Texas Industries: A Sharp Pullback And More To Come

Texas Industries (TXI) has a rather simple business model, and for a stock that's down over 15% in just a couple weeks it's hard not to get excited. However, we have a real love-hate relationship with materials companies. On one hand they are heavily tied to the broader economy, and on the other hand they are instrumental to economic growth.

So, the point is that even though Texas Industries has had significant tailwinds related to the broader economy, it's still struggling to see meaningful EPS growth and will likely see more downside. Even though its key operations are in one of the fastest growing states of Texas, the company has managed to see EPS decline by an annualized 58% over the last five years. There appears to be too much optimism surrounding the company's ability to expand margins.

But don't feel too bad for Texas Industries' investors, the stock is still up over 80% over the last two years.

It's more than just a hiccup.

Texas Industries cement production/distribution facilities are heavily focused on Texas and California, while holding about 32% of the cement market share in Texas. And so, the overall Texas economy can have a big bearing on how Texas Industries performs. But, Texas, as a state, has been bustling. It has seen some of the best growth in terms of GDP and residential construction, and yet, Texas Industries has seen revenue fall over 30% over the last five years.

Meaning the bullish rebound in residential construction has done little to prop Texas Industries up. The question becomes; is there any catalyst that can increase sales?

In its major markets, the company is faces considerable competition from the likes of larger competitors Martin Marietta Materials (MLM), Vulcan Materials Company (VMC) and Cemex (CX). The main problem in competing with larger competitors is that Portland cement is Portland cement. Meaning that quality of product has little to do with sales, the key driver is price. This leaves Texas Industries somewhat handcuffed from a margin perspective.

Making things worse is that Texas Industries can do little to spur demand, with its sales reliant on the broader economy.

In regards to cement prices, Texas Industries continues to underperform the market. The company is heavily tied to cement, which accounts for 54% of sales, and another 33% of sales are from ready-mix concrete, which has cement as the major input.

Texas Industries pre-sold a large amount of cement at below market prices to start up its Hunter Plant. Cement prices are expected to see compressed prices through fiscal 2014 due to the Hunter pre-sales. And the news gets worse. Once the pre-sales are cycled through, the ability to increase prices to market levels will only be limited to roughly 30% of volume in Texas.

Another factor likely to affect Texas Industries over the long-term is imports of cement, particularly in Texas. We see lower-cost producers from outside of Texas looking to take advantage of the strong Texas market, hurting home-grown producers such as Texas Industries. On the earnings call, CEO Mel Brekhus addressed this issue:

"Long term though, I really do think that the State of Texas will probably need imports, especially if these trends continue that we're seeing. And when I say imports, I mean, imports from outside of Texas, whether it be South Korea, Greece or Indiana, Alabama, Oklahoma, we're going to need those imports. And I do think it will have an impact on pricing, in especially the Houston market."

Besides competition and cement prices, Texas Industries faces a difficult regulatory environment in California. California has a number of environmental initiatives that make operating in the state difficult for Texas Industries. CEO Mel Brekhus said as much on the company's earnings call:

"On the pricing side, it's been a slog in California. It's been very difficult to try to get prices up during this difficult time. But there are costs associated with doing business in California that are extraordinary."

Lofty expectations create an opportunity

Shares in Texas Industries have taken a hit over the past week after the company missed earnings expectations. The company reported EPS of $0.01, but that came from a $0.08 gain related to the sale of real estate. Without the real estate sale, EPS would have been a loss of $0.07. This is only 1 penny better than last year's $0.08 loss in the same quarter. Again, nothing positive to report on the earnings front.

The expectation of a rapid expansion in margins creates a big opportunity for the company to miss expectations. The company is targeting a gross margin of 15% for fiscal 2014, with SG&A as a percent of sales expected to come in at 8% or less. Currently, gross margin is at 11% for the TTM and SG&A as a percent of revenue is at 9.1%. We haven't seen a full fiscal year gross profit margin anywhere close to 15% since pre-2009, and we haven't seen SG&A as a percent of revenue down to 8% since pre-2006.

A very rich company

From a valuation perspective, Texas Industries is trading very richly, at half-decade highs. Its p/b is 2.1x and p/s 2.3x, compare this to the five year averages of 1.5x and 1.6x, respectively.

The company's also trading at 28x ev/ebitda; compared to some of the other major materials companies that's quite expensive. These include CRH (CRH), Smith-Midland (SMID), Monarch Cement (MCEM) and Cemex , which, together trade at an average 11.25x ev/ebitda.

EBITDA margins are down around 11.5% and it doesn't look like they'll be able to get back to the 18% plus that investors are desperately hoping for. If EBITDA margins remain compressed at 11.5% levels, based on fiscal 2014 sales estimates, the stock will still be trading at outsized multiples -- 21x ev/ebitda.

The upside for Texas Industries is very limited given what we're already seeing at the company. We just don't see any catalysts that can help drive the top line any more than it already has, and margin expansion expectations seem overexaggerated.

Where we could be wrong

• Noted value investor Mason Hawkins and his Southeastern Asset Management own 28% of the company. Going against him is not typical for us, however, he has enjoyed the 80% run over the past two years.
• If total cement demand returns to pre-2007 levels, which would boost the top- and bottom-lines for Texas Industries. However, those levels would assume a very robust, bubble-like, level of homebuilding.

All in all

Even an 11.25x multiple on 2014 EBITDA estimates -- using a generous 14% EBITDA margin -- puts intrinsic value at $28, which would cut Texas Industries' stock price in half. But, the other issue is sales could also come in below estimates (especially in the context of a slowing housing boom), and how do we grow margins by 400 basis points basis points in less than a year (which is what the market is expecting)?

There is little appeal to the company, besides Southeastern's stake and the fact that it operates in one of the strongest states in terms of growth. However, the top line upside will continue to be constrained by a slowing real estate market and below-average cement market prices. The company should begin to trade more in line with peers on a valuation basis, and continued margin pressure will only exacerbate the downside move. We see Texas Industries as being overvalued and the recent selloff as the start of a stronger move to the downside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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