2014.10.28 US Concrete (USCR; $24.60) Long

This idea is pretty simple, so I will try to keep it short and targeted.  USCR is virtually a pure play US ready mix concrete company, with over 90% of revs from ready mix, nearly 5% from aggregates, and the balance from other related business.  See the latest company presentation here for more information: http://files.shareholder.com/downloads/AMDA-1H4VMY/3581231133x0x778308/4f32c415-f648-4f6e-96e4-764b997ab076/

Ready mix is historically a cyclical, cash generative business, with limited moats over the long term (facilities are small, with low capital requirements, trucks are historically easy to lease or finance, and minimum efficient scale is small).  As might be expected, historically the business was largely a “cost-push” model, with ready mix pricing heavily influenced by the main input costs such as cement, aggregates, and admixtures.  However, the business can generate very strong returns during the right part of the cycle, and crucially, I believe we are in the right part of the cycle.  Moreover, the depth of the last downturn was so severe that this upturn should allow for stronger ready mix profitability for longer than otherwise expected or typical.

Along those lines, the US ready mix industry (“RM”) today is enjoying a very tight supply-demand situation, which is providing the industry with very strong pricing.  In prior cycles, RM sequentially would lag cement and aggregates in regaining strong pricing due to excess supply early in the cycle.  It typically wouldn’t be until later in the upturn that RM demand would be sufficient to satiate supply and allow for strong pricing.  This cycle, however, the opposite occurred, with RM pricing strengthening sooner and more powerfully than cement and aggregates.  Look here, for instance, at the yoy pricing reported by Cemex for their US operations for both cement and RM going back to 2004:

RM industry capital bases and borrowing capacity were heavily depleted by the magnitude of losses suffered during the downturn such that RM capacity early in this cycle has already been tight.  The shortage of truck drivers more broadly that many industries have been speaking about for years further lends tightness to RM.

US cement industry price increases are accelerating, with expectations for 2015 realizations particularly robust in many parts of the country.  Such an input cost increase for the RM industry should provide the impetus for RM pricing to continue to accelerate.  Historically, when strong demand is driving big input cost increases, RM demand is strong enough to enable RM price increases to MORE than compensate for the input cost increases.  The same thing has been happening to date in this cycle.  The RM “material spread margin” as reported by USCR has increased from 46.1% in 2012 to 46.8% in 2013 to 47.5% in Q2’14.  The RM “raw material spread per cubic yard” as reported by USCR averaged ~$45 in 2012, before steadily increasing quarter by quarter to exit 2013 at $50 in Q4’13 and $52.43 in Q2’14.  

Cemex is the largest RM operator in the US.  I believe that events over the years at CX have also conspired to improve the outlook for RM industry pricing.  Cemex’s US operations went from earning ~$2.4B of EBITDA on a pro forma basis at the last peak to negative EBITDA at the trough.  Meanwhile, the cement plants remained in the black on the EBITDA line (still a poor showing given the capital intensity of cement as opposed to RM), meaning that RM was sharply money losing at the bottom.  The new leader of Cemex US operations, Karl Watson, Jr, has done a remarkable job in hammering home the importance of pricing discipline.  It has been evident not only in Cemex US results, but also in the way that all the other geographic divisions of Cemex adopted much of the same language and individual policies around pricing discipline at this year’s analyst – clearly modeled after Karl and very different from prior years.  Given the level of Cemex’s vertical integration in the US, its very high level of balance sheet leverage, and its current EBITDA generation across its footprint outside of the US, it is clear that for CX to work going forward, US RM pricing better be good.  CX EBITDA cannot grow dramatically without the US supply the bulk of it, and the US cannot see dramatic EBITDA growth without RM profitability continuing to improve.  From USCR’s perspective, it can only help that CX incentives should be so aligned.

The acquisition of TXI by MLM can only help, as well, I think.  TXI was well known in the industry for being a spoiler on price and lacking discipline.  MLM has been known for the opposite.  Moreover, USCR has commented that Texas in general (largely Dallas area) has been the lowest margin geography for the company.  So improvements in Texas should help USCR.  The most recent USCR acquisition of Old Castle assets in the other Texas markets could also potentially add increased discipline to Texas broadly.

The evidence of strong pricing continues to roll in.  US PPI for RM is strong, Cemex in Q3 reported the highest YoY RM price increase thus far in the present cycle as shown above, MLM announced that RM pricing in its “heritage” business accelerated in Q3 to +13.5% YoY, EXP reported RM pricing up a solid +5.6% YoY in its September quarter, etc.

I like that USCR is a pure play and small.  The sell side coverage is obviously extremely limited.  While I’m certainly not banking on it, it is possible that USCR gets acquired as the cycle plays out.  Though upstream industry management teams claim to have learned lessons from the last cycle, that is basically what happened last time with CX buying RMC and Rinker and VMC buying FRK.  Industry veterans have remarked that the RM business makes so much money at the top of the cycle, that management teams lose sight of its challenges at the bottom of the cycle and find the “downstream integration” just too alluring.   By the time of the current cycle peaks, management teams may well have cycled on to the point that those who “learned” from last cycle are no longer around anyway.

The CEO of USCR strikes me as quite savvy for a company of this size.  I also like that 40% of his most recent Restricted Stock award is dependent on the stock price staying above $30.60 and $35.60 for over 20 trading days before September 2017, although the size of that award doesn’t seem large enough to him to make that a major point.

To frame the upside to USCR, I have applied EBITDA multiples to my EBITDA projections, and then sanity-checked my price targets with the implied P/E, EBITDA-Capex, EBIT, and FCF multiples:

As shown in the table above, USCR has 2 classes of warrants that were issued in connection with emergence from bankruptcy after the last industry downturn.  Each class of warrants has 1.5 million underlying shares and expires on August 31, 2017.  USCRW has a strike price of $22.69 / share and USCXW has a strike price of $26.68 / share.  Thus, the warrants are obviously a lot less liquid than USCR, but I think they are equally, if not more, interesting – particularly in an upside case where the cyclical upturn continues stronger for longer, as evidenced in the table above using my 2016 and 2017 projections.

I think the biggest risk to the thesis is that RM material spread starts compressing instead of continuing to expand.  There are no signs of that happening now (to the contrary as discussed above), but it is something to monitor.  Logically, for RM material spread to compress should require RM supply to outpace demand.  Typically this doesn’t happen until demand falls at the start of the next cyclical downturn.  Given how depressed RM demand and its drivers are today (residential construction, industrial and commercial construction, hwy and road construction) in volume terms vs historical norms, I would expect the next cyclical downturn not to be imminent. 

Aside from the more general macro risk of a US recession driving a cyclical downturn, the biggest concern I would have around demand would be that if oil prices crater, then much of the construction driven by the US energy build out in the affiliated geographies could fall hard.  I am far from being an energy expert, so aside from noting that such an eventuality ought to be something that one can hedge, I will simply note that it appears to this layman that most of the projects in question have a very long lead time, a long tail, economics that still make sense today, and marginal cost dynamics such that once construction begins, it almost always gets finished even if the strength of demand weakens during the course of the construction.

Catalysts

Earnings growth driven by continued RM price and volume increases and margin expansion.

Potential M&A.

Risks

Margin pressure from supply growth exceeded demand -- driven by a cyclical downturn or crude prices cratering.

Model Excerpts

Earnings growth driven by continued RM price and volume increases and margin expansion.

Potential M&A.