Martin Marietta: Valuation Indicates Upside

| About: Martin Marietta (MLM)

Summary

The company's top line is benefiting from rising construction activity.

Top-down margin accretion from overhauling of internal operations.

Buy call with a target price of $211 per share till Jun'17.

Martin Marietta (NYSE:MLM), being suppliers of aggregates and heavy building materials with operations in 26 states, is one of the largest suppliers of building products in America. The company supplies its product mainly to road, sidewalks and foundations construction, making it an ideal entity to benefit from the upswing in public and private construction. The recent passing of the FAST act would further provide the impetus for the top line of the company.

The company is enhancing its capacity through both internal expansion and external acquisitions. This characteristic of MLM would create greater future value for the firm, as the utilization rate would increase in the rising construction environment.

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The surge in the revenue was primarily due to rising volumes coupled with soaring prices of aggregates and materials. Further, as the above graph depicts, there has been a steady swell in the revenues of the firm, and going forward, I expect the ascent in the revenue would continue in double digits at a 3-year CAGR of 13% owing to the burgeoning construction activity.

Moreover, the bottom line growth of MLM is not merely driven by the top line but also through top-down margin accretion. As the below graph illustrates, expansion has been occurred in both gross and operating margins on the back of suppressed input prices coupled with the higher efficiency of new operations. The measures that contribute to the internal operating efficiencies are:

Productivity improvements through setting of additional rail car replacement of haul trucks with conveyor systems resulting in efficiency gains and enhancement in cement productive capacity through efficient and planned maintenance of the kiln.

Primarily due to the reasons listed above, I expect earnings to grow at a 3-year CAGR of 20% against the revenue 3-year CAGR of 13%. The below graph shows my future assumptions of EPS, where the number of shares outstanding is constant.

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Moreover, by improving administrative efficiency, MLM was able to bring down SG&A expenses to sales ratio. Thus, this has provided a further boost to the expansion in the net margins of the company. I expect the SG&A expense to remain constant at a normalized rate of ~6%, owing to a limited efficiency that can be achieved by a firm in administrative matters.

Additionally, the company has also witnessed a remarkable improvement in managing its working capital investment as the below graph shows. This can also be confirmed by applying formulas of WCI to sales ratio and cash conversion cycle. If we dig further into detail to find out the reason for improvement in these ratios, then we would come to know that the company has significantly drawn down the inventory stock when compared to sales. For additional detail, see the graphs below.

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In addition to the above-mentioned paragraph, the graph below illustrates an interesting relationship. The current ratio has declined from 3.78x in FY11 to 2.95x in FY15, while in the same period the quick ratio rose from 1.32x in FY11 to 1.58x in FY15. The inventory per unit of sales has dwindled owing to its efficient management by the firm, saving the company in terms of storage costs.

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Further, the company is consolidating its financial statement by reducing the debt-to-equity ratio and increasing its ability to pay a fixed charge on debt instruments. I opine that going forward, the company might continue to deleverage itself until the point of optimum weighted average cost of capital (WACC).

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The following are the historical and forecasted financial statements:

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Valuation

Right now, if you consider the conventional principle of finance and apply it, then you would come to know that the company is not making future value for its investors, as its cost of equity is minutely greater than the return on equity. But I opine that, the future return on equity of the firm would be greater than its required return primarily on the back of double-digit expansion in earnings.

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However, as the below graph depicts, it is interesting to note that the company's payout ratio has drastically declined on the back of rising earnings coupled with the policy of same constant dividend. This policy has increased the firm's cash flow per share, strengthening its liquidity position together with a strong balance sheet footing.

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MLM is trading at a P/E ratio of 37.13x against the construction sector P/E of 37.5x, approximately at par with the construction sector multiple. Going forward, I expect the company's dividend yield to shrink owing to the constant dividend policy of $0.4 per share.

Using the discounted cash flow method as illustrated below, I have a "buy call" on MLM with a target price of $211.39 per share until Jun'17, giving an upside of ~9.45% to the current closing.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.