Vulcan Material - Government Spending Cuts are too Great a Risk

This article first appeared on GuruFocus.

Introduction

Vulcan Materials produces and supplies aggregates mainly in the US. While the company is in a strong market position, I believe that current hopes are far too exaggerated.

Current Situation

As an aggregates producer, Vulcan Material is closely related to infrastructure, e.g., real estate and highways. This puts the company in a kind of tricky spot as its real estate could significantly pick up once we see the already expected interest rate cuts, likely starting at the end of the year. At the same time, a core policy of the current US government is budget cuts, which could reduce public spending on infrastructure and thereby is a huge negative factor for Vulcan.

Rate Cuts and the Housing Market

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While Jerome Powell was hesitant about cutting interest rates given the still elevated inflation, many market participants do expect rate cuts for the rest of the year. This could especially be the case if the Supreme Court cancels Trump's tariffs, which could have been a driver of Powell's decision not to cut so far. While the inflation rate is still elevated, it is likely that even if Powell is more hesitant, his successor in May, who will be appointed by Trump, will likely cut rates, enabling growth in the housing market. Morningstar currently forecasts single-family housing starts to be flat in 2026 but grow by almost 8% in 2027. Nevertheless, Morningstar also mentioned that there could be continued private market declines that would only be set off by a significant increase in infrastructure spending. While residential construction growth could also be a long-term driver of earnings, it generally is less material-intensive than nonresidential construction.

Infrastructure Spending and Budget CutsOne of the mechanisms that gave Vulcan stability in the past was that government spending on infrastructure has historically been ramped up during economic downturns to enable growth. However, this mechanism could easily stop working given the current budget problems of the US government. Since Vulcan is very reliant on public spending, a downturn in US public spending would likely have a huge impact on the company's revenues.

Growth Potential

While rate cuts are a clear booster for growth, public spending is likely the exact opposite by restricting a lot of growth. Moreover, with the recent acquisition of U.S. Concrete, Vulcan has increased its exposure to less profitable segments, highlighting that there might not be any suitable high-growth investments at the moment.

Story Continues

Another factor to consider is that the transport of aggregates is very costly. According to Morningstar, they typically sell for $20 per ton, while transportation costs between $0.15 and $0.65 per ton per mile. This again highlights how hard it is to grow in the aggregate business, given that companies need locations close to the buyer.

While the Vulcan has pricing power and has in the past been able to raise prices above inflation, the company's revenue growth rate has recently declined from a 5-year growth rate of 8.8% to a 3-year average growth rate of only 4.7%, given the higher interest rate environment. Considering that the company had a 9.2% average revenue growth rate over the last 10-years during a very favorable environment with interest rates close to 0%, a rising housing market and tons of public spending, I doubt that the company can reach this growth levels in the current environment where public spending will be lower and interest rates are unlikely to approach 0% any time soon, given that inflation is still elevated. Because of this, I estimate revenue growth to be around 7% for the coming years.

Revenue Drivers

While lower public spending will likely harm revenue, higher margins resulting from an increase in aggregate prices could partly offset this. To see the impact on revenue, I adjusted past revenue growth by increases in margins. The result is that the average revenue growth rate since 2015 would have been 7.5% instead of 9.1%. Since aggregate prices are likely to continue their uptrend, given the still increased inflation, combined with possible rate cuts, this could at least stabilize revenue a little bit, although public spending seems to be the more important factor.

Valuation

This brings me to the main problem of Vulcan as a stock: its price. Currently, the company is trading at a P/E of 40.9, as well as a P/B ratio of 4.6, which is comparable to Mag-7 stocks. As shown in Figure 1, displaying the company's P/E ratio over time, this is also in the upper bound of its historical valuation.Vulcan Material - Government Spending Cuts are too Great a Risk

The height of expectations becomes even clearer when using a discounted cash flow model. Even when using generous assumptions such as an EBIT margin of more than 20% (in the recent past, it's been between 13.8% and 19.1%), as well as slightly lower tax rates and a cost of capital of 7.3%, the current valuation still requires revenue growth of 10% just to be fairly valued under very optimistic margins. Given that the upcoming growth environment is, as I have demonstrated, likely to be worse than the past, where a revenue growth of 9.2% was achieved, I see the stock as a clear sell.

When using the growth rate estimated by me before, while keeping everything else the same, the implied fair value share price would be around $244.

Peer Comparison

The high valuation can be seen even better when comparing Vulcan to competitors like Eagle Materials and Martin Marietta, trading at P/E ratios of 17.3 and 35.2, respectively. Moreover, Eagle Materials has a much lower EV/EBITDA ratio than Vulcan, while 3-year average revenue growth and net profit margins are higher for both competitors. Furthermore, ROE and ROA are also higher for Eagle Materials and Maritin Marietta, suggesting that they have more profitable investments at hand than is the case for Vulcan.

Guru Activity

While there has been almost no recent Guru activity, hedge funds in general have reduced their exposure to the stock. Moreover, insiders have been selling this year, while there has been a lower amount of buying. It is still interesting to note, though, that stock picker Seth Klarman (Trades, Portfolio) prefers Eagle over Vulcan by holding the former and ignoring the latter.

Conclusion

In total, Vulcan Materials has a good business. However, the market's expectations for the stock seem to be exaggerated at the moment, making the P/E ratio of over 40 far too high for the stock. Should the stock approach $200 (20% discount to fair value), it would be a buy, but until then, it is a clear sell.

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