Description

Eagle Materials (“Eagle” or the “Company”) has been written up on VIC five times, the most recent one being Dec. 31 2007. Three of these write-ups are long recommendations, and the other two are arbitrage play recommendations on the two classes of EXP shares (the dual class capital structure has since been eliminated). The long recommendations give valuable background on the business and are worth reading. This write-up is a recommendation to sell short EXP.

Eagle is a cement, gypsum wallboard, paperboard, concrete & aggregates, and fracking sand producer. The primary drivers of revenue and earnings are cement and gypsum wallboard, which together account for ~75-80% of pre-overhead EBITDA. Eagle has been experiencing poor earnings in the gypsum wallboard segment which has been running at ~50-60% of non-idled capacity; this segment's share of pre-overhead EBITDA has gone from 58.7% in FY07 to 22.8% in FY12.  The Company's EBITDA peaked in FY07 (3/31 fye) at $345. Both FY11 and FY12 had EBITDA of under $100m, $92.3m and $99.5m, respectively. 

Cement:

The cement business is a relatively stable and good business. Approximately 50% of demand is from public construction; the other half is split between residential and commercial. Cement has a low value-to-weight ratio, so it is usually shipped within a 150 mile radius of the plants by truck and up to 400 miles by rail. As such, cement is mostly a local business. Eagle now operates six cement facilities in five major markets:  Texas, Nevada/Northern California, Mountain region (Wyoming), Upper Midwest (Illinois) and Midwest (Missouri/Oklahoma). In periods of domestic demand outstripping domestic supply, the Company will import cement; this is usually at low or no margin and is done merely to satisfy orders and maintain market position. US capacity has been steady at 100m (million) tons for years. EPA National Emissions Standards for Hazardous Airborne Pollutants (NESHAP) may force some capacity shutdown of up to 10m tons, but the deadline has been pushed back to September 2015 from 2013, allowing non-compliant producers to get into compliance. Domestic demand has been 70-75m tons from 2009-2012. Domestic demand peaked at 139m tons in 2006, meaning 30% of demand was met through imports.  Eagle’s cement operations have been profitable every year, with average EBIT per ton from 2001-2012 of $23.71 (high: $31.12; low: $17.21; median $23.82). Segment financials are below. The highest margin per ton was at the top of the cycle in FY07-FY09, and the last few years have seen the lowest margins. In November 2012 Eagle acquired two plants from Lafarge that in aggregate have 1.6m tons of capacity, bringing total net capacity to 4.4m tons. Eagle paid $279/ton ($446m purchase price) for the two plants, a discount to the estimated replacement cost of $300/ton. 

 n.b. Net Revenues is net of freight/shipping costs; % of Company EBITDA is prior to corporate G&A

Gypsum Wallboard:

Eagle operates five gypsum wallboard plants. The newest plant, built in South Carolina in 2007 with capacity of 750m square feet, has been idled since December 2009. The other four plants together have capacity of 3 billion square feet. Total industry capacity is ~36 billion square feet including idled plants. Very little capacity (~2 billion square feet) has been permanently closed since 2006. Approximately 85% of domestic wallboard capacity is provided by five players.  In 2012, the gypsum wallboard industry produced 20 billion square feet of wallboard, up 10% year-over-year.  There are fewer plants out west, where Eagle has its four currently operating plants. New capacity in the prior upturn had been added in the eastern half of the US, which was largely a function of synthetic gypsum availability, which is produced by coal-fired power plants scrubbing sulfur out of their stacks. Eagle’s advantage is access to its own supply of natural gypsum (with weighted average reserves of ~35 years) and being in the western market, which has less of a supply overhang than the east. Pricing and margins are volatile in this business. Steven Rowley, Eagle's CEO, described the pricing in gypsum wallboard market on a Q2 2008 call in this way: “We’ve kind of estimated in the past $125-$130 range is what we would call midcycle pricing, even though wallboard – it’s either tight supply or very loose and you go right through midcycle, you go up or down very rapidly to either very high pricing or a trough.” This pricing dynamic is evident from looking at the 2001-2012 financial results.

Paperboard, Concrete & Aggregates, and Fracking Sand:

The paperboard segment and the concretes & aggregates segment are not meaningful contributors to the bottom line. Average segment EBITDA for these two segments combined has been $34.9m from 2002-2012 (high: $46.8m; low $25.4m; median $34.3). The Company thinks the nascent fracking sand operation can contribute $50m in EBITDA once it is fully ramped-up. Operations are expected to commence at some point in the first half of 2013.

Valuation:

Prior peak EBITDA for the business was $345m in FY07. Since that time, the Company has built the gypsum wallboard facility in South Carolina, acquired two cement facilities from Lafarge, and embarked on the fracking sand opportunity. Company statements suggest these pieces can each contribute $50m, taking forward peak EBITDA to $500m. The company thus trades at 7.5x forward peak EBITDA and 11x peak free cash flow [fully taxed free cash flow = $290: $500 - $22m in interest and $20m in maintenance capex]. When peak EBITDA is actually reached, earnings will fall quickly and dramatically because gypsum wallboard only operates at full capacity when there is overbuilding. I estimate that next cycle's peak EBITDA will not exceed $400m, as it will be constrained by less-than-full capacity utilization in gypsum wallboard (which contributed $215m in segment EBITDA in FY07, 58% of EBITDA prior to corporate overhead allocation). The gypsum wallboard segment is a worse business than the current valuation of Eagle would suggest.

Another way to look at the business is to ask what the various parts of the business are worth. Taking the construction costs of Eagle’s Georgetown, SC wallboard plant as a proxy for reproduction value, Eagles’s gypsum wallboard operations are worth $750m (3,750m sf of capacity at $200/msf). The paperboard and concrete & aggregates businesses together contribute ~35m in mid-cycle EBITDA; say these are worth 6.5x for a value of $227m. Say that the fracking sand opportunity, which has yet to enter production, is worth $500m on a base case. This leaves the cement business requiring a valuation of $2.3bn to get to current enterprise value. Eagle paid $446m for 1.6m tons of capacity for the Lafarge assets, or $278/ton. Using this acquisition as a proxy, the cement business is worth only $1.2bn. At $325/ton it is worth $1.43bn. Reproduction costs have been pegged around $300/ton. The table below is not meant to pinpoint the value of Eagle’s assets, but rather to show that the Company’s enterprise value assumes very high values (on a multiple of earnings, reproduction cost, and recent acquisition multiples basis) for the individual segments.

Conclusion:

Eagle Materials is a business trading at 7.5x a bullish estimate of forward peak EBITDA. A return to housing market levels last seen in 2006 and a boom in public construction projects would be required to bring about this level of earnings. According to Edward Pinto at AEI, over 50% of all mortgages outstanding in 2008 were subprime or other non-traditional mortgages (Alt-A, affordable housing mortgages); the average American consumer has become less creditworthy since then (see the Peter Wallison dissent in the Financial Crisis Inquiry Commission final report for Pinto’s stats).  I believe it is likely that housing stays at levels below the peaks reached in the 2004-2007 housing bubble. If this is the case, the gypsum wallboard segment’s earnings will stay under pressure because the operating leverage inherent in the business will not be unleashed. Even if I am wrong about housing and gypsum wallboard segment earnings, this stock is still overvalued, trading as it is at a premium to reproduction cost. The risk-reward at this price is more squarely in the favor of the short seller. Company insiders have been selling. I suggest they be followed.

Risks:

Housing starts accelerate much faster than projections and return closer to 2006 highs.

The eastern US gypsum market is in worse shape than imagined and synthetic gypsum faces constraints, allowing Eagle and other providers who use natural gypsum to operate at a significant cost advantage with high margins ensuing.

The fracking sand opportunity turns out to be a much larger contributor to EBITDA than $50m.

Catalyst