2023-03-08 05:32:17 ET
Summary
- SUM is not a growth stock. Revenue growth was due to acquisitions that benefited from being in the uptrend part of the construction cycle.
- Revenue growth did not translate into better operating performance. Without the one-off gains, current ROE would be in single digits.
- The market priced SUM as a growth stock. Alternatively, the market thinks that the value of the reserves is not accounted for. In either case, the market is wrong.
Investment Thesis
Summit Materials Inc. ( SUM ) IPOed in 2015. Its rapid growth before that was due in large part to its acquisitions which were funded with Equity and Debt.
Post IPO, SUM continued with the same acquisition strategy. But it had managed to reduce its Debt level partly through new Equity as well as Cashflow from Ops.
Sadly, this growth has not created shareholders’ value due to its poor business performance. Until SUM can improve its returns, there is no margin of safety for the retail investor.
Thrust of my analysis
SUM is currently trading at 1.8 times its book value. There are 2 possible reasons for a brick-and-mortar company to have such a market multiple:
- It must be a high-growth stock.
- It must have some hidden or unreported resources in its Books.
I will show that it is not a high-growth stock. Secondly, the market may be ascribing a higher value to its reserves of recoverable stone, sand, and gravel than the Book Value. I will argue that this is double counting. At the same time, even if true, it should not be considered by a retail investor.
Not a fantastic performance
From its IPO in 2015 to 2022, SUM’s revenue had grown at 7.7 % CAGR. During this period, its ROE had grown from 0.2 % in 2015 to 13.8 % in 2022.
But this is not a fantastic performance. In the first place, revenue growth was due to a combination of organic and acquisition growth. From 2015 to 2020 (when organic revenue data was readily available), total revenue grew at 10.2 % CAGR whereas the organic revenue growth was 2.9 % CAGR. About only 1/3 of revenue growth came from organic growth.
Note that organic growth is defined as changes in revenue that are not due to the current year’s acquisitions. Organic growth included the increase in revenue from historical acquisitions.
This meant that the bulk of the revenue growth was via acquisitions. From 2015 to 2022, SUM spent about USD 1.1 for net acquisitions (acquisitions less divestitures). During the same period, it generated USD 0.8 billion in net income. Considering that part of the net income was from organic growth, this translates to about 15 years of payback for the acquisitions. Not exactly fantastic payback.
Revenue growth slowing down
Notwithstanding the acquisitions, revenue growth seems to be slowing down as illustrated in Chart 1. 2021 and 2022 saw several divestitures as part of its Elevate Summit strategy. Part of the revenue decline was due to these divestitures.
Chart 1: Revenue By Products (Author)
But an analysis of 2020 to 2022 organic revenue growth showed a 15 % decline in 2021 and a 7 % decline in 2022.
I derived the organic revenue for each of the years from the changes in volumes and prices for each of the product categories. These organic growth rates were provided in the segment reports. I then compared the computed total revenue with the previous year’s total revenue to derive the organic growth rates.
My point is that without the acquisitions, we are looking at revenue growth rates that were lower than the long-term GDP growth rate. This is not a sign of a growth company.
Drivers of earnings
I next broke down the profit into profit from operations, finance, and extraordinary items. Note that the extraordinary items are gains or losses from corporate activities such as divestitures.
I then compared the average performance of 2015 to 2017 with those of the last 3 years of 2020 to 2022. Refer to Table 1.
- Operating profit margins dropped over the period. There do not seem to be any efficiency improvements.
- About 1/3 of the past 3 years’ profits were due to gains from divestitures. This is not repeatable.
- The bulk of the increase in profits came from increased revenue. But I have shown earlier that about 70% came from acquisitions.
Table 1: Breakdown of Earnings (Author)
Note to Table 1: The Extraordinary loss from 2015 to 2017 was due to taxes from the IPO exercises. This was offset by the tax gain.
Without acquisitions to drive revenue growth, and without gains from divestitures, the average 2020 to 2022 ROE would be in single digits.
Tailwinds from the uptrend part of the cycle
SUM is in the construction materials business. The construction sector is cyclical thus making SUM a cyclical company. This is acknowledged by the company.
“Our industry is cyclical and requires that we maintain significant working capital to fund our operations…” SUM 2022 Form 10k.
You can see from Charts 2 and 3 that the latest peak-to-peak period is from 2006 to 2022. If you want to know more about these cycles, refer to “ Martin Marietta Materials: Revenue Growth Hides The Real Picture ” and “ Vulcan Materials: No Fundamental Basis For The High Price ”.
SUM has benefitted from this tailwind. Its past 8 years of operations (since its 2015 IPO) were in the uptrend part of the Aggregates demand and Housing Starts cycles.
The implication is that when the construction cycle goes into a downtrend, I would expect SUM performance to follow suit. This meant that in looking at the long-term performance, we should consider the performance over the cycle.
Chart 2: US Aggregates Demand (Vulcan Form 10k 2021)
Chart 3: US Housing Starts (TradingEconomics.com)
Not sustainable investments
From 2015 to 2022, SUM incurred USD 2.5 billion in Net CAPEX and Net acquisitions. The ‘net” here is after the deduction for the sales of PPE and divestitures.
The Cashflow Operations were not sufficient to fund these. SUM made it up through new Equity. Part of the Equity was also used to lower the financing level as well as increase the cash position. Refer to Table 2.
Table 2: Sources and Uses of Funds (Author)
On a positive note, SUM brought down the Debt Equity ratio from 1.7 in 2005 to 0.8 in 2022. As can be seen from Table 2, this could not be achieved without new Equity.
If SUM were to continue with this growth-through-acquisition strategy, it can only be done with one or more of the following consequences:
- There is no Dividend or share buyback.
- It cannot reduce its Debt further.
- If it issues new Equity, it will increase the number of shares and be dilutive.
There is a dilemma for SUM. To continue the acquisitions strategy it needs to address the funding issue. But any increase in Debt or Equity will affect its valuation.
The best option is to improve the Cashflow from Operations. But this will require improving its operations. Its Elevate Summit strategy is meant to address this, but there are no sustainable results yet.
Growth did not create shareholders’ value
For growth to create shareholders’ value, we must have the returns greater than the cost of funds.
In the case of SUM, assuming that the past 3 years’ returns are sustainable, we have an ROE of 10.4 % compared to the cost of Equity of 11.8 %. The cost of Equity was based on the first page results of a Google search for the term “SUM WACC”. The results are shown in Table 3.
You can see that the returns are lower than the cost of Equity. It did not create shareholders' value with all the growth over the past 8 years.
Table 3: Cost of Equity (Author from various)
Valuation
SUM is a cyclical company and to determine its long-term value, you have to base it on its performance over the cycle. Damodaran has this to say about valuing cyclical companies:
“…the biggest problem we face in valuing (cyclical) companies... 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 for SUM is that there is not enough data to compute either the average values or the normalized margins over the cycle. I only have data from 2015 to 2022.
To give you a sense of the over-valuation based on this data, I used the data from Vulcan Materials and Martin Marietta Materials Inc. Refer to Table 4.
You can see that the values for the 2015 to 2022 period are much better than those for the full cycle (2006 to 2022). Thus the valuation of SUM based on the 2015 to 2022 data would be overly optimistic in the context of its cyclical performance.
Table 4: Comparisons between full cycle and part cycle (Author)
Valuation of SUM
Due to the big difference between the market price and Book Value, I valued SUM based on the simple formula Book Value formula:
Value = Book Value X (ROE/Cost of Equity)
The average ROE from 2015 to 2022 was 6.7 %
Value = USD 17 X (6.7 / 11.84) = USD 10.
The market price of SUM as of 3 March 2023 was USD 31. There is no margin of safety. This is even before considering that the 6.7 % ROE is probably higher than the cycle ROE.
I am of course assuming that the future = the past. This is a reasonable approach given the cyclical nature. To improve the value, SUM needs to demonstrate that it can deliver better returns than the past. Unfortunately, there are as yet no concrete signs of this. Another worry is that we are possibly going into the downtrend of the Housing Starts cycle.
Value of non-operating assets
The Book Value of SUM is based on historical costs. You could argue that this does not fully capture the value of the reserves and resources.
According to its 2022 Form 10k, the company estimates “…the useful life of our reserves serving our aggregates and cement businesses are approximately 53 years and 172 years, respectively, based on the average production.”
So instead of USD 17 per share Book Value, you may argue that this could be high enough to justify the market price. I have 3 arguments to counter this.
Firstly, while I used a simple formula to estimate the value of SUM, it is derived from a DCF model. In a DCF model, we assumed that the cash flow is in perpetuity. In other words, the resources required to generate the cash flow are assumed to be available in perpetuity. So, adjusting for the reserves could be double counting.
Next, in 2022, SUM reported that it had 3.7 billion tons of proven and probable mineral reserves. In 2015, this was reported at 2.1 billion tons. The additional 1.6 billion tons would likely be from the acquisitions. I am sure that the acquisition price would have included the value of these reserves.
While I do not have the history of SUM before the IPO, I am confident that the 2.1 billion tons of reserves were also from acquisitions. This meant that the value of all the reserves have been accounted for.
We could argue that the value of the reserves were based on historical costs and there is some possible revaluation surplus. But to get USD 30 per share based on the Book Value formula, the revaluation surplus would have to be double the Book Value. Is this realistic?
My final argument is that as a retail investor, your returns come from Dividends and capital gains. Capital gains in turn come from a combination of business performance and market sentiments.
It does not matter how much reserves a company has. If it does not translate to earnings, the retail investor would not benefit from it.
Sure, if the company is a takeover target, the value of the reserves could be one factor. But as a retail investor, you cannot access the reserves. You cannot even access the earnings. You can only have the Dividends.
Furthermore, if the market has already priced in the value of the reserves, the market multiple is not going to change very much. For a retail investor, you are better off looking at Dividends (and indirectly at earnings).
Conclusion
What is a growth trap? I consider it as a company that seems "cheap" based on its growth record but is actually expensive because the growth is illusory. Think of it as the opposite of a value trap.
I would not consider the performance of SUM as befitting a high-growth company. It is not just about revenue growth. There must also be improvements in the operating margins. Based on its past 3 years returns, this is not the case for SUM.
No doubt SUM achieved 13.8 % ROE for FYE 2022. But this was due to the one-off gain from the sale of assets. If I excluded this, we would have a single digit return which is much lower than the 11.8 % cost of Equity.
SUM has to improve its business operations. If it fails to do so, growing via further acquisitions will not create shareholders value.
Of course, my analysis and valuation are based on historical performance. You may argue that the future would be better. But the jury is still out on whether SUM can drive higher organic growth and improve the operations.
Taking into account the above, together with the over-priced situation, this is not the time to go in yet.
For further details see:
Summit Materials: A Growth Trap For The Retail Investor