Summary
- MLM serves a low-growth cyclical construction sector. While its revenue grew faster than construction spending, this was via a combination of acquisitions and product mix changes.
- The growths and changes did not translate into positive trends for all the metrics that drove returns. ROE declined. Gross profitability also declined. Capital efficiency got worse.
- A Greenwald "Asset Value vs. EPV" analysis indicates that this is not a "franchise”. This is not a growth stock.
Investment thesis
Martin Marietta Materials Inc ( MLM ) has managed to grow its revenue at a faster pace than total construction spending over the past 17 years. This was via a combination of acquisitions and changes in the product mix.
However, this has not translated into better profitability or capital efficiency. The ROE today is lower than what it was in 2006. MLM is in a low-growth cyclical construction sector.
A Greenwald "Asset Value vs Earnings Power Value ((EPV))" analysis showed that this is not a growth stock. The appropriate valuation metric is EPV. On such a basis there is no margin of safety at the current price.
Thrust of my analysis
MLM is a natural resource-based building materials company. Over the past 17 years, its revenue grew at a 7.1 % CAGR via both organic growth and acquisitions. Over the same period, the US total construction spending only grew at 2.7 % CAGR.
You would think that MLM should be analyzed and valued as a growth company. I will show you otherwise and build my arguments along the following lines:
- The business is cyclical. The core business - Aggregates - did not have any shipment tonnage growth over the last cycle. Aggregates revenue growth was due to selling price growth.
- Despite its revenue growth, metrics that drove value did not improve appropriately. But it is financially sound. I would rate MLM's performance as average.
- I used the Greenwald "Asset Value vs EPV" analysis to show that MLM is not a "franchise". It is not a growth stock and its value should be based on the EPV or even the Book Value.
MLM business is cyclical
MLM has two business segments - Building materials and Magnesia Specialties.
The Building Materials business accounted for about 95 % of its 2022 revenue. This business is tied to construction spending which in turn is linked to Housing Starts. Both are not growth sectors:
- From 2006 to 2022, construction spending grew at 2.7 % CAGR.
- Over the past 70 years, there is no growth in the long-term average annual Housing Starts.
The construction spending and Housing Starts are also cyclical as can be seen from Charts 1 and 2.
Chart 1: US Housing Starts (Trading Economics.com) Chart 2: US Total Construction Spending ((FRED))
You can see that the latest peak-to-peak periods for both construction spending and Housing Starts are around 2006 to 2022. There is a high correlation between MLM revenue and these two over this period as can be seen in Table 1.
Table 1: Correlation with MLM Revenue (Author)
MLM has acknowledged this link.
"…The profitability of the Building Materials business…is sensitive to national, regional and local economic conditions and cyclical swings in construction spending…" 2021 Form 10k.
Valuation of cyclical companies
As a cyclical business, MLM valuation should be based on its performance over the cycle. Damodaran has this to say about valuing cyclical companies:
"Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable (the commodity price or the growth in the underlying economy) then it is on firm-specific characteristics…the biggest problem we face in valuing companies tied to either is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluation."
To overcome the cyclical issue, we have to normalize the performance over the cycle. Damodaran suggested 2 ways to do this:
- Take the average values over the cycle.
- Take the current revenue and determine the earnings by multiplying it with the normalized margins.
The challenge with the first approach for MLM is that the size of the company in 2022 is far greater than that in 2006. I thus adopted the second approach. However, there is even a challenge with the second approach as the product profile has changed over the cycle.
Aggregates performance
MLM today is different from that in 2006. In the first place, it is a much bigger company in terms of revenue. MLM revenue grew from USD 1.9b in 2006 to USD 5.7b in 2022 at a 7.1 % CAGR.
In 2006, the Aggregates business accounted for about 92% of the company's total revenue. At that juncture, Aggregate accounted for almost all the Building Materials business. But since then, MLM had diversified into other building products such as cement and ready-mix concrete. By 2022, Aggregates only accounted for about 60% of the company's total revenue.
Chart 3 illustrates this change.
Chart 3: Changes in Product Profile (Author)
You should not be surprised by this diversification as the US Aggregates sector is not exactly a growth one. From 2006 to 2021, the demand for Aggregates shrunk as can be seen in Chart 4.
Chart 4: US Aggregates Demand (Vulcan Form 10k 2021)
MLM Aggregates business reflects this demand situation. If you look at Chart 5, you can see that there was hardly any change in the shipment tonnage from 2006 to 2022. Rather Aggregates revenue growth was driven by price growth. From 2006 to 2022, the Aggregates selling price increased by 4.2 % CAGR.
The sad part is that while the selling price shows an uptrend, gross profit margins did not change very much. The Aggregates' average gross profit margins (excluding freight and delivery charges) for 2006 to 2008 was 27.7%. From 2019 to 2021 it averaged 29.8 %.
Cart 5: Aggregates Trend (Author)
Note to Chart 5: The index was based on dividing the values for each year by the respective 2006 values
MLM growth was not only due to product diversification but also acquisitions. From 2006 to 2022, MLM spent USD 5.5 b in cash acquisitions. To give you a sense of the scale, during this period:
- The Total Capital Employed (TCE) increased by USD 10b. I defined TCE as = Shareholders' funds + Minority Interests - Cash.
- MLM also spent USD 5.1 b for CAPEX (excluding the acquisitions).
The acquisitions and CAPEX translate into a Reinvestment rate of about 55% where:
- Reinvestment rate = Reinvestment / EBIT(1-t).
- Reinvestment as = Acquisitions + CAPEX - Divestitures - Depreciation & Amortization + Net Changes in Working Capital.
Effectively about half of the after-tax earnings were diverted to investing for the future. With such a rate, I would expect not just revenue growth, but also improvements in profitability and returns. But this was not the case.
Business performance
I would consider MLM performance over the cycle as average based on the following:
- ROE to decline from 20 % in 2006 to 13 % in 2022. This was because revenue and PAT grew faster than the capital employed.
- Gross profitability (gross profits / total assets) declined from 21 % in 2006 to 10 % in 2022.
- MLM's Return on Assets over the cycle was better than those of its peers.
- MLM is financially sound.
As you can see not all the metrics point to improvements. It is a mixture of good and bad.
Profitability and return trends
You can see the trends in the revenue, PAT, and Gross profitability in Chart 6. Both the revenue and PAT dipped during the trough part of the cycle before going beyond the 2006 values.
The key concern is Gross profitability. Its performance throughout the cycle was less than the 2006 values. I would consider it as "static" over the recent past. According to Professor Novy-Marx, this metric has the same power as Price to Book in predicting returns for stocks.
Chart 6: Performance Index (Author)
A DuPont analysis over the cycle showed that the decline in the ROE was driven by the decline in Leverage and Asset turnover. Refer to Chart 7.
While declining Leverage is a positive sign, a declining Asset turnover points to decreasing operational efficiency. The other positive sign was the Profit margin. While I could not discern an improving trend, the values for the past few years were better than that in 2006.
Chart 7: DuPont Analysis (Author)
To get a better understanding of Leverage and Asset turnover, I charted the performance of 3 key metrics that I used in my valuation. Refer to Chart 8 that shows the trends over the cycle.
- Gross profit margins (GP margins in the chart) showed some improvements over the cycle.
- Selling, General, and Administration margins (SGA margin in the chart). There was hardly any improvement (reduction in the margins) over the cycle.
- TCE/Revenue. This is a measure of capital efficiency. You can see that the TCE/Revenue increased over the cycle. This is not good news as it meant using more capital for the same level of revenue.
Chart 8: Profit Drivers (Author)
I had earlier shown that the Gross profit margins for the Aggregates business did not change very much over the past 17 years. Looking at Charts 8 and 3, I would conclude that the improvements in the overall gross profit margins must be due to the changes in the product mix.
I also believe that the acquisitions and changes in the product mix made MLM less efficient when viewed through the TCE/Revenue lens.
The takeaway is that when normalizing the various metrics used in valuing MLM, we should not use the average values from 2006 to 2022. The nature of the business has changed. It may be more realistic to base them on the 2015 to 2022 period.
Unfortunately, this period covered the uptrend part of the cycle only. As such the intrinsic values determined using the 2015 to 2022 averages must be considered optimistic.
Peer comparison
According to MLM, it operates in a largely-fragmented industry with over 5,000 domestic aggregates producers. These include large, public companies and a large number of small, privately-held companies.
In its 2021 Form 10k, MLM listed 7 publicly traded companies that are among the top 10 Aggregates producers.
I compared MLM returns as measured by the Return on Assets (ROA) with 6 of these peers. I used ROA as the performance metric rather than ROE to avoid the impact of Debt. Refer to Chart 9.
You can see that except for the trough part of the cycle, MLM did better than most of its peers.
Chart 9: Peer ROA comparison (Author from TIKR.com)
Note to Chart 9: I could not find the data for Lafarge Holcim which was listed on the US or European stock exchange.
Financial performance
I would rate MLM as financially sound for the following reasons:
- It currently has a Debt Equity ratio of 0.70 down from 0.88 in 2021. The 2022 DE ratio is lower than most of the 7 peers.
- It achieved positive cash flow from operations every year over the cycle with an average of USD 565 million per year. This is commendable when compared with the average PAT over the same period of USD 359 million per year.
- Its Debt would be equal to an AA rating (Fitch). This is based on its current EBIT/interest coverage ratio and using Damodaran synthetic rating approach.
Valuation
I determined the EPV of MLM based on the single-stage FCFF model. For details on the parameters and formulae used in this model, refer to " BlueLinx: The Market Is Not Pricing This As A Cyclical Company"
I considered 2 Scenarios:
- Scenario 1 - the normalized values are based on the average 2006 to 2022 values. I assumed that there is no significant change in the product profile. As I have shown earlier, this is not realistic. However, I used this as the base case.
- Scenario 2 - the normalized values are based on the average 2015 to 2022 values. I assumed that the business and product mix has changed since 2006 and the future will be more represented by the 2015 to 2022 values.
A summary of the key variables and the EPV under both Scenarios is shown in Table 2.
Based on Scenario 2, the EPV is USD 88 per share compared to its Book Value of USD 116 per share. The market price of MLM as of 20 Feb 2023 was USD 372 per share.
You can see that EPV under Scenario 1 is much lower than that for Scenario 2. Note that I had earlier pointed out that the intrinsic value under Scenario 2 is an optimistic one.
Table 2: EPV under 2 Scenarios (Author)
For those interested in the details, I have presented in Table 3 an example of how I computed the EPV under Scenario 2. The notes in the table listed the steps involved.
For the WACC, I did a Google Search for the term "MLM WACC" and took the average values of what I found on the first search page. This is summarized in Table 4.
Table 3: Sample calculation of EPV (Author) Table 4: Estimating WACC (Author from various sources)
Greenwald analysis
According to Professor Bruce Greenwald, you can get strategic insights by comparing the Asset Value with the EPV. In a freely competitive environment, Asset Value = EPV.
You only have EPV > Asset Value if the company has some economic moat. He refers to such companies as "franchises". He opined that we should only consider growth in the valuation if we have a situation where the EPV > Asset Value.
If you have a case of EPV < Asset Value, this points to under-utilization of assets.
Greenwald recommended that we use the Reproduction Value to determine the Asset Value. But this is not necessary in the case of MLM as the EPV is significantly less than the Asset Value.
EPV = USD 88 per share
Asset Value = USD 116 per share.
This points to under-utilization of assets. From a valuation perspective, I would not consider MLM as a growth stock. Rather I would expect management to improve its performance so that EPV = Asset value. On such a basis, the best I would consider as the value of MLM is USD 116 per share.
There is no margin of safety even if I assumed the Book value.
Limitations and risks
MLM is trading at about 3 times its Book value. For a brick-and-mortar company, this is an unusual situation. One possible explanation for this is that the Book Value or EPV did not capture the full value of its Aggregate reserves.
In its 2021 Form 10k, MLM reported that its Aggregates reserves represents approximately 78 years at current production levels. With such large reserves, the market may have considered some portion of it as non-operating assets and ascribed some value to it.
Think of Reproduction Value and you can see the logic of adding some amount to the Book Value. Even if you adopt the DCF approach, you add the value of the non-operating assets to the DCF value. Part of the Aggregates reserves could be non-operating assets. If you follow this logic, then the Book Value or EPV could be adjusted upwards by this "excess" Aggregates reserves.
But I would not advise this, especially for the retail investor. As a retail investor your return comes from both dividends and capital gains. Dividends depend on earnings. Capital gains depend on the both earnings and changes in the market multiple.
The EPV is based on earnings in perpetuity. It assumed that MLM has the reserves to deliver perpetual production. Adding some Aggregates' reserves as non-operating assets would be double counting.
Even if the assets are revalued to account for the market value of the Aggregates' reserves, a retail investor cannot access the valuation "surplus". The valuation "surplus" only makes sense if you are taking control of the company. But as a retail investor, having a larger Book Value is only beneficial if the "surplus" is distributed. But such a "surplus" is not meant for distribution.
Secondly if the market multiple has already accounted for some of the "surplus", you are not going to get much capital gain due to this.
My point is that as a retail investor, do not count the excess Aggregate reserves. Rely on either the Book Value or EPV.
Conclusion
MLM serves the construction sector. This is a cyclical sector with a 2.7 % CAGR in construction spending from 2006 to 2022. Over this period, MLM managed to achieve revenue growth of 7.1 % CAGR. But this was via both organic growth and acquisitions.
It is a tough sector to be in. During this period, MLM ROE to decline from 20 % in 2006 to 13 % in 2022. Gross profitability also declined. While MLM had managed to improve its Gross profit margins, its capital efficiency declined.
A Greenwald Asset Value vs EPV analysis showed that MLM is not a "franchise" and should not be valued as a growth company. We actually have a case of under-utilization of assets. Given this, the most optimistic value is the Book value. But even with the Book value, there is no margin of safety at the current price.
For further details see:
Martin Marietta Materials: Revenue Growth Hides The Real Picture