Value Investors Club / MARTIN MARIETTA MATERIALS (MLM)

Description

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."

Thesis summary:

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 Chaiet Rahman 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.

Miami - http://www.businessinsider.com/miamis-real-estate-market-slowdown-2016-

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:

New York City

- http://www.businessinsider.com/manhattan-office-demand-just-couldnt-keep-up-with-new-supply-in-2016-2017-1

Los Angeles

- 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.

The firm Construction Labor Market Analyzer (CLMA) projects a 1.1 million skilled tradesperson shortage by 2020 (20% of demand).

A wide range of factors is likely to keep this trend in play for years to come:

A) Wages are going up but not enough to pull sidelined tradespeople (perhaps working in the energy sector now) into the market. As of December, construction wage growth was only at 3% which is not far from the long-term average. There are several reasons for this weak wage growth (weak when you consider the massive shortage):

- If construction companies increase wages to get a few incremental workers, pay tends to go up for everyone. As a result, it is more economical to delay projects rather than face cost overruns;

- As mentioned, there are very few if any truly sidelined skilled tradespeople. The new worker payoff from wage increases is very low.

B) The existing construction workforce is aging/retiring and a much smaller group of young people are entering the system. Barriers to new supply include:

- Becoming a skilled tradesperson is not easy. It usually involves tradeschool followed by years of work at relatively low pay (in the cold, rain, etc.);

- Injury rates are still still relatively high in construction.

- Blue collar work, especially construction, has been undervalued by society in the past few decades in favor of "everyone going to college." Many people would rather make $40,000 per year as an accountant than $70,000 a plumber.

- There are roughly 10 million men missing from the labor force. Construction workers are primarily men so the industry has been hit hard by this dynamic.

Because of these factors, the construction labor shortage isn't going away anytime soon. It is driven by cultural forces that take decades to move.

Population Growth Slowing (economic growth = population growth+ productivity growth + capital growth)

- In addition to the skilled labor shortage, population growth is a major driver of underlying demand for MLM products. 1 person = 8-12 tons of annual aggregate

cement demand. Currently, U.S. population growth is at its lowest level since the great depression.

Several long-term factors impact population growth:

- Aging baby boomers;

- Weak household formation (impacting birthrates);

- Immigration (inflow and outflow) and its potential to decline (new administration policies). Labor shortages are already slowing single family construction. Because undocumented workers are a major driver of single family construction, there is a risk the Trump administration's immigration policies (fewer people coming in, more leaving) could have a material impact on construction.

Texas Economy Slowing

The Texas economy, especially Houston, is showing signs of weakness (Texas is a major source of MLM revenue). In Q4 2016, Houston's job growth went negative. One underlying reason for the weakness is the overbuilding. Vacancies are rising and delivies are set to increase in 2017.

Infrastructure projects take a very long time to get going with execution risk:

A) Politics (I am trying to be as objective as possible here but feel free to disagree): What are the odds of Republicans in congress getting into a battle with Trump? I would argue the odds are material.

First, Trump's approval ratings are very low for this phase of the political cycle. If Trump continues to drop in the polls, GOP in Congress might turn on Trump.

Second, the odds of Trump getting impeached in Vegas is up to 50%. Why? Most Republics would clearly prefer Pence and the Democrats aren't likely to defend Trump. And, Trump clearly has political enemies on both sides of the aisle.

B) Practical construction issues - once approved, infrastructure projects can take a long time to plan and execute:

Risks to the short thesis:

1) The shift toward infrastructure projects will result in a less labor intensive mix (impact starting in 2018). Road construction has become more automated in recent years. Additionally, pre-fabricated construction materials have had some impact on the labor demand (very gradual impact).

Infrastructure Execution Risk

2) MLM has a strong position as an industry leader. The company could find ways to outpeform in a weak market.

3) At times, economies grow the fastest at the end of the cycle. If this dynamic develops, 2017 could be very strong years for the economy which could validate MLM's valuation in the short-term.

Overall, I think the new adminstration's emphasis on fiscal policy is unlikely to boost growth above its current trend (after Q1/Q2) mostly because we are now at full employment and new workers entering the labor market are likely to be much less productive. In the construction industry, for example, firms are recruiting less experienced and much less productive workers now simply because some new workers is better than no new workers. Manufacturing firms are also having a difficult time finding semi-skilled and skilled production workers. All of this points to an economic cycle that is fragile (aging). The next mini-external shock could easily cause a recession.

Even if the cycle continues for several years, the skilled construction labor shortage will be a drag on construction growth and at a minimum reduce upside potential.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1. Continued slowdown in construction hiring (a proxy for the labor shortage)

2. Continued weakening in construction demand (commercial, multi-family)

3. Ongoing weakness in Texas especially Houston

4. Political gridlock

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			2017	2018
Price:	220.00	EPS	9.41	10.91
Shares Out. (in M):	63	P/E	22.3	19.3
Market Cap (in $M):	14	P/FCF	29.4	23.8
Net Debt (in $M):	2	EBIT	800	884
TEV (in $M):	16	TEV/EBIT	19.5	17.7
Borrow Cost:	Available 0-15% cost