Stock Analysis: Vulkan Materials (VMC)

Company Description:

Vulcan Materials Company (Vulcan), incorporated in 1956, is a producer of construction aggregates, as well as a producer of asphalt mix and concrete. The Company's business consists of the production, distribution and sale of construction aggregates, and other construction materials and related services. Construction aggregates include crushed stone, sand and gravel, rock asphalt and recrushed asphalt and concrete.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 12/31/06):

Overview

Vulcan provides essential infrastructure materials required by the U.S. economy. We are the nation’s largest producer of construction aggregates – primarily crushed stone, sand and gravel – and a major producer of asphalt mix and concrete.

We operate primarily in the United States and our principal product – aggregates – is consumed in virtually all types of publicly and privately funded construction. In 2006, aggregates accounted for 70% of net sales. We shipped 255.4 million tons in 21 states, the District of Columbia and Mexico from 287 aggregates production facilities and sales yards. Our top 10 states accounted for 85% of total aggregates shipments.

Reserves largely determine the ongoing viability of an aggregates business. Our current estimate of 11.4 billion tons of zoned and permitted aggregates reserves represents a net increase of 3.3 billion tons since the end of 1996. We believe that these reserves are sufficient to last, on average, 44.3 years at current annual production rates. Additionally, we produce and sell asphalt mix and concrete in California, Texas, Arizona and New Mexico.

While aggregates are our primary business, we believe vertical integration between aggregates and downstream products, such as asphalt mix and concrete, can be managed effectively in certain markets to generate acceptable financial returns. As such, we evaluate the structural characteristics of individual markets to determine the appropriateness of aggregates only or vertical integration strategy.

Agreement to Acquire Florida Rock Industries, Inc.

On February 19, 2007, we signed a definitive agreement to acquire 100% of the stock of Florida Rock Industries, Inc. (Florida Rock), a leading producer of construction aggregates, cement, concrete and concrete products in the Southeast and Mid-Atlantic states, in exchange for cash and stock valued at approximately $4.6 billion based on the February 16, 2007 closing price of Vulcan common stock. Under the terms of the agreement, Vulcan shareholders will receive one share of common stock in a new holding company (whose subsidiaries will be Vulcan and Florida Rock) for each Vulcan share. Florida Rock shareholders can elect to receive either 0.63 shares of the new holding company or $67.00 in cash for each Florida Rock share, subject to proration to ensure that in the aggregate 70% of Florida Rock shares will be converted into cash and 30% of Florida Rock shares will be converted into stock.

We intend to finance the transaction with approximately $3.2 billion in debt and approximately $1.4 billion in stock based on the February 16, 2007 closing price of Vulcan common stock. We have received a firm commitment from Goldman, Sachs & Co. to provide bridge financing for the transaction. The transaction is intended to be non-taxable for Vulcan shareholders and non-taxable for Florida Rock shareholders to the extent they receive stock. The acquisition has been unanimously approved by the Boards of Directors of each company and is subject to approval by a majority of Florida Rock shareholders, regulatory approvals and customary closing conditions. The transaction is expected to close in mid-year 2007.

Divestiture of Chemicals Business

On June 7, 2005, we sold our Chemicals business, known as Vulcan Chemicals, to Basic Chemicals, a subsidiary of Occidental Chemical Corporation. The sale of assets included our chloralkali facilities in Wichita, Kansas; Geismar, Louisiana and Port Edwards, Wisconsin; and the facilities of our Chloralkali joint venture located in Geismar.

Acquisitions

In 2006, the total purchase price of acquisitions amounted to $20.5 million, down $73.5 million from the prior year. Acquisitions completed during 2006 included an aggregates production facility and asphalt mix plant in Indiana, an aggregates production facility in North Carolina and an aggregates production facility in Virginia. The 2005 acquisitions included five aggregates production facilities and five asphalt mix plants in Arizona, one aggregates production facility in Georgia, four aggregates production facilities in Indiana and one aggregates production facility in Tennessee.

End Markets

Demand for our products is dependent on construction activity. The primary end uses include public construction, such as highways, bridges, airports, schools, and prisons, as well as private nonresidential (e.g., manufacturing, retail, offices, industrial and institutional) and private residential construction (e.g., single-family and multifamily).

Customers and Competition

Customers for our products include heavy construction and paving contractors; commercial building contractors; concrete products manufacturers; residential building contractors; state, county and municipal governments; railroads; and electric utilities.

Customers are served by truck, rail and water distribution networks from our production facilities and sales yards. Due to the high weight-to-value ratio of aggregates, markets generally are local in nature. They often consist of a single metropolitan area or one or more counties or portions thereof when transportation is by truck only. Truck delivery accounts for approximately 86% of our total shipments. Additionally, sales yards and other distribution facilities located on waterways and rail lines substantially increase our geographic market reach through the availability of rail and water transportation.

Zoning and permitting regulations have made it increasingly difficult for the construction aggregates industry to expand existing quarries or to develop new quarries in some markets.

We estimate that the 10 largest aggregates producers in the nation supply approximately one-third of the total national market, resulting in highly fragmented markets in some areas. Therefore, depending on the market, we may compete with a number of large regional and small local producers.

Research and Development Costs

We conduct research and development and technical service activities at our facility in Birmingham, Alabama. In general, our research and development efforts are directed toward new and more efficient uses of our products. We spent approximately $1,704,000 in 2006, $1,554,000 in 2005, and $1,341,000 in 2004 on research and development activities.

Environmental Costs and Governmental Regulation

Vulcan is frequently required by state or local regulations or contractual obligations to reclaim its former mining sites. Our operations are subject to federal, state and local laws and regulations relating to the environment and to health and safety, including noise, water discharge, air quality, dust control, zoning and permitting. We estimate that capital expenditures for environmental control facilities in 2007 and 2008 will be approximately $16,559,000 and $7,949,000, respectively.

Properties

We have 202 locations in the United States and 1 in Mexico at which we engage in the extraction of stone, sand and gravel.

Of the 203 permanent reserve-supplied aggregates production facilities which we operate, 72 (representing 46% of total reserves) are located on owned land, 39 (representing 21% of total reserves) are on land owned in part and leased in part, and 92 (representing 33% of total reserves) are on leased land. While some of our leases run until reserves at the leased sites are exhausted, generally our leases have definite expiration dates, which range from 2007 to 2159.

Stock Repurchasing Program

On February 10, 2006, the Board of Directors authorized the Company to repurchase up to 10,000,000 shares. Through December 31, 2006, a total of 6,544,461 shares had been repurchased pursuant to this authorization. We may make share repurchases from time to time in the open market or through privately negotiated transactions, depending upon market, business, legal and other conditions.

Seasonality of Operations

Virtually all our products are produced and consumed outdoors. Our financial results for any individual quarter are not necessarily indicative of results to be expected for the year, due primarily to the effect that seasonal changes and other weather-related conditions can have on the production and sales volume of our products.

Normally, the highest sales and earnings are attained in the third quarter and the lowest are realized in the first quarter. Our sales and earnings are sensitive to national, regional and local economic conditions and particularly to cyclical swings in construction spending. These cyclical swings are further affected by fluctuations in interest rates, and demographic and population fluctuations.

Risk Factors

• A decline in public sector construction work and reductions in governmental funding could adversely affect our operations and results.
  

• Weather can materially affect our quarterly results.
  

• Within our local markets, we operate in a highly competitive industry.
  

• Our long-term success is dependent upon securing and permitting aggregates reserves in strategically located areas.
  

• We use large amounts of electricity, diesel fuel, liquid asphalt and other petroleum-based resources that are subject to potential supply constraints and significant price fluctuation.
  

• We use estimates in accounting for a number of significant items. Changes in our estimates could affect our future financial results.
  

• We are involved in a number of legal proceedings. We cannot predict the outcome of litigation and other contingencies with certainty.
  

• The costs of providing pension and healthcare benefits to our employees have risen in recent years. Continuing increases in such costs could negatively affect our earnings.
  

• Our industry is capital intensive, resulting in significant fixed and semi-fixed costs. Therefore, our earnings are highly sensitive to changes in volume.
  

• Our products generally must be transported by rail, truck, barge or ship, usually by third party providers. Significant delays or increased costs affecting these transportation methods could materially affect our operations and earnings.
  

• We have acquired, and expect to continue to acquire, other businesses. Failure to manage and successfully integrate them could adversely affect our business.
  

• Our future success depends greatly upon attracting and retaining qualified personnel, particularly in sales and operations.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations

2006 versus 2005

Net sales and earnings for 2006 surpassed 2005’s record levels. Improved pricing for all key products more than offset lower shipments and resulted in a 16% increase in net sales, which exceeded $3.0 billion for the first time in our history. Aggregates pricing improved approximately 15%. The increasing demand for aggregates in a broad range of public infrastructure and nonresidential construction helped offset the correction that has occurred in residential construction. Our consistent earnings growth is a reflection of both our broad geographic and end-use markets and a pricing environment for aggregates that recognizes the high cost of reserves replacement and product distribution in high growth metropolitan markets.

Operating earnings were a record $695.1 million, an increase of 46% from the 2005 amount. Improved aggregates pricing more than offset the effects of the slight decline in aggregates shipments and higher production costs related to diesel fuel, parts, supplies and electricity.

Asphalt mix and concrete earnings also increased significantly as pricing improvements exceeded the effects of lower volumes and increases in raw material costs. Compared with 2005, the cost of diesel fuel and liquid asphalt were $13.7 million and $58.8 million higher, respectively. Gross profit as a percentage of net sales was 31% for 2006, up 4 percentage points from 2005. Selling, administrative and general expenses increased $31.9 million from the prior year. Approximately one-half of the increase resulted from higher provisions for incentive compensation, including the effect of expensing stock options, and increased professional fees.

Earnings from continuing operations before income taxes were $703.5 million, an increase of $223.2 million or 46% from the prior year. The 2006 earnings include a gain of $28.7 million related to the increase in the carrying value of the contingent ECU (electrochemical unit) earn-out received in connection with the sale of our Chemicals business compared with a $20.4 million gain in 2005.

2007 Outlook

We remain confident in our ability to continue strong earnings growth in 2007. Overall, we expect earnings from continuing operations for 2007 to be in the range from $5.51 to $5.91 per diluted share. In January 2007, we closed a real estate sale transaction in California that resulted in a net after-tax gain of $0.25 per diluted share, which is included in our guidance. Our current earnings outlook is based on overall aggregates price improvements in the range of 10% to 11%, a decrease in the average unit cost for diesel fuel compared with 2006 and aggregates shipments that are in line with 2006.

Broader economic factors such as low interest rates, job growth, falling office vacancy rates and the solid fiscal condition of most states should continue to aid the more aggregate-intensive infrastructure and private nonresidential end use markets in 2007. Overall demand for aggregates in our markets should remain relatively stable. The residential construction slowdown in the U.S. continued in the fourth quarter of 2006 and contributed to lower aggregates shipments for the year. However, with mortgage interest rates still at relatively low historical levels and household formations increasing in high growth markets, residential construction has the potential to stabilize by the second half of 2007.

Aggregates demand from highway construction in the markets we serve should increase in 2007, primarily as a result of higher state spending levels and moderating liquid asphalt costs. In 2006, construction cost inputs for highway projects increased significantly, particularly liquid asphalt and diesel fuel, resulting in some delays for new contract awards.

We believe private nonresidential construction will continue to improve in 2007. This end market includes a wide array of project types and generally is more aggregates intensive than private residential construction. Economic factors such as job growth, vacancy rates, private infrastructure needs and demographic trends help drive demand for this type of construction.

Financial Highlights:

Revenue Growth (1-yr): 15.5%
Revenue Growth (9-yr average): 8.9%

Net Income Growth (1-yr): 39.0%
Net Income Growth (9-yr average): 11.0%

Earnings-Per-Share Growth (1-yr): 45.2%
Earnings-Per-Share (9-yr average): 11.5%

Free Cash Flow Growth (1-yr): (-44.0%)
Free Cash Flow Growth (9-yr average): 11.6%

Net Profit Margin (current): 14.3%
Net Profit Margin (10-yr average): 10.5%

Return On Equity (current): 23.2%
Return On Equity (10-yr average): 19.4%

Debt Ratio (current): 0.42
Current Ratio (current): 1.48

Financial analysis:

• Vulkan’s debt ratio has stayed fairly consistent throughout the past decade and ranged between 0.30 and 0.54. Currently, debt ratio is at a very reasonable 0.42.
  

• ROA hasn’t been most impressive and stayed in high single digits and low teens during the past ten years. Currently it stands at 13.5% and 10-yr average is 11.9%.
  

• ROE has been somewhat consistent; currently it’s at 23.2% and 10-yr average is an outstanding 19.4%.
  

• Similar to the ROA trend, profit margin has been in high single digits and low teens throughout the past ten years. Currently it stands at 14.3% and 10-yr average is 10.5%.
  

• Revenue growth has been rather bumpy, with dips into negative territory in 2002 and 2004. The company has averaged 8.9% annual revenue growth for the past nine years and in the most recent fiscal year (2006) has seen growth of 15.5%. I’m not overly impressed with these growth rates, but the 8.9% 9-yr average is not bad.
  

• Net income growth has been just as bumpy, with growth being negative in 1999, 2000, and 2002. Vulkan’s net income increased by 39% in the 2006 fiscal year and its 9-yr average is 11%. I like the impressive recent growth, but I wonder if that means that next few years net income growth will be negative, or close to it, considering how cyclical this company’s growth has been and probably will be.
  

• Free Cash Flow margin has stayed fairly consistent at mid-to-high single digits during the past ten years; currently margin is at a pretty low 4.3%. FCF growth has been extremely inconsistent: it was negative in 6 out of the last 9 years, then posted triple digit growth (186%) in 1999. Average growth for the last nine years is 11.6% and -44% for the 2006 fiscal year.
  

Discounted Cash Flow (DCF) Analysis:

I used discounted cash flow analysis to arrive at the intrinsic value of the company. I estimated that free cash flow would grow at an average rate of 10% per year for the next 10 years and at 3% (trailing GDP growth) perpetually after that. Company’s free cash flow grew at an average rate of 37% during the past nine years, which makes my conservative estimate very plausible.

I used a discount rate of 11% because Vulkan Materials is somewhat more exposed to the market risk than the average company.

Using the assumptions listed above, my intrinsic value of the stock came out to $31.92. My intrinsic value of Vulkan is significantly less (more than 4 times less) than Morningstar’s “fair value” of the company. This company is very capital intensive and free cash flow isn’t as robust as one would expect, which is the main explanation for my low value of the company. Also, Morningstar’s valuation of the company includes proposed acquisition of Florida Rock Industries, which they think will benefit the company greatly. I really don’t have an opinion on that assessment either way as I’ve never dealt with companies in that situation, but it does seem to me that Morningstar is overvaluing the company at this point.

Pros:

• Demand from the public sector will likely to stay strong as infrastructure is getting upgraded on the federal, state, and municipal levels.

• Vulkan’s strong position in the industry allows it to command premium price for the limited supply of aggregates it controls in certain regions of the country.

• Company is likely to benefit from the announced merger with Florida Rock, it’s just not clear the extent of the benefits and how long it will take for them to materialize.

• Company consistently returns money to shareholders in the form of dividends and by buying back shares of the common stock.

Cons:

• Residential construction has significantly decreased and isn’t likely to rebound in the near future, which hurts a fairly significant portion of company’s sales.

• Although the company does have some pricing power, the overall volume of product sold has been decreasing and is expected to decrease further.

• Vulkan is a highly cyclical company that depends on the construction demand in the markets it serves, which is difficult to predict.

Final Decision:

Vulkan Materials seems like a company that commands pricing power and respect in its industry. Also, if the acquisition of Florida Rock does go through as planned, company will become an even more dominant player in this fragmented industry. That being said, Vulkan is highly cyclical, which makes it difficult to properly valuate it. Its market price is current at $83/share, while my DCF model values the company at $32/share, and Morningstar has priced the company at more than 4 times the value I’ve assigned to it. So, I really don’t know what to say here. I’ll be honest, I’m confused with the valuation of this stock. If I decide to have a highly speculative section in my portfolio, I might add it, otherwise I’ll pass on it. Another way to play this, is to buy Florida Rock Industries in a merger arbitrage opportunity currently up for grabs. I’ve discussed it yesterday: Merger Arbitrage Opportunity: Florida Rock Industries.