Martin Marietta Has a Solid Foundation for Profit Growth

Instead, we think the fading optimism regarding President Donald Trump’s oft-promised $1 trillion infrastructure plan, which was pushed into the political background by healthcare and tax legislation, is largely to blame.

Regardless, we expect that even without a big federal plan, increased infrastructure spending and rising housing starts will buoy aggregates demand in the years to come, leading to especially strong revenue growth for Martin Marietta, thanks to a geographic footprint dominated by fast-growing and fiscally healthy states. Also, the significant operating leverage inherent to the business should amplify the impact of top-line growth on the bottom line.

While the markets have good reason to doubt that a big Trump plan is forthcoming--details have been scant--a legislative failure won’t be enough to scuttle the growth in U.S. infrastructure spending because the FAST Act secures federal funding through 2020 and states are taking on more responsibilities themselves. We think the market underestimates the growth prospects for aggregates demand and the benefits that will accrue to Martin Marietta’s bottom line, offering investors an attractive entry point to one of the few stocks in the materials sector that combine high quality with high growth.

Consistent Earnings Growth Belies Volatile Share Price Martin Marietta shares trade with greater volatility than one might expect, given the company's steady earnings growth after the Great Recession. In fact, the stock experienced two major pullbacks even though EBITDA continued to rise. The two major share price declines--August 2015 to January 2016 and July 2016 to October 2016--were in response to management's reduced near-term guidance and warning on volume. Notably, both announcements were focused entirely on the near term and should have done little to dent the company's long-term prospects. Accordingly, for longer-term investors, the sell-offs created buying opportunities.

In both cases, shares not only recovered but continued to rise as near-term fears abated. The generally upward trajectory of Martin Marietta’s stock over the past several years has been attributable to a combination of strong earnings growth and improved funding outlook. More and more state and local governments have passed improved funding mechanisms. In addition, the FAST Act, passed in 2015, secured more than $200 billion in federal funding for roads through 2020. These measures give states’ transportation departments funding for more construction projects while they wait for new long-term federal funding. The election of Trump, who touted a $1 trillion infrastructure plan on the campaign trail, generated further market optimism, although this has waned in 2017.

By mid-2017, market valuations for U.S. aggregates and concrete stocks fell, as optimism regarding the likelihood and timing of an infrastructure bill faded. Enterprise value/forward EBITDA multiples faded during the third quarter of 2017 for both Martin Marietta and Vulcan Materials VMC. Yet, in contrast to Vulcan, whose multiple fully recovered, Martin Marietta’s has not. At present, Martin Marietta’s EV/EBITDA ratio trades more than a half turn below early 2017 levels and a full turn below what we think is merited, which creates a buying opportunity.

Martin Marietta’s share price implies a more dour outlook for earnings growth than previously anticipated. However, we think the market is underestimating how well Martin Marietta is positioned to transform still-improving construction demand into massive free cash flow growth. At the heart of Martin Marietta’s free cash flow growth, we estimate that EBITDA will more than double by 2021, driven by volume, price, and fixed-cost leverage.

Volume By 2021, we forecast that Martin Marietta's aggregates shipments will rise to nearly 211 million tons. This is a 33% increase from the 159 million tons we forecast for 2017 but remains below peak shipments of 226 million tons in 2005 (pro forma for the 2014 acquisition of Texas Industries). While we anticipate rising aggregates volume nationwide, Martin Marietta is poised to see outsize growth.

The company has an attractive geographic footprint exposed to fast-growing states that will need additional infrastructure and buildings to support larger populations. Martin Marietta’s aggregates operations focus primarily on Texas, the Denver metro area, Iowa, and the Southeastern United States. The company’s cement operations sit entirely in Texas. Martin Marietta has proportionately greater exposure to fast-growing states than peers Vulcan, U.S. Concrete USCR, and Summit Materials SUM.

Yet population growth isn’t enough to drive actual construction, as underspending and deterioration have become all too common in the U.S. In our analysis, we assign each state a score based on its road construction funding mechanism compared with the other states, taking into account non-gas-tax fee funding mechanisms such as dedicated transfers from other tax sources, any state history of drawing funds away from its highway fund for general spending, and any automatic gas tax adjustments. On this measure, Martin Marietta’s footprint is good but not great, weighed down by Colorado’s poor funding mechanisms.

Offsetting our concern about the funding mechanisms in Martin Marietta’s states is that they are generally in good financial health. These states average a nearly triple A credit rating. States with good fiscal health are more likely to raise taxes to increase road funding, as they’re unlikely to need to raise taxes for other budgetary purposes. Of course, raising too many taxes on constituents is a risk for re-election. Furthermore, healthy states are much less likely to draw from their road funding to shore up general budget shortfalls. Rather, these states have the potential to bolster road spending with general fund dollars. With Martin Marietta weighted toward states with strong need for new roads and with the potential to pay for them, we see a strong foundation for robust volume growth.

Price Amid healthy volume growth, we think Martin Marietta will be able to realize meaningful price increases. We forecast about 5% average annual price increases through 2021, a somewhat slower pace than price increases of 7% and 8% in 2015 and 2016, respectively. The company enjoys barriers to entry in the form of cost advantages and intangible assets related to permitting and "not in my backyard" tendencies. Accordingly, Martin Marietta can introduce large price increases during times of strong demand. Its price increases typically exceed inflation: From 2005 to 2016, the company's price per ton rose more than 70% while inflation rose more than 30%. Martin Marietta raises prices aggressively when demand is strongest. And while the company may not increase prices every year, it rarely lowers them, allowing it to keep most of the gains over time.

Operating Leverage The remainder of EBITDA growth stems from falling incremental unit costs as capacity nears full utilization in Martin Marietta's high fixed-cost leverage businesses. The company's high free cash flow growth rate partially stems from significant fixed-cost leverage. Martin Marietta estimates that roughly 70% of aggregates' direct production costs are fixed or semifixed, likely including a mix of labor and related benefits; depreciation, depletion, and amortization; repairs and maintenance; and contract services.

Fixed costs are even higher in the company’s cement business, as energy costs--roughly 20%-25% of production costs--can also be leveraged across volume. A key step in cement production is the feeding of a limestone mixture through a kiln at a temperature of about 2,600 degrees Fahrenheit (1,450 Celsius), which takes a tremendous amount of fuel. So being able to keep the kiln in continuous production generates even more fixed-cost leverage. By avoiding the costly step of getting the kiln up to operating temperature, higher capacity utilization lowers the effective cost per ton.

Narrow Moat Based on Cost Advantage and Intangible Assets In general, we believe aggregates and cement producers can sustainably extract excess economic returns, which serves as the basis for Martin Marietta's narrow economic moat. This narrow moat augments the company's ability to extract incremental free cash flow when aggregates demand is strong and tends to prop up free cash flows when demand is weak. Martin Marietta earned excess returns on capital in most years, except during some of the weakest construction markets in history in the years after the Great Recession. With our expectation of stronger construction markets to come, we think the company will continue to generate strong returns on invested capital.

Partly because of the widespread availability of rocks, aggregates typically sell for roughly $10-$15 or more per ton (price differences are attributable to local dynamics), leading to an extremely low value/weight ratio. Cement also has a low value/weight ratio, given the widespread availability of its key raw material, limestone. In contrast, a ton of copper would cost $6,000 at current market prices.

Because the materials sell for such a low value relative to their weight, cement kilns and quarries need to be near population centers, where demand is strongest, to minimize transportation costs. In addition, the need to be near populations means most volume ships by truck, which costs roughly $0.15-$0.35 per ton per mile, limiting the range of deliveries to about 70 miles or less before the costs begin to exceed that of the materials themselves.

Though barges and trains are cheaper alternatives, access to waterways and rails is often unavailable. As such, markets rely heavily on trucks and are thus extremely localized. With transportation accounting for such a relatively high share of costs, local companies tend to hold a low-cost advantage that outsiders struggle to overcome.

This advantage is bolstered by high barriers to entry in the form of intangible assets. It’s incredibly difficult, if not impossible, for new competitors to enter established markets. While populous metropolitan areas are the centers of construction activity, new cement kiln and quarry permits are difficult to obtain as a result of not-in-my-backyard tendencies. Residents will typically oppose the opening of a new kiln spewing pollution or a quarry introducing explosion-caused shockwaves in their neighborhoods. Combined with the transportation-based low-cost advantage, high barriers to entry establish markets as highly localized and typically allow the incumbent to generate economic profits.

Accordingly, Martin Marietta can typically raise prices aggressively during periods of high demand. Over the past decade, Martin Marietta raised prices every year except 2010, which followed a year of extreme demand weakness due to the recession. From 2006 to 2016, prices increased 4% per year on average, while volume actually declined 2% per year on average.

We think Martin Marietta’s attractive market position is sustainable because of its significant aggregates reserves. At current production and reserves, Martin Marietta has roughly 100 years of aggregates production and more than 50 years of cement production. In addition, we do not anticipate the importance of cement and aggregates in construction to diminish, transportation costs to fall, or new permits to become easier to obtain. Therefore, we think Martin Marietta’s competitive advantage is sustainable for more than 10 years, a necessary condition for a narrow moat rating.

During the most recent construction demand trough (one of the longest droughts in history), the company failed to generate returns on invested capital in excess of its cost of capital. During slow construction markets, weak demand prevents Martin Marietta from meaningfully raising prices and maximizing capacity utilization. The company struggles to increase prices beyond inflation or achieve high enough utilization to drive high margins during troughs in the cycle. As a result, we’re not confident that demand will be strong enough to reach appropriate levels of utilization throughout the entire cycle. The industry’s high cyclicality and the company’s high operating leverage reduce our conviction that economic profits will, more likely than not, be positive 20 years into the future; this prevents us from assigning the company a wide moat rating.

Few Details, Uncertain Timing on Trump's Infrastructure Plan Increased infrastructure spending is a rare issue that enjoys strong bipartisan support. Yet when it comes to figuring out who pays for that spending, partisan politics return. This has left spending at inadequate levels, leading to the continued decline of aged U.S. roads, water systems, and other infrastructure.

With a Republican majority in both the House and the Senate, there seemed to be few roadblocks to passing Trump’s $1 trillion infrastructure plan, which would be a major boon to aggregates producers like Martin Marietta. But there are a few reasons to doubt a big plan will be passed anytime soon.

The first is funding. Initially, it appeared as if Trump saw public-private partnerships as the solution to partisan bickering over funding. More recently, though, he seems to have lost interest in using public-private partnerships to fund his infrastructure plan. In late September 2017, media outlets reported that he no longer saw public-private partnerships as a solution, believing that the partnerships didn’t work and even citing Indiana’s experiences as evidence (Vice President Mike Pence was a major proponent during his time as governor). For now, it seems that the president would prefer states and local municipalities to pay a larger share for infrastructure, which would continue a long-running trend.

The second is focus. Infrastructure has taken a back seat to the administration’s priorities of healthcare and tax reform. Given the significant challenges and failure to make any major progress on either of these issues, we’re unsure when infrastructure will be addressed. Furthermore, the political battles for healthcare and taxes may leave little political capital when the administration takes up infrastructure.

Third, Trump’s self-proclaimed “infrastructure week” in June was a big letdown, in our view, with no tangible or detailed announcements. Instead, he released a short outline that was light on detail, particularly when it came to the biggest problem--funding. During the event’s initial press conference, all media questions were instead focused on the chaotic neo-Nazi rally and counterprotests in Charlottesville, Virginia, that left one person dead and many injured.

Lastly, while the president passed executive orders to speed up the environmental permitting process and remove former President Barack Obama’s flood requirements, these solutions don’t address the critical issue of funding. Furthermore, improving the efficiency of the federal permitting process isn’t new. Obama passed similar measures, and former President George W. Bush formed a task force to modernize the National Environmental Policy Act. While we appreciate that reducing bureaucracy can help speed up infrastructure projects, it fails to address the country’s bigger problem of underspending.

While a $1 trillion infrastructure plan remains uncertain at this point, we think it doesn’t necessarily matter when a new plan is passed. States have recognized that underspending cannot continue; this is reflected in their increasing share of spending. In addition, the FAST Act, signed in 2015 by Obama, authorized roughly $226 billion for roads through fiscal 2020.

For Building Materials, Recovery Is in Early Stages We think investors should look past the uncertainty surrounding a potential Trump infrastructure bill. Underlying demand is strong, and the FAST Act and bigger state road budgets should provide enough money to boost construction activity.

Following an extended malaise in construction, aggregates demand has finally started to improve in the past few years. But demand remains well below historical norms, which wouldn’t be so alarming if infrastructure weren’t operating well beyond designed lifespans, leading to systemic deterioration.

The problem is most apparent when looking at aggregates consumption on a per capita basis. In theory, consumption per capita should be relatively stable: More people require more housing, buildings for business and services, and infrastructure. However, per capita consumption remains well below the average since 1990, excluding the Great Recession: 8% below average for crushed stone and 17% below average for sand and gravel.

We expect consumption to improve to normalized levels closer to the historical average. However, years of underconsumption have formed a need for additional construction activity to stem systemic deterioration and make necessary renovations, which bodes well for even more aggregates demand. If demand per capita had remained at the average level consumed from 1990 to 2008, we estimate there would have been additional volume of 2.7 billion tons of crushed stone and 2.5 billion tons of sand and gravel. This backlog, equivalent to 1.9 and 2.4 years of annual demand, respectively, would be in addition to the incremental volume generated by a return to normalized annual demand.

Underconsumption has created a significant demand backlog that is apparent across a few different end markets. Arguably one of the most important end markets, U.S. roads have seen their overall quality worsen over time. According to the American Society of Civil Engineers, 20% of U.S. highways were in poor condition in 2014. Worse still, 32% of urban roads, which have heavier usage, were in poor condition. ASCE estimates that these road conditions led to $160 billion in time and fuel wasted in traffic.

Roads are one of the most aggregates-intensive construction categories. According to the Mineral Information Institute, just one-quarter mile of a four-lane interstate requires 85,000 tons of aggregates. As such, the need for significant repair offers a meaningful backlog for aggregates demand.

Both nonresidential and residential construction have also seen limited recovery since the Great Recession. Despite growing nominal GDP, construction has grown slowly, losing relative share of GDP as a result. At first glance, nonresidential construction experienced a less drastic decline and has had a better recovery than residential construction. However, not all nonresidential sectors are created equal when it comes to aggregates intensity. So, while nonresidential construction has improved overall, the most aggregates-intensive sectors have been left behind. While nonresidential construction (excluding infrastructure) has risen 34% over the last decade, infrastructure spending has lagged meaningfully, increasing at just 17%. We don’t think this trend is sustainable, as U.S. infrastructure cannot operate forever beyond initial lifespans.

Residential construction has languished since the Great Recession; its share of GDP is nearly 40% below the prerecession average. While near-term challenges have slowed the recovery, the long-term outlook is positive. We expect stronger household formation among the massive millennial generation to propel housing starts to a peak of more than 1.9 million units by 2021. Rising housing starts bode well for aggregates demand--the average new home uses 120 tons of aggregates, according to the Mineral Information Institute. We forecast a nearly 700,000 rise in housing starts by 2021 from 2017. This would add annual demand of 84 million tons, a 5% increase from 2016 crushed stone consumption.