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|Net Debt (in $M):||646||EBIT||0||0|
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Regional oligopoly business with robust asset value benefiting from strong industry tailwinds and dramatically improved operations, offering a +15% Yield and 25% IRR potential from a fully covered Fixed Income investment.
We recommend investors buy New Enterprise Stone & Lime (NEEST) 11% Senior Notes due 2018 at the current market price of around 90. As we outline below, the company operates a regional oligopoly business that is benefiting from strong industry trends. Despite some past choppy performance, NEEST’s business has improved markedly due to restructuring initiatives. Finally, the Enterprise Value of the business easily covers the debt, enabling a near-term re-financing and providing downside protection.
Headquartered in New Enterprise, PA, NEEST is a vertically integrated construction materials company operating in Pennsylvania and western New York. The company’s core business entails the mining, production and sale of the construction materials, including Aggregates, Asphalt and Ready Mix Concrete; NEEST was the 11th largest U.S. Aggregates company in 2014. 
The term “Aggregates” broadly describes the crushed rock and stone used as the foundation for construction projects, with significant volumes consumed in infrastructure projects. Asphalt involves the combination of aggregates (~95%) and petroleum-based products (mostly bitumen, the remaining 5%) to create the construction material used in road surfacing. Ready Mix Concrete combines cement with aggregates, water and other chemicals, to create concrete, which is used in nearly all construction activities.
Leveraging its construction materials operations and expertise, NEEST also provides road-building capabilities through its Heavy/Highway Construction segment. Finally, the company’s Safety Services & Equipment unit rents highway-related products (safety cones, roads signs, etc.).
An overview of NEEST’s business by segment is as follows:
Source: Company financials
As of year-end FY 2016 (ended 2/29/2016), New Enterprise had 55 quarries (42 active), 28 hot mix asphalt and 15 fixed and portable ready mixed concrete plants, three lime distribution and two construction supply centers.
NEEST’s capital structure is provided below:
Prior to March 2017, the company has the option to pay interest on the Senior Secured Notes entirely in cash or 4% cash / 9% PIK. After that date, the company must pay 100% of the interest in cash. Management has committed to paying cash on the Notes in FY 2017.
There are a number of covenants that NEEST must abide (please see Appendix 1: Covenant Summary). The key element of the docs, however, is the “springing maturity” provision. In short, the Credit Agreement has a final maturity of February 2019, but the facility becomes due if the company fails to refinance its Secured Notes prior to December 14, 2017 or if the company fails to refi its 11% Senior Notes by June 1, 2018. Because the company will likely have to refinance the secured and unsecured Note together, we view December 2017 as the effective maturity date for the bonds.
Our bullish view on the credit partially reflects the high expected IRR from a near-term refinancing of the capital structure:
NEEST’s checked history in the credit markets partially explains why an outsized opportunity exists today.
New Enterprise issued its 11.0% Senior Notes in August of 2010, using proceeds to pay-down bank debt. Not soon after, the company’s operations fell-off, with EBITDA declining from $74.1mn at the end of FY 2011 (ended 2/28/2011) to $45.8mn at the end of FY 2013 (ended 2/28/2013). (We will provide more details on “why” below). During this time, the company issued new 13% Senior Secured PIK Notes (1st Lien on PP&E and 2nd on ABL collateral) to repay bank debt and eliminate certain restrictive covenants. Compounding its operational issues, NEEST failed to file its 2012 financials in a timely manner after difficulties implementing a new ERP system. The delay prompted a notice of default, which the company ultimately cured, but bonds got pummeled in the process, earning the animus of many holders.
The bull-case for New Enterprise remains relatively simple: NEEST operates in an objectively attractive industry, which boasts high valuations and asset values that provide more than sufficient coverage for bonds. Plus, despite past operating difficulties, NEEST’s operations should continue to dramatically improved, helped by higher infrastructure spending and improved execution and cost structure. Below we provide more details on the attributes of this credit story:
High Barriers to Entry. Aggregate producers enjoy near monopolistic market dynamics. Crushed stone and rock offers little intrinsic value. Their worth derives from the fact that shipping aggregates often costs more than the product itself, creating significant value for quarries located near population centers and/or transportation corridors. An industry “rule of thumb” suggests miners can economically ship within a 100 mile radius.
Regulatory requirements re-enforce rational market conditions by limiting new mines. Again, aggregates located in the middle of nowhere have little value. However, obtaining permits for new quarries located near cities can be a Sisyphean task given their environmental impact. Hence, fully permitted and functioning mines become difficult, if not impossible, to replicate.
As a related concept, Aggregates are also isolated from many of the challenges that businesses confront today. There is no obsolescence risk or substitute product for crushed rock and stone. There is limited threat that Amazon or some other App will try to “disrupt” this market with an e-commerce solution given its limited value-to-weight ratio and hyper-local dynamics.
Aggregate providers are also largely linked to their domestic economies. Hence, unlike Oil & Gas companies, Aggregates players do not have to worry about global supply-and-demand in-balances. Macro issues like Chinese currency devaluation, “Brexit” or other geo-political risk de jour do not directly impact these businesses.
Federal funding tailwinds. New Enterprise derives around 50-55% of its revenue from the public sector, with the remainder from private (largely non-residential) construction activity. Recent changes in funding mechanisms for public infrastructure contributes to our bullish view of New Enterprise.
At the Federal level, in December 2015, Congress passed the FAST Act (Fixing America’s Surface Transportation Act), establishing five years of committed infrastructure spending. The bill, commonly referred to as “The Highway Bill,” represents the longest transportation funding measure in 17 years.
Previously, Federal transportation dollars had been allocated under extensions to SAFETEA-LU (an earlier Highway Bill) signed in 2005 and which expired in September 2009. Congressed re-upped SAFETLE-LU ten times after it expired, before enacting a two year measure Map-21 (Moving Ahead for Progress in the 21st Century Act) in 2012. Congress extended Map-21 as well, keeping it in place until May 2015. In short, prior to the FAST Act, the Federal government had allocated infrastructure spending through temporary legislative fixes.
Because infrastructure projects fit the very definition of “long-lead-time,” recent funding uncertainty has created an overhang for the Aggregates industry. Capital plans of five years are typical within government planning organizations. The uncertain funding environment has, therefore, resulted in project delays in recent years. With most planning activity conducted in the Spring, the initial benefit of the FAST Act should start showing up in the coming quarters.
As for the level of spending, the FAST ACT allocates $225.2bn from the Highway Trust Fund (HTF) for highway investment—a $20.2bn of increase over five years. Every state receives a 5.1% increase in FY16, followed by annual increases from 2.1% in 2017 to 2.4% in FY 2020:
Source: U.S. Department of Transportation, Federal Highway Administration
A discussion about the failings of the Federal Highway Trust Fund (specifically its underfunded status) is outside of the scope of this discussion. The FAST Act transfers into the HTF additional funds from the general account to keep it solvent through the end of FY 2020.
Funding specific to New Enterprise’s operating territories are as follows:
Source: American Road & Transportation Builders Association
Notably, the pace of new Federal spending is weighted toward this year, implying a near-term benefit. We would highlight that a modest revenue uptick can produce meaningful earnings gains in this high fixed-cost business.
State funding higher as well. State level funding should begin benefitting New Enterprise too. In November 2013, Pennsylvania Governor Tom Corbett signed Senate Bill 89, which will increase the state’s annual funding by $2.3bn for highway, bridge and public transit by FY 2017-18.
The Bill increases gas taxes and various motor vehicle fees to phase-in the new funds over a five year period. The $2.3bn increase to will represent a 40% increase over PennDot’s FY 2013 level of spending.
Higher funding levels are finding their way into project activity as evidenced by higher “letting” levels by PennDOT in recent years:
New Enterprise has yet to see much of a revenue lift from this new activity as management has commented that recent lettings have skewed toward eastern PA/Philadelphia, outside of their core western operating area. As spending normalizes statewide, we anticipate NEEST will start seeing the benefit of higher state funding.
Improving credit story. New Enterprise remains a family owned business, with no private equity sponsor and other investors. A lack of outside oversight likely contributed to the operational difficulties the company encountered shortly after its first bond offering. The company has taken a number of steps to improve its execution and cost structure, however.
In May 2013, Paul Detwiler III, who previously served as CFO, replaced his father Don Detwiler as CEO of the business. The move, more importantly, brought in outside management, with the appointment of Albert Stone as the company’s new CFO. Mr. Stone served in a similar role since 1997 for Aggregates Industries—a U.S. and U.K. Aggregates company. Later that year, James W. Van Buren (married to a Dewiler daughter/sister) stepped down as Chief Operating Officer as well. Robert Schmidt joined the company in September 2014, assuming much of Van Buren’s duties before becoming COO in April 2015. Mr. Schmidt has more than 30 years of experience in the construction materials industry. We view outside management as a significant positive for NEEST it has helped professionalize operations.
New Enterprise has brought in consulting help as well. At the end of 2013, the company hired BDO to serve as auditor and to identify $10mn of cost savings in 2015. NEEST also engaged Capstone Advisory in January 2015 to implement further cost cuts.
As part of its restructuring efforts, NEEST has also sold-off certain non-core businesses to improve productivity (while also boosting liquidity). The company conducted more than $30mn of asset sales in recent years, including the following:
Source: Company reports
The company has also entered into a lease arrangement for its precast structural concrete business in Roaring Springs, PA.
NEEST’s recent financial performance clearly reflects the benefits of these operational improvements. SG&A has declined from $77.1mn in FY 2013 to $50.7mn in FY 2016—an impressive reduction of greater than 30%:
Gross profit and gross margins have improved as well: from $119.6mn and 17.7% in FY13 to $146.9 and 22.5% in FY16:
NEEST posted this improve profitability despite a 3.7% revenue decline over that period (much of it related to asset sales).
Lower fuel prices should provide a further benefit stemming from lower transportation costs for aggregate shipments. Further, the company’s costs for bitumen—a key ingredient of Asphalt and an oil derivative—should benefit from cheaper oil as well.
Most construction contracts contain pass-through mechanisms limiting the upside of lower oil (and protecting downside in a reversal), but there are opportunities for cost saves. While NEEST has refrained from providing much color, Summit Materials (a public peer construction materials company) noted a $2.4mn benefit in its Asphalt operations in 1Q16 due to lower raw material costs. We cannot expect the same magnitude of savings for NEEST (SUM delivered 2.5 Asphalt tons in the quarter compared to NEEST’s 3.1 tons in FY 2016), but SUM’s results underscores the benefit of lower oil.
Valuation/Asset Value. In addition to industry growth and markedly improved cost structure, our confidence in the New Enterprise credit story revolves around the company’s strong asset value. As the following chart highlights, the market ascribes high multiples to the Construction Materials space:
Source: SEC Filings, Bloomberg
These lofty valuations reflect the compelling value proposition of this sector. Again, though cyclical, construction material companies side-step many of the structural issues beguiling businesses today.
Valuing NEEST at the average forward multiple for industry peers, or 9.0x, implies a sizable cushion for bondholders:
Further refining the comp universe suggests that 9.0x may be conservative, however. First, we would drop Lafarge and Cemex as comps given their significantly greater scale and instead focus on NEEST’s domestic peers:
Source: SEC Filings, Bloomberg
Within this universe, we highlight that U.S. Concrete (USCR) generates most of its revenue from Ready-Mix Concrete, which lacks the hard asset value of Aggregates companies (hence the lower multiple). Eagle Materials (EXP) also has relatively little Aggregate exposure, leaving VMC, MLM and SUM as the most comparable businesses. The average forward multiple for these peers is 10.6x—implying a sizable equity cushion on NEEST’s 6.4x leverage.
At minimum, we believe NEEST should be valued in-line with SUM, their closest match from a business mix, size and leverage stand-point. As background, Summit Materials began roughly five years ago as a roll-up of construction materials companies and has completed more than 40 acquisitions since inception. Much like NEEST, SUM operates a vertically integrated model, with construction services acting as a conduit for its Construction Materials products.
SUM does have an important differentiation in its asset mix, though. Specifically, last year the company purchased two cement plants and related assets in Iowa from Lafarge (as part of its acquisition of Holcim) for $450mn. Cement kiln have many of the same attributes as Aggregates—difficult to replicate due to the time, capital intensity (~$350mn for new construction) and permitting challenges—but are more costly to operate and are higher fixed cost; the relative value of Cement versus Aggregates can be debated, we would argue.
SUM offers greater geographic diversity than NEEST, but has significant exposure to TX (33% of revenue) giving it greater exposure a downturn in Oil & Gas-related construction. While Pennsylvania has Energy exposure as well, it is small relative to Texas. By way of comparison, Oil & Gas represented 57.4% of TX’s GDP in 2014 versus 4.4% for the state of Pennsylvania.
Net net, there are arguments for investors preferring either SUM or NEEST. Regardless, we believe SUM provides a reliable valuation metric for NEEST, which, again, at 8.9x forward, suggests a sizable cushion for the credit.
Frist off, we would argue, if not for NEEST’s spotty history in High Yield, these bonds would have been refinanced before now (hence, the opportunity for investors). Net leverage of 6.4x, while nominally high, is not out-of-line for a company with significant asset value/equity cushion and visibility into fundamental improvement.
For perspective, SUM issued new 8.5% Senior Notes due 2022 (Caa1/B) in February that now trade around 7.0%. A similar offering from NEEST would require a sizable premium given their lower rating (Caa3/CCC), higher leverage (6.4x vs. 4.8x) and spotty history. Nevertheless, the relative comparability of Summit Materials and New Enterprise suggest that NEEST bond are certainly re-financeable.
Management has stated for several quarters that they are exploring options for refinancing. The company has an incentive to de-risk by refinance soon, but they will likely receive better terms after showing continued EBITDA improvement. In our “base case,” we expect NEEST will look to refi next summer, when they can show investors a forward EBITDA in the ~$120mn range—dramatically improving their leverage metrics.
Our FY 2018 EBITDA is based off of the following assumption. First, with assets sales largely completed and new FAST Act funding starting to rollout, the company should return to top-line growth. Our revenue growth forecast of 1.0% in FY 2017 and 2.25% in FY 2018, will likely prove conservative, given Federal transportation spending increases of 5.1% and 2.1% this year and next.
Second, we model Gross Margin improvement of nearly 175bps this year and 90bps in FY 2018, with much of the improvement coming in the high fixed-cost Construction Materials business. We forecast this segment will generate GM of 28.9% in FY17 and 29.7% in FY18, but highlight that the business generated GM of 52.4% in FY11.
As for SG&A, the company’s contact with Capstone has rolled-off, which should translate into $3mn of lower corporate spending.
Based on these assumption, we expect NEEST to post EBITDA of $111.6mn in FY 2017 and $120.4mn in FY 2018 (please see Appendix 2: Financial Summary and Outlook for more detail). On their FY16 earnings call, management forecasted operating profit growth of 15% this year, which suggests our outlook for this year is conservative.
NEEST’s first choice would likely be tapping the High Yield market again to keep long-term financing in place. The company’s terrible performance in the FY11-13 time-frame may preclude this from happening, though. There are a handful of other options NEEST will likely explore.
Syndicated Loan market
New Enterprise may receive a better reception with a new credit audience, specifically the syndicated loan market. We believe NEEST could finance up to 4.0x of 1st Lien Leverage in the loan market, taking out its secured debt, while refinancing its unsecured bonds with 2nd Liens. Should the company continue to post improved results, we believe the company’s 1st Lien debt could be issued at a low Single B rating; new issue clearing yields for Single B loans has been 5.83% in the last 30 days. An all bank debt capital structure might look like this:
We would highlight the markedly lower interest burden and improved coverage metrics resulting from this refinancing.
Private market refinancing
BDC-lead private financing have become an increasingly important source of capital as evidenced by Ares Capital Corp.’s $1.1bn financing for the Qlik buyout.
NEEST’s refinancing need, ~$680mn would likely require a handful of BDC’s teaming up for a club deal, but we believe this represents a viable option for the company. A privately financed New Enterprise deal could potentially mirror the $800mn recapitalization last summer of American Seafood (another High Yield issuer that had disappointed its bondholders). In that transaction, Ares Capital acted as the anchor order and syndicated with 20 other lenders.
NEEST may be well suited for a Unitranch transaction, a structure that includes senior and subordinated debt into one piece of paper.
Minority interest / Out-right sale
New Enterprise is effectively 100% owned by the Detwiler family. In a bear-case scenario (predicated on a total market collapse), the company could potentially sell a minority interest to a PE sponsors or explore the sale of the company. These are highly valuable assets and businesses of this size and scale do not come up for sale often.  If the company somehow faced the prospect of bankruptcy due to an inability to refinance (a prospect we view as remote, at best), I am confident the family would sell equity rather than risk getting wiped out,
Even in the remote scenario of a bankruptcy, as outlined below, we believe unsecured bond holders would not have their claims impaired:
Again, this is a relatively straight forward story: the New Enterprise credit profile should continue to improve in the coming quarters due to higher Federal and state infrastructure spending and an improved cost structure. The bond’s high coupon, price discount and relatively short duration provides investors an equity-like return in a fully-covered fixed income investment. More importantly, should the company struggle to refi—due to market turmoil and/or failure of execution—we are confident there would be a strong market bid for these assets, ensuring a full recovery for bondholders.
New Enterprise has long struggled with a “material weakness” related to their financial reporting. NEEST has implemented a new ERP system and has hired a Chief Information Officer to help improve their processes, but this remains a concern for investors.
This investment is premised on the company successfully completing a refinancing in a relatively short time horizon. As evident earlier this year, liquidity can evaporate overnight during period of a market disruptions. I expect NEEST management will wait until after its FY 2017 results (and the expected EBITDA improvement) before looking to tap the market, which could provide a tight window.
The convexity in this trade is admittedly skewed to the downside. While I expect a full recovery in a bankruptcy, bonds will get hammered at the prospect of a filing, exposing investors to marked-to-market risk. Holders with a long-term investment horizon will win in this trade, but that does not mean it will be liner if the market rolls over.
Although NEEST’s generates 50-55% of their revenue from public works, the remainder stems from private construction activity, making the business, at least in part, cyclical. I would expect NEEST’s business would decline in the event of a recession.
Third Avenue Management owns $42mn of the NEEST 11.0% Senior Notes, according to Bloomberg. Investors will recall the company’s Focused Credit Fund collapsed at the end of last year. The fund is conducting an orderly liquidation but this remains a technical overhang.
 LCD “Weekly Clearing Yields,” June 10, 2016
 Christopher Barnett-Senior Engineer at Parsons Brickerhoff, Deutche Bank conference call May 23, 2016
Near term refinancing candidate
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