Vulcan Materials: An interesting asset play in a disliked sector

We at LTIM are attracted by businesses that have large barriers to entry, and therefore, are involved in markets where there are few competitors. When companies have certain positive attributes that create such a market structure, we find few companies that are unable to make exceptional profits.

We are even more excited when we see the pricing of the financial securities of such companies are trading at prices that do not include the potential value generated from having the ability to generate exceptional profits.

The aggregates business is a simple one whereby companies own or lease land where quarries are mined, and the extracted rock is sold. Customers primarily use the material for the development of roads or property (in the majority of cases).

Aggregates are a relatively cheap material (approx. 10 $/ton), but very difficult to transport. As a result, a local quarry will often have a monopoly of the local supply of aggregates.

VULCAN MATERIALS has one of the largest aggregates reserves in the USA. They are very large in the South East, states that have the largest population growth in the country. In these areas they consistently have greater than 40% of the crushed rock quarries under their ownership. This gives them a large market share in the areas they conduct business.

The common stock has suffered a large decline since 2007. In that period it was trading close to 120 $/share. Now it is trading at approx. 43 $/share.

At this price we believe the stock is an interesting asset play. Indeed, over the last few months we have presented various asset play ideas that derieve from a currently weak US housing sector. Though we do not believe the housing sector in the US will bounce back to 2007 levels next year, we think current pricing has been to aggressive in discounting the value of real hard assets. In this case of aggregates, in past examples like St Joe, physical land.

Many investors are currently focused on the short term earnings of Vulcan materials and how much they can increase volumes or pricing in the next quarter or two.

I am more concerned on how much their aggregate reserves are worth. Here is my simple calculation:-

Reserves = 14 billion tons of proven and probable aggregate reserves at its production facilities in the US and Mexico

Aggregates sell for approx. 10 $/ton

This implies a valuation of 140 bln

However, margin for extracting aggregates is often around 10% (normalised over the business cycle)

Hence we have a valuation of 14 bln

If we remove total liabilities of 4.5 bln

We have a value of 9.5 bln (lets say 9 bln)

The current market cap of the company is 5.5 bln

The company also extracts other materials and has a cement plant in Florida. We assume those assets are worth zero for simplicity and to be conservative. There seems to be a suitable margin of safety if you agree with the above mentioned reasoning.

Risks to consider? Considering current production rates it would take over a 100 years to exhaust their resources. One could express concern that during such a large period the pricing of aggregates may decline significantly. We take shelter in the fact that this material has been used since biblical times in construction, that permits to open new quarries are becoming more difficult to achieve (no one wants a quarry in their back yard!) and that the concentration of the market should allow princing power to be maintained to a satisfactory level. The problem is volume variation as demand is cyclical and costs are primarily fixed (hence a large margin reduction will be felt during a recession. This can be clearly seen from the financial statements as well as the stock price, which is very sensitive to the income statement).

Another cause for concern that must be followed closely is how the cost structure of the company evolves. For example, such capital intensive companies often have relatively large energy costs. It would not surprise me if next quarter earnings will be below expectations due to the strong performance of the oil price. Many mines use diesel power as a source of energy. If these costs can be passed over by higher pricing than the current normalised margin can be used to estimate the future value of their resources (we ignore their earning power. Our only assumption is that over the business cycle they will not burn cash).