A Rock-Solid Investment

 | Jan 30, 2012 | 3:30 PM EST  | Comments
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mlm

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vmc

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txi

They say that out of a crisis comes opportunity. In business, economic crises combined with capitalism can lead to industry transformations that can then lead to an opportunity. One such opportunity could be brewing in the aggregates industry. 

In December, Martin Marietta Materials (MLM), the second-largest producer of aggregates in the U.S., announced an all-stock merger with Vulcan Materials (VMC), the largest producer of construction aggregates in the U.S. Martin offered Vulcan shareholders a half a share of Martin for each share of Vulcan, originally valuing the deal at about $4.7 billion. At the time, this offer represented a 15% premium to Vulcan's share price -- Martin shares trade for about $81, while Vulcan shares trade for about $43, or slightly above the implied conversion price.

From the very beginning, Vulcan has argued that the offer was insufficient, while Martin has argued otherwise. It was only after nearly two years of a friendly attempt to merge with Vulcan that Martin decided to go hostile and take its plan directly to shareholders in December. Based on the all-stock offer, 58% of the newly combined Martin-Vulcan would belong to existing Vulcan shareholders.

Vulcan's argument that the proposed terms inadequately value the company are likely valid; the construction industry is in the midst of an all time cyclical low and Vulcan's valuation reflects that. Five years ago, Vulcan shares were trading for more than $100. But what can be said about Vulcan is true of Martin Marietta as well. Martin shares are also trading much lower than they were five years ago, but Martin shares have significantly outperformed Vulcan over that period of time.

Indeed, while Martin may be getting Vulcan's assets on the cheap, Martin is also using its undervalued stock price as a form of currency. Vulcan shareholders are basically trading one form of undervalued currency for another. Given Vulcan's substantial leverage compared with Martin, it can be argued that Vulcan's operating business has significant upside leverage in a recovery scenario. And after four years of a depression-like housing environment, a recovery is inevitably closer with each passing year.

Investors can play this recovery trade owning either Vulcan, Martin or both. In all likelihood, the combination of these two sand-and-gravel juggernauts will eventually happen. Both have strong exposure in the nation's fastest-growing states, including Texas and Florida. According to Martin, there are more than $2 billion in cost-saving synergies to be had from this deal. Martin's $1.60 per share dividend effectively means that Vulcan shareholders would get $0.80 per share based on the merger terms, up from the $0.04 that Vulcan currently pays its shareholders.

If Martin Marietta truly believes in this deal and its potential value creation, there is certainly room to increase the offer price; hence, the case for owning Vulcan shares. Yet owning Martin shares today and the likelihood that that means owning 42% of the global leader in sand, stone and gravel is also an attractive long-term proposition; hence, the case for owning Martin shares.

Indeed, Southeastern Asset Management, founded by value investor Mason Hawkins, has been betting heavily on construction aggregates for well over a year through its significant stake in smaller player Texas Industries (TXI). In addition, Southeastern owns 13% of Martin Marietta and 9.9% of Vulcan shares. On Jan. 12, Southeastern sent a letter to Vulcan in support of the merger but also opining, "We understand that a higher offer from Martin Marietta will be necessary to complete a deal, and as Vulcan shareholders, we support seeking a higher offer. That being said, Vulcan shareholders will receive undervalued Martin Marietta stock."

The depression-like conditions in the construction industry compels a combination of two giants like Martin and Vulcan, especially since there are no significant regulatory hurdles to prevent such a deal. Going into a recovery, a bigger, more efficient Martin-Vulcan is likely to command a higher valuation.

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