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09/01/2010

Construction Materials Outlook: Some Hope on the Far Horizon


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The Finance Professionals' Post spoke with Jack Kasprzak, managing director of Equity Research at BB&T Capital, for his outlook on the three principal sectors of the construction materials sector—public works, housing, and commercial building—in the run-up to NYSSA’s Fifth Annual Construction & Materials Conference, to be held on September 29.

A FLAT OUTLOOK AT BEST FOR PUBLIC WORKS SPENDING

Kasprzak reports that federal stimulus money for highway construction, combined with the core federal highway budget, has failed to appreciably revive the public works construction sector. That’s because states experiencing huge deficits have reallocated funds they might otherwise have spent on street repairs to plug holes elsewhere in their budgets. While the expectation had been that highway construction spending would be up as much as 10% in 2010 it is in fact up less than 5%. “The overall impact from the stimulus has been far less than many had forecast,” he reports.

What’s more, the Federal highway program, which has in the past been renewed every six years, expired in September 2009 and a new round of funding has yet to be legislated. While successive highway programs have invariably come with significant increases in overall spending, it is unlikely that substantial funding increases will be allocated in 2011, given the current recession’s negative impact on gas tax revenues. “As the bulk of stimulus monies rolls off, we are likely to face a highway construction market that is flat or possibly down in 2011,” says Kasprzak.

While the stimulus bill allocated some additional funding for mass transit construction it was not enough “to move the needle,” in Kasprzak's view: “The total budget for highways is about $41 billon while that for mass transit is less than $15 billion.”

NEW HOME CONSTRUCTION STALLED UNTIL INVENTORIES SHRINK

Nor is there much good news in the new home construction sector. Housing starts, a key driver of demand for construction products and materials, is down 80% from its peak of more than 2 million units annually to less than 600,000, the lowest level since World War II. “We have a glut of as much as 3 million existing homes, foreclosed ones, and those underwater,” says Kasprzak. “This needs to be cleared out of inventory before we can get a new home construction cycle to start.”

Whether we experience a double dip in the housing market will be a function of the jobs market, he maintains, but his expectation is that there will be “a slow workout process to get the market toward equilibrium. We are seeing prices stabilize in lots of markets around the country so the market is correcting although it is a very arduous process.”

POCKETS OF STRENGTH IN AN OTHERWISE WEAK COMMERCIAL MARKET

The commercial market cycle characteristically lags the economy and, true to form, the housing market was well into a downturn before the commercial market peaked about 18 to 20 months ago. “We think office vacancy rates will peak in early 2011,” Kasprzak reports. “The commercial market in general is not overbuilt in the way that the housing is so the upturn in the commercial market will be purely a function of employment and economic activity.” Kasprzak notes that there also remain pockets of strength and stability in the commercial market despite the generally weakness of the sector. For example, some industrial projects related to alternative energy are still sources of demand for materials suppliers.

OPPORTUNITIES IN GREEN RETROFITS AND RENEWABLE ENERGY PROJECTS

Green building retrofits may generate some opportunities in the industry as well. “The majority of energy use and waste occurs from office buildings that are old and inefficiently insulated. Similarly, houses built in 1960s and 70s are also energy inefficient,” says Kasprzak. “Given the excess inventory there could be a move to retrofit buildings to make them more efficient.” With some meaningful government incentives this is a market that has the potential to take off, he maintains.

INDUSTRY CONSOLIDATION WILL RESUME WITH CONTINUED PRESSURE ON EARNINGS

Kasprzak expects to see a resumption of industry mergers and consolidations when the economy begins to recover. He reports that it has become increasingly problematic to build Greenfield plants given the scarcity of raw materials and production inputs close to major markets and the high cost of gaining permits to construct new plants. These almost insuperable barriers to entry are creating a business environment where assets, reserves, and plants will be held in fewer and fewer hands.

Competition among industry participants for existing contracts also remains intense. “We are seeing some price pressure which has impacted earnings, something investors have not seen in these sectors for quite a long time,” says Kasprzak.

NOT ALL DOOM AND GLOOM

Despite the severity of the current downturn, Kasprzak believes there will be an upturn in construction again, although not until well into 2011. “It has been a long downturn by historic standards,” he admits, “and it has created a lot of pain for investing in the sector, but it is not all doom and gloom. New home inventories have never been this low and the US is unique among developed countries in that it has had pretty strong population growth fueled by immigration, so underlying demand is building. That suggests we are eating into inventory and will get to that point of stability.”

–Susan Arterian Chang is a financial writer and content developer for the Capital Institute.

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