Three basic materials stocks with upside potential

These undervalued companies are well positioned to benefit from larger infrastructure investment.

Vikram Barhat 26 September, 2018 | 5:00PM

The emerging themes of resurgent U.S. housing starts and increased infrastructure spending have brought the unloved and unglamorous basic materials sector back in focus. The sector comprises a wide spectrum of companies that mine and refine metals, supply construction materials and forestry products, and process commodities. These companies become more profitable when strong economic growth and government spending trigger greater demand for their products.

The ongoing recovery of U.S. construction spending, spurred by public and private sector demand, bodes well for companies that produce a range of goods for residential, commercial and infrastructure construction. In no small measure are the prospects of these companies tied to the public infrastructure spending, which is set to grow at a rate of 6% per year in the U.S., compared to an annual growth rate of 3.5% over the past decade and a half, as projected by Morningstar equity analyst Kristoffer Inton.

Private-sector demand, which consists of residential and non-residential construction, is another source of revenue for companies that provide building materials such as cement, gravel, stone, lumber and sand. The basic materials sector also includes companies that mine metals and are beneficiaries of consumer trends such as electric vehicles and smartphones that rely on lithium for longer battery life.

Select basic materials companies boast strong growth prospects, wield meaningful pricing power and cost advantages, are well positioned to benefit from larger infrastructure investment, and are trading at a sizeable discount to their fair value, according to Morningstar equity research.

Vulcan Materials Co.
Ticker: VMC
Current yield: 0.94%
Forward P/E: 21.8
Price: US$114.12
Fair value: US$138
Value: 17.3% discount
Data as of Sept. 24, 2018

The largest producer of construction aggregates -- industry jargon for stone, sand and gravel -- in the United States,  Vulcan Materials (VMC) sold 183 million tons aggregates, along with 10 million tons of asphalt mix, in 2017.

Vulcan is well positioned to exploit the pickup in U.S. construction activity. The company stands to particularly benefit from stable public-sector demand which accounts for roughly half of shipments as projects such as highway construction are more aggregate-intensive. "At a national level, we expect public infrastructure spending to grow by 6% per year on average," says a Morningstar report, noting that this benefits Vulcan as its key markets -- Texas, California, Virginia, Georgia and Florida -- have significant road spending needs and strong finances to support high growth.

The company's geographic footprint is particularly attractive in the South region (stretching from Texas to Florida and on to the Bahamas and Mexico), where it has nearly 3.8 billion tons of aggregates reserves and more than 100 operating facilities. Shipment growth in this region is expected to outpace the national average, says Inton, adding that while the region isn't as rich in aggregate deposits as other parts of the country, the company's significant presence there and its ability to supply those parts enables it to capture the region's growth.

Given scarcer resources, the firm's South region operations are well protected from new entrants, creating a competitive advantage that could last for more than 10 years. "With most aggregates producers lacking efficient water or rail alternatives, markets tend to be extremely localized, with high barriers to entry," says Inton, who appraises the stock's fair value at US$138, prompted by robust demand for road network in its key markets.

Martin Marietta Materials Inc.
Ticker: MLM
Current yield: 0.94%
Forward P/E: 16.7
Price: US$190.90
Fair value: US$265
Value: 28.0% discount
Data as of Sept. 24, 2018

The second-largest producer of construction materials in the U.S.,  Martin Marietta Materials (MLM) sold 158 million tons of aggregates in 2017. The company's key markets -- California, Colorado, Florida, Georgia, Iowa and Texas -- account for nearly 60% of sales.

"Martin Marietta is well-positioned to benefit from the ongoing recovery of U.S. construction spending," says a Morningstar report, citing "strengthening demand growth for the public sector and modest growth for the private sector" as key drivers.

The aggregates producer, which also has profitable cement production capacity in Texas, boasts strong pricing power in each of its local markets, a source of its competitive advantage. "The low value/weight ratio of cement and aggregates establishes Martin Marietta's cost advantage against out-of-market competition," says Inton, noting that the company also benefits from intangible assets built on high barriers to entry, as opening new quarries near populated areas is incredibly difficult.

A recovery in construction remains in the early stages, and building materials consumption is still to take off from its current levels. "Moreover, current demand doesn't even include the backlog of projects created from the recession and from years of underspending on infrastructure," says Inton, who pegs the stock's fair value at US$265, prompted by solid demand for road work, driven by growing populations and a significant backlog of repair. "Historically, limited funding has prevented this demand from being unleashed, but based on two key factors [increased federal funding and drive for better infrastructure], the money will be there."

Inton expects Martin Marietta's EBITDA to surge 140% by 2022 as strong demand pushes higher volume. "A combination of robust price increases and the benefits of operating leverage as production volume rises should drive materially higher profits," he forecasts.

Albemarle Corp.
Ticker: ALB
Current yield: 1.26%
Forward P/E: 17.5
Price: US$104.70
Fair value: US$135
Value: 22.4% discount
Data as of Sept. 24, 2018

The world's largest lithium producer,  Albemarle (ALB) controls around one third of the lithium carbonate market. Albemarle produces lithium from its salt brine deposits in Chile and the U.S., and its joint-venture mine in Australia. The firm's Chilean assets are among the world's lowest-cost sources of lithium and make up approximately 80% of its lithium profits.

Albemarle is well positioned to benefit from a robust lithium demand growth led by a rapidly burgeoning market for electric vehicle batteries. Morningstar projects lithium demand to grow at a 19% annual rate from 220,000 metric tons in 2017 to 1.5 million metric tons through 2028, as electric vehicle adoption increases. "Albemarle's Chilean expansions and its Talison joint venture [in Australia] will ramp up production to help meet strong market demand growth," says a Morningstar report, noting lithium has "one of the best growth profiles among commodities."

Albemarle's assets will be able to fulfil a sizable portion of demand growth through major production expansions. "Albemarle is looking to grow its Chilean brine lithium production capacity from 27,000 metric tons in 2016 to over 140,000 metric tons over the next decade," says Morningstar equity analyst Seth Goldstein. "Furthermore, the company's Talison joint venture will triple its spodumene capacity [from which lithium is derived] from 80,000 metric tons to 250,000 metric tons," of which Albemarle will continue to receive roughly half."

The firm generates 20% of lithium profits from its Australian joint venture, but large-scale capacity overhaul will increase this number to roughly 45% by 2025. "A combination of higher lithium prices and [additional] volumes will help Albemarle increase EBITDA by double-digits annually for the next decade," says Goldstein, who recently upped the stock's fair value from US$125 to US$135.

Albemarle will also to continue to generate profits from its bromide and chemical production segments, he forecasts.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Albemarle Corp63.22 USD-4.08
Martin Marietta Materials Inc255.11 USD0.73
Vulcan Materials Co143.36 USD0.06

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.