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I've been walking on the railroad--and thinking about investing in infrastructure
04/02/2013 10:30 am EST
In this column I’m going to give you a four-part system for thinking about infrastructure investing and seven high tech and two distinctly low tech infrastructure ideas to research.
Today the long deserted canal and the tracks that once belonged to the Baltimore & Ohio Railroad (now the CSX Corp. (CSX) share a tiny bit of flatland between a huge finger of rock and the Potomac River. This stretch of land was the prize in an epic court battle in 1828 between the canal company and the railroad, with Daniel Webster and future Supreme Court Chief Justice Roger Taney leading the two sides. The battle almost bankrupted the canal company before the two sides reached a compromise that gave the railroad the right to share the narrow right of way. The canal company’s attempt to use the courts to block its competition failed within 30 years. By1850 when the canal reached Cumberland, Maryland, the midpoint in the company’s plan to tie the Ohio Valley to the Atlantic, the railroad had already been in business in that town for eight years. The canal company abandoned its plan for Ohio; by 1889 the canal company and its right of way were owned by the Baltimore and Ohio Railway, which itself used its control of the Point of Rocks right of way to block the Western Maryland Railway. In 1924 the canal went out of operation.
If you stay overnight, as we did, in the house at Lock 28 that once sheltered the lockmaster and his family, you know that what was once the B&O Railroad still carries a lot of freight—often in the middle of the night. The B&O, the first railroad in the United States to offer freight and passenger service to the public, broke ground for its network in 1828. By 1889 the railroad was handling 89% of U.S. tidewater traffic in soft coal. And then came competition with other railroads—by 1896 the B&O was shipping just 4% of that soft coal traffic. And then competition with highways for passenger travel. Revenue passenger miles that had been 878 million in 1925 had fallen to 64 million in 1970. By 1964 the Baltimore and Ohio was effectively owned by the Chesapeake and Ohio Railway and in 1987 the B&O became part of the CSX system.
As you walk to the lock house, you pass the bridge that takes U.S. 15 across the Potomac to Virginia. U.S. 15 is one of the original 1926 generation of U.S. highways. Parts of its 792-mile length now run parallel to the more modern U.S. Interstate Highway System. But the highway is still a critical link in moving people and goods from South Carolina to New York. (The Potomac U.S. 15 Bridge played a major role in killing the Potomac River ferries. Today White’s Ferry, just slightly downstream from Point of Rocks, is the last operating ferry on the river.)
So what’s all this got to do with investing in infrastructure? This scene gives you a rough scheme for separating good from bad infrastructure investments.
First, infrastructure categories do die—even if the death throes can be very drawn out. It took a long, long time to actually kill off the C&O Canal even if by the time it reached Cumberland, Maryland, eight years behind the railroad, the demise of the canal company was assured. Because so much money has been invested in an infrastructure company such as the canal, however, the business has the ability to raise large sums of capital on those assets to cover “temporary” losses. And there often seem to be an endless stream of new owners who believe they can turn the situation around.
Second, infrastructure categories can re-organize and re-invent themselves. The railroads are a good example of this—they shed their money-losing passenger services (the state of Maryland now runs the commuter trains that run on the old B&O tracks)—and after rounds of mergers re-invented themselves as profitable freight operations.
Third, new infrastructure categories do emerge to kill off or to seize a major share of business from entrenched infrastructure champions. Highways did this to railroads, for example (with the benefit of public sector funding.)
And, fourth, some infrastructure categories look to be so valuable that re-investment to keep them operating is just about guaranteed. That U.S. 15 Bridge across the Potomac fits that category.
Which current infrastructure investments fit into under these four rubrics?
Airlines are probably not Category 1—they seem unlikely to disappear short of the invention of Star-Trek style Transporters—but they don’t seem to fit smoothly into Category 2 either. I don’t see an easy model that produces consistent profits from existing (or even merged) airline companies because it remains far too easy to raise capital to buy planes and start a new airline. In my scheme airlines are struggling to find a transformation equivalent to that of railroads, and until they do they remain a cyclical bet. Buy the best operators when the losses for the industry are really large and sell when profits are in a recovery mode.
Overnight document and freight companies such as FedEx (FDX) and United Parcel Service (UPS) look to have a clear route to a railroad-style restructuring. Alternative document delivery technologies continue to eat away at that part of these companies’ business, but that leaves them with the lucrative just-in-time freight delivery market. And that market is growing as more and more of commerce moves to the Internet. Every sale at Amazon.com (AMZN), for example, is also a sale of FedEx and UPS. The attractiveness of that business and its solid prospects are currently buried under the difficulty of restructuring the delivery networks at those companies to cut out some of the costs inherent in a door-to-door one-document at a time delivery system.
The big March 21 earnings miss at FedEx, for example, was largely a result of delays in achieving $1.7 billion in cost savings by 2015. The consensus among analysts is that this job is so hard that the company will wind up producing a series of quarterly earnings disappointments as it misses savings targets again and again. A good time—clearly not yet—to buy the stock is when everybody has thrown up their hands at the halting nature of the company’s progress. That is, if you think, that time-sensitive international shipments of goods will continue to grow in volume.
The Internet is the disruptive infrastructure category of our time. The fact that many of the initial technologies of the Internet were supported by government spending suggests a comparison to the Interstate Highway System, but I think the more telling pairing is with the growth of the U.S. railway network. The addition of more connections to the network makes the network as a whole more useful and valuable whether it’s the Internet or the rail net. The move from primitive steam-driven locomotives to faster and more powerful steam engines able to pull more freight and deliver it faster is similar to the increased speeds of Internet connections enabling faster on-demand services. And then on the rail side there came diesels, and boxcars with tracking chips and computerized logistics. And on the Internet side cloud-based services, and app stores, and virtual networks.
I’d say that the Internet infrastructure is still under construction by companies such as Akamai Technologies (AKAM), Rackspace Hosting (RAX), VMware (VMW), Google (GOOG), Amazon.com, Cisco Systems (CSCO), and Netflix (NFLX.)
But you don’t have to go all high tech to find infrastructure opportunities. The most interesting over the next year might be in gravel, or to get more technical, construction aggregates.
Major portions of the Interstate Highway System are now 50 years old. At this age you can’t just slap another layer of asphalt or concrete on the road surface. You actually have to rebuild the roadbed of crushed stone that supports the road surface. As a highway ages, the surface cracks and buckles. That lets water into the roadbed and produces cracks and holes in the roadbed itself. Paving over those holes at the surface won’t any longer do the job since the holes in the underlying layer of stone cause the surface to break and buckle again.
All this is bad news for state highway budgets but good news for the companies that make up the $17 billion (2010 sales) aggregate industry. Production of construction aggregates fell by 37% in 2010. But 2012 looks like it was a turn around year with aggregate production climbing 1% on the recovery in the U.S. housing industry and the beginnings of a pick up in highway construction. That recovery looks likely to continue in 2013 with the housing industry continuing its climb and with more federal and state money available for highway repair.
The most positive development for the aggregates industry is the number of states that have passed new funding mechanisms for highway projects. The 22 states that have passed bills to increase highway spending—and to fund it include: Virginia ($1.4 billion from 3.5% wholesale tax (indexed to inflation) on motor fuels); Maryland ($4.4 billion from an increase in the gasoline tax); and Wyoming (a 10-cents a gallon increase in the gasoline tax.)
What companies should you take a look at? I’ve got two suggestions.
Vulcan Materials (VMC) is looking at an 8% to 10% increase in sales in 2013 and then a 10% to 12% increase in 2014, according to Standard & Poor’s. With operating margins projected to improve to 8.9% in 2013 and 11.4% in 2014 (from 2.9% in 2012) that should be enough, S&P calculates, to push earnings to 25 cents a share in 2013 from a loss of 48 cents a share in 2012. Earnings will climb to 80 cents a share in 2014. Shares trade at 64 times projected 2014 earnings. Which seems expensive except that the company earned $2.08 a share in 2008 and $4.66 a share in 2007.
Or Martin Marietta Materials (MLM.) The company projects volume to climb 4% to 6% in 2013 and aggregate prices to increase by 2% to 4%. Operating margins, Standard & Poor’s projects, will climb to 13.2% in 2013 and 15.8% in 2014 from 10.3% in 2012. Earnings will grow to $3.30 in 2013, an increase from $2.29 in 2012, and to $4.25 in 2014. Peak earnings per share hit $6.05 in 2007.
In May 2012 a court blocked Martin Marietta’s hostile bid for Vulcan on the grounds that Martin Marietta had improperly used confidential information obtained in pursuing a friendly takeover in its hostile offer. The ban on Martin Marietta’s pursuit of Vulcan expired in September, but so far there’s been no formal announcement of a renewed bid.
This uncertainty has made the two stocks volatile with Vulcan Materials share price reflecting an assumed takeover premium that may not actually materialize. Martin Marietta’s share price has fluctuated with comments from high-profile bears such as David Einhorn about the prospects for a deal. I’m inclined to wait and see what develops. I like the prospects for the aggregate sector but I certainly wouldn’t mind picking up shares of either of these two companies on a temporary drop on merger news.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did own positions in Akamai Technologies as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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