Description

Eagle materials is an attractive investment to investors looking for a solid cash yield to equity, an under priced stock to its peers and an exceptional track record. We believe EXP is worth $75/ share which represents a 33% return. (For those interested, there is also a write up regarding an arbitrage in the capital structure.) Eagle Materials (formerly known as Centex Construction Products) is a Dallas-based company that manufactures and distributes cement (34%/46% of Sales/EBITDA), gypsum wallboard (43%/32%), recycled paperboard (12%/19%) and concrete and aggregates (11%/3%).

On February 2, 2004, Centex Corporation (CTX) distributed their 65% ownership control of EXP (formerly CXP). In order to effect a tax-free spin-off, EXP created a two class capital structure. These shares are EXP and EXP/B, which are nearly identical expect that EXP/B controls 85% of the board seats. Centex shareholders received approximately 0.044322 shares of EXP (the original class of common stock that went public in 1994) and approximately 0.149019 shares of EXP's new Class B common stock for each share of Centex common stock. There are approximately 9.3 mil shares outstanding of EXP/B and 9.5 million shares of EXP. Given the control factor and its relative cheapness to the EXP shares, we have been buying the B class. Please note that valuation numbers contained within are based on the pricing of the class B.

Historic Performance:
Although EXP’s assets have historically traded at a discount to their peer group (10 yr Avg.: 8.08x vs. 18.19x; 5yr Avg.: 7.19x vs 14.63x {Unleveraged after-tax asset multiple =EV/ EBITDA-Capex-taxes-Int*tax rate}), EXP’s financial performance is in a league of their own. As the table below demonstrates, over a five and ten year period, none of EXP’s comparables came close to their ROC, ROA or ROTA without rolling up assets at a cost to equity. (Rinker has been excluded because it wasn’t US listed during our investigation period). We believe that the market will soon appropriately recognize EXP as the strongest financial performer in the group now that it is out from Centex’s shadow. To be conservative in our estimates, we are taking full capex not maintenance. Also please note that USG is in bankruptcy for asbestos exposure.

EXP FRK VMC MLM TXI USG LAF RMIX Avg
5yr 5yr 5yr 5yr 5yr 5yr 5yr 5yr
ROC 19.7% 5.9% 12.5% 8.7% -4.3% 5.8% 5.9% 22.6% 9.6%
ROTA 16.9% 5.3% 11.0% 7.8% -3.8% 5.0% 5.1% 16.1% 7.9%
ROA 16.4% 4.8% 9.6% 5.9% -3.3% 5.0% 4.6% 10.0% 6.6%
ROE 23.6% 7.4% 16.3% 10.2% -11.0% 26.2% 7.2% 16.3% 12.0%
ROTE 25.0% 8.5% 22.9% 21.2% -15.1% 26.2% 9.0% -37.7% 7.5%
ROMVE 14.6% 3.0% 5.7% 4.3% -8.5% 45.5% 5.9% 10.2% 10.1%
Mrgn 20.4% 5.0% 9.9% 7.5% -3.7% 4.3% 5.1% 6.0% 6.8%
Trnover 0.95 x 1.28 x 1.26 x 1.18 x 0.94 x 1.47 x 1.11 x 3.70 x 1.48 x
EXP FRK VMC MLM TXI USG LAF Avg
10Yr 10Yr 10Yr 10Yr 10Yr 10Yr 10Yr
ROC 20.6% 6.2% 13.6% 11.5% -0.1% 11.5% 9.0% 10.3%
ROTA 17.7% 5.4% 11.9% 10.3% -0.1% 9.1% 7.7% 8.8%
ROA 17.3% 5.1% 11.0% 8.7% 0.0% 7.9% 7.3% 8.2%
ROE 24.0% 7.9% 17.5% 15.6% -3.7% -153.1% 12.6% -11.3%
ROTE 24.9% 8.8% 21.3% 23.6% -5.6% -62.6% 13.9% 3.5%
ROMVE 13.5% 4.7% 7.0% 6.2% -3.2% 32.9% 10.0% 10.2%
Mrgn 18.7% 4.7% 10.1% 10.4% 0.5% 6.8% 8.3% 8.5%
Trnover 1.09 x 1.33 x 1.33 x 1.17 x 1.17 x 1.74 x 1.11 x 1.28 x

Based on 5 and 10 year Averages, EXP has beaten their peers’ ROC by nearly 1000 bps, ROTA by nearly 700 bps and ROA by nearly 1000 bps. The only competitor that comes close to their ROC was RMIX. RMIX is a concrete roll-up which aggregated assets using debt and their stock. Although they have achieved respectable ROC over the past 5 years, it came at the expense of tangible book value of equity, which is negative. Only MLM and VMC, have ROTE in the range of EXP’s. In comparison, EXP has achieved their mid-twenty percent return on both tangible and total equity by organic growth and smart acquisitions. They paid only a 12.5% premium over the fair value of the assets they acquired in Nov. of 2000.

The most important point to take away from the above analysis is that although EXP has historically turned over their capital at a lower rate then their peers, their efficient use of capital (i.e. read fat margins) more then compensates for their lower turnover. In essence, management runs a tight ship.

Financial Forecast:
We believe management’s FY 2005 forecast of $3.70-3.90 per share in earnings are conservative given our view of wallboard pricing, however we have used their numbers to validate our cashflow projections for FY 2005 (March YE). From a LTM perspective, management’s revenue forecast imply a 10.9% revenue growth, 22.2% EBIT growth and 21.8% earnings growth. However, we have looked at EXP on a cash basis. At the Enterprise level, EBITDA-Capex is projected to grow by 10.8% (our capex assumption is nearly double LTM to error on the side of conservative). These growth effects will not all trickle down to equity because EXP has an advantageous tax asset that is expiring. We forecast cashflow to equity to be about $5.50, which is about flat from LTM cash. This represents a current cash yield to equity of about 9.72%. Management has historically paid out about 30% of Net Income in the form of dividend, which will equal about $1.20 per share. As you will notice below, EXP trades at a discount to its peer groups in terms of dividend yield.

Current Relative Valuation:
EXP/B MLM VMC TXI USG RMIX LAF FRK
PRICE (2/10/04) $56.50 $46.66 $47.08 $36.59 $19.25 $7.00 $41.71 $45.32
LTM ($ IN MILS)
MC $1,062 $2,289 $4,828 $772 $830 $194 $3,069 $1,982
DEBT $90 $718 $886 $808 $1,007 $162 $734 $94
CASH $0 $54 $330 $35 $660 $6 $428 $39
EV $1,152 $2,954 $5,384 $1,545 $1,177 $351 $3,375 $2,038
EBITDA - CAPEX 120.1 174.0 404.0 44.6 228.0 27.4 402.5 146.7
EV / EBITDA - CAPEX 9.6 17.0 13.3 34.6 5.2 12.8 8.4 13.9
AT Unlev CF 109.8 129.4 339.9 20.2 194.5 22.9 244.8 106.5
EV/ AT Unlev. CF 10.5 X 22.8 X 15.8 X 76.6 X 6.1 X 15.3 X 13.8 X 19.1 X
After tax Asset Yield 9.5% 4.4% 6.3% 1.3% 16.5% 6.5% 7.3% 5.2%
Cashflow to Equity 105.6 103.4 306.9 -9.1 189.0 12.8 208.3 105.6
Equity Multiple to Cash 10.1 X 22.1 X 15.7 X -84.5 X 4.4 X 15.1 X 14.7 X 18.8 X
Equity Yield 9.9% 4.5% 6.4% -1.2% 22.8% 6.6% 6.8% 5.3%
DIVIDEND 1.2 0.7 1.0 0.3 0.0 0.0 0.8 0.7
Dividend Yield 2.1% 1.5% 2.1% 0.8% 0.0% 0.0% 1.9% 1.5%

On an LTM basis, EXP’s assets are trading at 9.5% unleveraged after-tax yield, while the industry is trading at 5.17% unleveraged after-tax yield. This excludes USG which is in bankruptcy for their asbestos exposure. We believe that as the market gets comfortable with EXP’s financial performance, EXP will, at minimum, be valued in line with their peers if not at a premium.

If EXP traded at the industry’s 5 year unleveraged after-tax asset yield of 5.5% (18.19x), then the stock would trade at roughly $90 after taking the debt off the enterprise value (no cash is assumed to be on the balance since they paid out a large dividend as part of the spin-out). If EXP traded at the industry’s 10 year unleveraged after-tax asset yield of 6.83% (14.63x), then the stock would be worth about $75. Given that the current industry average unleveraged after-tax yield is 5.17% (19.35x), we are comfortable with using the 10 year industry average as the appropriate pricing.

In order to put this industry’s asset valuations into perspective, we analyzed the 10yr treasury on an after tax basis over the same period of time. It is worth noting that the 10yr traded, tax adjusted, at 3.06% and 3.45%, on average, over the past 5 and 10 years, respectively. We were initially concerned with how tight the industry traded to treasuries, but we justified current values by analyzing 10 years of valuation history.

In addition, we analyzed the current valuation from two different perspectives. First, management has a history of aggressively buying back stock at the right valuation when it is accretive to shareholders. Management has stated they will increase their debt levels to 40% of book value, if they find opportunities that are accretive to shareholders. At the current valuations, it is about 4% cash flow accretive for management to be buying back their shares using some of their debt capacity. In another more simple approach, we analyzed the impact to EXP’s stock price if its dividend payout ratio was more in line with the industry average.The method which isn’t as strong, simply adjusts EXP’s stock price so that their dividend ratio is in line with its competitors. This produces a stock price of $75.

Upside Potential:
Upside cashflow and earnings potential exists in cement prices and wallboard prices. EXP has large leverage to increases in both of these prices given their high utilization rates. A $10 increase in either product produces approximately $25 million of pretax cashflow to equity. The US cement industry has greater demand than internal capacity. As a result, the US imports a good percentage of their cement from abroad. Given the decline of the dollar, imports are becoming more expensive which could provide an opportunity for domestic cement manufactures to increase pricing. Wallboard pricing usually hits an inflection point when the industry hits high 80% utilization rates. The industry is currently at this inflection point and EXP’s current sale price for wallboard is about $91/msf. The mid-cycle sale price for Eagle’s wallboard prices is around $105-115/msf. It is important to note that management has increased its wallboard sale price by over 9% in the past year. Given the inflection point, price increases may occur more rapidly, which could result in an additional $60 mil of cash flow to equity. Thus, these wallboard price increases could produce 60% upside from current cashflow.

The logical question to ask here: What will management do with the upwards of $100 mil of cashflow generated each year? Shareholders should gain confidence by management’s historic smart use of cash. They claims they will invest at a 20% pre-tax ROI hurdle, will reduce their debt balance, dividend out cash to shareholders and buy back shares opportunistically. Larry Hirsch, Centex CEO and Chairman, announced his retirement from Centex as of March 31st. Although Hirsch will have no official capacity at Centex, he has stated his intention to stay on as Chairman of EXP. Given his track record as a great steward of capital, we are very pleased to see his commitment to this recently spun out business.

Risks:
Housing market decline is much greater than commercial construction pick up
Natural gas costs increase above expected rates
As in 00/01 increased wallboard pricing leads to addition capacity driving pricing downward

Catalyst

March 04 results will demonstrate the effect of wallboard pricing increases
Managements increased interaction with Wallstreet
Control/Liquidity discount due to Centex ownership removed