Q2 Construction Materials Update: The Recession is Here. What Does it Mean?

The results are in and as of July 28th, 2022, the U.S. economy contracted for the second consecutive quarter. Although not yet official (still to be determined by the National Bureau of Economic Research), general consensus is that we are in a recession. For construction materials (CM) merger and acquisition (M&A) activity, buyers who see beyond the current economic environment could find themselves in a more fortified position. As Warren Buffet famously professed, “Be fearful when others are greedy and greedy when others are fearful.”

The economic downturn has been brought on by historic levels of inflation, subsequent interest rate hikes and supply chain constraints. The CM sector is not immune to these plights. However, there are two caveats for the sector that should mitigate the pain from a recession. These are the committed federal funds from the Infrastructure Investment and Jobs Act (IIJA) and the individual and unique markets where certain producers operate. As it relates to M&A activity in the sector, large publicly traded buyers are still looking to grow while navigating this period of economic uncertainty. As such, buyers will deploy capital to strategic targets in favorable markets where they have existing operations. Those that are “greedy” in this time could see themselves in a much stronger position when the economy recovers.

Economic Factors

Inflation

 “Inflation is the most universal tax of all” – Thomas Sowell

Inflation has run wild in the global economy to the point of historic proportions. In June, the consumer price index (CPI), a measurement of average costs (and one of the main barometers for inflation) increased to 9.1 percent year-over-year, a 40-year high. Additionally, the producer price index (PPI), a measurement of average change in selling prices reached 11.3 percent in June. The dedicated construction segment of the PPI logged an eye-popping 19.2 percent. All these metrics indicate that the cost of goods has risen dramatically, hurting consumer purchasing power, and resulting in margin erosion for companies. Some specific components of inflation have impacted CM in a greater way. As seen in exhibit 1, certain facets of the PPI (i.e., energy and steel) have increased significantly over the past year. These cost increases hurt CM producers’ profits. As such, the CM producers that can pass on increased costs to customers will fare much better than those that cannot.

Exhibit 1: Producer Price Index, June 2022

Interest Rates

Opposite the inflation dilemma is the monetary response. The Federal Reserve has begun an aggressive campaign to tame inflation by raising interest rates four times this year alone, the most aggressive pace since the 1980s. Raising interest rates increases borrowing costs and reduces demand for goods. This concludes with prices declining, thus bringing down inflation. At the July meeting, the Fed raised the federal-funds rate by 75 basis points to a range between 2.25 percent and 2.50 percent. Additionally, the Fed has signaled that there will be more rate hikes throughout the year. While monetary policy is important, the focus should be on how this specifically relates to CM. First, this directly impacts the residential sector as home borrowing costs have increased significantly over the course of the year. Second, with the cost of debt increasing, financing equipment through loans will continue to become more expensive. Although uncomfortable, increasing interest rates is necessary to set prices back to sustainable levels.

Supply Chain

The interconnectivity of all these issues has compounded the ongoing problem of supply chain. The initial problems brought on by the pandemic and tariffs have only been exacerbated by war and global economic turmoil, resulting in major bottlenecks to supply chains. The strained supply chain has directly impacted the CM sector as it pertains to equipment purchases. Long lead times for equipment have pushed planned investments to 2023 and beyond. Additionally, equipment costs have increased significantly to compensate for the high demand. However, according to The Economist:

“Recent data has shown that there may be some relief on the horizon. An index of supply-chain problems complied by the New York Fed, comprising global transport costs and the opinions of purchasing managers, among other things, has clearly eased, though it remains well above the pre-pandemic norm.” (see Exhibit 2)

The easing of supply chain constraints should aid in the fight against inflation and assist CM producers in getting much needed equipment in a timelier fashion.

Exhibit 2: Global Supply Chain Pressure Index

Construction Materials Outlook

Despite the negative headlines, some CM operators have a way to mitigate the impact from an economic downturn – the federal funding from the IIJA. The $1.2 trillion bill was enacted last year and earmarks about $350 billion for roads, bridges and major projects. The funding from the IIJA was originally scheduled for disbursement to state departments of transportation in 2022 but has been delayed. Operators expect the allocated dollars to be spent in 2023 through 2026. Brian Strawberry, chief economist at FMI, highlights the benefits for CM in his recent report "How Bumpy Is It Going To Get? Mapping Recession Scenarios." “On the nonresidential heavy civil side, the IIJA will fund horizontal infrastructure projects through the forecast period, benefiting the highway and street [and] transportation…infrastructure.” As shown in exhibit 3, FMI is calling for highway and street and transportation spending to buoy nonresidential construction spending through 2026. Resource constrained transportation departments are experiencing several factors that could result in major project delays. Therefore, resurfacing projects will continue to be popular. Public infrastructure-focused CM firms will benefit from committed funding for the next five years.

Exhibit 3: Total Nonresidential Construction Spending Put in Place 2021 and Forecast Growth (2021 through 2026) by Construction Segment

The residential sector tells a different story. The once darling segment of construction during the pandemic is beginning to experience a hiccup. The Fed raising interest rates has increased borrowing costs for prospective homebuyers, thus dampening the market. The monthly supply of new single-family homes reached an alarming 9.3 months in June 2022 (eight months is a recession predictor), after both April and May had been greater than eight months. However, it is vital to remember the classic adage “construction is a local business.” CM operators with residential exposure in strong markets will be less affected by national trends.

Current Performance

There are a few bright spots in the recent economic data. Demand for construction aggregates remains high with the U.S. Geological Survey (USGS) revealing that crushed stone and sand and gravel production increased by 3.5 percent and 5.2 percent respectively in the first quarter of 2022 compared to the same period in 2021. On cement outlook for the remainder of the year, Enrique Escalante, CEO of GCC, pointed out that the company’s “system is sold out, supported by [a] considerable backlog.” Additionally, there is an oddity in the labor market as it relates to the recession. Of the 12 recessions in the U.S. since 1948, the jobless rate has always risen above 6.1 percent. As of June 2022, the labor market remains tight with a 3.6 percent unemployment rate. Therefore, there is a “margin of safety” before employment trends coincide with historic recessions. Based on May data, there are almost two jobs available for every unemployed person, which means the labor market remains resilient.

Construction Materials M&A

The combination of unprecedented government stimulus, a historically accommodative borrowing environment and stock prices reaching all-time highs was a winning formula for M&A activity in 2021. The realities of the current economic environment, however, are beginning to impact M&A. Exhibit 4 shows total global transaction value declining 24 percent year-over-year in the first half of 2022. The CM industry is beginning to see the market contract as pandemic-fueled aggressive fiscal and monetary policies are tightening. As such, buyers are exercising more caution in M&A pursuits and focusing on strategic targets. Michael Haack, President and CEO of Eagle Materials, summed up buyer sentiment best on the company’s first quarter of 2023 earnings call, “Our first priority remains growth and improvement investments…we will not compromise either aspect and pursue growth for growth’s sake.”

Exhibit 4: Global M&A Value ($), Quarterly (2020-2022)

So how are buyers defining “strategic” targets? These targets are in attractive markets, adjacent to buyers’ current operations, with stable funding and positive population trends. These factors present an investment thesis attracting multiple buyers, thus, creating a competitive sale process and ultimately leading to attractive valuations. Strategic targets tend to have defensible market share with predictable earnings, giving buyers comfort against negative economic environments. Additionally, for international firms, the U.S. presents a more stable market for capital investments compared to markets abroad, which should help fuel domestic M&A for international CM buyers. Sellers that fit these criteria will still receive premium valuations despite the pending economic uncertainty.

Construction materials M&A has seen large “thunderclap” and platform acquisitions in recent years, such as Vulcan’s acquisition of U.S. Concrete, and Martin Marietta’s acquisition of Lehigh Hansen’s western assets in 2021. FMI anticipates that buyers will be more focused on bolt-on acquisitions in the near-term. These acquisitions help reduce risk for buyers when deploying capital and can bolster current geographic footprints. “These investments should bolster and expand existing home markets and position the company for consistent profitable growth,” said Kyle Larkin, president and CEO of Granite Construction, on the company’s second quarter of 2022 earnings report. They also present attractive opportunities to consolidate overhead and broaden product offerings to customers. Given current market conditions, buyers’ scope of attractive targets has been refined, with bolt-ons becoming more of a preference.

Conclusion

FMI is calling for a recession in the near-term. Economists, pundits and talking heads are now debating the length and severity of the downturn. Despite the negative headlines, there are still positives for the CM sector. Guaranteed funding from the IIJA has the ability to outlast high inflation, and demand for products has showed no signs of slowing down as of yet. We must always remember that construction is a local business, and certain markets will remain resilient despite signals of a cooling residential sector. For M&A, buyers are still active and willing to pay premium valuations for strategic targets in attractive markets. Those willing to take calculated risks during these uncertain times could see themselves in a stronger position to capitalize on the inevitable recovery.