Wednesday, October 31, 2007

U.S. Concrete [ RMIX ], a hedge

Ouch! When I left yesterday for the golf course, MLM was down $3. When I returned it had completed a $10 swing and finished up the day plus $6+! To make matters worse, I lost $7 on the course.

Happily my puts are still profitable, just less so. I listened to both the VMC and MLM conference calls and still think that residential development won’t recover as fast as they believe and was encouraged that MLM saw a “slowing of commercial construction growth.” Zelnack termed that area as a”big uncertainty.” Vulcan still hadn’t seen any negatives in the non-residential area. I think it’s happening now and it will be noticeable in the current quarter.

So, I’m going to ride this horse a little longer. But, I’m going to hedge my bet somewhat.

I’ve been buying some U.S. Concrete [ RMIX ] as a hedge. If MLM runs upward, hopefully US will also and that profit will help offset the drop in value on the MLM puts.

US is a smaller redi-mix concrete company that has additional operations in aggregates, concrete block, and precast concrete pipe. Their big markets are the Bay Area in California, Dallas, Memphis, Detroit, and New Jersey. They have been growing by acquisition and their efforts have been on integrating and acquiring, not wringing out profits. That should come in time.

In the last three or four months the stock has moved down from $9.50 to $5. It sells at a forward P/E of 10X and a PEG ratio of 1.23X. You’re buying it at a Price to sales ratio of .23 and a very conservative price to book ratio of .72. Enterprise value to EBITDA is 6X. They need to start making some more money and generating more cashflow to make me a long term owner, but it suffices as a hedging devise and if they do start improving their earnings they can stay in my portfolio as I like the industry and will buy both VMC and MLM later.

Tuesday, October 30, 2007

MLM’s results better than VMC

Kudos to Steve Zelnak and his team at Martin Marietta Materials. When comparing their performance to rival VMC, Martin clearly came out ahead this quarter. While Vulcan could do no better than flat earnings in the face of the housing downturn, MLM grew earnings significantly. They increased net sales by 4% and earned $2.12 per share. The earnings figure had $.12 of tax benefit included and I’m not sure if the analyst community had that factored into their consensus figure of $2.04. Results could be either a Beat or a Miss depending on if the tax impact was expected, or not. Either way it was one helluva quarter. Better than I was expecting. My guestimate of 10/27/07 overestimated income taxes as the company actually had a tax rate for the quarter of 26%.
The conference call should shed more light on the future, but Zelnak did state that they are seeing a “pause” in some types of commercial construction in addition to the residential carnage. They are still looking for a good finish to the year. no word about 2008 yet.
Today will be interesting as VMC was down $5 in the premarket and both of these companies will be having conference calls. At to that all the Fed interest rate cut chatter and who knows what MLM’s share price will be by market close. The good news for my Puts is that while MLM had a good quarter, they didn’t say that shipments were increasing and the construction slowdown was over. I still don’t think they can hit the 2008 projections that analysts are counting on so I’m content to wait.

Monday, October 29, 2007

Vulcan falls far short of expectations

I’ve been waiting for Vulcan [ VMC ] to report earnings as they are MLM’s most direct, national competitor. The numbers are out and they, like TXI, EXP, and RMIX, were not good. Their performance, similar to what I expect of MLM, continued to be among the best of the construction suppliers, but not what wall street was expecting and worthy of a healthy P/E ratio.
Revenue was down 3% to $905M. Analysts had been expecting $952M, Residential construction continued to be a drag and commercial and infrastructure couldn’t take up the slack as all major product lines had lower shipments. The bright spot was gross profit as margin was up to 33% from 32%. The result of the lower volumes was flat net income of $1.38 per share vs $1.39. Analysts had been expecting $1.59. The strong pricing/growth story is coming to an end for the next several quarters and with it a lower earnings multiple.
MLM reports before the market opens tomorrow.Given Vulcan’s performance, matching what analysts expect will be an accomplishment.

Buffett’s view on derivatives

Yesterday I wrote a missive about the current credit crisis and why I was confident that it would end badly using the Penn Square/Continental Illinois bank failures as a history lesson. The derivatives, CDOs, and Asset Backed Commercial Paper Programs are so complicated and illiquid that determining price has been a problem. Beyond what is the proper balance sheet treatment, the imperative question is can I sell the security at anywhere near par?
Warren Buffett’s experience with General Re’s derivatives portfolio gives us a clue to the magnitude and difficulty of the problem. Keep in mind that those derivatives were an early vintage portfolio, Berkshire’s General Re had the luxury of time that capital provides, and the Oracle of Omaha was assisting in the winding down. Many of today’s financial institutions won’t be as fortunate as Buffett.
From page 14 of Berkshire’s 2006 Annual Report: “You will be happy to hear—and I’m even happier—that this will be my last discussion of the losses at General Re’s derivative operation. When we started to wind this business down early in 2002, we had 23,218 contracts outstanding. Now we have 197. Our cumulative pre-tax loss from this operation totals $409 million, but only $5 million occurred in 2006. Charlie says that if we had properly classified the $409 million on our 2001 balance sheet, it would have been labeled “Good Until Reached For.”
“Good Until Reached For” is what the world’s financial institutions are struggling with today. Who is going to absorb the losses and what will be the unintended consequences? Right now, the banks don’t know, the regulators don’t know, CNBC and the media doesn’t know so stay far, far away from financials and don’t buy the financials on the dips.

Sunday, October 28, 2007

La Salle Street; home of the former Continental Illinois

As I read the daily articles about the “credit crisis”, my banking experience tells me that this crisis will not end painlessly. Lower rates on Fed Funds, a more accommodating Discount Window, and a Super SIV sound like they will solve the crisis, but they will only delay the inevitable. The inevitable result is the failure of the worst offenders of credit risk disregard. Many of the world’s largest financial institutions played the game. All will be hurt, the most egregious violators will fail. In addition to the shareholders of the failed institutions, we all lose as most financial companies will have lower earnings, credit is curtailed, and the economy slows.
When a credit bubble develops it appears to affect only a certain industry. That is rarely the case as it couldn’t develop if the tried and true standards of controlling risk were adhered to. Subprime real estate lending was at the forefront of our current crisis and initially it appeared to be a minor irritant for the economy. We are now seeing that decisions at the CEO level of commercial banks, investment banks, hedge funds and other investment companies, around the world, fed the spread of loose credit throughout the economy.
Not only have we seen buckets of poorly underwritten subprime mortgages, we’ve seen the home equity market decline, the Alt-A ARMs approach reset disaster, and asset backed commercial paper become unmarketable. With a sputtering economy and no home equity to refinance, credit card portfolios will soon have major delinquencies. Commercial credit looks okay today, but when the music stops there will be problems there also. The first indication of those problems was when the bank’s, all of a sudden, woke up and decided they had been too easy on LBO credit and couldn’t find participants for their commitments.
The headlines always bring me back to the 1980’s and a booming oil patch. A small Oklahoma City bank, Penn Square, failed due to loose lending. It’s problems appeared contained to Oklahoma. They wasn’t. Penn Square originated loans, other bank’s letters of credit guaranteed the loans, Continental Illinois and other big banks purchased the loans and resold participations to smaller banks and insurers.Everyone was happy. Growth was robust, yields were high, and why worry, the nation’s 7th largest bank was involved.
Penn Square failed. Bank’s issuing the guarantees failed. Continental thought the problem was contained to their oil patch lending division until they started looking closer at all of their lending. They had relaxed their risk controls throughout the bank and the result was problems across all lending platforms. Is this starting to sound familiar?
People thought that CINB was too big to fail. The Fed loosened it’s discount window rules and kept the liquidity flowing. The problem was too large. The FDIC closed the bank and reopened it as Receiver. Chicago lost it’s biggest bank, shareholders were creamed, bank regulators were embarrassed, and prudent lending rules, though old fashioned, were proven to be of value.
But we easily forget, and a new generation of whiz kids create new products [ derivatives CDO’s & conduits ] that disregard the risk inherent in them. Citicorp, Merrill, Barclays or some other large financial institution will fail. The ones that feasted the most will disappear, all will develop a renewed appreciation for calculating the risk inherent in loan repayment.
As the banks start to slow their lending, coupled with very expensive oil, the economies of the developed world will cool. Earnings will come down and so will stock prices. It won’t be the end of the world, but investors will need to be good stock pickers and it will help overall portfolio results if one has a moved a decent amount of net worth into short term bonds. A 4% T-Bill won’t look bad compared to falling equities.
Steer clear of financial stocks, raise some cash, and be aware that times will become more difficult over the next 24 months.

Saturday, October 27, 2007

Martin Marietta Aggregates [ MLM ] remains overvalued

Long term I like this industry and this company. They have become much more efficient through the use of automation, accessed new markets through the use of rail and panamax vessels, and recognized that while rock is everywhere a new quarry or mine is very difficult to permit. No one wants to have blasting or rock trucks creating dust clouds near residential areas. So, if you already have the locations you have a valuable asset.
Company management has been very adept at telling Wall Street this story and backing up their thesis with significant, regular price increases that far exceeded covering any rising costs. The result has been dramatically increased net earnings and an expanding P/E ratio.
Generally I’m a buyer of stocks and tend to hold for long periods. In this instance I can’t buy the stock because it is significantly overvalued. Once again, MLM is an excellent company and one that I would gladly own, but at a lower entry price and I think I will see that more rational opportunity.
Why do I believe that MLM is/was priced too richly? Management has oversold the rock scarcity story and analysts have an average eps for 2008 of $7.76. Actual earnings for 2006 were $5.19 and the 2007 estimate is still $6.41.
The 2008 estimate is a 21% growth over ’07 and 52% over the ’06 results. I don’t think the last six months of 2007 will be good enough to earn $6.41 and the ’08 number is going to have to come way down. The economy isn’t cooperating and MLM needs a true “goldilocks” economy to come close to growing earnings by 20% again.
MLM’s business has three major components: residential, non-residential, and infrastructure. The fact that residential development has tanked is no secret. So far, in ’06 and interim ’07, the other two categories, plus price increases have allowed earnings to continue to grow in spite of the disaster in residential. On the last conference call the company noted that non-residential was flat, no longer growing and highway projects were being delayed. The CEO stayed by guidance and promised continued margin expansion. Zelnack, the CEO, sits on Beazer Homes board of directors so he isn’t unaware of the terrible housing situation. He remains confident.
However, on numerous occasions during the past 6 months, both he and SVP Sipling have sold large blocks of stock. While that isn’t normally a red flag, in these cases I believe it is. On multiple occasions, they exercised options that had 5-7 years of life left and elected to exercise, sell, and pay tax on millions early. You don’t see that very often, even near retirement. Buffett would advise that you should compound your money and delay paying your taxes till the last minute. Why sell millions of dollars worth of your stock early if you didn’t think the best of times were behind you. Not necessarily operating best of times, but irrational stock pricing best of times.
For years, this company has been run conservatively. With their recent pricing power they have garnered operating margins of 18% and a ROE of 24%. They’ve spent their cashflow to modernize and expand their facilities.
While not outright wild, the balance sheet has been leveraged up this year and debt now stands at $1.2B for a debt/equity ratio of 1.3:1. The proceeds of $500M borrowing during the last two quarters was used to retire stock. The company bought back over 3M shares for an average cost of $138 per share. So far, the current price is near $124, not a good use of cash other than juicing the eps number since less shares are outstanding. Interest expense will be rising also in the third quarter after the debt issuance.
In the past few days both TXI and EXP have reported their quarterly numbers. While the former is a major cement manufacturer and the latter is a wallboard leader, they both have divisions that sell aggregates and concrete so they are comparable to MLM. Volumes were down and pricing wasn’t robust like in prior quarters. They both have some operations in Texas, a big MLM market. Additionally RMIX, a concrete and aggregates operator, just pre-announced that they would miss analysts estimates and they too have a large Texas presence.
EXP reported that revenue for concrete and aggregates was down 11%! Operating profit was down 18% in that division. Concrete shipments were down 11% and aggregates shipments declined 20%! Rock pricing was up only 1% over third quarter ’06! while concrete managed to maintain 5% higher prices. The 18% operating profit decline is the troubling number.
TXI fared modestly better in aggregates and concrete. Aggregates revenue was down to 40 M from 43M in ’06. Concrete sales were 80M vs. 73M last year. Combined the division grew sales by 3%. TXI didn’t breakout operating profits so we can’t tell if costs grew by more or less than 3%.
Three somewhat similar companies and the results are not measurably better than the same quarter in 2006. Granted, these companies are not exactly comparable, but they do demonstrate that the residential decline is impacting the companies more than the non-residential and government work can compensate for. MLM is priced at a high P/E multiple and a huge Enterprise Value/EBITDA and that cannot continue if earnings aren’t growing at a robust clip.
VMC reports after the market closes on Monday and MLM announces before the open on Tuesday. Neither has pre-announced any shortfall for the third quarter. Whether they miss or hit expectations, the real important information will be available on the conference call. Future expectations and construction market conditions will be key to how well the share price behaves.
MLM could meet the analysts expectations of $2.04 for the quarter. Using TXI’s 3% sales growth produces Revenue of 622M.If they can maintain their 2nd quarter 29% gross profit they will have $180M to offset $39M in SGA, $18M interest, and $9M in inventory re-evaluation they won’t have this quarter. The company has announced that they will have a 2% lower tax accrual, 29%, so they could have net income of $85M. After the buybacks there are approximately 42M shares outstanding. The above scenario produces $2.02 eps vs. the Wall Street consensus of $2.04. But given the difficulty of RMIX, EXP, and TXI odds of a miss is significant.
While I think they may miss, I think they will likely guide lower or hedge somewhat which will cause concern. Current ’08 estimates are for a 21% increase in eps.You can’t be awarded with 20+ P/E if you aren’t growing earnings at a good clip, no matter how low bond rates are. There is virtually no residential development starting and significantly reduced housing starts so residential volumes are continuing to decline. Tighter credit standards are bleeding over into commercial construction and that will become noticeable as 2008 progresses. The public sector is still building, but even government bodies are showing “some” restraint in face of falling property values. Volumes will decline again in 2008 and I don’t think, after 2 years of out-sized price increases, that pricing will cover rising costs from here forward. Less business will cause competitors to become price sensitive to cover ongoing expenses and still make good money, although not as good as a public company will need to keep a high share price.
How have I played this investment? Not knowing when my thesis would prove correct, I purchased Jan’09 140 Puts. At MLM’s current $125 price I’m doing fine as I’ve been gaining “in the money” value faster than I’ve been losing “time value.” Obviously this can change quickly if results are as expected and the conference call is positive. The Fed could produce a big pop for MLM as well on Wednesday. The LEAP puts give me the luxury of time to continue to monitor the situation.
Now here’s something interesting. Within the past 6 months Goldman Sachs, an Egyptian billionaire, John Skully’s SPO, and, worst of all, highly respected, Ruane Cuniff have all taken very large, reportable positions in MLM. I’m confident, I’m crusty, and I’m keeping my position until I see something that changes my mind. But I wish it were 28 year old Harvard MBAs that had taken those big positions.
Come back for my interpretation of the VMC and MLM results.
Add to Technorati Favorites