One of the first “rules” of investing I learned is not to recommend a cyclical on peak earnings. I think it is a near certainty that Eagle’s earnings have peaked for this cycle, so those of you who subscribe to this adage should read no further.  Wallboard, which comprised 58% of operating earnings last year (3/31/06) prices have started to slip.  Industry operating rates have fallen and are likely to decline more over the next couple of years.  My model shows that segment earnings will decline roughly 50% in F08 and stay depressed in F09—even though the company will open a new low-cost wallboard plant late in calendar 2007. 

 

Importantly, though, cement earnings—tied to both strong industry conditions and a plant expansion poised to open in the near future—should take up at least some of the slack and become the most profitable segment of Eagle next year (F08).  Two more cement plants will be modernized (with significantly lower operating costs) and expanded over the next three years.  Accordingly, barring a severe recession cement earnings should almost double by F10. Note that cement producers are accorded higher multiples because of their less cyclical earnings stream.

 

Looking out three years, Eagle should be earning over $5/share.  I estimate that future “peak” earnings based on the capital programs underway should approach $7/share.  Eagle has very modest debt and should have ample cash flow both to meet higher capital spending levels and continue to buy back stock without stretching its balance sheet.  On earnings power alone, Eagle should be a very good stock over the next several years.  At some point, though, this is a highly attractive acquisition candidate, either for a private equity firm or, more likely, an industrial buyer.  Recent building materials acquisitions have been in the 9X EBITDA range.  This yields $80/share based on my estimate of cash flow in three years (F10).

 

Corporate History:

 

Centex did a partial IPO of Eagle (then known as Centex Construction Products) in 1994 and spun off the remainder to shareholders in early 2004.  Nantembo wrote it up for VIC at the time of the spinoff, and it is worth reading.  I bought the stock at $19 on the strength of his report and it has obviously performed very well.  Based on a shortage of wallboard and, I suspect, a short squeeze, EXP more than doubled from May of last year to this May.  The stock then was cut in half by September and I renewed my interest in it.

 

Wallboard:

 

Eagle is currently the 5^th largest US producer of wallboard.  With the completion of a new, low cost plant in South Carolina late in 2007, EXP will account for 9% of industry capacity.  It’s hard to prove this from public information, but management has asserted repeatedly that Eagle has the best cost position in the industry. 

 

The wallboard industry has grown at an annual rate of 3.5% in units over many years, albeit with great pricing cyclicality.  Ten years ago there were 13 US producers; today there are only 8.  Furthermore, USG, Koch Industries (which acquired Georgia Pacific, and National Gypsum (also private) account for 2/3 of the market.  Industry capacity utilization was 98% in 2005, leading to a steep runup in prices. New residential construction is the largest segment, comprising 50% of demand in 2005.  As housing starts have tailed off in 2006, capacity utilization (and pricing) has started to decline even though the other major segments, non-residential construction and repair and remodel, have continued to grow. Eagle management estimates that industry capacity utilization will decline to 94% for all of 2006 and it currently approximates 90%. (A very informative presentation may be found on their website.  Additionally, Chris 815 recommended USG on VIC in September; his report is also quite helpful on industry dynamics).

 

 

Industry capacity is forecast to increase around 16% by the end of 2009.  Thus, I anticipate further declines in capacity utilization over the next two years, bottoming out in the low-mid 80’s.  In the last down cycle more capacity (30%) was brought on in a shorter period of time and, furthermore, Lafarge was a new entrant to the market and could only compete on price.  Accordingly, prices dropped over 40% peak to trough.  My guess is that this cycle will be severe, but a little more tempered for several reasons:  no new entrant, greater industry consolidation, less new capacity, a less coincident commercial construction cycle, and repair and remodel account for a somewhat larger percentage of demand.  I model the pricing bottom for Eagle at $110/MSF in F09—or 37% below the peak of this spring.  Even at these levels the South Carolina plant should add to profitability, so I think operating earnings will fall from the $190MM I expect in the current March year to around $90MM in both F08 and F09 (pricing should be somewhat worse in F09 given the new plants but the offset is that Eagle has a full year of production from its new plant).  By F10, segment profits should recover to around the F06 levels of $154MM.

 

Cement:

 

Though nothing could be more prosaic, the cement industry actually has very attractive characteristics.  Long-term, US cement demand has grown around GDP levels, with public construction accounting for the largest share at 50%.  Imports represent about 30% and foreign-owned companies control 80% of the market.  High shipping costs relative to value (current prices are around $90/ton) really make it a regional business.  Although Mexican duties have been eliminated, high shipping costs, rapid growth in Chinese demand, and dollar weakness all are a boon to US producers.  Accordingly, the industry has gained pricing power in recent years and almost all producers have already announced $10-12/ton price increases effective January 1. Industry capacity increases should approximate market growth over the next 5 years, although a severe recession would probably lead to some pricing erosion.

 

Eagle is now the 12^th largest producer in the US.  The company is in the early stages of an ambitious project to expand and lower costs at three of its cement facilities:  a $65MM project at Illinois Cement is just starting to ramp up, a $200MM project at Nevada Cement (serving Reno and Northern California) will come on in late calendar 2008, and a $120MM project in Wyoming will start in 2009.  Overall, internal production will grown 41% to 3.8MM tons and management believes that unit costs will decline by 25%. 

 

I believe average pricing will increase about 8% for EXP in F08 and then level off over the next two years.  Unit costs should decline modestly, although for the sake of conservatism I haven’t been as ambitious as management would suggest.  Hence, if pricing is weaker than I anticipate there may be a little cushion.  With these assumptions and the capacity increases, segment earnings should climb from about $109MM this year to around $150MM in each of the next two years and then to $200MM by F10.  At that point, even though I forecast a wallboard recovery starting in F10, cement should comprise over 50% of Eagle’s operating earnings.

 

Paperboard and Concrete/Aggregates:

 

These are small in the scheme of things (together less than 10 of operating earnings).  I believe EXP is well positioned in both areas and will respond to any questions but I just don’t believe they are worth a lot of discussion.   

 

Capital Management:

 

Since the Centex spinout Eagle has been a systematic buyer of its own stock:

 

F04:  176,000 @ $17.66  (note that the spinout occurred just before year end)

F05:  1,990,000 @ $22.02

F06:  4,550,000 @ $36.35

F07:  (through early October)  2,160,000 @ $35.02

 

In November the Board created a new authorization of 6MM shares.   Note also that Chairman Larry Hirsch bought 400,000 shares in the open market in September in the mid-30’s.

 

In my model EXP will generate $840MM after dividends from now through the end of F10.  Total new project costs are estimated at $535MM and normal capital expenditures should rise from the current $30MM annually to $40MM in the out years.  Thus,  Eagle should have a surplus of $165MM without assuming additional debt for further repurchase; I have simply modeled 1MM shares/year assuming a gradual rise in the stock price.

 

Risks:

 

 

 

      3.  MBO limits upside.