I thought I’d summarize my Eagle Materials (EXP) write up since it’s a wee bit long. Eagle is a construction materials manufacturer that produces wallboard and cement. These are straightforward commodity products, although Eagle seems to have at least a relative focus on costs compared to some peers. My difficulty thinking about the business is whether or not they are genuinely a quality business or just the tallest midget. They have remained profitable throughout the downturn, although this is as much a function of a more sane capital structure relative to peers.
1. Low cost? Part of the answer lies in an abstract conception of “culture” while the other part is identifiable in numerous marginal factors that cut away at costs. The cement and wallboard plants have expanded in efficiency over the years through a combination of operational improvement and capital spending. The wallboard and cement capacity are vertically integrated with easy access to raw materials and rail and road access to markets. Management expanded capacity at one cement plant over the past five years with high efficiency equipment and built one new wallboard plant in the backyard of a coal power plant which gives it a very low cost (due to production cost of gypsum, proximity to existing rail line, and energy source). There are identifiable factors, which contribute to low costs, although it is wishful thinking to believe that these markets are not filled with aggressive competitors interested in replicating the contributing factors. While none of this amounts to a truly enduring low cost position, there is a demonstrated operational nonstupidity.
2. Capital Structure/What if I’m wrong? Perhaps they overreached in 2006-2008 in taking on some debt to repurchase shares, but the business has remained solid overall. Eagle has remained conservatively financed and hasn’t had to reissue shares to shore up its capital position. There is still $285m in debt on the balance sheet that does not present any short term financing issues, and amounts to a little under 4x debt/TTM EBITDA and interest coverage of 6x (EBITDA/interest) - both with depressed numerators. While Eagle’s end markets are clearly at a cyclical low, the duration remains to be seen. Due to Eagle’s ability to curtail capital expenditures – as well as the overcapacity and lack of pressing need for additional expenditures – Eagle should be able to continue to meet interest payments and generate excess cash to pay down debt. Eagle has much more flexibility than its peers (especially USG and Texas Industries, which I highlight in my write up) to persevere through continued weakness. While housing needs to recover in order to make money, the timing issue is not sensitive if the current environment persists for several years.
3. Valuation Eagle would be quite overvalued if the current economic environment were extrapolated. Eagle is very capable of earning $2/share in FCF mid-cycle of an economic expansion (see write up for why this is an intellectual honest and low hurdle). There is some additional upside in the lumpiness of results. Eagle is in a position to grow the company at the expense of overly indebted rivals looking to dispose of certain assets. I think there is additional upside in Eagle’s ability to take advantage of a weak environment.
