Description

Long – Forterra (FRTA)

Forterra (FRTA) represents a company in transformation, within an industry in transformation, as it leverages its market leadership positions in the water infrastructure and drainage industries to dramatically improve its margins, earnings power and cash flows.  This transformation has been driven by a new CEO, Karl Watson, who has already overhauled the Company’s pricing strategy and cost discipline in his short time at the helm.  Through strong management and favorable industry dynamics, we believe FRTA will generate $332 million of EBITDA in 2021, which should translate to a share price of $35.28 based on comparable company multiples, representing 151% upside from current levels.

On the surface, FRTA participates in attractive businesses with well-consolidated industry structures that should drive strong margins and returns.  In its water segment, the Company is the clear market leader in a three-player oligopoly.  In the drainage business, FRTA is also the largest player with revenues 67% greater than those of the next largest competitor.

Despite FRTA’s market share leadership in attractive industries, its business had performed poorly before Karl Watson was appointed CEO.  Shortly after the Company completed its initial public offering in October 2016, results deteriorated rapidly.  In both Q1 and Q2 2017, the Company reduced its outlook significantly, triggering a painful share price decline from $19.72 prior to the Q1 report all the way to a low of $3.06 in September of that year.  With the poor performance, leverage increased to disturbing levels.  Additionally, the Company’s private equity sponsor was unable to pursue a secondary offering, leaving the trading float too thin for a company of its size.  Over the next year and a half, the stock languished and investor confidence deteriorated.  Many investors began to question whether FRTA’s business was less attractive than it appeared or if it were simply mismanaged. 

Since Karl Watson was appointed as CEO in June 2019, he has demonstrated that FRTA’s primary issue was poor management as he has already executed a dramatic turnaround of the business.  Under the new leadership, FRTA has seen EBITDA improve by 38% in just one year.  This performance has continued unabated in Q2 2020, where FRTA improved its EBITDA by 40% as many companies struggled with economic carnage from the Covid-19 shutdowns.  While FRTA’s turnaround to-date has been impressive, we believe that this is just the beginning of a multi-year transformation.  Additionally, the Company was recently able to pursue a long-awaited secondary offering for its sponsor, which should serve as a re-IPO of the new Company and bring much needed new and more focused sell-side coverage.

Over the coming years, we see FRTA’s management unlocking the significant value inherent in its shares through the following three drivers: 1) strategic value-based pricing that should improve margins to appropriate levels given the favorable industry structure of both businesses; 2) focused execution on cost reduction opportunities to further enhance profitability and margins; and 3) strong cash flows that can be utilized to transform the Company’s balance sheet.  Additionally, we believe that there is significant optionality for further gains should the US Government pursue a long-awaited infrastructure bill which would benefit both of the Company’s segments.  We believe that FRTA can earn $332 million of EBIDA in 2021, reducing its leverage to levels that are much more appealing to investors.  At a peer EV/EBITDA multiple of 10.2x, this should result in a stock price of $35.28 per share, representing 139% upside from current levels.  By 2023, FRTA should be able to achieve its target margins which would drive $406 million of EBITDA and a $49.72 share price over time, 236% higher than current levels.  

Company Description

FRTA’s business currently consists of a water segment that represents 44% of last-twelve-month sales and a drainage segment that makes up the remaining 56%.  The water segment manufactures ductile iron pipe and associated fittings that are used for primarily for water mains.  This business has stable demand as it derives the majority of its revenue from water utilities and fixing broken pipes.  This dynamic makes the water segment acyclical to such an extent that its volumes were flat in Q2 2020 while the economy was crashing.

FRTA’s drainage business makes reinforced concrete pipe, manholes and storm water drainage systems.  Its demand is 45% driven by municipal and infrastructure spending with another 30% driven by residential construction, which is benefitting from the urban flight associated with the Covid-19 pandemic.  Additionally, highway spending is an important driver for this business as roadways require associated drainage systems.  While slightly more cyclical than the water business, volumes were still only down 13% in Q2 2020, significantly outperforming most building products peers.

Improved Pricing Strategy Should Drive Significant Margin Expansion

The biggest driver for value creation at FRTA will come from the margin transformation at the water segment.  When FRTA completed its IPO in 2016, the Company had just put together two major players in the ductile iron pipe market to establish a dominant market leadership position in a highly consolidated industry.  At the time, FRTA was estimated to have a 48% market share followed by American at 26%, McWayne at 25% and all other players at 1% of the business.  This market structure, combined with FRTA’s leadership position was expected to give FRTA and its competitors strong pricing power to drive improved margins over the cycle.

However, when scrap steel prices began to rise on the back of Trump’s China tariffs, FRTA and its competitors did a poor job of passing through pricing and even engaged in a war for market share, decimating the profitability of the business.  This ultimately resulted in the water segment’s pro forma adjusted EBITDA margins dipping from above 18% at the time of the IPO to a mere 10% in 2018.  Overall EBITDA in this business line dipped to $67 million, which was over 60% lower than expectations at the time of the IPO.

Competitor Price Increase Announcement Shines a Bright Light on Water Pricing Problem

While margins gradually began to recover in early 2019, two major events triggered a rapid margin recovery over the course of 2019 and into 2020.  First, in 2019, McWayne promoted a new head of its water business from outside the industry.  This new manager realized that the returns on the company’s water business were extremely poor for an industry with such a consolidated market structure.  Therefore, in April 2019, McWayne announced a 60-70% price increase on its ductile iron pipe products.  While this price increase was ultimately unsuccessful it provided a strong signal to other industry participants that McWayne was willing to pursue strong price increases to bring its returns on capital in the water business to acceptable levels.  Subsequently, FRTA followed McWayne’s lead and announced a more tolerable 10% price increase effective July 1, 2019.

Karl Watson Changes Pricing Behavior of FRTA

The second major catalyst for change in FRTA’s water business was appointing Karl Watson as CEO in June 2019.  Mr. Watson had come from Summit Materials (SUM) where he had witnessed first-hand how industry leaders like Martin Marietta Materials (MLM) and Vulcan Materials (VMC) could drive strong pricing and margins in the cement aggregates business.  These aggregates players trade at high multiples of 15.3x and 16.7x EV/EBITDA because of their ability to consistently and predictably increase pricing over time, well above the 10.2x building products multiple used for our FRTA price target.

At FRTA, Mr. Watson was quick to diagnose the key issue negatively impacting the water business.  As he said on the Company’s Q2 2020 earnings call, the only reason for FRTA to be earning such low margins in its water business was that it either had “…a cost problem or a pricing problem.  And a cost problem wasn't hard to diagnose…. We didn't really have a cost problem. So, it had to be price problem and I think we had to look internally before we look externally.  We had looked at our processes and methodologies, our philosophy strategy and tactics….And we've dramatically changed those in conjunction with our customers.”

It was clear to Watson that FRTA needed to bring prices up to a level where it could achieve strong margins and returns on capital regardless of the price of its key raw materials.  However, he knew that he could only do so if it was not disruptive to his customers’ business with large unexpected price increases like the one pursued by McWayne.  His conclusion was that FRTA would use its leadership position to establish a predicable price increase cadence.  The Company would announce two price increases every year to take effect on April 1 and October 1.  These price increases would be announced two months in advance giving customers ample ability to plan their businesses and competitors time to follow FRTA’s increases.

FRTA immediately began to pursue this policy announcing a 6% price increase on August 1, 2019 for effect in October.  Both FRTA’s 10% and 6% price increases have been successful.  Unfortunately, FRTA did end up withdrawing their next announced 3.5% price increase in April of this year as we were in the depth of the pandemic-driven recession.  However, they subsequently announced a 5% increase in August to take effect in October.  Our channel checks indicate that this price increase is likely to be successful.  More encouragingly, the August price increase was actually led by FRTA’s competitors several days before FRTA was scheduled to make its own pricing announcement.  This suggests that FRTA’s methodology is working and that all industry players remain committed to a rational pricing strategy.

The New Pricing Strategy Should Yield Significant Improvements in Water EBITDA

We believe that investors have not fully appreciated the opportunity FRTA’s new pricing strategy has to improve its EBITDA.  In 1H 2020, FRTA realized a 12% price increase in its water business which drove a 94% increase in water EBITDA.  It is clear that FRTA’s pricing has been the primary contributor to its EBITDA growth as 90% of the EBITDA increase one would expect from these price increases has fallen to the bottom line.  However, despite these positive results in 2020, current consensus estimates are not very optimistic about margin expansion at the Company in 2H 2020 and 2021.

If we take the current price increases that FRTA has already announced in its water business, pricing for the business in 2021 should increase by 6% before the potential for any 2021 price hikes.  Additionally, FRTA has been achieving pricing of 4% in its drainage business in 2020 and it is reasonable to assume that it would look for similar price increases in 2021.  If we take these price increases, pricing alone should contribute $79 million of EBITDA growth in 2021.  While it is reasonable to assume that raw material inflation will offset some of the benefits of FRTA’s price increases in 2021, current consensus estimates suggest that FRTA’s EBITDA will only grow by $19 million.  This suggests that only 24% of FRTA’s price increases will flow to the bottom line, which seems extremely pessimistic as compared to the 90% flow through on the water business in 1H 2020.  Similarly, 2H 2020 estimates also assume that only 41% of pricing in the water business flows through to the bottom line and that drainage EBITDA is relatively flat.  If we only assume a 60% flow through of pricing in 2H 2020 and 2021, we arrive at an EBITDA estimate for 2021 of $332 million, which is 18% higher than current consensus estimates.

Beyond 2021, we still see several years of opportunity for FRTA to pursue mid-to-high single digit price increases on an annual basis.  This is consistent with the price increases that were announced this year.  In February, FRTA announced a 3.5% price increase prior to the pandemic, which would have amounted to 7% on an annual basis had the August price increase come in at a similar level.  Then, the August price increase is expected to be 5%, confirming that FRTA will continue to seek 5-7% annual price increases.  As investors begin to understand FRTA’s aggressive pricing philosophy and the impact that it will have on the bottom line, we believe that FRTA will be at least awarded a peer multiple if not a premium multiple. At a peer EV/EBITDA multiple of 10.2x, the shares should be worth $35.23, compared to today’s price of $14.05.

Drainage Pricing Enhancement Should Drive Strong EBITDA Improvements

While the water business clearly has the most significant upside, the drainage business still has room to improve its EBITDA at a double-digit rate over the next several years.  Unlike the water business, the drainage business is much more local in scope since the shipping radius for these products is shorter.  FRTA is a clear market leader in this business with an estimated 18% market share.  The Company is 67% larger than its next largest competitor in this business and over two times as large as the next biggest.  Even with the more local nature of the drainage business, FRTA’s scale matters as the Company can negotiate better deals for raw materials and participate in larger projects which may require multiple sites to produce them.

Much like in the water business, Karl Watson and his team have brought an enhanced pricing discipline to this business that is beginning to translate to stronger profitability.  However, the drainage business has been more impacted by the recent recession, so this pricing has not had the same impact on bottom line results to date.  This year, FRTA has managed to pass through price increases of around 4% despite a weaker demand backdrop.  These price increases have allowed the Company to grow EBITDA by 13% in the drainage business while volumes have dropped by 10%.

The drainage business is generally driven by highway construction, residential construction, and non-residential construction that follows residential.  These end markets have actually performed relatively better than FRTA’s volumes suggest, so we believe that FRTA should see a snap back in demand next year.  With a more constructive demand backdrop, we see the potential for a strong improvement in profitability in the drainage business in 2021.  We fully expect FRTA to continue to raise its prices at the current 4% rate and anticipate a recovery in demand, which should drive EBITDA growth of 11% in 2021.  Currently, consensus expectations call for relatively modest 2% EBITDA growth.  We believe that this disconnect is caused by the fact that analysts do not yet understand the power of FRTA’s improved pricing discipline in a better volume environment, since the benefits of pricing in 2020 were somewhat offset by weaker volumes.

Long Runway of Cost Opportunities Should Further Enhance EBITDA

While improved pricing in both businesses is the primary driver of EBITDA growth for FRTA, the Company also has a large backlog of cost improvement opportunities that will allow improved pricing to flow to the bottom line.  While pricing improvements can be implemented quickly, these cost improvement opportunities will provide a second leg to the margin improvement story at FRTA.  Upon his appointment as CEO, Karl Watson did an assessment of the two businesses in terms of their cost discipline.  On a scale of 1 to 10, he rated the water business as slightly below 1 and the drainage business as somewhere between 3 and 4, suggesting substantial room for improvement.

The Company is in the early stages of a lean manufacturing implementation, and has focused on empowering local plant management to provide specific ideas of how to better manage labor efficiency and improve scrap.  While the cost improvement journey is in its early stages, there have been several success stories.  For example, in the Stacy, Minnesota drainage pipe plant, the team has been able to improve labor productivity by 40%.  Labor productivity is of paramount importance in the drainage business because labor costs can be 30-35% of the costs to manufacture the product.  Currently, management is investing in robotics, technology and cement lining capability to further improve the cost structure.

However, in 2020, we believe that very little improvement has flowed to the bottom line particularly in the water business.  Indeed, management has actually taken some of the strong EBITDA growth from pricing initiatives and reinvested in the businesses to set the stage for longer-term process improvements.  Finally, as a legacy of the roll-up to create FRTA, the Company is still operating on four ERP systems, which is down from seven at the time of IPO.  Over time, the Company has the opportunity to consolidate down to one system, which will reduce duplicative overhead and allow the Company to digitize manual processes.  However, currently the Company is too early in its cost improvement journey to risk the potential for disruption.

The powerful combination of rational pricing and cost improvements should result in a substantial margin opportunity for both the drainage and water businesses over time.  Through a combination of steady 4% price increases and disciplined cost management, we believe that the drainage business can earn a 25% EBITDA margin over the next several years, representing approximately 400 basis points of improvement from current levels.

Moreover, the margin opportunity in the water business is much more significant. We believe that Karl Watson is on the path to improving water EBITDA margins to a range of 25-30% over time from current margin levels of 17% on a last-twelve-month basis.  As he stated on FRTA’s most recent earnings call, the water business “is a low asset term business, it's got high barriers to entry, it's got very stable demand, it's a national business with three players.”  This all argues for EBITDA margins that are higher than the Company’s drainage business.  While the drainage business is a good business if operated well, the margin entitlement is higher in the water business given the better market structure.

As FRTA achieves its target margins, we see several more years of strong double-digit EBITDA increases ultimately resulting in $406 million in EBITDA in 2023.  While we have not based our price targets on this level of future EBITDA, we believe investors should begin to understand this trajectory over the coming year and award FRTA with a higher trading multiple.  Over time, however, if one were to apply the industry average EV/EBITDA multiple of 10.2x to this 2023 opportunity, it would result in a stock price of $49.72, or 236% higher than current levels.

Improved Cash Flows Lead to Rapid Deleveraging of the Balance Sheet

FRTA’s rapid EBITDA growth and strong free cash flows will allow the Company to rapidly deleverage its balance sheet, meaningfully expanding the universe of potential investors.  FRTA has done an excellent job of growing its earnings and proving its business is much less cyclical than feared.  Nevertheless, many long-term investors will not look at small capitalization stocks with net debt-to-EBITDA ratios over 4.0x and FRTA is still at 5.0x on a trailing-twelve-month basis.  Moreover, under prior management, FRTA did not generate substantial cash flow to pay down debt, leaving investors wary.  However, under Karl Watson, FRTA has already generated strong free cash flow of approximately $200 million and dramatically improved its balance sheet.  Thus, the Company should soon be at leverage ratios that will expand its appeal to a larger group of investors.

Over the past year, FRTA has dramatically improved its leverage profile and eliminated hidden liabilities that could have slowed its progress.  Over FRTA’s first two and a half years as a public Company, its total free cash flow was negative $54 million.  When this cash burn was coupled with its significant EBITDA declines, the Company’s leverage ratio was at a troubling 7.6x net debt-to-EBITDA when the new management team took over.

This trajectory has changed dramatically since Karl Watson and his team have arrived.  Over their first year, FRTA’s new management team has generated an impressive $198 million of free cash flow ($3.03 per share) through a combination of improved earnings and diligent working capital management.  Additionally, the Company settled an arbitration dispute over a $100 million earn-out payment that was allegedly owed from an acquisition prior to the IPO, resulting in no further payments from FRTA.  When this dispute was settled, FRTA’s shares rallied by 23% over the next several days until a secondary offering derailed the share price momentum.  We believe that this share price reaction demonstrates investor sensitivity to the Company’s balance sheet, which highlights the upside inherent in the shares as the Company further deleverages over the next year.

We see very strong free cash flow generation over the next several quarters which should transform the Company’s balance sheet and investor perceptions of the stock.  Since FRTA historically generates the majority of its free cash flow in the second half of the year, the next two quarters will be pivotal in this transformation.  Over the second half of the year, we believe FRTA will generate $142 million of free cash flow ($2.17 per share).  This should reduce FRTA’s leverage ratio to 3.8x net debt-to-EBITDA by year-end.  Additionally, over the course of 2021, we believe FRTA will produce another $186 million of free cash flow ($2.84 per share), further reducing its net debt-to-EBITDA ratio to 2.7x.  This would put the Company’s leverage ratio below its longer-term target of 3.0-3.5x net debt-to-EBITDA.

While equity investors have been slower to recognize these improvements, the credit ratings agencies have taken notice of the Company’s deleveraging momentum.  FRTA has seen ratings upgrades from both S&P and Moody’s over the last several weeks.  In the Company’s press release around the Moody’s upgrade, we believe that management confirmed our analysis around deleveraging with a subtle change in language.  Until this press release, the 3.0-3.5x leverage ratio was always called a medium-term target.  However, in the Moody’s release, FRTA’s CFO suggested that the Company would achieve its leverage target “in the near-term.”

We believe that this enhanced cash flow generation will be a major catalyst for investors to reevaluate FRTA’s shares.  First, the free cash flow that FRTA should generate over the next six quarters is worth $5.02 per share, representing 35% of the current share price.  Second, lower leverage levels should decrease the stock’s volatility whenever there is a sell-off in the equity markets.  Finally, bringing leverage to 3.0x net debt-to-EBITDA or below should substantially increase the universe of investors who are willing to invest in the shares.

Conclusion

At the end of 2021, FRTA should not look much like the Company that Karl Watson took over in the middle of 2019.  We estimate that EBITDA will have grown by 89% over the two and a half years, and the Company’s leverage ratio will have decreased from a concerning 7.6x net debt-to-EBITDA to an appropriate 2.7x.  This progress has been achieved by a more rational pricing backdrop in the water business coupled with strong management execution around pricing, cost management and cash flow generation.  Therefore, we believe FRTA should trade at a 10.2x EV/EBITDA multiple, in line with its building products comparable peers, resulting in a $35.28 share price, 139% above current levels.

That said, we see further runway for FRTA to ultimately increase its EBITDA to $406 million over the next several years, driving strong double-digit EBITDA growth and a $49.72 share price, 236% above current levels.  While FRTA has historically traded at a multiple that mirrors its building products peers, the Company’s products are actually used in the water and drainage markets with a smaller exposure to more cyclical residential and commercial construction markets than its peers.  Water and drainage companies currently trade at a 15.7x EV/EBITDA multiple, materially higher than building products companies.  If we were to apply this multiple to our 2021 estimates, the stock would be worth $63.82 per share, representing 332% upside in the shares.

Finally, in our estimates we have assumed slow and steady end-market demand growth for FRTA’s water and drainage end markets.  However, currently there is a strong belief that there may be a larger infrastructure bill introduced in Washington in 2021.  Two major objectives of such a bill would be to improve highways, benefitting FRTA’s drainage business, and to improve water infrastructure, benefitting the water business.  If such a bill were passed, it would provide further upside to our FRTA estimates and generate additional investor interest in the shares.

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete. We undertake no responsibility or obligation to revise or update such St

Catalyst

1) Earnings and margin upside

2) FCF and further debt paydown

3) Future price increase announcements

4) Potential for infrastructure package