The Right Materials for Building a Recovery

We think aggregates producer

For nonresidential construction, we forecast 4% average annual nominal growth over the next decade, including higher near-term growth as pent-up demand is unleashed in certain sectors. Our nonresidential forecast is more moderate than most--we expect that efficiency gains, the ability to do more with a smaller construction footprint, will lead to nonresidential construction’s declining share of GDP. However, we think aggregates and cement companies have a disproportionate exposure to higher-growth sectors, such as manufacturing and highway and street.

For residential construction, we forecast housing starts rising to 1.9 million by 2019, and the best decade for new residential construction since the 1970s. The next decade will see millennials, the largest generation in U.S. history, form households and buy their first homes. So far, a toxic combination of consumer debt, underemployment, weak wage growth, and tight underwriting has undermined this demographic's potential and stalled a full housing recovery. In the process, an enormous amount of pent-up demand for housing has been created. We expect tighter labor markets and looser mortgage eligibility standards to unleash much of it. Although less aggregate- and cement-intensive, residential construction growth should still provide a tailwind to demand over the next decade.

Robust Demand in Both Public and Private Sectors We forecast strengthening construction demand growth for the public sector and modest growth for the private sector. Accounting for roughly half of shipments, public-sector demand is generally more stable, and projects are more aggregate-intensive. With most funding coming from government sources, demand is less volatile even during weak economic cycles. Almost half of shipments go to highway construction, and these projects have historically been less prone to partisan politics. Yet, Federal Highway Trust finances have weakened over time, as the $0.18 tax per gallon of gasoline that funds it has not been updated since 1993. Lower fuel consumption due to improving mileage and less driving has further sapped funding stability. Though we can't predict when a bill will be passed, we expect that a longer-term solution will be passed in the medium term. Given the direct impact poor infrastructure has on constituents' daily lives, we don't think government officials could continue to use infrastructure as a political football. We expect public-sector nominal demand growth to increase to 5%, compared with the historical average of roughly 4% per year, as higher funding levels are needed to maintain current road conditions.

Private-sector demand consists of residential and nonresidential construction, including commercial and industrial properties. Market demand is highly affected by general economic cycles, including employment growth and lending markets. Nonresidential construction is much more aggregate-intensive than residential construction, and is the key driver for private-sector aggregate volumes. We forecast robust nonresidential demand growth in the near term, after which we expect nominal demand growth to slow to 4%, compared with the historical average of about 5%-6% annually. We expect many key sectors to make more efficient use of their construction spending, weighing on future demand growth.

Texas Industries Acquisition Yields Synergies Our fair value estimate is $168 per share. Our expectation that aggregates shipment volume will grow to about 212 million tons within our five-year explicit forecast period is due not only to recovering construction demand, but also the inclusion of Texas Industries, acquired in 2014. This estimate compares with sales of 154 million tons in 2014 and peak sales of 226 million tons in 2005, including volume from Martin Marietta and Texas Industries.

We expect that Martin Marietta’s gross margin excluding freight and delivery will improve to 32%, compared with 19% in 2014 and a recent peak of 29% in 2007. Our margin forecast is based on medium-term price increases outpacing cost inflation, higher volume providing some leverage over fixed costs (mostly depreciation, depletion, and amortization), and synergies from the Texas Industries acquisition. In addition, we believe Martin Marietta’s significant exposure to high-growth states Texas and California will drive the company’s revenue growth and margin improvement. We assume a cost of equity of 11% and an exit multiple of 9 times enterprise value/EBITDA.

Barriers to Entry Strengthen Economic Moat We maintain our narrow economic moat rating. Aggregates typically sell for roughly $10 or more per ton, leading to an extremely low value/weight ratio. Given the location of quarries, more than three quarters of aggregates ship by truck. Transportation by truck costs roughly $0.15-$0.35 per ton per mile, limiting the potential range of deliveries to roughly 70 miles or less before transportation costs begin to outweigh the cost of the aggregate itself. With most lacking efficient water or rail alternatives, markets tend to be extremely localized, with high barriers to entry for imports from outside markets. Furthermore, while populous metropolitan areas are the centers of construction activity, new quarry permits are difficult to obtain as a result of not-in-my-backyard tendencies.

Even at peak production levels, Martin Marietta has more than 50 years of aggregates production at current reserve levels. In addition, because we do not anticipate the importance of aggregates in construction to diminish, transportation costs to fall, or new quarry permits to become easier to obtain, we think Martin Marietta’s competitive advantage is sustainable for more than 10 years.

While we think Martin Marietta’s aggregates business is moatworthy, we do not think its specialty products business operates with a sustainable competitive advantage. The segment sells magnesia-based chemical products and dolomitic lime to a variety of industries. We don’t think this business enjoys the barriers to entry that protect the company’s aggregates business, as the location of facilities is not as important and the ability to open new kilns is not as difficult. Nevertheless, as the segment accounts for roughly 10% of the company’s total sales, we do not think the business’s lack of competitive advantage is enough to negate the moat established by Martin Marietta’s aggregates business.

During the most recent construction demand trough, the company failed to generate returns on invested capital in excess of its cost of capital. We think that high capacity utilization will be necessary to generate excess returns. Because we do not have the confidence that demand will be strong enough to reach appropriate levels of utilization throughout the entire construction cycle, we refrain from assigning the company a wide moat at this time.

Management Protects Shareholder Value We assign Martin Marietta an Exemplary stewardship rating. We believe management exercised good stewardship of shareholder capital by avoiding the large, pricey debt-financed acquisitions that many of its peers undertook during peak construction markets before the recession. During the severe downturn in construction activity following this period, Martin Marietta's balance sheet remained relatively healthy as result. For example, while many peers that acquired these expensive assets were forced to cut their dividends during the recession, Martin Marietta has maintained its dividend levels since 2009. We believe that prudence allowed Martin Marietta to acquire Texas Industries in 2014 in a much more favorable M&A environment. Not only do we think the transaction made strategic sense, but we believe management was able to consummate it at good price. Martin Marietta increased its footprint in Texas and entered California--two of the largest and highest-growth construction markets in the United States.

C. Howard Nye was appointed CEO in 2010 and chairman of the board in 2014, replacing Stephen Zelnak, the long-serving former CEO and chairman who had been with Martin Marietta for 33 years. Under Zelnak, the company increased revenue to over $2 billion through more than 70 acquisitions. Nye joined Martin Marietta in 2006 as president and COO. He previously served in a number of positions with Hanson Aggregates North America for 13 years. Given Nye’s prior service as COO under Zelnak and Zelnak’s continued service as a board director, we believe Martin Marietta’s disciplined approach to acquisitions is unlikely to change.