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Regional oligopoly business with robust asset value benefiting from strong industry tailwinds and dramatically improved operations, offering a +15% Yield and 25% IRR potential from a fully covered Fixed Income investment.
We recommend investors buy New Enterprise Stone & Lime (NEEST) 11% Senior Notes due 2018 at the current market price of around 90. As we outline below, the company operates a regional oligopoly business that is benefiting from strong industry trends. Despite some past choppy performance, NEEST’s business has improved markedly due to restructuring initiatives. Finally, the Enterprise Value of the business easily covers the debt, enabling a near-term re-financing and providing downside protection.
Headquartered in New Enterprise, PA, NEEST is a vertically integrated construction materials company operating in Pennsylvania and western New York. The company’s core business entails the mining, production and sale of the construction materials, including Aggregates, Asphalt and Ready Mix Concrete; NEEST was the 11th largest U.S. Aggregates company in 2014. 
The term “Aggregates” broadly describes the crushed rock and stone used as the foundation for construction projects, with significant volumes consumed in infrastructure projects. Asphalt involves the combination of aggregates (~95%) and petroleum-based products (mostly bitumen, the remaining 5%) to create the construction material used in road surfacing. Ready Mix Concrete combines cement with aggregates, water and other chemicals, to create concrete, which is used in nearly all construction activities.
Leveraging its construction materials operations and expertise, NEEST also provides road-building capabilities through its Heavy/Highway Construction segment. Finally, the company’s Safety Services & Equipment unit rents highway-related products (safety cones, roads signs, etc.).
An overview of NEEST’s business by segment is as follows:
Source: Company financials
As of year-end FY 2016 (ended 2/29/2016), New Enterprise had 55 quarries (42 active), 28 hot mix asphalt and 15 fixed and portable ready mixed concrete plants, three lime distribution and two construction supply centers.
NEEST’s capital structure is provided below:
Prior to March 2017, the company has the option to pay interest on the Senior Secured Notes entirely in cash or 4% cash / 9% PIK. After that date, the company must pay 100% of the interest in cash. Management has committed to paying cash on the Notes in FY 2017.
There are a number of covenants that NEEST must abide (please see Appendix 1: Covenant Summary). The key element of the docs, however, is the “springing maturity” provision. In short, the Credit Agreement has a final maturity of February 2019, but the facility becomes due if the company fails to refinance its Secured Notes prior to December 14, 2017 or if the company fails to refi its 11% Senior Notes by June 1, 2018. Because the company will likely have to refinance the secured and unsecured Note together, we view December 2017 as the effective maturity date for the bonds.
Our bullish view on the credit partially reflects the high expected IRR from a near-term refinancing of the capital structure:
NEEST’s checked history in the credit markets partially explains why an outsized opportunity exists today.
New Enterprise issued its 11.0% Senior Notes in August of 2010, using proceeds to pay-down bank debt. Not soon after, the company’s operations fell-off, with EBITDA declining from $74.1mn at the end of FY 2011 (ended 2/28/2011) to $45.8mn at the end of FY 2013 (ended 2/28/2013). (We will provide more details on “why” below). During this time, the company issued new 13% Senior Secured PIK Notes (1st Lien on PP&E and 2nd on ABL collateral) to repay bank debt and eliminate certain restrictive covenants. Compounding its operational issues, NEEST failed to file its 2012 financials in a timely manner after difficulties implementing a new ERP system. The delay prompted a notice of default, which the company ultimately cured, but bonds got pummeled in the process, earning the animus of many holders.
The bull-case for New Enterprise remains relatively simple: NEEST operates in an objectively attractive industry, which boasts high valuations and asset values that provide more than sufficient coverage for bonds. Plus, despite past operating difficulties, NEEST’s operations should continue to dramatically improved, helped by higher infrastructure spending and improved execution and cost structure. Below we provide more details on the attributes of this credit story:
High Barriers to Entry. Aggregate producers enjoy near monopolistic market dynamics. Crushed stone and rock offers little intrinsic value. Their worth derives from the fact that shipping aggregates often costs more than the product itself, creating significant value for quarries located near population centers and/or transportation corridors. An industry “rule of thumb” suggests miners can economically ship within a 100 mile radius.
Regulatory requirements re-enforce rational market conditions by limiting new mines. Again, aggregates located in the middle of nowhere have little value. However, obtaining permits for new quarries located near cities can be a Sisyphean task given their environmental impact. Hence, fully permitted and functioning mines become difficult, if not impossible, to replicate.
As a related concept, Aggregates are also isolated from many of the challenges that businesses confront today. There is no obsolescence risk or substitute product for crushed rock and stone. There is limited threat that Amazon or some other App will try to “disrupt” this market with an e-commerce solution given its limited value-to-weight ratio and hyper-local dynamics.
Aggregate providers are also largely linked to their domestic economies. Hence, unlike Oil & Gas companies, Aggregates players do not have to worry about global supply-and-demand in-balances. Macro issues like Chinese currency devaluation, “Brexit” or other geo-political risk de jour do not directly impact these businesses.
Federal funding tailwinds. New Enterprise derives around 50-55% of its revenue from the public sector, with the remainder from private (largely non-residential) construction activity. Recent changes in funding mechanisms for public infrastructure contributes to our bullish view of New Enterprise.
At the Federal level, in December 2015, Congress passed the FAST Act (Fixing America’s Surface Transportation Act), establishing five years of committed infrastructure spending. The bill, commonly referred to as “The Highway Bill,” represents the longest transportation funding measure in 17 years.
Previously, Federal transportation dollars had been allocated under extensions to SAFETEA-LU (an earlier Highway Bill) signed in 2005 and which expired in September 2009. Congressed re-upped SAFETLE-LU ten times after it expired, before enacting a two year measure Map-21 (Moving Ahead for Progress in the 21st Century Act) in 2012. Congress extended Map-21 as well, keeping it in place until May 2015. In short, prior to the FAST Act, the Federal government had allocated infrastructure spending through temporary legislative fixes.
Because infrastructure projects fit the very definition of “long-lead-time,” recent funding uncertainty has created an overhang for the Aggregates industry. Capital plans of five years are typical within government planning organizations. The uncertain funding environment has, therefore, resulted in project delays in recent years. With most planning activity conducted in the Spring, the initial benefit of the FAST Act should start showing up in the coming quarters.
As for the level of spending, the FAST ACT allocates $225.2bn from the Highway Trust Fund (HTF) for highway investment—a $20.2bn of increase over five years. Every state receives a 5.1% increase in FY16, followed by annual increases from 2.1% in 2017 to 2.4% in FY 2020:
Source: U.S. Department of Transportation, Federal Highway Administration
A discussion about the failings of the Federal Highway Trust Fund (specifically its underfunded status) is outside of the scope of this discussion. The FAST Act transfers into the HTF additional funds from the general account to keep it solvent through the end of FY 2020.
Funding specific to New Enterprise’s operating territories are as follows:
Source: American Road & Transportation Builders Association
Notably, the pace of new Federal spending is weighted toward this year, implying a near-term benefit. We would highlight that a modest revenue uptick can produce meaningful earnings gains in this high fixed-cost business.
State funding higher as well. State level funding should begin benefitting New Enterprise too. In November 2013, Pennsylvania Governor Tom Corbett signed Senate Bill 89, which will increase the state’s annual funding by $2.3bn for highway, bridge and public transit by FY 2017-18.
The Bill increases gas taxes and various motor vehicle fees to phase-in the new funds over a five year period. The $2.3bn increase to will represent a 40% increase over PennDot’s FY 2013 level of spending.
Higher funding levels are finding their way into project activity as evidenced by higher “letting” levels by PennDOT in recent years:
New Enterprise has yet to see much of a revenue lift from this new activity as management has commented that recent lettings have skewed toward eastern PA/Philadelphia, outside of their core western operating area. As spending normalizes statewide, we anticipate NEEST will start seeing the benefit of higher state funding.
Improving credit story. New Enterprise remains a family owned business, with no private equity sponsor and other investors. A lack of outside oversight likely contributed to the operational difficulties the company encountered shortly after its first bond offering. The company has taken a number of steps to improve its execution and cost structure, however.
In May 2013, Paul Detwiler III, who previously served as CFO, replaced his father Don Detwiler as CEO of the business. The move, more importantly, brought in outside management, with the appointment of Albert Stone as the company’s new CFO. Mr. Stone served in a similar role since 1997 for Aggregates Industries—a U.S. and U.K. Aggregates company. Later that year, James W. Van Buren (married to a Dewiler daughter/sister) stepped down as Chief Operating Officer as well. Robert Schmidt joined the company in September 2014, assuming much of Van Buren’s duties before becoming COO in April 2015. Mr. Schmidt has more than 30 years of experience in the construction materials industry. We view outside management as a significant positive for NEEST it has helped professionalize operations.
New Enterprise has brought in consulting help as well. At the end of 2013, the company hired BDO to serve as auditor and to identify $10mn of cost savings in 2015. NEEST also engaged Capstone Advisory in January 2015 to implement further cost cuts.
As part of its restructuring efforts, NEEST has also sold-off certain non-core businesses to improve productivity (while also boosting liquidity). The company conducted more than $30mn of asset sales in recent years, including the following: