Description

I would like to recommend a long-term long position in Ash Grove Cement Company (ASHG, bid 128, offered 133.5).  Ash Grove trades on the pinks and does is not registered with the SEC, and refuses to give out shares to non-shareholders.  The way to get financials is to buy a share and ask them to send you a copy (you’ll probably need to send them a copy of your statement or trade confirmation – or you can go through the expense of getting a certificate).  Actually, for a non-reporting company, the annual report is pretty decent (auditor was Grant Thornton in 2010); the company also puts out adequate quarterlies.  But the recent financials won’t include much about past years, so I’ve extracted some key numbers from about 10 years worth of data into a spreadsheet that you can examine here:

https://docs.google.com/spreadsheet/ccc?key=0ArOjJzFQSct8dGVvSGo2bmtOQlI4eFNleE1OOVVGOGc.  

Since the full-year 2011 numbers are not out yet, for consistency I will use the 2010 year-end numbers in this report.

Ash Grove’s primary business is the manufacture of Portland cement in its eight US cement factories.  The company also has interests in cement terminals (including for import), limestone, aggregates, etc.  Needless to say, these markets have not been doing well, a result which has reflected itself in the share price over the past five years: the stock hit $289 in 2007, vs. around $130 today.  The theme of this recommendation is that this significant share price drop allows buyers to get a very conservatively-financed cyclical company at a low point in the cycle.  The conservative balance sheet should guarantee that Ash Grove makes it to the other end of the downturn without major trouble, and the significant discount to replacement cost/peak earnings should result in an excellent capital gain when earnings recover.

As far as the balance sheet goes, the company (as of Dec. 31, 2010) had $73mm in cash (about $9 per share), vs. long-term debt of around $83mm ($46mm needing to be refinanced in 2013, with no other significant maturities until after 2015).  The company also has $175mm of available-for-sale securities (included with “Other Assets” in the spreadsheet), including some auction-rate headaches it has been slowly liquidating and a large position in Eagle Materials (EXP), which works out to about $22 / share.  Even not counting those securities, the company has current assets of $383mm ($47 / share) vs. current liabilities of only $82mm ($10 / share).  In fact, current assets + available-for-sale securities are larger than total liabilities by $54mm ($7 / share).

Even better, the company is still earning a modest amount of money ($4.56 / share in 2010).  Even these depressed earnings are not as bad as they seem due to the significant amount of depreciation from their new cement plant (more details on this later).  Combining their strong balance sheet with modest earnings and better cash flow, it seems pretty clear that Ash Grove is going to make it through the remainder of the downturn.

The remaining questions seem to be: (1) what will it be worth when the market turns, and (2) when will the market turn.  On the later, I admit to having only limited insight.  Certainly current conditions are not very good in the construction industries!  Ash Grove may not be the right investment for people who believe the construction business will never turn around.  My real argument is that the company is sufficiently safe and cheap that even if it takes 10 years to turn, returns will be adequate; if the market turns faster returns should be considerably better.

One way of valuing a business engaged in physical manufacturing is by estimating the replacement cost of the PP&E.  Ash Grove’s PP&E has listed cost of $2,466 million ($303 / share), with accumulated depreciation of $1,092 million ($134 / share), for a net of $1,375 million ($169 / share).  Since the company is 130 years old, it is safe to assume that some assets are on the books for a small fraction of their current replacement value.  The company’s number is likely conservative as well because it has demonstrated an eagerness to aggressively write off assets that still have probable value.  For example, in 2007 the company wrote off $56 million for a project that had to be terminated, despite maintaining ownership of a considerable amount of equipment “for which the company does not have a currently identifiable use… the company is exploring options to use the equipment in other Ash Grove projects or to sell it”.  It’s hard to put a finger on an exact number, but after adding back current assets and available-for-sale securities and removing current liabilities, long-term debt, and pension/postretirement liabilities; I am confident that replacement cost is north of $230 / share, potentially considerably north.

Another way to value a cyclical at the bottom of the cycle is to determine what the price to peak earnings ratio is.  Ash Grove’s peak earnings were in 2006, when it earned $25.66 / share, implying a ratio of 5.  When it was actually earning those kinds of numbers, the stock was trading around 10x peak earnings, or in the $250 / share range.

Interestingly, there is good reason to believe that Ash Grove’s future earning power could be higher still.  In 2010 the company finished construction of its 1.7 million ton Foreman, AR plant.  Although ASHG’s investment in the plant was clearly ill-timed, the plant has the potential to be a significant addition to the top line: in 2006, Ash Grove’s best year by tonnage, the company sold 9.4 million tons.  In addition to increasing Ash Grove’s tonnage capacity by almost 20%, the new plant is positioned in Ash Grove’s strongest market and contains state-of-the-art technology.  I believe that the Arkansas plant could materially affect Ash Grove’s earnings and cash flow in any economic recovery.  Moreover, quite a few competitors have had significant troubles in the downturn (I’m looking at you, Cemex!), which should help Ash Grove’s positioning on the other side.

Management pays a modest dividend (around 2% at current prices) and clearly agrees that the price is cheap, as indicated by buyback activity ticking up, despite the weak earnings.  Management owns approximately 2/3rds of the stock, so at the very least you know that their interests are partially aligned with yours.

In terms of returns, the “bear” case (other than simply: construction spending shrinks forever!) would seem to be that it takes 10 years for the economy to turn, allowing management to buy back more stock at recent prices and continue to improve their PP&E.  If the company earns $25 again (which given the new plant and a reduced share count should not be much of a stretch in a decent economy) then a $250 price once again looks reasonable, implying an ARR of 6.75%, plus 2% in dividends, for just under 9% annually.  Not sexy, but I think perfectly respectable for a relatively negative scenario.  Yes, it’s true that 10x is a bit of a simplistic way to guess the value, but as I tried to indicate above, this number is also in the neighbourhood of replacement cost.

In a happier “bull” case, the company earns $35 in 5 years (construction finally restarts, the new plant works like crackerjack, and weakened competitors allow for market share gains), resulting in a $350 share price, or 22% annually (24% with dividends).  I think most investors would be delighted with such a result.  Of course, it’s possible to imagine even happier cases, but with construction so weak I don’t think it’s worth stressing.

In summary, I think Ash Grove is a relatively simple story (buy strongly financed cyclicals at the bottom of the cycle) that offers an attractive risk/reward tradeoff for long-term investors.

Catalysts:

(1) Construction markets finally recover
(2) New AR plant starts to prove itself
(3) Continued stock buybacks

Catalyst