The Rising Cost of Materials and Its Impact On Valuations

Even before Hurricanes Katrina and Rita hit the Gulf Coast in September, basic materials prices had been rising for many construction inputs. Cement prices had increased 4.4 percent, steel 4.5 percent, and 12-inch reinforced concrete pipe 7.6 percent year over year as of September 30. The increase for PVC was more pronounced, with record high oil prices and strong demand in the residential housing sector sparking a 13 percent rise in six-inch PVC water pipe prices over the same period. The PVC increase in September alone was 2.1 percent. Gypsum drywall, ready-mixed concrete and steel prices are projected to continue increasing in to next year before a possible easing.

At the same time, overall demand for construction materials is projected to grow as construction activity increases. While the residential housing boom is expected to slow somewhat, the level of residential building activity was running 12 percent ahead of last year’s record pace through the first seven months of this year. According to Robert Murray, chief economist for McGraw-Hill Construction, total construction starts for the U.S. are still expected to rise about six percent in 2005, even with the near-term loss of new construction in the Gulf region. He feels “the major uncertainty relates to the price and availability of building materials, which means in the near-term that the construction industry will continue to adjust to a higher cost structure.”

This projection is bolstered by various recent surveys of owners and construction managers. Residential costs are expected to rise 10 percent to 15 percent in the impacted region and five percent to 10 percent nationally over the next two years. Nonresidential costs are projected to rise five percent to 10 percent locally and five percent nationally.

The speed with which material suppliers are able to repair manufacturing and distribution channels in the region, such as shuttered cement operations, will affect these estimates. Also, labor costs are expected to rise in the region and nationally as workers and management are attracted to the area and manpower supply is stretched nationally as a result.

These rising costs, coupled with increasing oil and gas prices and passage of the SAFE-TEA highway bill, as well as the overall increased levels of construction activity and expected re-building efforts in the Gulf, have various implications for valuations of both publicly traded and privately held engineering and construction companies and material supply firms. In comparing the change in share prices of public firms from June 30 to September 30, 2005, one can see the run-up in the value of these firms. We track five groupings of engineering, construction and material supply/building products firms as noted in the tables below. The median third-quarter share price change across engineering and construction firms was 26.6 percent, while the median change for material supply/building products firms was 19.2 percent.

While these prices have eased somewhat since September 30, overall earnings multiples are higher across the sector year over year.

So, what does this mean for the valuation multiples (the value of a given company stated as a multiple of its earnings) of industry firms? In reviewing this data and purchase price multiples for acquisitions made in the space in the past two years, we observed the following:

• Larger public firms (“strategic buyers”) presented the best source of capital for a smaller firm when it comes to options for an owner looking to exit his or her business at a time of perceived higher values and optimism. The larger strategic buyers have had a more valuable currency in their shares, more cash on the balance sheet in general, and better access to borrowing capacity that can be used to finance acquisitions.
• Higher multiples have been paid recently for engineering and construction firms that have a “niche.” That is, proprietary skill sets or technology that can provide an edge to a larger firm. Specific recent areas of interest include oil and gas, water, environmental services, governmental services and facilities maintenance.
• Historically, potential buyers consider how “exposed” a particular firm is to fluctuations in energy costs, base material prices, transportation costs, supply surcharges, etc. when valuing a potential acquisition. Hedging against such increases with supply agreements, forward purchasing arrangements, third-party hedge contracts or other such instruments has been considered favorable when a firm is valued by an outside party.
• For material suppliers, larger firms, again with strong stock currencies and stronger balance sheets, have been willing to pay a premium for aggregate reserves, niche building products or strong distribution channels, especially at the wholesale level.
• Private equity buyers have had an impact in the building products and materials space, where higher growth rates and better access to borrowing capacity have attracted interest. Increasingly, these firms are playing a role in ownership transition in the engineering and construction space as well.

In summary, construction material and building products cost increases were already impacting industry firms before the hurricanes in the Gulf. Katrina and Rita exacerbated this situation, pushing costs up greatly in the past two months. Share prices and valuations of publicly traded design, construction and material supply firms responded in kind, due to a variety of factors. This may represent an opportune time for owners to assess their strategic alternatives in light of this increase in valuations. Overall, in spite of rising costs, many industry sources believe that opportunities are available for firms in the greater construction industry.