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Construction Stocks and Public Spending
Posted by: Damian Illia (IP Logged)
Date: September 16, 2013 09:37AM

While the recent state of construction activity has been weak, the outlook is encouraging, in particular for infrastructure. Generally, public sector spending is much more stable than the private sector because the public construction projects are less affected by general economic cycles. Let’s look at three different stocks that could add value to your portfolio.

Cost Saving Actions and the Right Markets Targets Will Count

Vulcan Materials Company (VMC) is the largest producer of construction aggregates, asphalt mix, concrete and cement, mainly in California, Virginia, Texas, Florida, and Georgia. The company holds important competitive advantages within an industry that is characterized by high barriers to entry, mainly on account of its proximity to large metropolitan cities.

Although the downturn in construction activity has hit them big time, the company is already showing improvements as the US economy recovers. Vulcan's second-quarter aggregates shipments grew 2% YoY, and average realized selling prices increased ahead of inflation by 4%. This should result in expanding margins and resilient returns on invested capital.

Vulcan's most important end markets are infrastructure, nonresidential building construction, and housing. Therefore, demand drivers include job growth, vacancy rates, interest rates, demographic trends, and the transportation bill. Furthermore, Vulcan serves many of the states that are expected to see above-average population growth in the coming years.

Aggressive cost control measures to counterweight rising cost of certain essential materials along with soaring prices of diesel fuel are still in progress. The rising prices of these necessary resources has negatively impacted Vulcan’s margins in many quarters. Last year, cost saving actions resulted in improved per-ton margins and 11% lower Selling, General and Administration costs. Latest Guru trades include Pioneer Investments recently selling out its positions while Steven adding some to its portfolio. With EPS expected to increase 109% this year and 19% next year, I would recommend Buying shares of Vulcan Materials.

Optimistic Outlook for Developed Markets Will Favor Cemex

Cemex Sab De Cv (CX) is one of the largest producers of cement, ready-mix concrete, and aggregates in the world. Cemex’s earnings are determined by the demand for construction materials mainly in Northern Europe, Mexico, the US and South/Central America and the Caribbean.

The firm is based in Mexico, and its local sales account for about half of total EBITDA. Moreover, EBITDA margins reach approx. 35% thanks to a competitive advantages, such as long-term and low-cost fuel and electricity contracts. However, the country has been a drag on EBITDA lately due to political instability in the presidential transition

Cemex’s biggest risk is a continued decline in demand for building materials, especially in the US and Mexico, and an increase in energy costs that cannot be matched through higher pricing. The firm’s aggressive acquisition and financing strategy adds more risk, as it increases shareholders’ exposure to cyclical downturns. However, the cement industry is fairly consolidated and has high barriers to entry that usually translate into a favorable pricing environment for producers like Cemex.

With the US showing signs of recovery, I would expect some spillover in Latin America, which would help boost profit margins in the company. Latest Guru trades include Andreas Halvorsen and Ken Fisher adding 43% and 13895%, respectively, to its positions. Although these shares trade a little expensive, at 32.5 times its earnings, I would still recommend adding them to your portfolio, mainly based the expected recovery of developed markets, which would increase the demand for building materials.

Biggest Potential Is in the Replacement Market

Watsco Inc. (WSO) is the largest distributor in the U.S. of air conditioning, heating and refrigeration equipment as well as related parts and supplies such as thermostats and insulation materials. Watsco also operates in Puerto Rico, Latin America and the Caribbean.

The biggest potential lies within the replacement market, as old units have to get substituted by more energy-efficient and environmentally-friendly ones, in compliance with governmental standards. In addition to increasing sales, the company should see its margins improve as more efficient units drive higher pricing and margins.

Watsco has an option to purchase an additional 10% interest in the Carrier joint venture in the Sun Belt region, which becomes exercisable in July 2014. If this option is exercised and a positive trajectory in the housing sector in confirmed, Watsco is expected to be benefitted from increased sales, better selling margins and operating efficiencies.

Some of the latest numbers at Watsco are quite encouraging: its operating margin of 6.6% ranks higher than 76% of the companies in the electronics distribution industry, where the median is 2.90. What’s more, ROE is 13.8, higher than 88% of the companies with a median of 3.80, which shows that the company reinvests its earnings more efficiently than its industry peers. Finally, income from operations increased 53% to record $30.5 million.

Meridian Funds has recently add 16.31% to its holdings of the share, while Paul Tudor Jones has sold out all its position. Shares of Watsco are currently trading at 24.4 times its trailing 12-month earnings multiple, compared to the 17.4x industry average. Overvalued and expected to perform in line with the market, I would recommend holding for now.

Bottom Line

As households reverse the current housing trend to become owners, residential and commercial constructions will nourish volumes and demand. Vulcan Materials and Cemex are expected to deliver strong growth figures in the future and outperform the market; but, it seems that Watsco will need more than just increasing economic growth to offer convincing reasons for a buying recommendation. A considerable increase in consumer confidence will make a difference to Watsco.

Disclosure: Damian Illia holds no position in any stocks mentioned

Guru Discussed: Andreas Halvorsen: Current Portfolio, Stock Picks
Ken Fisher: Current Portfolio, Stock Picks
Stocks Discussed: VMC, CX, WSO,
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