Description

Thesis Summary: MLM is a late-cycle construction materials company with deep moats, pricing power and significant cyclical upside over the next 2 years. 31% upside to year-end 2018 target at 22x $13.21 FY19 EPS vs. consensus at $11.04 FY19 EPS. MLM currently trades at 17.0x FY19 earnings vs. a 10-year historic average valuation range of 13.5x-35x fwd earnings. Target assumes an 18% tax rate (vs. historic 29%).

Key variant perception is that MLM is on the cusp of a cyclical upcycle in volumes. MLM has under-performed expectations for the past two years for a host of the reasons, but pent-up demand from public construction activity is growing from a low base based on positive survey data and current activity levels versus history. While weather and politics can defer activity, these projects eventually need to get done. MLM also enjoys a more idiosyncratic exposure to an upturn in volumes related to energy, specifically drilling activity in Texas.

Additional upside comes from the integration of an acquisition that has yet to close but is meaningfully accretive in 2018-2019 (Bluegrass) and a lower tax rate due to tax reform.

Key risks to our thesis are as follows: (1) state and local government infrastructure spend is deferred yet again and volumes continue to disappoint; (2) concerns about non-residential private construction activity peaking drive down the multiples of the aggregates companies; (3) Bluegrass acquisition is delayed further or blocked by DOJ

Background: Martin Marietta Materials (MLM) is the second largest aggregates producer in the U.S., and, after its 2014 acquisition of TXI, it is the largest cement producer in Texas.   The company also produces downstream products (asphalt, ready mix concrete, and road paving construction services) and specialty products used in industrial, agricultural, and environmental applications.  MLM ships product to customers in 32 states (the largest being Texas, Colorado, North Carolina, Georgia, Iowa, Oklahoma, and Florida) from 270 aggregates quarries and distribution yards.

Aggregates (crushed stone, sand, and gravel) and cement are used predominantly in the construction industry. Highways and and other public infrastructure are the largest segment with the balance going to residential and nonresidential construction.

Investment Thesis:  The market has been eagerly awaiting a cyclical upturn in aggregates volumes for several years now, only to be disappointed time and again. Excluding tax-reform related revisions, street estimates for 2017 EPS for MLM have fallen 25% since December 2016. MLM is expected to miss its initial 2017 guidance by 11% on EBITDA and 5% on volumes. Key to our thesis, we believe the volume deficiencies of 2016-2017 are not lost forever – they are deferred. Our above consensus volume expectations, the expected contribution of the Blue Grass acquisition and a reset of the company’s tax rate to 18% leave us expecting $13.24 in EPS in 2019, 20% above the street. Even assuming some of these factors are embedded in buy-side consensus, this creates an attractive 31% upside within the next year.

• After several years of disappointing results, there is significant buy-side skepticism of MLM achieving meaningful aggregates volume growth in 2018. We disagree, modeling +5% growth in ’18 and ’19

• Public infrastructure construction spending is the largest end-market for MLM, representing 40% of aggregates volumes and half of cement volumes. While private non-residential construction has recovered back to prior peaks, public infrastructure spend has been a severe laggard vs history

• This lag in public spending has translated into a lag in industry aggregates volumes relative to prior cycles

• Industry and company commentary suggests this dynamic is a coiled spring. Backlogs are as robust as they’ve been all cycle, implying that the industry is due for a catch up period

• Because of MLM’s exposure to TX, the company has also faced a direct headwind from lower aggregates volumes going into energy applications. Approximately 7.5mm tons of product were shipped into shale basins in 2014. That number declined to 3.8mm in 2015 and 1.4mm in 2016. This implies another 4% potential upside to volumes as rig counts recover

• The nature of the aggregates businesses allows for very high incremental margins. If we are right on volumes, there is room for incremental margins to move significantly higher. Gross incremental margins are set to be 44% in 2017. The last time aggregates volumes were greater than 4%, organic incremental margins (excluding acquisition of TXI) were 65% in this segment for MLM

• Blue Grass acquisition is highly accretive on a full-year annualized basis. We model $0.86 full-year run-rate accretion while consensus does not include any contribution for this deal yet

• While MLM has reported the volumes and revenue associated with Bluegrass in a bond prospectus in December, they have not reported margins. Our work concludes Bluegrass is roughly a 50% margin business, because it is pure aggregates (i.e. no downstream) and also operates in some of the most concentrated markets in the United States

• As a business with consistent pricing power, MLM is an obvious tax candidate to retain most of their benefits from tax reform. Over 98% of sales are made in the United States. We model the tax rate falling to 18%, while most sell-side estimates have yet to be updated to reflect this reality

• MLM’s tax rate has typically been in the high 20s (despite 35% statutory rate) due to the benefits they enjoy from statutory depletion and domestic production deductions. While the domestic production deduction is going away, MLM will instead be able to fully expense short-lived capital equipment for 5 years. Given the lack of a corporate AMT, MLM’s tax rate may fall to the high-teens. At an 18% tax rate we get to $10.24 of earnings per share in 2018 (up 49% YoY and 16% above consensus).

Margin of Safety: Medium margin of safety

• Favorable risk-reward: 31% upside with a $292 target price

• Earnings variant perception: FY19 estimates are 5% too low for EBITDA and 20% too low for earnings

• Valuation is modestly in our favor: The market has long rewarded MLM (and its more pure-play peer VMC) with above-average valuation premiums to reflect the quality of the aggregates business. Todays 40% premium (on consensus) to the S&P 500 on an NTM P/E ratio is almost standard deviation lower than the 12 year trend. We believe this reflects MLM’s recent history of disappointing investor expectations. Bears would argue this reflects MLM reaching its cyclical peak (we disagree)

• Management has proven competent on managing the business, but is promotional by nature and financial incentives are only modestly aligned. Chairman/CEO Ward Nye has led the company since 2010. He owns $25 million in MLM shares vs. an annual base salary of $1 million and $8 million of total compensation in FY16. His unvested options are all deeply in the money. Long-term incentives are set based on A) 75% from 3-year cumulative sales and EBITDA growth and B) 25% from TSR. Management has a poor track recording of hitting numbers. The business is highly weather-dependent and yet they have consistently set a high bar for themselves:

• High quality business with sustainable pricing power. Aggregates businesses enjoy considerable pricing power due to low value to weight ratio of their product and natural barriers to entry for new supply

• Aggregates sell for just $13.50 per ton and shipping them costs $0.15/$0.35 per mile on truck (which carries 76% of volumes for MLM). As such, at the midpoint, you are paying 2% of price to move product just one mile. Rail covers most of the remainder and offers better economics (4-9 cents/ton/mile). Economic shipping range is less than 30 miles for truck, less than 135 miles for rail

• New capacity is exceedingly difficult to bring on-line. Provided you have approvals, it will take 5-8 years. Approval process is rife with opportunities for NIMBY opponents to block the process (you need state, city and county approval)

• The low value/weight ratio and barriers to new capacity have allowed the industry to regularly enjoy positive inflation

• Cyclical risk mitigates some margin of safety. As with any construction business, MLM is cyclical and therefore dependent on the business cycle continuing in a favorable pattern.

Key Risks:

• State and local government infrastructure spend is deferred yet again and volumes continue to disappoint. Public infrastructure projects are very long-cycle, require significant manpower and cooperative weather patterns to execute on a timely basis. As with 2016 and 2017, MLM could once again face adverse weather, tight labor availability and deferred state and local spending which inhibits aggregates volumes    

• Concerns about non-residential private construction activity peaking drive down the multiples of the aggregates companies.  Unlike public construction, it is hard to argue private non-residential construction is below mid-cycle. In fact, it’s reached a new peak as of 2017. The end-market barely grew in 2017 and recent leading indicator data suggests this trend will continue in 2018. Just under 1/3 of MLM’s products go to private non-residential. As such, if the market begins to feel the end-market is at peak, it’s likely to be bad for the multiple

Private non-residential construction capex

Architectural Billings Index

• Bluegrass acquisition is delayed further by DOJ. When the acquisition of Bluegrass was announced in June 2017, MLM anticipated a quick close of the deal during 4Q17. Instead, the company has received a DOJ second request in the third quarter and is now guiding to a transaction close in 1H18. While management remains confident that the likelihood of a substantial divestment (i.e. 10% or more of EBITDA) is extremely low, any delays in the deal closing might be disappointing to investors. Aggregates demand is highly seasonal; if Bluegrass closes after the Spring it is a lost opportunity to raise prices for the year

Catalyst

Positive earnings revisions on aggregates volumes, closure of Bluegrass and tax