The market loves a good, old-fashioned spin-off story. Bowing to activist pressure, Eagle Materials (EXP) is next in a (very) long line of companies that are going to eschew diversification in the name of shifting to discrete, publicly-traded pure plays on certain businesses. While the market has been receptive to the news here, Eagle Materials still trades significantly below many estimates of sum-of-the-parts fair value (e.g., Hedgeye, Sachem Head). I wanted to take a look at this deal, alongside the comps, to see if that valuation truly made sense. In my opinion, it is very tough to justify a valuation case materially higher than where we are today. Despite the catalyst, I think there are better plays in the construction space.
Eagle Materials is a supplier of construction and building materials, a business line that ties its fate to the health of the construction and infrastructure end markets here in the United States. The firm can trace its roots back to the ‘60s where it began life as a subsidiary of home builder Centex; that former parent has since been bought out by PulteGroup (NYSE:PHM). Those assets were spun out of Centex in 2004 to help drive shareholder value, and the company has been a material acquirer of new assets ever since, eventually transitioning into one of the largest players in its markets. There has always been a strong bias towards diversification here; Eagle Materials generates revenues from gypsum wallboard, paperboard, cement, concrete and aggregates, and even a nascent oil and gas proppants business.
In my view, Eagle Materials has always been too diversified. It’s an area of contention (which I’ll get into), but it has caused a bit of an identity crisis internally as well as a perception problem from the market on exactly what Eagle Materials is. Conglomerate-like structures are not favored today and tend to be valued a little haphazardly. With that said, Eagle Materials has long gotten a free pass due to stellar returns and a great balance sheet. Management (rightly) notes its pre-tax margins and returns on equity are well in excess of any peer (Source: Eagle Materials, May 2019 Investor Presentation, Slide 23 and 24). While gross margins are incrementally better due to strong cost positioning, to a large extent, these excess returns have been driven by a great balance sheet. While the construction industry has undergone a lot of consolidation over the past several decades, and many publicly-traded firms still carry quite a bit of debt on balance sheet as a result of that, Eagle Materials does not. That comes down to a multitude of factors: the initial asset base, free cash flow dedication to debt paydown, timing, spin-off structure, management style and skill. The company carries investment grade credit ratings, a goal of many management teams that is often pretty elusive in this area of the market. Ratings agencies often take a cautious approach to these businesses that are quite often both cyclical and seasonal as well as low margin.
A Shift In The Narrative
However, as we got later in the business cycle, Eagle Materials execution has started to slip. The entry into the frac sand business in particular (via the buyout of CRS Proppants in 2014) was poorly timed. I got the initial rationale. As an ardent frac sand bear for several years now, even I initially go the allure of owning sand (I owned US Silica from $25 to $40 per share in 2016). And besides, frac sand clearly aligned somewhat with management core competencies in aggregates production for concrete. Plus, the logistics end of the frac sand business shares a lot of similarities with cement. Eagle Materials was not the only company that got caught up in the oil and gas heyday of 2014 and the “frac revolution”. Nonetheless, the division never was able to stand on its own two feet, and there is just not enough scale. As an owner of a couple of mines, a handful of processing centers, and an in-basin distribution platform, there just is not enough scale to make it work versus larger competitors.
With the stagnant share price despite the healthy balance sheet and arguable sum of the parts discount, risk-averse value investors have long been interested. It was no surprise to see hedge funds move in to try to create value as well. Sachem Head Capital Management, founded by Scott Ferguson (a protégé of Bill Ackman at Pershing Square) built a material stake and pushed for change – change that included pushing for several new members for the Board of Directors. That pressure was enough for management to cave to demands: hence the separation plan that came about after the strategic review. Having spoken with this management team before, I’m not surprised to see that take place. Both CEO Dave Powers and CFO Craig Kesler have been with this Eagle Materials since the spin-off and have deep knowledge of the construction industry. They know that the market has perceived the structure as a problem and, as a group focused on long-term shareholder value creation, I did not expect much pushback from them. After all, this is a natural path given where the firm came from given its origins. While details are sparse, I wanted to get into what the economics of this separation and, perhaps importantly, what value might be present on balance sheet.
*Source: Eagle Materials, May 2019 Investor Presentation, Slide 4
Eagle Materials announced that it would separate into two entities: “Eagle Light” and “Eagle Heavy”. The Eagle Light business would be made up of the gypsum wallboard and recycled paperboard business while Eagle Heavy would be made up of the cement, concrete, and aggregates assets. Both carry roughly similar size in the portfolio and similar margins.
This has been pushed in order to force the market to value these assets cleanly versus peers. Before getting into the benefits and relative case valuations, there are risks. This split will separate the company into two discrete, publicly-traded entities. Number one, this means more general and administrative costs. Number two, it will create two companies of only modest size with a high degree of product, end market, and geographic concentration. No question that this means a higher degree of underlying cyclicality to both businesses versus being joined at the hip under one structure. So, while valuations might improve, I expect the new equity stubs to be much more volatile.
Overall End Market Outlook, Proppant Business Failure
As a prior owner of USG Corporation, I’m a fan of the wallboard assets. Shipped volumes continue to grind higher (new builds, reconstruction) and industry effective capacity is near 100%. It is not easy to get greenfield or brownfield (restart of old capacity approved) due to environmental concerns, and with the whole “Chinese Drywall” fiasco of the early 2000s (Source: Consumer Product Safety Commission), there is still an unwillingness to use imported product – particularly among the major national homebuilders.
Likewise, the cement business is doing quite well. Cement does face import competition, but the Eagle Materials footprint lies primarily inland in the Midwest where most imports are not price competitive. Once outside of 200 miles from the coast, import competition falls to zero. Shipping costs versus the value of cement per ton ($60/ton or so) just does not lend itself to being transported unless absolutely necessary. If it is very much a local market. There are high barriers to entry due to resource availability (limestone) and, just like with wallboard, permitting and regulatory headaches keep new facility launches to a minimum. However, this also makes the cement business very sensitive to trends in the central United States. The concrete and aggregates business serves only the greater Kansas City, northern California, and Austin markets.
The Proppants business is, for a lack of a better word, a bust. Built off the acquisitions of CRS Proppants, Wildcat, and internally funded growth, there just is not a lot of material value here. With large peers like U.S. Silica (SLCA) and Hi-Crush (HCR) trading at 7x forward EBITDA expectations, no question that they sell this business and eat a loss in excess of $100mm. That is okay. The business is a lost cause, but it is not the end of the world versus the value of the portfolio. At least management is recognizing now that it has to cut its losses, sell the assets, and take the tax benefit because of how that industry has changed.
Sum Of the Parts
- $215mm EBITDA estimate in Cement
- $25mm EBITDA estimate in Concrete
- $170mm EBITDA estimate in Gypsum Wallboard
- $40mm EBITDA estimate in Paperboard
- $15mm EBITDA estimate in Proppants
To be clear, my estimate for $465mm in 2019 EBITDA is above current Wall Street Consensus of $450mm. Note that this assumes zero additional cost (which there will be some) from operating as two independent entities. While I’ve seen price targets thrown out there in the $120.00/share range for a broken up Eagle Materials, that would require an EV/EBITDA multiple in the 13x range to make sense. That’s a tough sell to me.
USG Corporation, a competitor in gypsum wallboard, was acquired by Knauf at an 11.7x multiple. It's hard to justify a higher valuation here versus what was a much larger firm with a better brand presence in my view. The recycled paperboard business, in general, should be slower growing and lower margin, so I’d view that as likely coming in lower valuation wise. Meanwhile, cement comps abound. CRH (CRH) bought Ash Grove for 11.5x EBITDA and currently trades at 10x itself publicly; LafargeHolcim (OTCPK:HCMLF) and Cemex (CX) are even lower. As many know, ready-mixed concrete in particular trades at substantially lower multiples, and the Eagle Materials business is unfortunately biased toward concrete batching plants. The Northern California aggregates facility probably has quite a bit of value (910mm tons of reserves), but I think my base case of 9x valuation remains fair. Proppants is distressed. I’m not sure how hedge funds can justify calling for such steep valuation multiples at Eagle Materials – even with the implied lower leverage and safety. It’s a great business, but I don’t think it deserves to trade at such premiums.
Spin-offs often create value. Personally, I always lean towards buying pure plays when I can. However, the valuation at Eagle Materials is not what I would call distressed. While I get the argument that this is a firm with a stellar reputation, great assets, and a near impeccable balance sheet, there is only so much premium that could/should be baked in versus comps. It would be unusual to see trading valuations come in ahead of take-out acquisition multiples (USG Corporation, Ash Grove) given those always have a bit of an above-market premium built in. There is a lot to like here, but the valuation just isn’t enough to be enticing to my eye.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.