Rock stock rubble and some aggregate scuttlebutt

There were some interesting suggestions in the comment section of my post on scuttlebutt.  There are certain 10-Ks I’ve read and thought that there was enough information to understand the company.  Certainly that isn’t the case with analyzing a healthcare company where the basic economic landscape is changing.   On the other hand, certain industries are not very susceptible to change and so older information can still be news to me.

One source of scuttlebutt I mentioned was the Sequoia Fund Investor Day Transcripts.  They give straightforward and detailed answers on their holdings and industries.   One of the industries they discuss is aggregates.  It is just rocks that go into every type of construction project: roads, homes, offices, etc.  Boring industry.  I probably read most of these transcripts over a year ago, but a lot has stuck in my head (it really is cumulative).  I recently wrote about how the housing related industries being really beaten up in the most recent sell off and that there were probably some real gems in the rubble.

Sequoia used to have positions in Martin Marietta Materials (MLM) and Vulcan Materials Company (VMC).  They took the MLM position in the 3^rd quarter and the Vulcan position in the 4^th quarter of 2007.  They had come off their peaks, but were still quite high.  The stocks have been on a steady slide ever since and are lower than in March 2009.  While the outcome hasn’t been great, the process was rock solid.  At the 2008 Investor Day they had this to say about their purchases and the industry:

     “It's not part of a greater strategy. It's based on the economics of the companies themselves. I'll talk a little bit about the quarry operators — Martin Marietta and Vulcan. First of all, Martin Marietta and Vulcan produce aggregate. It's used in infrastructure; it's used in nonresidential and residential construction projects, as railroad ballast — anything you need rock for, it's used.

     The great thing about this business is that it's simple — there's no risk of technological obsolescence. It's hard to find substitutes at $10 per ton, which is about the cost of rock these days. For Martin Marietta, they have over 50 years of reserves in the ground beneath their feet and Vulcan has 43.

     Let me give you an example of why we like these businesses. The key is really in their pricing power. The weight of rock is very high relative to its cost to transport, and that leads to the markets' being very local in nature.

     Truck transportation — which is the most common form of transportation for rock and also the most expensive — can reach as high as 30 cents per ton per mile. That means that if you have a job 30 miles away from my quarry, by the time you deliver that rock to your job, you've more or less doubled its cost.

     By the same token, if you have a job next door to my quarry and the nearest competitor is 30 miles away, I can double my price before you have an economic incentive to go somewhere else. Ideally, I would have quarries blanketing a growing metropolitan area. So for any job in that area I would be more likely to have a quarry that is closest to that job and I could price according to my transportation advantage.

     If you draw a circle with a 30-mile radius around a typical Martin Marietta quarry, that circle will contain a competitor's quarry only about as frequently as it does another Martin Marietta quarry. Vulcan's quarries fall into a similar competitive pattern. Other large aggregate companies face local competitors significantly more often than both. If you increase the radius of that circle — just to give you simple metrics — but if you increase the radius to 50 miles, Martin will have on average only three competitors within that 50 mile radius, and a typical US quarry will have five. And that's impressive since Martin Marietta has only 197 — as of the end of 2007 — producing locations out of thousands of producing locations in the US.

     It also helps to be in growing markets. Both Martin Marietta and Vulcan established footprints in growing metropolitan areas through acquisitions over the years. Between 1995 and 2002, Martin acquired 62 companies. Vulcan has also been an active acquirer. Notably, they acquired Florida Rock for $4.2 billion in 2007. They are still integrating it.

     So why does being in a growing market help? Well, population growth helps in two ways. First, it spurs demand for rock. Second, it raises the barriers to entry because quarries are unwelcome in populated areas. Nobody wants explosions shaking the walls of their house. Nobody wants oversized trucks clogging their roadways.

     So it's extraordinarily difficult, these days, to obtain a permit for a new green field quarry in a growing metropolitan area in America. The barriers are very, very high. That difficulty in permitting means that Martin and Vulcan both know who their competition is and where their competition is for a very long time into the future — say at least the next five years.

It also means that their competitors in that area understand that permitted rock in a growing area is an increasingly scarce resource, and they will price accordingly.

     Finally, with population growth, commercial and residential construction will cover potentially competitive quarry sites over the course of time due to sprawl. So your transportation advantage in those markets grows over time.

     The bottom line is that in difficult times, which we are in today, we're seeing precipitous declines in volumes in the rock business. But even in this environment, these firms have still shown an ability to raise prices. Martin Marietta just raised their expected price increase for 2008 to six to eight percent. Vulcan is expecting eight percent in 2008.

     Just to give you an idea of the market dynamics, in 2007 Martin Marietta produced 182 million tons of rock. That's the lowest level of production they've had since the year 2000. But they earned $6.06 per share in 2007 versus $2.39 in 2000. So even in a difficult environment, if the pricing power hypothesis holds and if these companies can raise prices on the order of six to seven percent per year over the course of a cycle, we'll do well.”

So that was quite long, so I will summarize:

1.     Zero technological risk due to simplicity and low cost creating no economic incentive for innovation

2.     Huge pricing power because the weight of transportation costs can really crush competitors. 

3.     Digging big holes creates a moat.  Nobody wants new quarries near them, but being near “them” is what gives a quarry its competitive advantage.  This is called reflexivity.

4.     Capacity has little to no effect on the pricing power of business, so even in a bad time, prices still rise. 

I’m no expert, but these all make sense.  I don’t care if there are no economies of scale.  I don’t care if it is tarred with the label of being a commodity.  That is exactly what I want to know about an industry that I simply don’t have the resources to figure out on my own.  Even if I did have the resources, I still wouldn’t really know how to even begin researching that.  This type of information hits the nail on the head in regards to what I want to know about a business or industry, but is rarely available in perfectly packaged nuggets like this.

Sequoia doesn’t own Vulcan or Martin Marietta anymore due to pessimism and a lack of comfort with capital allocation.  Vulcan has a lot of debt, Martin Marietta has a good amount, and both had to issue shares recently to pay down debt.  This contrasts to their buying back of shares in the go-go years.  Maybe one of these is forgivable, but combined it doesn’t paint a pretty picture. 

Martin Marietta was doing dandy.  They bought back ~10% of their shares in 2007.  They were drowning in cash.  Vulcan had the same problem.    They bought back a bunch of shares in 2006, but in the past 4 years have increased the share count 30%.  Vulcan also acquired a business for $4bn in 2007.  They issued about 15m shares for that, which is fine since their share price was high too.  In 2009, they had to issue an additional 15m shares to lower their debt load.  Vulcan had $300m in LT debt in 2006, but in 2010 they had $2,428m.  Even with pricing power, entering a weak patch of demand is not the time to take on debt, especially in that magnitude.

In one way this reflects how good the business truly is, because it seems like the people there certainly aren’t behind the financial performance.  These are great assets that probably will earn plenty of money.  It’s not the equivalent situation, but it is similar to trusting Steve Ballmer with Microsoft’s cash flow.  The aggregate companies are much more limited in the boundaries of expansion. MLM has a history of  dividends while Vulcan just cut theirs.  They aren't looking to expand into any ancillary industries, which is a positive sign.  They could be doing better, but they could be doing a lot worse.  If the value is clearly there and the price is low enough, the businesses don't fall into the "too difficult to know what they do with the cash" pile.  I'd echo Sequoia's concern about the capital structure as a reason to take pause before jumping in.

Cemex is probably my favorite example of stupidity in the broader cement industry and example of idiots running a company one day.  I owned this stock in a fake portfolio circa late 2006-early 2007 when there was that mini crash in May 2006 from the interest rate cut.  Then the market marched steadily higher.  I thought I was pure brilliance, as do all 16 year olds witnessing positive outcomes. 

Cemex was touted in all these lists in Forbes, Fortune, Businessweek, etc as a future dominant company that started in a developing country.  There was – likely still is – this red herring argument about how all these emerging giants were going to give incumbents a run for their money (Embraer, Tata, and some others that I can’t recall).  Well, Cemex just gave the incumbents their money. 

Cemex purchased Rinker pretty much at the peak in 2007.  Compounding management’s tone deafness was funding the acquisition with tons of debt.  This was their largest acquisition ever.  Their second largest was done in 2005.  Hindsight is 20/20, but this was dumb.  They thought they were really smart and savvy so they just used a bunch of debt to fund both and figured future cash flow would take of it.  Like the 16 year old who purchased Cemex in a fake portfolio, management felt pretty good basing their confidence in themselves on the outcome and not the process.

Management was/is able to protect its moat in Mexico, which allows it to produce cement cheaply and sell it dearly.  This doesn't make their debt fueled acquisitions any smarter though.  This all sounds like Monday morning quarterbacking, but if you look at the sheer amount of debt they used, it’s just insane.  For a cyclical, commodity product, it’s just silly.  If I had some spare change, I’d bet that the lead banker on that deal who got the advisory fee and the debt issuance commission is retired on his submarine equipped yacht laughing at the world.  S/he might be the only one laughing who has been involved with this business for the past 2-3 years.

This mentality isn’t a phenomenon limited to newcomers on the global business scene.  Walmart thought they were cute going into Germany and got a Clausewitz inspired lesson on competition - Aldi's and German frugality simply were interested in the fact that Walmart had cornered rural America retial.  It happens to everyone.  Tesco is finding out the same in their foray into US markets.  It’s easy to confuse past success with future guaranteed success, but it’s worth pointing out when it simply isn’t so.

I’m interested in the industry because the premise put forth by Sequoia seems simple and easy to understand, while the stocks have been beaten down a lot recently.  I’m reluctant to stomach the debt loads when infrastructure or new construction can easily be deferred.  While it would bode well for the future of the business, it would need to overcome the present hurdles of interest payments.  Luckily, both businesses are quite profitable even in this depressed environment.  I don’t have a position in MLM or VMC, but I’m interested in digging deeper.