Eagle Materials Summary

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.

Eagle Materials Write-Up

Eagle Materials (EXP) is an interesting angle on my sense that there may or may not be some houses built in the future.  It's certainly not pretty to look at right now and its a cyclical business.  I think it's pretty cheap and well positioned to take advantage of weakness.  I even put a picture in this write-up, so I'm really pulling out all the stop for you, dear reader.  I'd be interested in hearing your thoughts on commodity producers.  Is Eagle just the tallest midget and gets permanently impaired if I'm wrong?  They seem to be in a position that if things get worse, others will suffer a lot sooner than they do and as a 2nd or 3rd level thinker, the "market" corrects itself as a result and Eagle is fine.  The basic case is that Eagle is still profitable and everyone else isn't.  Is that self-serving and wishful thinking?  I don't believe this is a particularly great business, but I think it's cheap and nobody seems to like it, so I'm naturally drawn to it.  For thought.
Exp Write Up

Housing stock #1: American Woodmark

American Woodmark (AMWD) is one company I’ve looked at as a company whose stock price is among the rubble of the recent selloff and is related to housing.  It’s an understatement to say they have a simple business.  They make cabinets.  I think I can understand this.  There are certain factors that are appealing – capable of 20%+ ROE in good years, chairman owns 24% of the company, and a net cash position.  I didn’t find much of a competitive advantage though as they are heavily reliant on Lowe’s and Home Depot for 70%+ of their sales.  While I don’t think people will find new ways to store their dishes and whatever else people put in cabinets, the heavy concentration on one product line and 2 selling channels makes this a pass.  It’s an interesting example of competitive dynamics and insightful for future analysis.

It does not get more boring than this.  American Woodmark makes cabinets.  That's it.  Just wood, screws, hinges, and a coat of paint/veneer/lacquer.  There's no secret sauce here.  No hidden assets.  Their owned manufacturing plants are in places like Gas City, Indiana or Hardy County, WV (that means the middle of no where, not even an incorporated municipality).  There's really no angle here other than the pessimism surrounding its current industry.  They were originally a division of Boise Cascade in the 1980s until a management LBO.  

The company is sort of cheap.  They actually canceled their dividend at the end of August as well, which practically had no relative effect since it coincide with a broader selloff.  The company has averaged $0.92/share or $15m in net income over the past 10 years.  It’s earned ~$30m in good years and lost ~$20m in bad years.  The 10 year average ROE is 7.82%.  At a current price of $13/share, it definitely will be worth more in a housing recovery since earnings will be above average.  The business has remained cash flow positive due to cutting back discretionary capital expenditures and closing down plants.  Bankruptcy risk is arguably minimal due to a net cash balance of $45m ($70m cash, $14m is restricted contingent on the $25m debt from its revolver).  Their defined pension benefit plan is underfunded by $38m using an 8% return assumption, so while it won’t bankrupt them, the financial condition is not as stellar as a passing glance would lead one to believe.

I think this indicative of several things, but importantly it is a reason to be hesitant about the qualitative attractiveness of the business.  Sales growth through the boom came on the back of Home Depot and Lowe’s.  There are instances – power tools, white goods, etc. – where people are going to come in and buy exactly what they want, but Home Depot and Lowe’s both have exclusive brands that American Woodmark produces for them.  They account for 70%+ of sales, so you tell me who has the upper hand in this relationship.

I don’t like to just say something then hope the facts bear this out.  There are certain instances where a concentration of sales isn’t awful.  Defense contractors don’t seem to get the short end of the stick, which is a pity for taxpayers but not shareholders.  Why do I think AMWD doesn’t have this kind of relationship? 

From Fiscal 2002-2006 (April start), revenue went from $499m to $838m, or a 68% increase.  During this same period A/R + Inventory went from $66m to $122m or an 84% increase.  This slight divergence in revenue growth and A/R + inventory isn’t terribly worrisome on its own, but A/P only grew from $23m to $34m, or a 47% increase. 

So working capital didn’t grow in line with revenue, it outpaced it.  If you just use the difference between A/R + Inventory and A/P, it went from $43m to $88m, or a 102% jump.  So the increased volume AMWD was doing with Lowe’s and Home Depot went solely to the benefit of the retailers.  That isn’t it either.  AMWD has to install their own promotional displays at these stores and the cost sits on their balance sheet at $6.6m in the most recent quarter.  That’s just another indicator that they don’t call the shots.

Another way to skin the cat is observe that from 2002-2006, the company’s sales went from $499m to $838m, but net income went from $32m to $35m.  That they couldn’t eke out more than $3m in profit from $339m in revenue from the scale of producing more cabinets indicates zero operating leverage, which is bizarre.  Even when the sky knew no limit, they didn’t go along for the ride – although they are no suffering from it.  The ROE from 2000-2006 actually dropped from 22% to 14% during a housing bubble!  So the business quality actually declined since it took a greater investment on behalf of owners to maintain the same amount of profits. 

In my prior post on housing, I mentioned how it wasn’t intelligent to simply pluck numbers from historical results and assume they will be achievable in the future.  In the past 12 months, AMWD has had $474m in revenue and reported losses of $20m, whereas in 2002, they reported profits of $32m on $499m in revenue.  The difference?  Even though AMWD and plenty of others have closed down plants and cut down on, the market is still weak.  Straight from the 10-Q:  “the Company’s largest remodeling customers have continued to utilize aggressive sales promotions in the Company’s product category to boost sales.  These promotions typically included free products and cash discounts to consumers based upon the amount and/or type of cabinets they purchased.  The Company’s competitors have participated vigorously in these promotional activities and the Company has generally chosen to meet these competitive offerings.”

In both good and bad times, the market is pushing around AMWD with little control over their destiny.  In their defense, management is doing a good job operationally.  They are turning their inventory over 18x annually or every 20 days.  Not that it’s in any way comparable, Owens & Minor, a company I’ve written about, turns their inventory over 10x and they consistently get awards for being a very efficient distributor.  Dealing with a tangible good like cabinets, its impressive that they achieve this.  It is a shame they aren’t achieving attractive returns as a result though.

AMWD never maintained steady margins through the boom (declining in fact) so it is difficult to peg a “normalized” earnings range.  If they managed a 10-12% ROA like they did in 2002-04, earnings could be $26-32m.  Even though 6-7x normalized earnings is a generally attractive proposition, the paucity of returns makes the business unattractive to own and the customer concentration creates risks to achieving normalized earnings.  They do have the financial wherewithal to be around for a housing revival assuming they don't lose their key customers.

Housing stock and housing stocks

If you watch the recent Charlie Rose interview with Warren Buffett, or pretty much any recent interview with friend of the blog Warren, he always chimes in about housing.  Not next quarter on some specific date, but his general sentiment is that housing will recover.  Is this really something worth debating beyond the issue's ability to generate hits, clicks, and magazine sales?  The US is now supplying fewer houses than the long-term demand, and sooner or later this will kick in and new homes are going to necessary (homes, apartments, trailers, etc.).  This seems logical when viewed with a bird’s eye perspective, but it’s clearly no surprise that this does not seem intuitive if one were to extrapolate the current weakness in the US economy.

Prior to the go-go years when people would be flipping Miami condos a dozen a day, the only thing sexy about the housing industry was shag carpeting.  All of the businesses associated with the industry are dull, but I think there is a strong likelihood that there are gems in the rubble.  In the past few months, a basket of stocks I would broadly define as housing related has dropped even more than the market (30-40%), so I’ve begun poking around.  This has much more to do with cheapness relative to some vague conception of normalized earnings power than some macro call.

For those who look beyond Berkshire’s insurance operations, another major contributor to the company is housing related industries: Shaw Industries (carpet), Johns Manville (insulation), Acme Brick, MiTek (connectors), Clayton (trailers), and Benjamin Moore (paints).  If you look at the 2000-2006 letters, the housing related businesses get mentioned as easy to understand businesses that make attractive returns on tangible capital over an economic cycle.  For once, I don’t think he is making it sound a lot easier than it really is.

With the exception of Clayton, all of these businesses contribute a small but important part to the final product.  Instead of paying Michael Porter to reveal a secret of the business world, I’ll just throw it out there for free.  When someone produces a product that is a very small but crucial element to an entire system, it creates a competitive advantage.  Whether or not the competitive advantage is exploited will reveal itself in the financials.  Shaving 30% of your costs off an input that is 1% of your total cost is meaningless to the bottom line if it means your end product is crap.  Such a cost differential becomes increasingly irrelevant as the expected life of the product increases.  This is probably why stuff like backyard furnace steel is usually not a hit.  Nobody wants to drive over a bridge or sleep in a building made with that stuff. 

Cheap imports exist for sure, but there is a degree of brand equity and reputation for certain products.  Never doubt that there are people always looking to cut corners and eke out a couple basis points more of margin.  In at least one instance, the relative cost of a slightly more expensive initial input is vastly overshadowed by the legal costs and damages stemming from issues like Chinese drywall (links, links, links if you don’t remember reading about this).  The concentration of these issues in Florida might suggest purchases of inferior inputs are linked to more speculative builders and the broader industry is reliant on reputable suppliers, although perhaps it is a self-serving interpretation.  One might say that it means domestic producers are facing pressure.  Not every input for a building is supplied by someone with a competitive advantage.  MiTek, which makes truss connectors, has a competitive advantage because people don’t care about relative savings of $200 on a $100,000 building if it means the roof will cave in.

I don’t think the above narrative that every housing related company makes a small part of a larger system is correct, but I think it is the right qualitative aspect to seek in the sector.  All of the write offs and restructurings over the past 5 years should have them on solid footing by now in terms of cost structure.  A house that is worth $100k or $800k still needs sinks, cabinets, doors, etc., so one isn’t betting exclusively on a recovery in home prices, even though that will probably be the evidence that many people point to as housing recovering.  Certain industries such as gypsum or concrete may not have obvious competitive advantages that stem from brands, but they can be low cost producers and be able to survive just a little longer than the other guy.  All of these factors should minimize the need to fret over the macro picture, in addition to buying the companies cheap. 

To bring this back to what Buffett is talking about with housing, nobody really knows exactly when it recovers.  The rocket science is in recognizing people need places to live and there are going to be more people tomorrow than there are today.  The calculus is fudged since household formations are being pushed out by poor economic prospects.  Perhaps I’m being stubborn in assuming people will always want to eventually live without their parents or friends.  The average in annual housing starts from 1959-2010 was ~1.5m and recent years have been well below that – ~.6m in 2010.  Is there a huge risk in betting on a reversion to the mean in the next 5 years with a skewed risk/reward scenario due to the prices of the relevant businesses?

So even though incremental demand exceeds incremental supply in theory, the lack of household formations isn’t tipping the balance.  There’s a chicken and egg problem with people talking about how housing will get the economy going again, when the inverse is equally true that getting the economy going again will boost housing.  As Sam Zell pointed out in a recent interview, there are actually more single family homes rented than apartments in the US.  Home ownership rates and house prices are not the only things that matter, since people need places to live.  There are many dueling data points.  Time is an oft-ignored factor that has an effect on the economy, but nobody talks about it since there is nothing they can do about it - no articles to write when all people should do is wait, no sales commissions to be generated, no political talking points.

I can’t calculate any of this with precision, but feel comfortable stating that the housing industry will revert to the mean sometime over the next 5-10 years.  If there is a business that trades at 5x normalized earnings and will survive, you have a double or triple bagger within the next 5-10 years if it eventually trades at 10-15x normalized earnings, which produces a nothing to scoff at 15-30% annualized return.  A bias to avoid is just picking earnings from 2004-2006 and thinking that’s “normalized” – housing starts were well above the 1.5m average then (easily adjustable graph of all the data).  Can we just pluck earnings from years when housing starts were 1.5m, then?  No.  Plenty of companies have closed down facilities in the past 5 years, so perhaps differing competitive dynamics will emerge with better positioned suppliers. It's not so simple that tossing around multiples and gathering evidence to support self serving normalized earnings will generate investment returns.

I don’t know what will fix housing and I don’t know what will happen.  I do think the current macroeconomic rumblings from everyone are myopic and present an opportunity.  Well capitalized, cash flow positive, housing related stocks with a demonstrated history of attractive returns over a cycle, and then wait sounds like something that might work.  This is an edge for long-term value investors since it requires patience and a temporarily contrarian perspective.