization bills and annual budget appropriations using funds largely from the Federal Highway Trust Fund. This Trust Fund receives funding from taxes on gasoline and other levies. The level of state spending on infrastructure varies across the United States and depends on individual state needs and economies. In 2015, approximately 26% of VMC aggregates sales by volume were used in highway construction projects.
FEDERAL HIGHWAY FUNDING: On December 4, 2015, the President signed Fixing America's Surface Transportation Infrastructure Act (FAST Act) which received strong, bipartisan support in both the House and the Senate. The Federal-Aid Highway Program is the largest component of the law and has provided, on average, 52% of all state capital investment in roads and bridges over the last 10 years. The FAST Act also contains important policy changes. To further accelerate the project delivery process, it augments the environmental review and permitting process reforms contained in the prior law.
WATER INFRASTRUCTURE: In 2014 Congress created a five-year pilot program to promote private sector participation in water projects: the Water Infrastructure Financing and Innovation Act (WIFIA). Modeled after the highly popular TIFIA program in the surface transportation sector, WIFIA allows for federal credit assistance to water resources projects in the form of low-cost loans, loan guarantees and lines of credit.
PRIVATE SECTOR CONSTRUCTION The private sector construction markets include both nonresidential building construction and residential construction and are considerably more cyclical than public construction. In 2015, privately-funded construction accounted for approximately 51% of our total aggregates shipments.
NONRESIDENTIAL CONSTRUCTION: Private nonresidential building construction includes a wide array of projects. Such projects generally are more aggregates intensive than residential construction. Overall demand in private nonresidential construction generally is driven by job growth, vacancy rates, private infrastructure needs and demographic trends. The growth of the private workforce creates demand for offices, hotels and restaurants. Likewise, population growth generates demand for stores, shopping centers, warehouses and parking decks as well as hospitals, churches and entertainment facilities. Large industrial projects, such as a new manufacturing facility, can increase the need for other manufacturing plants to supply parts and assemblies. This end market also includes capital investments in public nonresidential facilities to meet the needs of a growing population. Nonresidential construction is expected to continue to be a stable source of volume growth to meet the needs of a growing population.
RESIDENTIAL CONSTRUCTION: The majority of residential construction is for single-family houses with the remainder consisting of multi-family construction. Public housing comprises only a small portion of housing demand. Household formations in VMC markets continue to outpace household formations in the rest of the United States. In 2015, total annual housing starts increased to more than 1.1 million units. The growth in residential construction bodes well for continued recovery in our markets.
Source: Company IR website
2. LONG TERM EARNINGS POWER - A RETURN TO "NORMAL"
Source: Company IR website
The Vulcan business model is relatively simple: historically, pricing has always been positive as those who need aggregate must pay the required price. However, there is a balance between the rate of change in pricing and unit volumes particularly early in the cycle as builders begin to bid jobs. Unit growth leads to firmer pricing over time. Overall, the Aggregates industry needs to grow between 40% - 50% cumulatively to reach "normalized" demand. This "normal" number essentially draws a trend line across long-term demand and assumes that the early 2000s housing bubble is a non-repeatable period. There is no assumption for an acceleration of a major US Infrastructure program. If one purchased VMC today with run rate industry Aggregate Units at about 180 million tons, then it takes about 5.5% compounded unit growth to get back to "normal" in 7 years across the entire nation. VMC serves faster growth markets and is likely to grow units faster.
Source: Company IR website
Since 2004, VMC price increases have averaged 5.1% per annum. These increases include a period when the industry went through a major unit volume disaster. Given expectations for accelerating unit volumes and current prices trending towards double digits, a 10 year pricing assumption of 5% compounded seems rational. For historical context, since 1945 pricing in aggregates has improved every year except 5 years with the worst decline 2.7%.
Model & Assumptions
Source: Company IR website
Note: VMC guides to incremental gross margins of 60%. Using the chart above, the Company estimates gross margin dollars at "normal demand" would be $2.1 Billion. The Company vaguely guides for EBITDA > $2 Billion at normal demand. Using VMC numbers, the 15 billion tons of reserves would theoretically have gross profit earnings potential of $124 Billion. These numbers substantially under estimate the earnings potential in the business model.
3. THE VMC BUSINESS MODEL ANALYSIS
When projecting a business 10 years out, we are not attempting to go to the second decimal point precision. Our training is to try to "see the forest through the trees." We recognize that if we were acquiring a company in an LBO or buying a stock in a nearer term circumstance, the modeling would require a different form. We are simply looking to understand the long term EPS and Cash Flow power of the business using simple assumptions.
With respect to VMC, the core assumptions are:
The business will grow units at 5% compounded The business will raise prices at 6% compounded Revenue will fall through at an incremental gross margin of 60% SG&A expenses will inflate by 4.5% per annum compounded Cap Ex begins @ 9% of sales and ramps down to 7% as the cycle extends A portion of free cash will reduce share count modestly, but the majority will simply build on the balance sheet. In the real world, VMC will likely use free cash to buy smaller competitors.
These assumptions produce a scenario where VMC's EPS grow from $4 in 2016 to $30 in 2026. Free cash ramps from $3 to $29. Aggregates requires little if any working capital. Cumulative cash generated is $17 Billion.
The key assumptions in the compounding series are: (1) no significant recession during the 10 year time frame; (2) the incremental margin of 60% can be sustained throughout the period. At 5% unit growth, the model gets demand back to "normal" between years 7 & 8. At that point, the US will have been running for several decades below normal levels of infrastructure spend. If recession comes prior to that point, then the probability of a major infrastructure spending response increases significantly. Most industry experts regard the 5% unit growth forecast in the next 5 years as likely too low. Few have projected out past Year 5. It is possible that a "down" unit year happens somewhere between years 1 -7, but it is also probable that a fiscal response would put the industry back on trend. As for pricing, VMC's pricing is currently running higher than 6%. In a sustained +5% unit growth climate, pricing should sustain in the mid single digits.
It is difficult to sustain incremental margins at 60% for a decade. It is our experience that businesses do not sustain at the incremental margin forever. To test the EPS & Cash Flow power if incremental margins are less aggressive, the same basic assumptions are presented at a 50% incremental margin. Under this scenario, EPS grows from $4 to $26 per share and FCF from $3 to $25 per share. Cumulative cash generated is $14.9 Billion. Surprisingly, the change in incremental margin from 60% to 50% does not fatally detract from the investment if all else is held constant.
Our projections for VMC at "normalized" levels appear about 25% higher than VMC soft guidance based on VMC's gross profit per ton slides. We believe that if it takes about 7 years to compound at 5% units and 6% price at a 60% incremental margin, then Gross Profit per ton will be closer to $10 than $8. Of course, perhaps VMC in contemplating a faster ramp in Units and a slower ramp in price. We think that the slides are mostly meant to be roughly illustrative of the economics and confirm the notion of the underlying economic leverage in the business.
4. RESERVE BASE
The Aggregates industry does not value itself on an NAV basis relative to reserves as does the Oil & Gas industry. The value of aggregate reserves ranges by geology, cost of transportation, economic vibrancy of the served market and the market competitiveness (pricing). However, reserves still connote value and duration to the investment particularly in a case such as VMC which is a geographically diversified player.
VMC has 15.7 billion tons of proven and probable aggregates reserves. Depletion is running at about 100 million tons net of green field development. The Company also adds to the reserve base via acquisition.
According to the VMC 10K, estimates of reserves are of recoverable stone, sand and gravel of suitable quality for economic extraction, based on drilling and studies by our geologists and engineers, recognizing reasonable economic and operating restraints. The 15.7 billion tons of estimated proven and probable aggregates reserves reported at the end of 2015 include reserves at inactive and green field (undeveloped) sites. The table below is taken from the Company's 10K and presents, by division, the tons of proven and probable aggregates reserves as of December 31, 2015 and the types of facilities operated.
5. VALUATION & PRICE TARGET
The purpose of this memo is to identify a buy & hold 10 year investment. Such an investment requires a degree of intrinsic value protection and attractive long term upside. The intrinsic value at VMC is the market position of the business which allows for consistent pricing power. It is ironic that the low tech product aggregates turns out to be proprietary, because rock is sufficiently heavy and costly that outside competitors cannot enter the local markets which become reserve based duopolies.
VMC is a 10 year "buy and hold" investment, because "the big cycle" is in front of the company. The big cycle is the renewal of the US Infrastructure. Applying simple but realistic math to the VMC business model, VMC has the potential to earn $25 to $30 per share in 2026 and generate a similar amount of free cash flow. Terminal EBITDA should be between $4.9 and $5.8 B. Cumulative cash generated should be between $14 and $17 B. Assuming that $10 billion pays off all debt and buys back 20 million shares (average price $350), the balance sheet has about $7 billion remaining at the end of 2026. In practice, the Company will employ cash to buy other companies.
VMC is generally valued on an EV/EBITDA basis. By 2026, one can assume that a cycle is full and interest rates are higher than today. At 10x EV/EBITDA, VMC would trade at $560 per share an approximate 17% compounded annualized return. The return is depressed by the assumption that the terminal value at 10x is lower than today's current 14x EV/EBITDA trading multiple. Should the stock trade on EPS (it does not currently trade on EPS), then at a 15x P/E, the Company would trade at $450 though the share count would likely be reduced materially by the significant excess cash on the balance sheet.
6. Why the Valuation Disconnect Between Today's Price and The Future Target Price?
Now that one has slogged through this presentation, the simple question is: if this is such a great business and can be a $500+ stock in 10 years, why is VMC only trading for $117 today?
First, the $500+ price target is a 10 year forward price target which is a 17% compounded return for a growth cyclical business. If we said that our minimum hurdle rate for this type of investment is 12%, then the current price of the stock should be about $180. The stock is mispriced today, but it is not worth $500+ today.
Second, the assumptions are positive assumptions. The projections assume that the Infrastructure Era is here. We have actually had some recovery since 2009. Essentially, we assume 17 years of positive unit growth in aggregates. The good news is that this growth never really gets us past prior peaks from the early 2000s. Still, is it reasonable to assume such a lengthy period of positive unit growth? If you put several negative numbers into the compounding series, then the numbers at the end of 10 years will look a lot lower.
Third, it is very hard to run a business at the incremental margin for 10 years. Costs creep in. We have run numbers at a 50% incremental margin also. To our suprise, the numbers remain very compelling. This is a less critical assumption than first thought.
The beta of the stock is 1.4, but practically the volatility is worse as this is a stock which gapped from $107 to $80 during the winter sell-off. People are scared of a major recession in the US. Most investors have one foot out the door most of the time. During the 2007 - 2009 recession, VMC's pricing went up, but units went down 50%. The stock went from $116 to below $30 during the financial crisis. When people are terrified, they rarely think "Cement & Aggregates." No one is prepared to think long term about VMC Materials or an Infrastructure Era. That is the investor disconnect.
The next time we get in trouble there is no Monetary way out of trouble. There will only be a Fiscal approach. We will be building every road, bridge and tunnel we can imagine. Many of us believe that Infrastructure stocks will prove oddly counter cyclical in that scenario.
Introduction: Why Infrastructure Matters: The Brookings Institute
What the Presidential Candidates Need to Know about Infrastructure: http://www.brookings.edu/~/media/research/files/papers/2015/11/campaign-2016-ccf/galston-puentes_final.pdf
Since the beginning of our Republic, infrastructure-starting with transportation and water management-has played a central role in advancing the American economy. From the railroads that linked the heartland to industrial centers to the interstate highway system that forged regional connections, a sharp focus on prioritize, strategic, and rational infrastructure investments underscored periods of regional growth and national prosperity. But what the United States once understood, we seem to have forgotten. During the past three decades the United States has significantly under invested in infrastructure. This shortfall has made it difficult to maintain existing infrastructure assets and impossible to create a globally competitive system. Our failure to meet long-term infrastructure requirements has impaired economic efficiency, impeded the creation of stable middle-class jobs, and slowed our response to the threat of climate change. It also is imposing direct costs on individuals and businesses. Several studies have documented sharply higher costs for vehicle maintenance and have attributed much of that increase to poor road conditions. Our nation's infrastructure is in desperate need of upgrading and modernization. From highly publicized bridge collapses and levee breaches to airport delays and traffic congestion, every American has experienced the frustration-and in some cases the dangers-of aging, overcrowded, under-maintained facilities. Closing the infrastructure investment gap would have at least four beneficial consequences. First, it would boost the creation of jobs that often provide middle-class wages and opportunities to workers with modest levels of formal education. Second, it would enhance economic growth by decreasing overhead cost to business while efficiently moving people, goods, and ideas. Third, it would better connect households across metropolitan areas to higher quality opportunities for employment, health care, and education. Fourth, it could reduce greenhouse gas emissions while helping to protect the nation from an increasingly unpredictable natural environment. For these reasons, among others, presidential candidates would be well advised to address infrastructure issues. The Problem "In a growing economy," a Congressional Research Service paper notes, "infrastructure should hold its own, but other data show that that has not been the case. While total government spending on infrastructure adjusted for inflation increased from $92 billion in 1960 to $161 billion in 2007, it actually declined from $1.17 per capita in 1960 to $0.85 per capita in 2007."i According to one expert, "from 1950 to 1970 we devoted 3 percent of GDP to spending on infrastructure….[s]ince 1980 we have been spending well less than 2 percent, resulting in a huge accumulated shortfall of needed investment."ii Just since 2002, CBO estimates, inflation adjusted spending for highways at all levels of the federal system has fallen by 19 percent.iii The problem runs from top to bottom. Political wrangling and dysfunction mean that the federal government has ceased to be a reliable partner and effective leader. Furthermore, the rise in federal interest payments, the increase in entitlement spending, and the decline in traditional sources of government revenue, such as the gasoline tax, mean that competition for limited resources is fierce.
Disclosure: I am/we are long VMC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.