Martin Marietta Materials – Revenue Development Hides The Actual Image. (NYSE:MLM)

Investment thesis

Martin Marietta Materials Inc (NYSE:MLM) has managed to develop its income at a quicker tempo than complete building spending over the previous 17 years. This was through a mix of acquisitions and modifications within the product combine.

However, this has not translated into higher profitability or capital effectivity. The ROE at present is decrease than what it was in 2006. MLM is in a low-growth cyclical building sector.

A Greenwald “Asset Value vs Earnings Power Value (EPV)” evaluation confirmed that this isn’t a progress inventory. The applicable valuation metric is EPV. On such a foundation there is no such thing as a margin of security on the present value.

Thrust of my evaluation

MLM is a pure resource-based constructing supplies firm. Over the previous 17 years, its income grew at a 7.1 % CAGR through each natural progress and acquisitions. Over the identical interval, the US complete building spending solely grew at 2.7 % CAGR.

You would assume that MLM must be analyzed and valued as a progress firm. I’ll present you in any other case and construct my arguments alongside the next traces:

• The enterprise is cyclical. The core enterprise – Aggregates – didn’t have any cargo tonnage progress over the past cycle. Aggregates income progress was as a consequence of promoting value progress.
• Despite its income progress, metrics that drove worth didn’t enhance appropriately. But it’s financially sound. I’d fee MLM’s efficiency as common.
• I used the Greenwald “Asset Value vs EPV” evaluation to point out that MLM isn’t a “franchise”. It isn’t a progress inventory and its worth must be based mostly on the EPV and even the Book Value.

MLM enterprise is cyclical

MLM has two enterprise segments – Building supplies and Magnesia Specialties.

The Building Materials enterprise accounted for about 95 % of its 2022 income. This enterprise is tied to building spending which in flip is linked to Housing Starts. Both usually are not progress sectors:

• From 2006 to 2022, building spending grew at 2.7 % CAGR.
• Over the previous 70 years, there is no such thing as a progress within the long-term common annual Housing Starts.

The building spending and Housing Starts are additionally cyclical as might be seen from Charts 1 and a couple of.

You can see that the most recent peak-to-peak intervals for each building spending and Housing Starts are round 2006 to 2022. There is a excessive correlation between MLM income and these two over this era as might be seen in Table 1.

MLM has acknowledged this hyperlink.

“…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 firms

As a cyclical enterprise, MLM valuation must be based mostly on its efficiency over the cycle. Damodaran has this to say about valuing cyclical firms:

“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 challenge, we’ve got to normalize the efficiency over the cycle. Damodaran urged 2 methods to do that:

• Take the typical values over the cycle.
• Take the present income and decide the earnings by multiplying it with the normalized margins.

The problem with the primary strategy for MLM is that the scale of the corporate in 2022 is way better than that in 2006. I thus adopted the second strategy. However, there may be even a problem with the second strategy because the product profile has modified over the cycle.

Aggregates efficiency

MLM at present is completely different from that in 2006. In the primary place, it’s a a lot larger firm by way of income. MLM income grew from USD 1.9b in 2006 to USD 5.7b in 2022 at a 7.1 % CAGR.

In 2006, the Aggregates enterprise accounted for about 92% of the corporate’s complete income. At that juncture, Aggregate accounted for nearly all of the Building Materials enterprise. But since then, MLM had diversified into different constructing merchandise equivalent to cement and ready-mix concrete. By 2022, Aggregates solely accounted for about 60% of the corporate’s complete income.

Chart 3 illustrates this variation.

You shouldn’t be shocked by this diversification because the US Aggregates sector isn’t precisely a progress one. From 2006 to 2021, the demand for Aggregates shrunk as might be seen in Chart 4.

MLM Aggregates enterprise displays this demand scenario. If you have a look at Chart 5, you’ll be able to see that there was hardly any change within the cargo tonnage from 2006 to 2022. Rather Aggregates income progress was pushed by value progress. From 2006 to 2022, the Aggregates promoting value elevated by 4.2 % CAGR.

The unhappy half is that whereas the promoting value reveals an uptrend, gross revenue margins didn’t change very a lot. The Aggregates’ common gross revenue margins (excluding freight and supply costs) for 2006 to 2008 was 27.7%. From 2019 to 2021 it averaged 29.8 %.

Note to Chart 5: The index was based mostly on dividing the values for annually by the respective 2006 values

MLM progress was not solely as a consequence of product diversification but additionally acquisitions. From 2006 to 2022, MLM spent USD 5.5 b in money acquisitions. To offer you a way of the dimensions, throughout this era:

• The Total Capital Employed (TCE) elevated by USD 10b. I outlined TCE as = Shareholders’ funds + Minority Interests – Cash.
• MLM additionally spent USD 5.1 b for CAPEX (excluding the acquisitions).

The acquisitions and CAPEX translate right into a Reinvestment fee of about 55% the place:

• Reinvestment fee = Reinvestment / EBIT(1-t).
• Reinvestment as = Acquisitions + CAPEX – Divestitures – Depreciation & Amortization + Net Changes in Working Capital.

Effectively about half of the after-tax earnings had been diverted to investing for the longer term. With such a fee, I’d count on not simply income progress, but additionally enhancements in profitability and returns. But this was not the case.

Business efficiency

I’d think about MLM efficiency over the cycle as common based mostly on the next:

• ROE to say no from 20 % in 2006 to 13 % in 2022. This was as a result of income and PAT grew quicker than the capital employed.
• Gross profitability (gross income / complete belongings) declined from 21 % in 2006 to 10 % in 2022.
• MLM’s Return on Assets over the cycle was higher than these of its friends.
• MLM is financially sound.

As you’ll be able to see not all of the metrics level to enhancements. It is a combination of fine and dangerous.

Profitability and return developments

You can see the developments within the income, PAT, and Gross profitability in Chart 6. Both the income and PAT dipped throughout the trough a part of the cycle earlier than going past the 2006 values.

The key concern is Gross profitability. Its efficiency all through the cycle was lower than the 2006 values. I’d think about it as “static” over the current previous. According to Professor Novy-Marx, this metric has the identical energy as Price to Book in predicting returns for shares.

A DuPont evaluation over the cycle confirmed that the decline within the ROE was pushed by the decline in Leverage and Asset turnover. Refer to Chart 7.

While declining Leverage is a optimistic signal, a declining Asset turnover factors to reducing operational effectivity. The different optimistic signal was the Profit margin. While I couldn’t discern an bettering development, the values for the previous few years had been higher than that in 2006.

To get a greater understanding of Leverage and Asset turnover, I charted the efficiency of three key metrics that I utilized in my valuation. Refer to Chart 8 that reveals the developments over the cycle.

• Gross revenue margins (GP margins within the chart) confirmed some enhancements over the cycle.
• Selling, General, and Administration margins (SGA margin within the chart). There was hardly any enchancment (discount within the margins) over the cycle.
• TCE/Revenue. This is a measure of capital effectivity. You can see that the TCE/Revenue elevated over the cycle. This isn’t excellent news because it meant utilizing extra capital for a similar degree of income.

I had earlier proven that the Gross revenue margins for the Aggregates enterprise didn’t change very a lot over the previous 17 years. Looking at Charts 8 and three, I’d conclude that the enhancements within the general gross revenue margins have to be as a result of modifications within the product combine.

I additionally consider that the acquisitions and modifications within the product combine made MLM much less environment friendly when considered by way of the TCE/Revenue lens.

The takeaway is that when normalizing the assorted metrics utilized in valuing MLM, we should always not use the typical values from 2006 to 2022. The nature of the enterprise has modified. It could also be extra practical to base them on the 2015 to 2022 interval.

Unfortunately, this era lined the uptrend a part of the cycle solely. As such the intrinsic values decided utilizing the 2015 to 2022 averages have to be thought-about optimistic.

Peer comparability

According to MLM, it operates in a largely-fragmented trade with over 5,000 home aggregates producers. These embrace massive, public firms and a lot of small, privately-held firms.

In its 2021 Form 10k, MLM listed 7 publicly traded firms which can be among the many high 10 Aggregates producers.

I in contrast MLM returns as measured by the Return on Assets (ROA) with 6 of those friends. I used ROA because the efficiency metric quite than ROE to keep away from the impression of Debt. Refer to Chart 9.

You can see that aside from the trough a part of the cycle, MLM did higher than most of its friends.

Note to Chart 9: I couldn’t discover the info for Lafarge Holcim which was listed on the US or European inventory trade.

Financial efficiency

I’d fee MLM as financially sound for the next causes:

• It presently has a Debt Equity ratio of 0.70 down from 0.88 in 2021. The 2022 DE ratio is decrease than a lot of the 7 friends.
• It achieved optimistic money movement from operations yearly over the cycle with a mean of USD 565 million per yr. This is commendable in comparison with the typical PAT over the identical interval of USD 359 million per yr.
• Its Debt could be equal to an AA score (Fitch). This relies on its present EBIT/curiosity protection ratio and utilizing Damodaran artificial score strategy.

Valuation

I made up my mind the EPV of MLM based mostly on the single-stage FCFF mannequin. For particulars on the parameters and formulae used on this mannequin, seek advice from “BlueLinx: The Market Is Not Pricing This As A Cyclical Company”

I thought-about 2 Scenarios:

• Scenario 1 – the normalized values are based mostly on the typical 2006 to 2022 values. I assumed that there is no such thing as a vital change within the product profile. As I’ve proven earlier, this isn’t practical. However, I used this as the bottom case.
• Scenario 2 – the normalized values are based mostly on the typical 2015 to 2022 values. I assumed that the enterprise and product combine has modified since 2006 and the longer term will probably be extra represented by the 2015 to 2022 values.

A abstract of the important thing variables and the EPV below each Scenarios is proven in Table 2.

Based on Scenario 2, the EPV is USD 88 per share in comparison with its Book Value of USD 116 per share. The market value of MLM as of 20 Feb 2023 was USD 372 per share.

You can see that EPV below Scenario 1 is far decrease than that for Scenario 2. Note that I had earlier identified that the intrinsic worth below Scenario 2 is an optimistic one.

For these within the particulars, I’ve introduced in Table 3 an instance of how I computed the EPV below Scenario 2. The notes within the desk listed the steps concerned.

For the WACC, I did a Google Search for the time period “MLM WACC” and took the typical values of what I discovered on the primary search web page. This is summarized in Table 4.

Greenwald evaluation

According to Professor Bruce Greenwald, you will get strategic insights by evaluating the Asset Value with the EPV. In a freely aggressive surroundings, Asset Value = EPV.

You solely have EPV > Asset Value if the corporate has some financial moat. He refers to such firms as “franchises”. He opined that we should always solely think about progress within the valuation if we’ve got a scenario the place the EPV > Asset Value.

If you’ve gotten a case of EPV < Asset Value, this factors to under-utilization of belongings.

Greenwald beneficial that we use the Reproduction Value to find out the Asset Value. But this isn’t mandatory within the case of MLM because the EPV is considerably lower than the Asset Value.

EPV = USD 88 per share

Asset Value = USD 116 per share.

This factors to under-utilization of belongings. From a valuation perspective, I’d not think about MLM as a progress inventory. Rather I’d count on administration to enhance its efficiency in order that EPV = Asset worth. On such a foundation, the very best I’d think about as the worth of MLM is USD 116 per share.

There isn’t any margin of security even when I assumed the Book worth.

Limitations and dangers

MLM is buying and selling at about 3 instances its Book worth. For a brick-and-mortar firm, that is an uncommon scenario. One potential rationalization for that is that the Book Value or EPV didn’t seize the total worth of its Aggregate reserves.

In its 2021 Form 10k, MLM reported that its Aggregates reserves represents roughly 78 years at present manufacturing ranges. With such massive reserves, the market could have thought-about some portion of it as non-operating belongings and ascribed some worth to it.

Think of Reproduction Value and you’ll see the logic of including some quantity to the Book Value. Even if you happen to undertake the DCF strategy, you add the worth of the non-operating belongings to the DCF worth. Part of the Aggregates reserves could possibly be non-operating belongings. If you comply with this logic, then the Book Value or EPV could possibly be adjusted upwards by this “excess” Aggregates reserves.

But I’d not advise this, particularly for the retail investor. As a retail investor your return comes from each dividends and capital positive factors. Dividends depend upon earnings. Capital positive factors depend upon the each earnings and modifications available in the market a number of.

The EPV relies on earnings in perpetuity. It assumed that MLM has the reserves to ship perpetual manufacturing. Adding some Aggregates’ reserves as non-operating belongings could be double counting.

Even if the belongings are revalued to account for the market worth of the Aggregates’ reserves, a retail investor can not entry the valuation “surplus”. The valuation “surplus” solely is smart if you’re taking management of the corporate. But as a retail investor, having a bigger Book Value is just useful if the “surplus” is distributed. But such a “surplus” isn’t meant for distribution.

Secondly if the market a number of has already accounted for a number of the “surplus”, you aren’t going to get a lot capital acquire as a consequence of this.

My level is that as a retail investor, don’t rely the surplus Aggregate reserves. Rely on both the Book Value or EPV.

Conclusion

MLM serves the development sector. This is a cyclical sector with a 2.7 % CAGR in building spending from 2006 to 2022. Over this era, MLM managed to realize income progress of seven.1 % CAGR. But this was through each natural progress and acquisitions.

It is a tricky sector to be in. During this era, MLM ROE to say no from 20 % in 2006 to 13 % in 2022. Gross profitability additionally declined. While MLM had managed to enhance its Gross revenue margins, its capital effectivity declined.

A Greenwald Asset Value vs EPV evaluation confirmed that MLM isn’t a “franchise” and shouldn’t be valued as a progress firm. We even have a case of under-utilization of belongings. Given this, probably the most optimistic worth is the Book worth. But even with the Book worth, there is no such thing as a margin of security on the present value.