2023-12-08 17:00:28 ET
Summary
- Since I covered it last, Tecnoglass stock has lost around 20% of its value but is showing signs of potential recovery.
- The company's high profit margins may not be sustainable in normal economic conditions, especially if there is a decline in construction activity.
- The construction market is highly cyclical, and Tecnoglass's sales and margins are tied to construction activity in Florida, which is likely peaking.
- The company has efficient use of capital and is positioned for long-term growth, but it still appears overvalued in the one to three-year horizon.
In July, I covered Tecnoglass Inc. ( TGLS ) with a bearish outlook in "Tecnoglass: Cyclical Construction Reversal To End Bull Market Rally." Since then, the stock has lost around 20% of its value but had lost over 30% until its recent rally. The stock fell dramatically after that article was published and is now showing some potential signs of long-term recovery. Accordingly, it is an excellent time to take a closer look at the company and its macroeconomic backdrop to better determine recovery or correction potential.
My core view regarding the company in July was that the building construction cycle had peaked. Even then, the firm had and continues to have, a low "P/E" valuation with robust EPS growth. However, given the structure of its business model, I believe there is a high probability that the firm will not maintain such a high-profit level in normal economic conditions. Further, if we see bearish conditions, such as a significant decline in construction activity in its key markets, then I doubt the firm will easily maintain profitability.
That said, most investors and analysts do not appear to agree with my view, with the consensus generally bullish due to its low valuation and growth record. Still, TGLS has a 5% short interest level, which indicates a small portion of bearish speculators are betting against it, though not excessively so. Operationally speaking, Teconglass has a few strong points, such as its virtual integration, low production costs, and focus on the attractive Florida market. That said, I believe investors should consider the potential consequences of a reversal in construction activity.
Can Tecnoglass Beat the Economic Cycle?
The construction market is highly cyclical. Tecnoglass sells glass products for commercial and residential construction projects, with a general bias toward commercial real estate (56% of Q3 sales). Its backlog is solid today at $836M, virtually all of which will likely be converted to revenue because glass is usually purchased in the later stages of the construction cycle. The company is also ramping up its production lines, potentially adding $300M in annual sales potential.
Notably, over 70% of its backlog is situated in Florida, with a minor focus in other states, mainly around the Southeastern US. This focus is a double-edged issue because, although these are rapidly growing markets, a reversal in that trend would have a pronounced impact on the firm. Further, let's consider that construction activity has been powerful across the US since 2020 and is highly prominent in Florida. We must believe that much of Tecnoglass's staggering growth is due to its key market's economic trend, not necessarily a core competitive advantage.
To a great extent, the firm's sales-per-share growth trend has matched Miami's property market trend. Miami had stupendously strong home price growth in 2020-2021 during the ultra-low mortgage rate period, aided by a population boom. Mortgage rates are nowhere near as attractive as before, but Florida's property market continues to benefit from very high population growth levels. At any rate, Miami home prices have stagnated at high levels, likely triggering stagnation in Tecnoglass's sales and margins. See below:
In regular periods, Tecnoglass had an operating margin of around 15%. The 2015-2019 period was undoubtedly not recessionary, so a "return to normal" should eventually push its margins back to that range as the shortage in building products continues to reverse. In my view, even without any home price declines or construction activity, we should expect Tecnoglass's operating margins to slip back down to the 15-20% level, which would still be slightly high compared to its pre-COVID range. This "margin normalization" would push its operating income to around $127-$170M, equating to a net income of around $85M - $115M after interest and estimated taxes, or an EPS of ~$1.8 to ~$2.4. That equates to an estimated forward "P/E" of ~16X to ~21.5X, which, though not high, is also not indicative of undervaluation, particularly given the negative trend in EPS that would come with a margin drop.
That is my "base case" outlook for the firm, assuming no recession but simply a normalization of market competition. Since 2020, the initial decline in production and the sharp rise in building demand in Florida (and across the US) led to a severe shortage of building products, temporarily lifting margins for virtually all building product companies much higher. Today, the building product shortage is fading as the market normalizes, very likely leading to the normalization of building product profit margins. See below:
Prices for construction glass remain high but are slowly trending lower from their post-COVID peak. Further, construction materials inventories and Tecnoglass's inventories are very high, indicating high demand on one hand but also a high potential for overproduction. In my view, the building materials market is still acting as if COVID-19 shortages exist when demand is likely declining with the fall in building permits. Of course, existing home sales are extremely low today and continue declining due to high mortgage rates, so even building permits seem unreasonably high in my view, given the demand trend. See below:
Home affordability and existing home sales have essentially never been this poor, potentially excluding the extreme set in 2010. This is undoubtedly a strong sign of a bust in the US residential housing market since low affordability and low demand will result in a glut, given high construction levels. Indeed, there will be regional differences in this trend, with many expecting the Florida market to remain stronger due to positive net migration into that area. However, excluding the western states and a few niche areas in the Northeast, the Florida market is the most unaffordable, particularly compared to the Southeastern and Midwestern US. Miami's rental market is also starting to cool after high growth in recent years, potentially indicating a peak in Tecnoglass's multifamily sales.
Tecnoglass Should Grow in the Long-Run
My slightly bearish outlook on TGLS stems mainly from what I believe to be an economic misunderstanding among most of its investors. In general, it seems that many analysts and investors are very focused on the company's strong historical performance without great regard for the economic causes behind its performance. Fundamentally, the firm's revenue and margin trend will be primarily tied to construction activity in the Florida market since its production levels and costs in Colombia are generally stable. This business model works exceptionally well because it produces glass in a cost-effective area not too far from its key market, a very strong demand area.
That said, investors value the company as if it will continue to generate high profit margins, which can only exist if the glass is in a shortage. As demand for homes and multifamily units slows, I believe we will inevitably see a slowdown in construction activity sufficient to end the shortage. Indeed, looking at inventory levels, I think that has already occurred, pointing toward a likely normalization in profit margins by next year. Thus, I doubt estimates placing its forward "EPS" at over $4 to $5 as that would require a continued materials shortage. To me, its forward "P/E" for 2024-2025 is likely closer to 15-20X, which is only reasonable if we assume the firm will continue to grow.
Indeed, Tecnoglass is investing much of its profits into operational expansion, as seen in its CapEx. Its balance sheet is also solid, with a low debt-to-equity ratio and high positive working capital. See below:
Fortunately, Tecnoglass is positioning itself to perform decently through a recession and continue to grow in the long run without diluting shareholders. The firm is investing its high profits well, likely leading to even better profits some years from now. Still, I do not believe that makes the company immune to recession risks, particularly a normalization of construction market activity, which could easily make the stock overvalued today.
The Bottom Line
Overall, I am slightly bearish on Tecnoglass today. If I only assumed that its operating margins would normalize, TGLS could be fairly valued given its high reinvestment into capital goods, which should eventually push its EPS back to its TTM level. Although TGLS may maintain its TTM EPS, I believe that is unlikely, given the slowdown in construction spending. Further, I am slightly bearish on TGLS because it seems there will be a recession in both the commercial and residential property markets. Florida, despite having good migration activity, cannot support extremely unaffordable housing forever, given its high construction activity levels.
By the end of next year, I expect a sharp decline in Florida construction activity, likely hampering TGLS's backlog dramatically and potentially pushing its margins to abnormally low levels. With that possibility in mind, I would not be surprised to see TGLS's price fall by 10-30% more as investors brace for a prolonged and larger-than-expected decline in its EPS. That said, I could become bullish on TGLS if it fell by over 20-30% because it is a fundamentally strong firm with a good managerial focus. Thus, long-term investors may not necessarily benefit from selling the firm today, and I would indeed not short the stock as its bearish argument is not excessively strong. That said, I believe its downside risk remains more significant than its immediate reward potential due to the apparent overestimation of likely temporary economic trends.
For further details see:
Tecnoglass: Correction Risk Remains High As Construction Activity Slows