Building Products & Materials Quarterly Newsletter: Q2 2011
Companies serving the transportation infrastructure market have dealt with polarizing industry dynamics over the past several years. While a significant need exists in the U.S. to maintain and upgrade much of the existing highway infrastructure in place, a lack of adequate public funding has continued to plague the industry. Similar to the tax incentives implemented in 2009 and 2010 to spur first-time home purchases, the 2009 stimulus package provided short-lived support to the U.S. infrastructure industry over the past several years. Upon a closer look, however, the stimulus might not have had quite the effect that many had hoped. Moreover, state and local governments, which increasingly have footed more of the bill for infrastructure projects than the federal government, have reduced infrastructure spending as a result of lower tax revenues. These dynamics, combined with the uncertainty surrounding the timing and funding of the next federal highway bill, appear to be weighing on M&A activity in the sector.
Current State of the U.S. Infrastructure System
Decades of underinvestment in basic infrastructure have resulted in a significant infrastructure deficit in the U.S. Not only has federal infrastructure spending as a percent- age of GDP declined over the past 50 years, but steadily rising input costs (e.g., fuel, building materials, labor, etc.) have increased the cost of infrastructure projects, thus eroding the impact of federal infrastructure expenditures. Adjusted for inflation, federal spending on highways steadily declined from 2002 to 2008, as depicted in the chart below.
Real Federal Spending on Highways (in billions of 2009 dollars)
A number of studies have been conducted in recent years, including those by the National Surface Transportation Infrastructure Financing Commission and the American Society of Civil Engineers, most of which estimate the annual need to maintain, im- prove, and rebuild the nation’s infrastructure systems at $135 billion to $260 billion. These totals are significantly larger than the funding amounts that federal, state, and local governments annually allocate to infrastructure, including recent stimulus funding. The reality is that road systems that were constructed with federal grants 40 to 50 years ago are now reaching the end of their lifecycles and must be repaired, upgraded, or replaced. This dynamic bodes well for companies in the space, as the infrastructure deficit is an issue that federal, state, and local governments cannot ignore indefinitely.
The “Stimulus” Effect
Despite President Obama initially touting the $787 billion stimulus bill as “the largest new investment in our nation’s infrastructure since Eisenhower built an interstate highway system in the 1950s”, only a small portion of the stimulus package was actually earmarked for infrastructure. Broadly defined, infrastructure was allocated $150 billion, but only $64 billion (approximately 8% of the total) was aimed at roads, bridges, public transport, rail, and other systems. Although the stimulus certainly helped offset the expiration of the last federal transportation bill (SAFETEA-LU) in September 2009, as well as provided much-needed funding to financially-challenged states, the benefits of increased federal infrastructure spending were primarily felt in isolated regions of the country where specific capital projects were allocated funds in favor of maintenance and upgrades. Additionally, given the lengthy federal permit process for construction and infrastructure projects (and as President Obama recently noted), “shovel-ready was not as shovel-ready” as the government had expected. With stimulus funding for highways expected to dwindle in 2012, and a new highway bill yet to be passed, the infrastructure industry will more than ever rely on regional and local governments for funding.
State and Municipal Government Challenges
Contributing to the infrastructure deficit has been a cutback in infrastructure spending by state and local governments, which have faced declining revenues and budget cuts. Adjusted for inflation, state tax collections were 11% below pre-recession levels through the third quarter of 2010. Although cumulative state funding data are not available for the 2008 to 2010 time period, evidence indicates that infrastructure funding at the state level declined significantly during the Great Recession concurrent with declining tax revenues.
While states are primarily funded by income and sales taxes, local governments depend heavily on property taxes, the revenue from which has declined along with falling hous- ing prices. Given the typical lag between falling home values and lower property tax receipts, local governments will likely continue to be cash flow constrained for the next several years.
The outlook for state-funded infrastructure is not as clear. State tax revenue recovered in 2010 as a result of tax increases implemented during the downturn and higher in- come tax receipts from stock market gains post-recession. However, beginning in July (the start of fiscal 2012), states will no longer have access to the $150 billion in stimulus funds that have supported them for the past two years. Having used federal fund- ing to fill budget gaps during the downturn, states are now scrambling to make cuts necessary to balance operating budgets. More than 40 states are projecting budget shortfalls in fiscal 2012, with a significant cumulative shortfall expected in fiscal 2013 as well.
Largest State Budget Shortfalls on Record
($ in billions)
The Next Highway Bill
The biggest unknown right now for infrastructure companies in the U.S. is what the next highway bill will look like and when it will take effect. The last federal transporta- tion bill (SAFETEA-LU), which was enacted in August 2005 and totaled $244 billion, expired in September 2009. While the bill has been extended seven times since its ex- piration, the lack of visibility into federal funding available for long-term projects has in many cases caused state DOTs and municipalities to delay much-needed capital projects. The best case scenario for companies serving the transportation infrastructure market would be the passing of President Obama’s proposed six-year $556 billion highway bill, although Congressional funding for a bill of that magnitude in today’s political climate is unlikely.
The aforementioned market dynamics are affecting an array of companies that directly or indirectly participate in the transportation infrastructure market. In addition to transportation-dependent companies such as asphalt and paving contractors and manufacturers of pre-cast concrete products (i.e., beams for bridges, concrete pipes, etc.), aggregates/cement/ready-mix producers rely heavily on the public infrastructure and highway construction markets in addition to the residential and commercial con- struction markets. The extent to which these companies have been affected has varied depending on footprint, end market diversity, and size. Producers of concrete reinforc- ing steel, for example, collectively pulled back production to approximately six million tons in 2010 from 10 million tons in 2007, representing a 40% decline. Manufacturers of commercial-class asphalt paving and other road construction and maintenance equipment have also suffered as contractors and DOTs have halted capital investment in response to the uncertainty surrounding continued federal funding. With the stimulus having focused more on one-off capital projects than widespread infrastructure im- provement, the benefits of increased federal spending have tended to be more localized in nature over the past several years.
Sector M&A Activity
As illustrated below, despite the challenges that have pervaded the transportation infrastructure market over the past several years, mergers and acquisitions activity in the sector has remained fairly constant, excluding a dip in 2009. The primary driver of continued M&A activity in the sector has been large, well-capitalized aggregates and materials companies acquiring cash-starved assets in an effort to increase market share and position for longer-term growth. With high transportation costs restricting competition to the local level, acquisitions have represented an attractive means for aggregate companies to gain market share in particular locales and thus increase scale, efficiencies, and pricing power.
Recent Transportation Infrastructure M&A Activity
Deals Completed by Year
Most Active Acquirers of U.S.-Based Heavy Building Materials Companies
January 1, 2009 — June 30, 2011
The near-term outlook for companies participating in the U.S. transportation infrastructure market is uncertain, and this uncertainty appears to have manifested in the M&A market through the first half of 2011. Certainly some of the M&A slowdown can be attributed to 2011 deals having been pulled into 2010 in advance of tax changes that never materialized. But the expiration of the stimulus, lack of a long-term federally funded highway bill, and financial health of state and local governments are certainly weighing on industry participants. The large, strategic acquirers historically most active in the U.S. have re-focused their attention on international acquisitions for the time being. And with the exception of a few sponsor-backed tuck-in acquisitions, the sector has been void of private equity investment over the past couple of years.
The importance of and need for significant infrastructure investment in the U.S. – not only to the industry but also the economy – should translate into a well-funded and sizeable multi-year highway bill later this year or early 2012. The passing of the bill, along with continued improvement in the economy and sustained health of the financing markets, should lead to an uptick in sector M&A activity in 2012 and beyond, particularly with private equity buyers re-entering the market for the first time in several years.