Description

SUMMARY

I am long Ash Grove Cement Co.  The stock is at $145 and I believe it is worth $234 right now, even after applying a liquidity discount of 30%, which it deserves because of the modest float and low trading volume of 200-300 shares per day.  That makes for 61% of immediate upside just on the current mispricing, then you have the potential to make even more as the business grows over time.  It’s paying a dividend of $2.20 per share for a yield of 1.5%. 

This unlevered well-run business is a low cost producer in a cyclical industry that makes an essential product (cement is mixed with aggregates to form concrete, the second-most used substance on earth after water) with no viable substitutes.  Significantly, Ash Grove was profitable through both of the last recessions. 

Let me frame this opportunity in the following way.  Assume for a moment that you had to invest in the building materials sector, but you could only choose between two options:

Option 1
A basket of domestic heavy building materials stocks with varying levels of business quality, trading at 21.5x LTM EBITDA and 3.6x tangible book value, representing expanded multiples on trough earnings: 

Option 2
Ash Grove (OTCBB: ASHG), with better than average profitability through the cycle, priced at 6.3x LTM EBITDA and 0.85x tangible book value, representing compressed multiples on trough earnings, and a discount to its historical P/B multiple of 1.02x. 

It’s an easy choice.  This high quality business comes with a phenomenal margin of safety.  Even at the height of the financial crisis, only Monarch and Texas Industries traded at cheaper multiples. 

Monarch troughed at 0.82x P/B and 2.3x EV/LTM EBITDA, but it’s a much lower quality business than ASHG.  Texas Industries troughed at 0.43x P/B and 9.2x EV/LTM EBITDA, but it’s also a lower quality business and it has been carrying substantial leverage (not less than 39% debt/capital since fall 2008) while ASHG has a net cash balance sheet.

What’s the catch? 

• Ash Grove doesn’t make public filings with the SEC (they only have app. 300 shareholders, below the 500 limit) so it’s hard for the market to know how much money they’re making.
• The stock is ~2/3 controlled by insiders and has been family-run for several generations, so the crystallization of value through a sale or levered recap probably isn’t a catalyst.

The company has always effectively been private, but they give out stock to employees as compensation.  At some point somebody sold stock to an outsider, which led to its eventual trading on the pink sheets.  The stock chart for ASHG on Capital IQ goes back to 1978 so the stock leakage must have first started happening a while ago.  If you want to know how the company is performing you have to send them a copy of your account statement that proves you own shares, and they’ll send you the latest annual report.  (If you hold shares in certificate form you’ll automatically receive the quarterly updates and annual reports.) 

The only outsider I have been able to identify as owning a material amount of stock is Royce Capital with 148,000 shares out of 8.065 million total, or 1.8%.  I believe the float is approximately 1 million shares. 

Buffett has said when you buy a stock you should be prepared to own it if the market closes the next day and stays closed for five years.  Owning this stock is a good test of that principle.  It’s a test worth taking because this is a good business and the margin of safety is so high.  It’s also a test I want to take because I am tired of seeing my stocks get yanked around by Atari-traders and robots. 

I’ll walk you through my argument in the following sections:

• Industry Profile
• Company Profile
• Company Financials
• Peer Comparisons
• Valuation Approaches

 

INDUSTRY PROFILE

Capacity
There are approximately 150 cement plants in the United States, with total domestic annual production capacity of 110 million short tons (equivalent to 100 million metric tonnes).  Unless noted I will be speaking in terms of short tons.

The top 10 domestic producers by my count are:

Ash Grove and Texas Industries are the only American-owned producers in the top 10.  Eagle Materials (3.1 million tons), Vulcan Materials (1.6 million tons), and Monarch Cement (1.3 million tons) together account for another 5% of domestic capacity.  These capacity numbers are not adjusted to reflect EXP’s recent purchase of two plants with a combined capacity of 900,000 tons from Lafarge.

The Portland Cement Association estimates that 1.6 million tons of capacity will be added in 2012 and 1.3 million tons will be added in 2013.  A further 6.7 million tons may be added 2014-2016.  If all the additions occur and there are no further plant retirements, then total capacity will be 120 million tons by 2016.

The United States doesn’t have enough domestic capacity to satisfy normalized demand.  Very roughly speaking, on a normalized basis we need to import at least 10 million tons per year.  Normalized consumption is ~120 million tons per year (~350 kg per person * 311 million people * 110% conversion factor from metric tonnes to short tons).  Normalized domestic production might be ~110 million tons per year (120 million tons 2016 capacity * >90% operating rate), for a shortfall of 10 million tons.

Cement’s low value to weight ratio means the product can’t be shipped very far before the costs of transportation quickly overwhelm the delivered cost of the product.

Current prices:

• Cement = $80 per ton
• Corn = $270 per ton (35.7 bushels per ton * $7.50 per bushel)
• WTI oil = $600 per ton (6.5 barrels per ton * $92 per barrel)
• Steel = $775 per ton (flat-rolled)
• Gold =  $51million per ton (14.58 troy oz per pound * 2,000 pounds * $1,750 per troy oz)

Therefore, the first quantities of import tonnage come from Canada because of its close proximity. 

Imports are currently running 1-2 million tons.  Roughly ½ of those tons are arriving from Canada where Lafarge has 1/3 market share.  Lafarge has 21.1 million short tons of North American capacity, divided between 14.1 million in the U.S. and 7.0 million in Canada.  Given the U.S. market is twice as big as Canada for that company, I doubt they’re going to foul the bigger market to support the smaller one.

Only when the cycle swings to the upside and prices increase does it make economic sense for more imports to come from abroad.  

Waterborne transportation costs might be ~1 cent per ton-mile.  Half the world’s cement capacity is in China.  China is about 6,000 miles from the West Coast.  Assuming a Chinese plant was right next to the port, at 1 cent per ton-mile the transportation costs to the U.S. alone would be $60 per ton.  That means they’d have to have cash operating costs of less than $20 per ton to be cash breakeven in the current environment where cement is $80 per ton.  I believe Chinese producers have a cash cost of ~$25 per ton.

Normalized domestic prices are over $90 per ton (peak pricing was ~$95 in 2007), so with $60 transportation costs they’d have to have cash operating costs of less than $30 per ton to be cash breakeven.   By way of comparison, domestic-owned producers like EXP, TXI, and VMC have cash operating costs in the neighborhood of $60.

Fortunately, the industry has a trump card against an invasion by low-cost imports: the big domestic producers control 95% of the import terminals.  And, once the waterborne imports arrive at the coast, they can’t move very far inland before land transportation costs further erode their cost-competitiveness.  95% of cement tonnage is moved domestically by truck, which has transportation costs of around 25 cents per ton-mile.  If the imported cement travels another 100 miles that’s an extra $25 per ton tacked on to the delivered cost.

Technology 
There are two main types of production technology for cement: 

• Wet production (old school, higher cost)
• Dry production (new school, lower cost) 

About 85% of the industry’s domestic production capacity is dry technology now, up from 61% 30 years ago.

“Cement is manufactured through a large-scale, complex and capital-intensive process.  At the core of the production process is a rotary kiln, in which limestone and clay are heated to approximately 1,450 degrees Celsius.  The semifinished product, called clinker, is created by sintering.  In the cement mill, gypsum is added to the clinker and the mixture is ground to a fine powder – traditional Portland cement.  Other high-grade materials such as granulated blast furnace slag, fly ash, pozzolan and limestone are added in order to modify the properties of the cement.”  (Holcim 2011 Annual Report)

The rotary kiln in a plant using wet technology might be up to 200m long and 6m in diameter.  When the limestone and clay mixture enters the kiln it is in the form of a wet slurry that might consist of 40% water.  It takes a lot of heat energy to evaporate that water.   Fuel + electricity make up 40% of the cash cost per ton.  

The rotary kiln in a plant using dry technology might be only 70m long and 6m in diameter, but still have the same production capacity.  The kiln can be shorter because the limestone and clay mixture is already dry when it enters the kiln, and doesn’t need more time on the “runway” to dry out.  It enters the kiln already heated to 900 degrees Celsius as opposed to 20 degrees for a wet kiln.

So, dry technology has lower operating costs because it uses less energy, and it has lower capital costs because the rotary kiln can be much shorter.

Demand
Domestic consumption peaked at 141.1 million short tons in 2005 and troughed at 78.3 million tons in 2010 for a “drawdown” of 45%. 
It was the worst drawdown since the Great Depression and WWII. 

Cement end markets by tonnage:

• 50% public infrastructure
• 25% commercial construction
• 25% residential construction
   

We need to build 1.3 – 1.7 million homes per year (I’ll use a midpoint of 1.5 million homes) to match household growth and changes in the housing stock.  Over the five years ending 2006 there were 9.4 million cumulative housing starts; we overbuilt by 1.9 million.   Over the subsequent five years ending 2011 there were 4.0 million cumulative housing starts; we underbuilt by 3.5 million. I may be overstating the level of recent underbuilding by not being more fine-tuned with my stats, but the basic point that there is pent-up demand still holds.  And, we are seeing green shoots.  The last three years we averaged just 584,000 starts per year.  The first eight months of this year saw monthly numbers in the 700,000 range.  In September the seasonally adjusted number was 872,000.

The nice thing about residential and commercial is that buyers and builders respond to market signals.

That’s not necessarily the case with public infrastructure.  The need clearly exists.  The American Society of Civil Engineers gives the nation’s infrastructure a report card every two years, along with an estimate of how much spending is required to meet America’s infrastructure needs over the coming five years.  The grades have been getting worse, and the spending estimates have been getting higher.

If there’s any good news on the public front, it’s that we just got a federal highway bill that provides funding for two years, as opposed to the short-term continuing funding resolutions that have been in place since 2009.  Also, the Department of Transportation has a program called TIFIA that provides funding to state Departments of Transportation in a way that allows them to leverage federal dollars to support big-ticket infrastructure projects.   The budget for the TIFIA program was just substantially increased.  Martin Marietta believes that the budget increase in conjunction with the federal highway bill has the potential to be more impactful than the 2009 stimulus. 

Economics
Breakdown of the typical cash cost per ton:

• 20% maintenance & repairs
• 20% electricity (136 kWh per ton on average)
• 20% fuel (3.3 mmbtu per ton on average)
• 15% labor (3.6 tons per man-hour on average)
• 10% contract labor
• 15% other

Falling coal and natural gas prices are good for this industry, primarily because they’re a direct cost input, but secondarily because they also lead to lower electricity prices, all else equal.
Normalized EBITDA margins are 25-35% for a well-run producer.  Returns on capital are 10-15% depending on the company.

COMPANY PROFILE

Ash Grove is a Delaware corporation.

The company was named after its original location of Ash Grove, MO, where railroad construction uncovered one of the purest limestone seams in the world.  It was incorporated as Ash Grove White Lime Association in 1882 and moved to Kansas City in 1891, where it’s still headquartered. L.T. Sunderland joined the company in 1909 and became President in 1913.  A member of the Sunderland family has run the company ever since. 

Charlie Sunderland, 55, is the fourth generation of the family to run the company.  He has been Chairman & CEO since 2000.  He was also chairman of industry trade group Portland Cement Association from 2006-2008.  He holds a B.A. in psychology from Trinity University in San Antonio.  His brother Kent is Vice Chairman.

I don’t have a good handle on their succession plans.  Charlie has two sons, 24 and 25 years old, and a 21 year-old daughter.  I don’t believe they’re involved in the business.  Charlie was diagnosed with leukemia in 1994.   As far as I know his most recent treatment procedure was in 2011.  He took some time away from running the business but appears to be back and in good health.  Kent ran the show during the interim.   

From what I can tell Ash Grove is an attractive place for employees to work.  They have a lot of long-term veterans.  Senior leadership appears to be down to earth – the opposite of Rick Wagoner and his famous separate elevator to the executive suite.  For example, they regularly eat lunch with the rest of the employees in the cafeteria at headquarters.

The Sunderland family has a foundation with assets over $80 million.  They seem to be pretty serious about philanthropy.  I believe the foundation owns a chunk of stock in the form of the C-class shares, which I will discuss in a bit.

Properties
The company is the sixth-largest domestic producer of cement and the largest domestic-owned producer of cement.  They expanded west from Missouri and by my count they have 8 cement plants with 8.6 million short tons of annual cement capacity pro forma for current plant construction projects.

Of the 8.6 million tons of cement capacity, 7.1 million (or 83%) will be the lower cost dry technology after the Midlothian project is finished.  That ratio is on par with the national average of around 85%.  All of their facilities should survive the gamut of environmental regulations that have recently been put in place. 

Only one of their facilities had a lost-time injury last year. 

They also own cement import terminals in Seattle and Houston, plus 21 distribution terminals.  They own a limestone quarry in British Columbia.  I don’t know the amount of reserves at the quarry, nor do I know the amount of limestone reserves located near each of their cement plants or the capacity of the import terminals.

I suspect there may be some hidden asset value in the form of appreciated land held at cost.  I don’t have any hard data to back that up.  It’s just a suspicion based on the nature of their business and the fact that they’ve been around for a very long time.  The peer companies in the comp group from time to time sell off material amounts of excess land at prices that represent huge markups to the balance sheet carrying values. 
 

Eagle Materials Stake
Ash Grove also owns 2.194 million shares of EXP, or 4.5% of the total outstanding.  They paid $24.38 per share in August 2008.  The current quote is $50 per share, which means the stake is worth $109.7 million, or $13.60 per share of ASHG.

Interestingly, at the time of the purchase they filed a 13-D that said, “Ash Grove made its purchases of Common Stock based on its belief that the Common Stock at current market prices represents an attractive investment opportunity.  At present Ash Grove has no plans other than to hold the Common Stock for investment purposes.”

Why file a 13-D if you bought the stock simply because you thought it was cheap?  The filing goes on to say, “…Ash Grove may also decide in the future to propose one or more representatives for election to the board of directors of Eagle or to propose other matters for consideration and approval by Eagle’s stockholders or board of directors.  Such matters may include transactions involving a sale of assets of Eagle or a merger involving Eagle in which Ash Grove may be a participant and which may involve a change in control of Eagle”.  (emphasis added)

Further, Eagle filed an 8-k in October 2008 stating, “After the date of the above filing, Ash Grove notified Eagle that Ash Grove has a good faith intention to purchase in excess of $63.1 million of Eagle common stock, including shares already held by Ash Grove, and that Ash Grove made a filing under the Hart-Scott-Rodino Antitrust Improvements Act of 1976…”

This is pure speculation, but I wonder if Ash Grove bought the EXP stock as a toehold position with an eye towards acquiring the whole company at some point in a stock for stock deal, not just because of the industrial logic of a business combination, but also as a backdoor way of going public.  That would almost certainly prompt a material re-rating of Ash Grove’s stock.

I don’t think antitrust issues would represent a problem.  The combined entity would control 13.6 million tons of capacity (pro forma EXP’s recent deal to buy 900,000 tons of capacity from Lafarge) or 12 % of national production capacity.   There’s hardly any geographic overlap between the businesses, and there would still be four other companies that would be bigger than the combined entity.

A deal would be a great opportunity to provide family members with liquidity.  You sometimes see that need develop with large family-run businesses that have been around for generations, where stock gets dispersed among a large number of family members that have differing financial objectives.  The recent Cargill/Mosaic distribution might be a good parallel that demonstrates how the desire for liquidity can drive large transactions when there are complicated family dynamics involved. 

Ash Grove’s management team has a relationship with Eagle’s management team and it is positive.  A merger would provide Ash Grove with managerial talent from Eagle that is well respected by Wall Street, which could be an important consideration in the unfortunate even that Charlie’s health deteriorates and they don’t have home-grown leadership ready to step in on a permanent basis. 

COMPANY FINANCIALS

Financial Statements
Their auditor is Grant Thornton.  The only annual reports I have are for 2010 and 2011.  Both contained unqualified audit opinions.  I also have the 6-month update as of 2012 Q2. 

I have summary financial data going back to 2003 thanks to broncos727’s original writeup, but I need the annual reports to calculate EBITDA so I just have 3 full years’ worth of EBITDA performance from 2009 through 2011. 

Unfortunately Ash Grove's annual reports don't contain the kind of granular operating data investors are used to having; metrics such as production volumes, unit pricing, segment financials, etc.

Ash Grove’s Capital Structure at June 30
Net working capital was $370 million.

Net cash:
+ $120 million cash
+ $173 million securities (over 90% is in Level 1)
= $293 million cash & securities
- $40 million debt
- $36 million non-controlling interest
= $217 million net cash

I should point out that that the shares of EXP are held at fair market value.  The stock has risen from $37.34 at June 30 to $49.85 as of October 19, for an increase in value of $27.4 million, or $3.40 per share of ASHG.  I am going to ignore that in my appraisal estimates.  Put that $3.40 in the margin of safety bucket.

Enterprise value at October 19:
+ 8.065 million shares outstanding
x $145 share price
= $1,169 million market cap
- $217 million net cash
= $952 million EV

They have a $250 million credit facility with Bank of America that expires July 11, 2013.  I believe it’s undrawn, with the only capacity utilization being due to modest amounts of letters of credit.  I don’t know if the facility is unsecured. 

They had underfunded/unfunded pension and health benefits totaling $203 million or 12% of total book capitalization at December 31.  This is a bit higher than the comp group, but when you roll that figure up with net deferred tax liabilities and the NPV of off-balance sheet obligations such as operating leases, as a percentage of book capitalization they are right in line with the group at around 20%.  Since the group is more or less similar in that regard on an all-in basis, I am not going to adjust the enterprise values for those numbers. 

Ash Grove has three share classes, all with the same par value: 

• Class A:  1,897,051 outstanding at Dec 31, 2011  (1 vote per share)
• Class B:  4,522,812 outstanding at Dec 31, 2011  (10 votes per share)
• Class C:  2,726,112 outstanding at Dec 31, 2011  (1 vote per share)

That adds up to 9.146 million shares vs. 8.065 million currently outstanding.  The difference of ~1 million shares is held as treasury stock.

The A shares are what I own.  The B shares are supervoting shares with 10 votes per share.  They are all held by family members, and if a family member disposes of the shares they get automatically converted to A shares.  The C shares are held by a family trust that I believe is linked to the Sunderland Foundation. 

The share count has shrunk by about 300,000 shares since the mid-2000s.  The company has a passive buyback in place, through which they will buy any stock that shareholders want to sell back to them.  I wonder if that program exists at least partly to give liquidity to family members, which may reinforce the idea that liquidity is an important topic for them. 

Comps
When I refer to “comps”, I’ll be referencing the domestic building material companies I mentioned earlier: 

• Eagle Materials (NYSE: EXP)
• Martin Marietta Materials (NYSE: MLM)
• Monarch Cement Company (OTC: MCEM)
• Texas Industries (NYSE: TXI)
• Vulcan Materials (NYSE: VMC)

Overhead
Ash Grove has approximately 3,000 employees.  2011 net revenues per employee of roughly $280,000 is a bit lower than comp group’s average of $313,000.  2011 SG&A % of net revenues at 9.5% for ASHG was almost exactly in line with the comp group’s average of 9.6%. 

2003-2011 Average Performance

 
*Note that ASHG’s median payout ratio of 14.6% was below the comp group’s median of 43.3%. 

The company has demonstrated above-average profitability and has been growing faster than average, yet shareholder returns aren’t even close to being compensatory. 
What’s happening?  I believe it’s multiple compression.

 
ASHG P/B ratio relative to comps at YE:

2003:  56% of comps’ average P/B ratio

2004:  54% 

2005:  38%

2006:  36%

2007:  43%

2008:  51%

2009:  38%

2010:  40%

2011:  34%

Why is this compression happening?  I suspect it’s because construction has been in a severe multi-year recession and as money leaves a sector the least liquid stocks get hurt the most.  Until recently the materials stocks were by and large abandoned.   Notice the relative multiple compression over the recessionary period from 2008-2011.  I would expect this to reverse as the construction recovery gains legs and investors comb through the materials sector looking for stocks that might have escaped the market's attention.

We might have a coiled spring on our hands.

2009-2011 Median Performance

Again, ASHG has delivered superior profitability but received a highly discounted multiple.  I am using medians instead of averages here not because ASHG’s results have been volatile (quite the opposite), but because it's such a short time frame and peer results were all over the place.  I want to avoid skewing the comparisons.

 

VALUATION APPROACHES

There are a few ways to come up with an estimate of fair value.  , so it's difficult to do bottoms-up earnings modeling.

I've used five other methods.  Each of them has their own merits.
The average of the five is $234 per share, for upside of 61%.

• $304/share:  using LTM EBITDA of $152 million
• $261/share:  using tangible book value of $170 per share
• $243/share:  using replacement cost for 8.6 million tons of capacity
• $190/share:  using normalized EBITDA of $280 million
• $174/share:  using EV/ton of capacity on 8.6 million tons

Liquidity Discount
I am going to use 30%. 

I’ll just copy and paste from a valuation opinion I obtained that was generated for a family limited partnership created for estate planning purposes:

“Discounts for lack of marketability are a familiar feature in valuing closely held businesses for gift tax purposes.  Discounts for lack of marketability are sometimes referred to as lack-of-liquidity discounts.  These adjustments typically reflect the differences between closely held shares being valued and those of publicly traded companies.  The discount is appropriate for interests in privately owned limited partnerships as well as shares of privately owned corporations.  Generally, the lack-of-marketability discount reflects the absence of an established market for the closely held business interests being valued.  As the IRS has acknowledged, ‘a minority interest in an unlisted corporation’s stock is more difficult to sell than a similar block of listed stock’ (Revenue Ruling 59-60).”

The opinion goes on to cite 15 studies of the average discount received on transactions involving restricted stock.  The average discount across all studies was 28.8%, so let’s just round that up to 30%.

LTM EBITDA ($304/share)
I estimate ASHG’s LTM EBITDA as of June 30 was $152 million.  The comps are trading at 21.6x LTM EBITDA.  On that multiple, ASHG would have an enterprise value of $3,283 million.  Add net cash of $217 million and you have a market cap of $3,500 million.  On 8.065 million shares out the value would be $434 per share.  Apply the 30% liquidity discount and you’re at $304, for upside of 110%.

Since EXP and TXI are priced than the group at 22.5x and 47.8x currently (TXI had a deeper earnings trough so you could argue a more expanded multiple is appropriate), I’ll go with the group multiple of 21.6x as it’s more conservative. 

Tangible Book Value method ($261/share)
The comps are trading at 3.6x tangible book value.  Ash Grove’s tangible book value per share at June 30 was $170; applying a 3.6x multiple would put the stock at $612.  Deducting 30% for the liquidity discount would put it at $428.

I should acknowledge that VMC and MLM are primarily in the aggregates business, where the major asset value is in the reserves (and the carrying value on the balance sheet vastly understates their actual worth), as opposed to the cement business where the major asset value is in the equipment, which gets fully capitalized. 

Therefore, when it comes to valuing Ash Grove on the basis of its tangible net worth, it’s more appropriate to use TXI since they get the highest proportion of their operating earnings from cement (60% through the cycle).

TXI is trading at 1.7x tangible book.  That multiple would put ASHG at $289; less 30% gets you to $202 for upside of 39%.

However, it should be noted that TXI’s PP&E is 35% depreciated.  Ash Grove’s is 48% depreciated.  If TXI’s PP&E were 48% depreciated that would lower their tangible book value by $5.40 per share (net of a 35% tax deduction on the additional depreciation) from $24.80 to $19.40.

On $19.40 TXI would be trading at 2.2x and using that multiple ASHG would be at $261 (net of liquidity discount), for upside of 80%.  That multiple happens to be almost exactly consistent with the historical multiples of Eagle and Florida Rock, another company that would have made a good comp were it not acquired by Vulcan in 2007.

You might argue that haircutting TXI’s net worth in order to level-set the two companies on that metric is unfair.  Assets are spent in the process of doing business.  TXI’s assets should be able to make money for a longer period of time than ASHG’s. 

Normally I would agree, but remember ASHG does have projects underway that will significantly boost GAAP tangible book.   Plus, ASHG appears to be a much better managed company than TXI and has a track record of squeezing more earnings out of its assets than TXI. 

Further, I could also argue that EXP should also be used as a direct comp and EXP is trading at a much higher multiple of tangible book than TXI; 6.8x would put ASHG at $809 (net of liquidity discount).  EXP gets 50% of its normal operating income from cement vs. 60% for TXI, so that’s pretty close.  EXP and ASHG also have similar levels of profitability; 2009-2011 average EBITDA margins were 22.4% for EXP and 19.5% for ASHG.  And, EXP’s PP&E is depreciated by an almost identical amount as ASHG (49.1% vs. 47.8% at 2011YE). 

But let’s not get carried away. 

Replacement Cost ($243/share)
Barron’s reports this weekend in a bullish article about Texas Industries that Sidoti estimates the replacement cost of new cement capacity is close to $300/ton.  Applying that number to ASHG’s 8.6 million tons of capacity would give you a value of $2,580 million.  Adding $217 million of net cash gets you to $2,797 million.  On 8.065 million shares out the value would be $347 per share.  Apply the 30% liquidity discount and you’re at $243, for upside of 68%.    

However, that ignores the replacement cost value of the cement terminals, the quarry in British Columbia, ready-mix operations, excess land held at cost, and the $3.40 per share of ASHG of appreciation on the EXP shares they own since June 30.    Throw that in the margin of safety bucket.

Normalized EBITDA ($190/share)
This method is a bit crude, but work with me.

I don’t have tax, interest, or depreciation data for the years 2003-2008, but consistent profitability appears to rule out the presence of abnormal tax rates caused by NOLs, and the company is so unlevered that interest expense has probably been cancelled out by interest income. 

Let’s just take average net income of $107 million, gross up by 35% for taxes, and add current run-rate depreciation of $115 million.  That results in normalized EBITDA of $280 million.  There are some puts and takes embedded in that number but on balance they’re somewhat neutral in terms of biasing normalized EBITDA higher or lower.  (For what it’s worth, management estimates maintenance capex is $50-60 million.)

Comps have historically traded at 7.0x EBITDA on a mid-cycle basis (M&A occurs at 8.5x just for reference).  That would put the EV at $1,960 million.  Add net cash of $217 million, divide by 8.065 million shares, and apply the 30% liquidity discount.  That gets you to $190 per share, for upside of 31%.

EV/Ton of Capacity ($174/share)
I think this is the most conservative metric on which I’ve chosen to value ASHG.  It also requires the longest explanation.

TXI is the easiest comp to for which to isolate the current market value for one ton of domestic cement capacity.   They have two other segments in addition to cement; aggregates and ready-mix concrete.  Ready-mix operations aren’t worth very much.  Aggregates is a great business, but TXI isn’t very good at it.  Nevertheless, let’s apply MLM’s implied value per ton of reserves (since they’re the purest play on the aggregates business) and subtract that out of TXI’s enterprise value and solve for the value of their cement capacity.

MLM had 12.6 billion tons of reserves at December 31; 6.8 billion owned/5.5 billion leased, or 54%/46%.  They assert that owned reserves are worth $1/ton and leased reserves are worth $0.40/ton.  That would imply their reserves are worth $9.0 billion on a replacement cost basis.  Owned reserves account for 76% of the value and leased reserves account for 24%. 

MLM’s current enterprise value in the market is $4,951 million.  They have a nice specialty materials segment.  Since the company began breaking out segment financials for specialty materials in 2005 it has accounted for 11.6% of gross profit on average and 13.9% of operating income on average, although last year it accounted for 22.1% of gross profit and 34.2% of operating income.

For now, let’s just assume 10% of the EV is based on specialty materials and 90% is based on aggregates.  That is a somewhat conservative approach with respect to the value of ASHG’s cement capacity because it results in a higher valuation for MLM’s aggregates business, a higher comp value for TXI’s aggregates business, a lower residual value for TXI’s cement capacity, and therefore a lower implied value for ASHG’s cement capacity.  Haircutting MLM’s $4,951 million EV by 10% results in $4,456 million market value for the aggregates business.

Assuming MLM’s owned reserves account for 76% of the replacement cost value, they also account for 76% of the $4,456 million market value, or $3,367 million.  That implies a value of $0.50/ton of owned reserves.

Assuming the leased reserves account for 24% of the replacement cost value, then they also account for 24% of the market value, or $1,088 million.  That implies a value of $0.20/ton of leased reserves.

TXI had 783 million tons of reserves at December 31.  79% or 619 million tons were owned.  At $0.50/ton they would be worth $310 million.  21% or 164 million tons were leased.  At $0.20/ton they would be worth $33 million.  Total value is $343 million. 

TXI’s operations are lower quality than MLM’s.  Since 2008 Q2 MLM has delivered an average LTM gross margin on their aggregates segment of 21.4%.  TXI has delivered 14.4%.  That’s 1/3 below the level of MLM, so let’s reduce the $343 million implied value of TXI’s aggregates segment by 1/3 as well.  That gets you to $229 million.

Subtract $229 million from TXI’s EV of $1,799 million and you’ve got a residual value of $1,570 million for the cement capacity.

TXI is within shouting distance of completing expansion projects that will take their capacity from 5.4 million tons to 7.6 million tons.  I believe the market is pricing in the future earnings power from that incremental 2.2 million tons of capacity, so let’s base our capacity valuation on the entire 7.6 million tons.  Again, we’re making the more conservative choice.

$1,570 million of value for 7.6 million tons of capacity = $207 per ton.   (For perspective, Eagle just paid $240 per ton for the two cement plants they bought from Lafarge.)

Applying that figure to ASHG’s 8.6 million tons of cement capacity you’ve got $1,780 million worth of value.  Add $217 million of net cash, divide by 8.065 million shares out and you’ve got $248 worth of value.  Apply the 30% liquidity discount and you end up at $174 per share, for upside of 20%. 

***

Just as TXI’s aggregates operations are lower quality than MLM’s, so are their cement operations lower quality than EXP’s.  The average operating margin of EXP’s cement segment over fiscal years 2005-2012 was 25.8% vs. 14.3% for TXI’s cement segment, or a ratio of 1.8:1.0. 

ASHG’s cement operations are much closer in terms of profitability to EXP than TXI’s so I think it would be more fair to value them based on EXP, but I find it harder to solve for the implied market value of EXP’s cement capacity. 

EXP had 3.1 million tons of capacity before the recent Lafarge deal.  It gets 50% of its operating income from cement through the cycle.  If I crudely assume 50% of its $2,058 million enterprise value at June 30 was based on cement, which implies a value of $332 per ton of capacity compared with $207 per ton based on TXI.

I have less confidence in the $332 number because EXP also gets a substantial amount of revenues from wallboard where profitability is highly volatile and has the potential for a huge rebound in a housing recovery.  Given that homebuilder stocks are on fire and EXP is up 94% YTD, it’s clear that some sort of wallboard earnings recovery is being priced in.  I just don’t have a good handle on how much of EXP’s enterprise value is based on expected wallboard earnings.

CONCLUSION

There you have it.  The quality of the business is not in doubt.  That the stock is cheap on an absolute basis is not in doubt.  Nor is there any doubt about whether or not the stock is cheap on a relative basis.

The question is why the stock would trade up to my estimate of fair value since it represents a premium to where it's traded in the past.  In the short-term, I'm not counting on it.  In the medium-term it should happen when there's further industry consolidation that reduces the number of investable domestic pure plays.  Of the five comps, MLM and VMC will almost certainly merge at some point, and there is a strong belief in the market that TXI will get sold.  

In the long-term it will happen if Ash Grove reaches 500 shareholders and has to start filing public financial statements, and/or if there's a transaction such as a merger with Eagle.

The X factor is your patience.  Good things happen to cheap stocks.  

Catalyst