U.S. Infrastructure Spending Outlook Brightens

Shares of heavy-side building materials companies severely underperformed the market in 2018, with fears of an economic slowdown serving as the key overhang. However, decades of underspending has caused U.S. infrastructure to deteriorate, a concern that must inevitably be addressed. Indeed, infrastructure is the most important end market for aggregates, cement, and downstream building materials. While funding limitations have historically weighed on demand, the outlook should improve. First, midterm election results should ultimately boost funding at the national, state, and local levels. Until then, the FAST Act will continue to provide near-term funding support, as the Highway Trust Fund has enough funding to cover large outlays through 2021.

For the heavy-side building materials companies we cover-- Martin Marietta Materials MLM, Summit Materials SUM, U.S. Concrete USCR, and Vulcan Materials VMC--current share prices are roughly 20%-50% below our fair value estimates. At these valuations, the market is underestimating future U.S. infrastructure spending made possible by an improved funding outlook.

Weakened Federal Funding Limited Realization of Underlying Demand Even though infrastructure demand has been strong for decades, construction activity has remained below even maintenance levels. This has led to system degradation over the years. Although this reality is acknowledged by Republicans and Democrats alike, limited funding continues to be a problem. This has left the system deprived of adequate financial resources and inspires concern about future demand for heavy-side building materials. However, we argue that these fears are overblown thanks to the implications of favorable midterm results and near-term support from the FAST Act.

Funding headwinds stem largely from a stagnant federal fuel tax that the federal Highway Trust Fund has historically relied on for funding. The tax of $0.184 per gallon of gasoline has not been raised since 1993, not even adjusted for inflation. Improving mileage as well as the growing number of hybrid and electric cars has further weakened the traditional funding mechanism. Accounting for about one fourth of total state spending, the federal government’s contribution remains an important part of infrastructure funding. However, amid the weakening effectiveness of the gas tax, the trust fund’s balance dipped to dangerously low levels, reaching less than $4 billion at the end of fiscal 2013. This amounts to less than 10% of annual outlays.

Although the funding problem has been well known and accepted, a broadly supported solution remains elusive. Instead, the U.S. government has relied on short-term cash infusions that provided the trust fund with just enough money to operate for several months at a time. Although this maintained solvency, the uncertainty that it caused weighed on construction. Infrastructure projects are long-dated, capital-intensive projects. As such, the uncertainty around the federal government’s ability to pay its share for projects weighs on state and local construction activity.

Infrastructure Has Bipartisan Appeal In terms of elections, we see reason for optimism at both the national and state levels. At the national level, the Democrats needed to take 23 Republican seats, winning 218 seats overall, to take control of the House of Representatives. The Democrats won 234 seats, taking control of the House, while the Republicans maintained control of the Senate.

We view mixed control of Congress as a positive for infrastructure. Increased infrastructure funding is a relatively easier issue for which to find bipartisan support than legislation regarding other issues like healthcare or immigration reform. In fact, following the results of the midterm elections, leaders of all three bodies--President Donald Trump, House Speaker Nancy Pelosi, and Senate Majority Leader Mitch McConnell--discussed infrastructure positively.

After winning enough seats to take control of the House on election night, Pelosi spoke with Trump about infrastructure on the phone. McConnell has mentioned infrastructure as on the agenda in 2019. Also, Rep. Peter DeFazio, chairman of the House Committee on Transportation and Infrastructure, has made noted efforts to improve infrastructure, including a previous proposal for $500 billion of investment in the Investing in America: A Penny for Progress Act. We view DeFazio’s support of an increased and inflation-indexed fuel tax as positive for sustainable long-term infrastructure funding.

Governors' Elections More Positive Than Negative Although the national elections proved generally positive across the board for infrastructure, the results were more mixed at the state level. We believe Summit Materials and U.S. Concrete benefited from the results of the gubernatorial elections while Martin Marietta and Vulcan had mixed results. Summit Materials should see significant benefit from the election of Laura Kelly as Kansas governor. Kansas suffered from severe road underfunding after former Gov. Sam Brownback's 2012 tax cut experiments failed to deliver any of the forecast growth and led to the state raiding $2.5 billion from its highway fund. Kelly's 10-year transportation plan is focused on investment in roads and infrastructure, optimizing urban roads, and expanded highways in rural areas--a meaningful improvement from recent years.

U.S. Concrete had positive outcomes in all its states that had gubernatorial elections this cycle. Incumbents Andrew Cuomo (New York), Tom Wolf (Pennsylvania), and Greg Abbott (Texas) had already made large infrastructure investments during their administrations, and we expect this to continue. Cuomo and Wolf have already discussed expanded investments for their next term. Former Lt. Gov. Gavin Newsom’s victory in California bodes well for a state that has some of the worst roads in the country. As part of the administration that passed the state’s gas tax increase last year, he’s said that he wants to double infrastructure spending. Similarly, Oklahoma Gov. Kevin Stitt has a stated goal of making Oklahoma a top-10 state in infrastructure. However, we note some caution around our optimism for Oklahoma until a more detailed plan, especially around funding, is announced.

Martin Marietta and Vulcan Materials had mixed results in their governors’ elections, although we believe there will still be a net benefit on an overall basis. In addition to Texas, we see positive election outcomes for Martin Marietta in Colorado, Iowa, and Maryland. In Colorado, Martin Marietta’s second-largest state by revenue, Gov. Jared Polis has stated an openness to exploring new sources of revenue to fund transportation infrastructure, which we view as somewhat positive, given the state’s historical stiff resistance to higher taxes. In Iowa, Gov. Kim Reynolds helped pass the state’s gas tax increase in 2017, which bodes well for infrastructure spending during her term. She opposed using tolls, but we think that may reflect a preference for certain funding mechanisms rather than a resistance to infrastructure. In Maryland, Larry Hogan was re-elected, which we view as positive, given his record and plans for additional investment.

We view the election outcomes of Florida, Georgia, and South Carolina as negatives for Martin Marietta. In Florida, Gov. Ron DeSantis previously blamed bureaucracy for the country’s poor infrastructure, an attitude that we view as problematic for increased funding. Gov. Brian Kemp has stated intentions to cut state spending and invest in rural Georgia, which we view as a potential risk for reduced infrastructure funding. In South Carolina, Henry McMaster was re-elected after replacing U.N. Ambassador Nikki Haley in 2017. Although McMaster is in favor of major highway expansions, we are troubled by his veto of a gas tax increase that would have greatly improved South Carolina’s infrastructure funding ability.

As Texas and California are its two largest states by revenue, Vulcan Materials should benefit from the elections of Abbott and Newsom, both of whom we see as positive factors for increased infrastructure spending. In addition, the election of Jay Pritzker in Illinois and Bill Lee in Tennessee should benefit the company. Pritzker has stated that infrastructure is a priority and plans to explore multiple funding options, including expanded gambling to boost tax revenue. Although Tennessee’s road quality is among the best in the country, Lee acknowledged the importance of maintenance work and seeks to cut other spending to protect infrastructure dollars.

For Vulcan, in addition to negative implications in the Florida, Georgia, and South Carolina elections, we view Doug Ducey’s victory in Arizona as challenging for increased infrastructure spending for the state. Although Ducey mentioned infrastructure as a priority, prior comments point to reliance on a federal plan by Trump to drive the increased spending. We view states that are proactive about improving their own funding mechanism as better prepared for any increase at the federal level.

Although the individual election implications for Martin Marietta and Vulcan Materials are somewhat mixed, we still view the overall outcome as positive for long-term infrastructure spending. Very few winners discussed cutting spending, so we would expect most states that are not increasing spending to at least maintain current levels.

2018 State Referendums Brought No New Money, but Protected Recent Progress There were only 12 state transportation-focused referendums throughout 2018. From a funding perspective, the results were not encouraging, as no company under our coverage operates in a state that approved more dollars. There were five proposals, although only the two in Colorado and one in Missouri meaningfully affect the heavy-side building materials companies.

As its second-largest state by revenue, Colorado is important to Martin Marietta’s outlook. And being one of the country’s fastest-growing states, and with 21% of its roads rated to be in poor condition, the state has a high level of demand for infrastructure work. However, the state struggles to find appropriate funding, which led to two separate referendums for a state bond issuance and increased sales tax to pay for roads. Neither measure passed at the ballot, leaving Polis tasked with searching out new sources of revenue.

Missouri accounts for 9% of Summit Materials’ revenue. Repair and replacement needs in the state are high, as 24% of its roads were rated to be in poor condition and 13% of its bridges were rated structurally deficient. Proposition D proposed a $0.10 gas tax increase to $0.27 per gallon by 2022 to fund the state Highway Patrol as well as the establishment of the Emergency State Freight Bottleneck Fund dedicated to road improvement projects. The measure failed at the ballot.

The silver lining in the 2018 state referendum results was California, which approved Proposition 69 in June and rejected Proposition 6 in November. Proposition 69 was a lockbox proposal that required funds raised from the state’s 2017 transportation tax increases only be used for transportation purposes. Proposition 6 would have repealed 2017’s transportation tax increases and require voter approval for any new or increased transportation taxes. Approval of this measure would have crippled any progress the state could make in addressing its terrible road quality, so its repeal was positive for Vulcan Materials and U.S. Concrete.

Where State Referendums Failed, Local Referendums Succeeded Referendums failed to bring new dollars on the state level but were significantly more successful on the local level. Vulcan Materials was the biggest winner with more than $25 billion in favorable transportation referendums passed, while Martin Marietta was a close second with more than $19 billion. U.S. Concrete's footprint in Texas and California passed more than $7 billion for infrastructure spending. Summit Materials lagged at about $2 billion in successful infrastructure referendums, although expanded funding passed in three of its four most important states.

We looked at all major local transportation initiatives for the major states of our heavy-side building materials coverage during 2018 and assessed every referendum’s impact. Notable successes include Texas, California, and Florida. Texas alone passed nearly $1.1 billion in new taxes, bonds, and transportation programs, which should benefit all four companies, given their operations in the state. Augmenting 2017’s successful statewide transportation initiatives, California passed $6.2 billion in local transportation initiatives, helping to boost Vulcan’s and U.S. Concrete’s operations there. Two large transportation initiatives passed in Florida, where $16.5 billion in new transportation money will help Martin Marietta’s and Vulcan’s sales in the state.

FAST Act Can Still Boost Near-Term Infrastructure Spending While the midterm elections boosted our confidence in improved long-term infrastructure funding, we think there is substantial funding already available for at least the next few years. In December 2015, Congress passed and President Barack Obama signed the Fixing America's Surface Transportation Act, or FAST Act, authorizing $305 billion for highway, mass transit, and other transportation infrastructure through fiscal 2020. As part of the law, $51.9 billion was immediately transferred into the Highway Trust Fund's Highway Account and $18.1 billion was transferred into the Mass Transit Account. Although the law did not address the increasingly ineffective gas tax, it did provide the most funding in years, giving more certainty and stability to the Highway Trust Fund.

Three years later, the Highway Trust Fund balance is still nearly $33 billion, or more than 60% of the original balance when the FAST Act was passed. Furthermore, this balance is still higher than any amount the fund has carried before the cash transfer. Enough resources remain to fund more than $45 billion in annual outlays through the end of fiscal 2021, providing near-term stability for infrastructure activity for at least the next three years.

Underlying Demand for Roadwork Remains Strong To assess the demand for aggregates and cement in the United States, we've looked at the key end market. Infrastructure tends to be the largest individual single category for Martin Marietta and Vulcan Materials. Although not the largest category, infrastructure is still a meaningful end market for Summit Materials and U.S. Concrete. These companies' focus on downstream products like concrete, asphalt, and paving lead to their higher exposure to residential and nonresidential construction. Nevertheless, historically, infrastructure has been an even more important category than it has been in just the last few years. Martin Marietta reports that infrastructure's recent share of 40% compares with 43% over the last five years and 50% over the long term.

We focus primarily on roadwork, since it tends to be the most cement- and aggregates-intensive infrastructure category. As a result of significant underspending on maintenance and delayed replacement work on roads, U.S. roads have seen their quality worsen over time. According to the American Society of Civil Engineers’ 2017 Infrastructure Report Card, 21% of U.S. highways are in poor condition. Worse still, 32% of urban roads, which have heavier usage, are in poor condition. ASCE estimates that these road conditions led to $160 billion in time and fuel wasted in traffic.

Road quality differs widely across states, with the percentage of roads in poor condition ranging from less than 5% up to 50%. Roadwork is handled by each state’s department of transportation, so differences in each state’s financial health, road funding mechanisms, and budget priorities have led to the wide range of quality.

Differences in individual states’ road quality leads to different levels of demand for repair and replacement work. Poorer-quality roads are in greater need of immediate attention and typically will require more material-intensive replacement work than simpler surface repair work. When we weigh each company’s footprint against individual state road and bridge quality, every company’s footprint has high repair and replacement work on an absolute basis, although Vulcan Materials and U.S. Concrete are in more attractive states on a relative basis. For bridges, Martin Marietta and U.S. Concrete operate in states that are in greater need of bridge repairs.

Repair and replacement work represent only a portion of demand. New roads are the other part of demand, and their construction tends to depend on population growth. Growing communities need not only new and expanded roads, but also everything from new housing to offices, hospitals, and retail. As a result, population growth tends to have an even bigger impact on overall heavy-side building materials demand, driving both residential and nonresidential construction.

Yet, like the wide range in road quality across the U.S., population growth varies widely across the country as well. The range of population growth in the U.S. from 2010 to 2017 was wide, with 31 states growing faster than the nationwide rate of 0.7% per year, while 11 states saw annual growth of less than 0.2%.

In weighing each company’s footprint against individual state population growth, we find that every company’s footprint has higher average population growth than the national rate, partially driven by Texas being one of the largest states for all four companies. However, U.S. Concrete’s exposure to the slower-growing Northeast leaves its average population growth rate lagging behind Martin Marietta, Vulcan Materials, and Summit Materials.

Heavy-Side Building Materials Share Prices Retreated in 2018 From 2015 to 2017, heavy-side building materials stocks soundly outperformed the broader market. U.S. Concrete shares nearly tripled, Martin Marietta and Vulcan Materials shares roughly doubled, and Summit Materials shares gained 50%, far outpacing the S&P 500's massive 30% gain over the same period.

These companies enjoyed consistent earnings growth, as construction markets finally thawed postrecession. Accordingly, we observed solid volume growth for aggregates, cement, and downstream building materials. Amid steady volume growth, companies were able to push robust price increases, and high capacity utilization drove rising margins. The election of Trump in November 2016 further accelerated share price gains, as optimism for better federal funding rose due to his campaign talking point of a $1 trillion infrastructure plan.

However, after a handful of underwhelming announcements that lacked specific detail on funding sources, optimism for a new infrastructure plan faded over the course of 2018. As such, heavy-side building materials stocks turned from being some of the best performers in the market into some of the worst performers. Martin Marietta fell 22% for the year, Vulcan Materials 23%, Summit Materials 61%, and U.S. Concrete 58%. The market declined roughly 6% over the same period.

However, we see a growing disconnect between heavy-side building materials share prices and underlying financial performance. Although the delivery of a new infrastructure plan has been delayed, we believe worries that profit growth will materially slow are unfounded. EBITDA for Martin Marietta and Vulcan has continued to grow at steady pace while the companies’ share prices have declined. We saw similar setbacks in 2015 and 2016 for both companies, and we believe that 2018’s pullback will see a similar recovery in share prices.

At current market prices, the market appears to be pricing the end of the construction cycle. Summit’s share price implies essentially no growth, and U.S. Concrete’s share price even implies contraction. The risk of a slowing economy appears to be rising, with some pundits forecasting a recession in the next few years. However, these are implied long-term growth rates, not short-term growth rates. Although the timing of reinvigorated infrastructure spending is difficult to predict, market-implied long-term growth rates should still capture our view that this spending will need to take place at some point in the not-so-distant future.