I’ve probably said this sentence too many times, but it’s worth repeating: Boring businesses can be fertile places to find great investments. What makes boring businesses so exciting? They never go away no matter the economic condition. This doesn’t mean that share prices of these businesses won’t falter if an entire economy declines; but it does mean that the company’s services will still be in high demand despite a downturn.
Scott Miller, manager of Greenhaven Road Capital, alluded to a conversation he had with a home repair professional regarding the stock market in one of his quarterly letters. Miller — and I’m paraphrasing — asked the man something along the lines of, “If the market drops 600 points, how does that affect your business?”. The story goes that the home repair person laughed in confusion as he didn’t understand how the stock market affects the day-to-day valuation of his underlying repair business. This is important. Although the market may gyrate wildly day in and day out, it doesn’t mean the value of the underlying business fluctuates that rapidly. In fact, it’s almost impossible for a businesses value to change as fast as the market makes it look. With that, let’s dive into Construction Partners (ROAD).
Double Digit Growth & Differentiated Drivers
ROAD operates in the large, growing highway and road construction industry. The company specializes in asphalt paving/servicing and is the market leader in the five Southeastern states it serves (NC, SC, GA, AL and FL). The company sports double digit revenue growth and double digit EBITDA margins. ROAD generated $680M in Revenues for 2018 and is projecting 2019 Revenues to be between $760 – $810M with $1B in Revenues by 2022. The company offers three major distinctions to its business that pose as competitive advantages: vertically integrated operations, leading choice for acquisitions and enhanced tailwinds from location.
Vertically Integrated Operations
ROAD covers virtually every aspect of road construction from Aggregate to manufacturing of HMA (hot mixed asphalt). The company has the capability to provide nearly every service required to build the final product from clearing & grading, setting roadway base, paving, storm drainage and curbs. The only services the company subcontracts are signage and roadway markers, guardrails / barriers and line striping / painting. To support this robust integration, ROAD owns / operates 30 HMA plants and 9 Aggregate Facilities. These HMA plants are located throughout their Southeastern region and provide tremendous competitive advantages. As it turns out, HMA plants can’t be transported long distances very quickly (shocking — I know). These plants enable ROAD to get all the HMA they need regardless of where they are in the Southeastern region, providing a huge advantage to the local competition which is mostly small to mid-sized “family run” construction companies that don’t have access to propriety HMA materials.
Strong Record of Bolt-on Acquisitions
At the time of its IPO in May, ROAD completed 15 acquisitions, enabling them to expand markets and geographic footprint. The company’s been able to add rather frequently while keeping their debt burden in check. In fact, ROAD is net-cash positive with a Debt-to-Equity ratio of 0.21. How is management able to keep leverage minimal while making nearly an acquisition a year? Decentralized command.
Management’s philosophy is simple at its core and extremely effective. Page 3 of the company’s 424-B (public filing for new IPOs) presents a clear case for their acquisition strategy. The company keeps local management in place and maintains all operational decisions at the local level. Upper management comes in only to provide strategic insights and leadership. The only part of the business that gets standardized at the local level is the implementation of ROAD’s bidding and management information systems, which frees up time at the local level of management, helping them focus more on capital allocation and business execution. This level of decentralized command enables ROAD to acquire great, local businesses without having to make costly personnel changes. Plus, who better to understand the local market than the best asphalt company in that local area?
Enhanced Geographic Tailwinds
Improving road conditions might very well be the one and only issue that both sides of the political spectrum agree on in the current environment. Both parties support an increased spending bill for infrastructure repair to our nation’s roads, bridges and airports. This increased effort was first seen in 2015 with the passing of the FAST Act, which allocated $305B for transportation infrastructure spending through 2020. 2019 will see around $900M more dollars in infrastructure spending than 2018, and the current administration appears equally excited to get a spending deal done on road rehab.
ROAD is located in the heart of some of the worst road conditions in the United States. According to the American Society of Civil Engineers, the states in which ROAD does business score extremely low on the grading scale. North Carolina: C, Georgia: C-, Alabama: D-, and Florida: C. Although the road conditions currently resemble that of an Amy Schumer Netflix special, each state is investing heavily into improvements. The average state in ROAD’s jurisdiction has committed over $1.1B in spending on road infrastructure. Back-dropping all of this spending is a region of the US that is growing faster than the national average in both GDP and population (2.7% GDP growth and 1.1% population growth). There is an estimated $836B in backlogs for projects to repair deteriorating bridges and highways throughout the US. ROAD is well positioned to take some of that pie.
The company has grown revenues, cash flows and EBITDA each of the last three years. Looking out to 2019, management is expecting EBITDA to be in the range of $85 – $91.5M. If management is able to to achieve even the low end of their EBITDA figure, that would imply an EV/EBITDA multiple of 5.3x at current prices. Industry average multiples are around 9x EV/EBITDA. Applying that multiple to the company’s most recent EBITDA figures gets us an EV of $612.9M. Adding back cash and backing out debt gets us to a market cap of $618M. Dividing the market cap by total shares outstanding (51.4) gets us an equity value per share of $12. So here’s a business that’s growing through strategic acquisitions while staying both net cash positive and low debt-to-equity. Industry tailwinds are well in place and the company is positioned in one of the higher-need areas for road improvement.
Risks
ROAD faces a few major risks to its continued revenue and EBITDA expansion. Reduced spending on public infrastructure, inability to successfully bid on DoT projects, sustained adverse weather conditions and taking on too much leverage for acquisitions seem to be the highest potential risks that could reduce the company’s outlook and shrink their runway. While I do not see those playing a huge role in the next 3 – 5 years, they are good reminders for me should any of them pop up. If I had to choose the one risk that I’m worried about the most right now, it would be leverage. The company is in an excellent position balance sheet wise. I don’t want them to take on more and more debt for the sake of acquisitions. A strong balance sheet will be crucial during an economic downturn and will make ROAD able to acquire more businesses at cheaper prices.
Valuation
Revenue and EBITDA growth in the low double digits should command a higher multiple in its industry. Industry averages are in the mid 9x’s while the company currently trades for 5x its 2019 EBITDA. If we look even further down the road — pun intended — we can approximate a roughly right 2020 EBITDA figure of $100M (based on 2020 target of $1B in revenues). A median multiple of 7.5x puts ROAD’s EV at $750M. If we take the three-year cash and debt averages, we arrive at a market cap of around $740M. Dividing by the current number of shares gets us a share price of $17.
Using management’s projections of EBITDA for 2019 & 2020 of $87M and $100M, we can add a conservative combined growth rate of 6.5% for the remaining three years to arrive at 2023 EBITDA of $125M. If we assume D&A remains around 10.50% of EBITDA and capital expenditures are roughly 50% of EBIT, we arrive at a 2023 estimated FCF of $57M. Assuming a discount rate of 11% gets us a private value of FCF of $35M and a sum of present values of $184M. Adding our present value to our PV of Terminal Value gets us a value for the whole business of $660M. Subtracting out our net debt of -$36M and dividing by 45M shares finds an equity value of around $15.
Current cost basis of my acquired position is around $8.50. Management buying shares as the price declined from $12 to $8 increased my confidence in effective capital allocation, and helps me sleep at night knowing interests are aligned. Current share prices indicate a market that is pricing no future growth in EBITDA. Average cost basis for my paper investment fund sit around $8.50.
The Market Plunger 