RainStar/E+ via Getty Images
RainStar/E+ via Getty Images
After my original article on Core & Main (NYSE:CNM ): Investing In Growing Waterworks Consolidator Alongside Proven Private Equity Firm, was published on November 6, 2021, the company announced third quarter earnings which easily beat both revenue and EPS estimates, and its updated EBITDA guidance for the full year was higher than I expected.
However, much of this outperformance was driven by strong PVC commodity price inflation, an exogenous factor and double-edged sword that could cut into earnings when PVC prices regress towards historical levels.
I believe PVC commodity pricing volatility creates both risk and opportunity. As such, my objective for this article is to stress test my original investment thesis, examine new information, and cut through the noise to assess the long-term fundamentals and valuation. (I highly recommend that you refer to my original article as it provides more helpful background on the company)
I re-examined the investment thesis I put forth in my original article (figure 1), which I will delve into more detail below:
Figure 1: Summary of original Core & Main investment thesis
Investing alongside CD&R-one of the leading private equity firms with a proven track record in building material and distribution businesses
(A) The demand of piping for infrastructure waterworks has increased
(B) Demand for fire sprinklers will continue to increase due to strong construction spending
The duopolistic structure gives rise to industry pricing discipline
Industry consolidation is continuing as expected
The industry is recession resilient
The stock is under-covered by the investment community
A. The need for water infrastructure maintenance and repair continues to grow
In my original article on Core & Main, I laid out the statistics on the large base of aging water infrastructure and leaking pipes that require upgrades and repairs, which I will not belabor. Instead, I will share my additional findings that reinforce the need:
- Poor ASCE report card: The American Society of Civil Engineers) rated US infrastructure for drinking water a C-, wastewater a D+, and stormwater drainage a solid D. It further noted that these systems require a cumulative $1 trillion in investment by 2029.
- Valueline analysis: The Valueline water utility industry report noted that:
"Every company here is in the midst of a large construction program. This is due to the nation's water infrastructure being in poor shape. Capital budgets should remain meaningful for years to come, which will require external financing."
- Consolidation in the water utility industry: Valueline continues,
"There are easily more than 50,000 separate water entities operating throughout the country. As a result, it is a very inefficient market. American Water Works has been the most active acquirer of these smaller districts. With the average age of a typical domestic pipeline being well over 50 years, many operators do not have the funds to modernize their assets"
The large consolidators have better access to capital markets to raise capital to perform the much-needed upgrades. Valueline notes that relations between the water companies and regulators has been constructive, while will the water utility industry to maintain a profit from upgrading their systems while also ensuring that water customers are not overcharged.
- Increase in capital expenditures of large water utilities:
Capital spending of large water utilities have increased steadily over time (figures 2 and 3), and there is no reason for the growth to slow down.
Figure 2: Capital expenditures for American Water Works (AWK) and California Water Service Group (CWT)
Source: Created by author based on publicly available company financials
Figure 3: Capital expenditures for Essential Utilities (WTRG) and Global Water Resources (GWRS)
Source: Created by author based on publicly available company financials
B. The recently passed Infrastructure bill provides an additional boost
From 1949 through 2015, US infrastructure spend has hovered around below 1.5% of GDP (figure 4), which is below the current global spend of 3% of GDP according to estimates by Oxford Economics.
Figure 4: US capital spending on infrastructure
The recently passed Infrastructure and Jobs Creation Act allocates $1.2 trillion in total funding over 10 years, including $550 billion in additional spending on top of what Congress was planning to authorize over the next eight years. The bill includes $55 billion for clean water, and $50 billion to protect against droughts, floods, heat, wildfires, and weatherization (figure 5). In addition, the $284 billion of new spending for transportation includes $135 billion in roads and bridges that will require storm drainage as well as airport infrastructure that will require waterworks and fire protection pipes.
Figure 5: US infrastructure spend on water and water-related projects
Source: Core & Main 3Q 2021 earnings presentation
In the company's 3Q 2021 earnings call, CEO Steve LeClair describes the infrastructure bill as a "once in a generation bi-partisan bill that makes transformational investment in our nation's infrastructure", and noted that the bill will provide multiyear tailwinds for the municipal water sector. However, he cautioned that it will take time for the money flow through due to constrained manufacturing capacity and labor shortages, and that the company may not see incremental volume as a result of the bill until 2023 or beyond. He believes that once the funds flow, the bill could add 1-2% of additional municipal end-market growth each year.
As I described in my article on construction design and project management software providers Bentley and Autodesk, the outbreak of COVID let the "work from home" out of the bottle and accelerated society's shift online, both of which will be near-impossible to reverse. To understand the impact, I examined the occupancy rates of the various real estate sectors as low or declining vacancies would stimulate the need for more construction, which would in turn drive demand for waterworks infrastructure and fire sprinklers.
Commercial offices: Even though demand for central business district commercial office space in gateway cities, as measured by the occupancy rates of large REIT landlords such as Boston Properties (BXP), Empire State Realty (ESRT), and Office Properties Income Trust (OPI) have been declining, demand for office space in non-gateway and tier two cities such as Charlotte, Nashville, Orlando, Richmond, and Washington DC have ticked up, based on the occupancy rates of Highwoods Properties (HIW) and Boston Properties' suburban properties.
Residential housing: Demand for apartments in second-tier cities and suburban areas has also grown with the dedensification of gateway cities as some urban dwellers now have the opportunity to work remotely. While the occupancy and lease rates of apartment REITS in gateway cities have been flat (e.g., as measured by Essex Property's (ESS) properties in San Francisco, Los Angeles, and Seattle), occupancy rates of apartment REITS in non-gateway cities (such as Camden Property Trust (CPT)) have risen. Furthermore, new residential construction starts are hovering around their highest levels in over a decade (figure 6).
Figure 6: Housing starts in the US
Logistics and distribution warehouses: As consumers shift their purchases online, demand for logistic distribution centers has skyrocketed. Leading logistics REIT Prologis (PLD) reported that their warehouse space is sold out and "demand at all-time high" while Duke Realty (DRE) - the largest US-only logistics REIT, reported occupancy of around 98%.
Data centers: Digital Realty (DLR), a data center REIT, reported year-over-year revenue growth of 11% for the quarter ended September 30, 2021, projects occupancy rates of 84% - 85%, down from 87.1% for the period ended September 30, 2020, but continues to build new facilities. Equinix (EQIX) reported year-over-year revenue growth of 10% and US cabinet utilization of 75% for the quarter ended, but is also aggressively expanding its facilities. It appears that data center REITS are building capacity ahead of the strong expected growth.
In summary: Reduced demand for gateway city commercial real estate and retail space is offset by increased demand for offices and residences in suburbs and second-tier cities as well as warehouses and datacenters that support society's online shift.
Core & Main and its main competitor Ferguson (FERG) continue to be the two dominant players in the distribution of waterworks infrastructure supplies, and together have a combined 30% share of the market. Both companies have grown share by leveraging their national scale and relationships with suppliers, which I expect will continue over time through additional organic growth and acquisitions
Core & Main has continued making progress to consolidate the space. It opened new greenfield locations in West Phoenix, Arizona; Logan, Utah, in addition to Austin Texas--these and its existing locations can be used as beachheads to expand into new geographics and strengthen existing market positions.
It has also made strategic acquisitions which will expand its geographical footprint, product and service offerings, and total addressable market. These include:
Similarly, competitor Ferguson also made four acquisitions in the last quarter, one of which (Sunstate Meter & Supply) competes directly with Core & Main.
In the 3Q2021 SEC 13F-HR filings, only three hedge funds reported holdings of Core & Main in excess of $10 million, and only one (Select Equity Group) had a position of over $100 million (figure 7). Furthermore, their positions in the company represented a de minimis percentage (< 1%) of their portfolios.
Figure 7: Large hedge fund holders of Core & Main
Since my article was published on November 6, the number of Core and Main followers on Seeking Alpha doubled from 245 to a whopping 299, just slightly more than 0.001% of Apple's 2.5 million followers.
Core & Main's 3Q2021 earnings report released on December 7, 2021 were strong and easily beat estimates. Third quarter revenues jumped 39% to $1.4 billion, $110 million above estimates. GAAP EPS of $0.39 beat estimates by $0.10 or almost 33%, and the company hiked adjusted EBITDA guidance to $560 million to $580 million, up from its previous guidance of $470 million to $510 million and representing year-over-year growth of 64% to 70%. Core & Main CFO Mark Witkowski attributed two-thirds of the sales increase in the quarter to price inflation, which was higher than expected.
The stock price rallied in response to the earnings but has since pulled back (figure 8) as investors posited that the PVC commodity price inflation driving strong growth is not sustainable over the long run and that a regression to historical PVC prices could negatively impact Core & Main's earnings.
The performance of main competitor Ferguson's civil/infrastructure waterworks segment also surpassed investor expectations. Segment revenues for the quarter increased 50% over the year ago period and gross margins increased to 31.3%, which Ferguson CEO Kevin Murphy noted was driven "half and half" between volume growth and price inflation.
For the year ended July 31, 2021, Ferguson's civil/infrastructure waterworks segment grew 17% for the year ended July 31, 2021, compared to Core & Main's 31% year-over-year growth for the year ended August 2021 (which included the sizeable acquisitions of R&B in San Jose and Long Island Pipe).
Figure 8: Core & Main stock price
Roughly half of the world's PVC resin manufactured annually is used for producing pipes for municipal and industrial applications. In the private homeowner market, it accounts for 66% of the household market in the US, and in household sanitary sewer pipe applications. PVC is also commonly sued as electric cable insulation and trays as well as in construction. Shortfall in PVC capacity will inevitably impact the pipe production and construction.
Data from the US Bureau of Labor Statistics shows that the producer price index of plastic water pipes has almost doubled since January 2020 (figure 9) along with the producer price index for plastics water pipe manufacturers (figure 10).
Figure 9: Producer price index for plastics water pipe
Source: Producer Price Index by Commodity: Rubber and Plastic Products: Plastics Water Pipe
Figure 10: Producer price index for plastics water pipe manufacturers
Source: Producer Price Index by Industry: Plastics Pipe and Pipe Fitting Manufacturing: Plastics Water Pipe
Strong demand, weather outages, capacity reductions in China, the supply chain crisis, and limited new capacity additions for PVC and piping capacity have contributed to the sharp price increases in PVC water pipes
A. Continued strong demand for PVC
(This was discussed in the investment thesis update above)
B. PVC resin plant shutdowns due to weather outages
Core & Main attributed the increase in PVC pipes costs to the increase in resin prices, which rose about 50% (figure 4) after 57% of American PVC production capacity was taken out earlier this year when severe winter storms shut down petrochemical facilities in the US Gulf Coast. This was followed by Hurricane Ida and Tropical Storm Nicholas in August 2021, which caused more shutdowns in downstream petrochemical plants in the region.
Plants have gradually restarted and resin prices are showing signs of peaking (figure 11) but still significantly above pre-2021 levels.
Figure 11: Producer price index of resins manufacturing industry
Source: Producer Price Index by Industry: Plastics Material and Resins Manufacturing
C. PVC capacity shortfalls exacerbated by coal shortages in China
About 50% of global PVC capacity is produced in China, of which about 80% is coal-based. Earlier this year, China reportedly shut down hundreds of dirtier coal mines in an effort push to reduce carbon emissions, and slapped restrictions on imports of cleaner coal from Australia as political tensions over China's early handling of COVID-19 escalated. The resulting decrease in coal supply drove coal prices to record highs and caused power shortages in China, but has also forced the shutdown of some PVC plants.
D. Clogged ports in California and the supply chain crisis
The Long Angeles and Long Beach ports, which are responsible for 40% of all shipped containers to the US, remain backed up. According to Marine Exchange, 123 ships were still waiting to dock as of December 6, down from a record 163 in November. The inability of ships to dock in a timely manner is exacerbating the supply chain crisis, slowing the delivery of valves, pumps, and pipe restraints, further contributing to price inflation.
E. Pipe manufacturer capacity limited
The near-doubling of prices for water pipes (figure 10 above) is greater than the increase 50% increase in PVC resin prices (figure 11 above). Furthermore, the water pipe prices continues to increase (albeit as a lower rate of increase) even as PVC resin prices tick down.
Albert Chao, the President and CEO of Westlake Chemical, the world's second largest PVC producer in the world and a large PVC pipe manufacturer, remarked in his 3Q 2021 earnings call that there were limited near-term PVC capacity additions, which along with strong demand, would lead a continued strong profitability in his company's downstream building products business.
Core & Main has benefited from the rapid price inflation in PVC pipes to its advantage by leveraging its size and supplier relationships to access and stock up on inventory ahead of announced price increases, which it re-sells to customers at a profit as price increases go into effect.
In the 3Q 2021 management call, Core & Main CEO Steve LeClair attributed two-thirds of the quarter's 30% revenue year-over-year increase to price inflation.
The company did not disclose the impact of price inflation on its profitability. However, the framework provided by Atkore (ATKR) (a large user of PVC for its electrical products and also a previous CD&R portfolio company) may be instructive. Atkore's 3Q 2021 volume and mix growth was about 5.2% (figure 12). However, Atkore was able to push price increases far more than cost inflation, causing its revenues to almost double, EBITDA to nearly triple, and EBITDA margins to tick up to 31.7%, up from 21.8% a year ago.
Figure 12: Impact of price increases on Atkore's revenues and EBITDA
Source: Atkore 4Q2021 earnings presentation
Commodity volatility is a double edge sword. Should PVC pipe prices drop precipitously, the company could be caught holding inventory acquired at a higher cost, which it will have to mark down and incur gross profit compression. However, if PVC pipe costs decline gradually, the company may be able to control and minimize inventory markdown losses.
Core & Main's profit spread is unlikely to hold up as it is highly improbable that PVC costs will continue increasing at the same rate over the long term. In fact, as competitor Ferguson's CEO Kevin Murphy pointed out, "we would expect [waterworks inventory cost] to moderate or come off at some point, but calling exactly when that will moderate is a bit difficult".
Commodity prices are cyclical but notoriously difficult to predict. As such, I believe long term investors should base their views on Core & Main's future prospects on volume growth and an "average" spread over a normalized period.
I anchored my guesstimates off financial results for the year-ended January 2021-the period before commodity prices inflation took off (figure 13, column H). For the period 2022-2024, I assumed the following:
Figure 13: Financial guesstimates for 2022-2024, assuming normalized commodity prices
***VERY IMPORTANT NOTE: These numbers are "guesstimates" that I put together only for illustrative purposes, so please do not rely on them for your investment decisions***
Source: Created by author strictly for illustrative purposes only
Using the $25.9 closing stock price of December 20, 2021 and applying the above assumptions, my EBITDA guesstimate for the year ended January 2022 would be $375 million based on "normalized" PVC commodity prices, which values the company at an EV/EBITDA multiple of 21x.
My EBITDA guesstimate of $539 million for 2024 values the company at an EV/EBITDA multiple of 14.6x.
As discussed in my original November 6, 2021 article, CD&R executed a dividend recap to take money off the table prior to the company's IPO, but has not sold any of its shares since.
There is a risk that Core & Main may be stuck with expensive inventory when PVC commodity prices regress to historical levels and forced to take losses due to inventory write-downs.
Mitigating factor: The fact that the stock priced declined despite the strong revenues and EBITDA beat suggest that investors are cognizant of this risk, which may be partly factored into the stock price.
Furthermore, given the strong increased demand and limited capacity additions discussed above, one possible scenario is that PVC commodity prices hold up until money from the infrastructure bill makes the way to the waterworks industry.
The company is currently valued at a full EV/EBITDA multiple of 21x normalized fiscal year 2022 EBITDA. This multiple will decline to a more reasonable 14.6x normalized EBITDA in FY 2024, but requires that the fairly aggressive assumptions in my guesstimates above hold true.
The investment thesis on Core & Main I put forth in my original article continues to hold due to positive developments.
We will be investing alongside CD&R-one of the leading private equity firms with a proven track record in building material and distribution businesses
(A) The demand of piping for infrastructure waterworks has increased
(B) Demand for fire sprinklers will continue to increase due to strong construction spending
The duopolistic structure gives rise to industry pricing discipline
Industry consolidation is continuing as expected
The industry is recession resilient
The stock is under-covered by the investment community
Even though the shortage of PVC products has driven the strong PVC price inflation that has enabled the company to beat earnings estimates and raise guidance for the year, investors have been appropriately cautious and driven down the stock by almost 20% from its all-time high.
I believe this pullback creates opportunity for investors, and plan to take advantage of the pullback to add to my position.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of CNM either through stock ownership, options, or other derivatives. 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.