Note: I apologize in advance for the formatting issues.
The opportunity: Martin Marietta Materials (MLM) is up 80% since January of 2016 and now trades at 14x 2017 EV/EBITDA (typically an early cycle multiple).
Thesis to short: Occording to the company's November investor presentation, the MLM is in the "early stages of a steady economic recovery."
1) Cyclical - the current construction cycle is nearing its end;
2) Secular - severe construction labor shortages will be a long-term drag on construction growth for at least the next 5 years;
3) Political risks (gridlock) are high.
Cyclical - the odds of a recession are climbing
Economic Cycle History - Playing the Odds
The average economic cycle lasts 8 years. The current cycle is 8 years old. Based on this alone, the probabilities of a recession in the next several years are very high. Not a contraversal viewpoint - in February of 2016 J.P. Morgan estimated that there is a 92% chance of a recession in the next 3 years.
There is a lot more that can be said here but assuming the past 10-15 cycles are rough guides for what will happen in the current cycle the odds of a recession in the next few years are fairly high. Note that a recession doesn't need to occur for this dyanmic to
impact MLM's stock price. Investors just need to realistically price in the risk and the stock will re-price.
Evidence of "late cycle" dynamics
There is a saying "recessions don't die of old age, they die of imbalances." That is true but old age tends to cause imbalances. Mini-bubbles (or mega bubbles) tend to form as trends overshoot (companies are expansionary by nature...). The below dynamics are essentially late stage imbalances that have the potential to cause the next recession.
Margin Pressure Building
- Construction companies are currently facing margin pressure:
1) labor costs are up;
2) construction material prices are rising again;
3) interest rates are trending up.
Overall, this increases the risk that: A) MLM faces pricing pressure or lower price increases; B) Lower end demand.
Single Family Housing - Vulnernable To a Negative External Shock
- Single-family construction faces several risks:
1) Affordability risk - S&P's David Blitzer in the December Case-Schiller report: "Nevertheless, home prices cannot rise faster than incomes and inflation indefinitely.”
2) Demographics (economic, social, etc.) - The economy is at full employment yet demand for housing is still relatively weak. Baby boomers are net sellers and the
smaller millenial generation face various hurdles to home ownership (student debt, less job security, lower marriage rates, etc.)
Multi-family construction is showing signs of overheating across the country
1) Prices are too high:
2) Construction is slowing - Analytics firm Axiometrics reported on Wednesday, "Half of the top 10 metros issued fewer multifamily permits [New York, Houston, Dallas, Los Angeles and Seattle] in the 12 months ending in November 2016 than they did the year before.
Hot Market Example (Seattle - most construction cranes of any city in the U.S.)
Jon Thorpe PCS Structural Solutions, Chad Maglaque Zonar, Lisa ChaietRahman Hillis Clark Martin & Peterson P.S.
The vacancy rate is now nearly 4.7 percent, up almost 0.7 of a percentage point from the previous quarter. Only once in the past 10 years has the vacancy rate
increased more during the fourth quarter, and that was after the financial crash of 2008.
Finding it harder to fill up empty apartments, landlords have more than doubled the amount of incentives, such as free rent. Apartment Insights reported that the
number of properties offering incentives surged from 12 percent last quarter to 20 percent.
The below chart from Jones Lang LaSalle summarizes the multi-family situation.
Nonresidential construction (especially commercial) is showing signs of peaking
According to Deutsche Bank and Morgan Stanley both see signs that nonresidential construction has peaked.
Deutsche Bank - "We find that most commercial construction metrics are at or near their prior cycle peaks, and funding has also begun to pull back. Overall, this makes it less likely that commercial construction can bounce back and more likely that cyclical headwinds may continue."
A few cities that are nearing a downturn potentially or are peaking:
- Downtown Los Angeles hasn't seen this much construction since the 1920s
- Hot money from China helping drive growth: “Chinese developers are not into buying land, letting it sit there for years and waiting for better times,” said Thomas Feng, Oceanwide Plaza’s chief executive and president. “We buy it at the right time and we build right away.”
Secular - severe construction skilled labor shortages will be a long-term drag on construction growth for at least the next 5-10 years.
- Even without a recession, the skilled trade shortage is in its early innings and will be a major drag on construction growth. Consider December of 2016: construction growth was negative yet demand for skilled trades people is very high. Why? There are very few if any skilled tradespeople sitting on the sidelines waiting for work.