Momentum Play: Valmont Industries (NYSE: VMI)

When you think business in Omaha, Nebraska, Warren Buffett’s Berkshire Hathaway comes first to mind. But there are other outstanding businesses headquartered in the Gateway to the West, including Union Pacific, ConAgra Foods, and TD Ameritrade. None of the four stocks mentioned so far qualify as small or mid-cap (i.e., below $10 billion), but a fifth one does: Valmont Industries, which sports a market cap of only $3.8 billion.

Valmont is an industrial conglomerate that operates in four main segments:

• Electric Utility Structures (29% of both sales and income) —  power transmission, power distribution, power substation
  
  
• Engineered Infrastructure (27% of sales, 12% of income) — outdoor lighting and traffic control, wireless communications towers, roadway safety (barriers, fences, workzone & traffic control), and industrial access structures (e.g., handrails and grates). 
  
  
• Irrigation Systems (25% of sales, 32% of income) – Pumps and sprinklers for focused distribution of water, fertilizer, and pesticides.
  
  
• Metal Finishing (9% of sales, 16% of income) – Galvanizing and powder coatings for weather resistance.

Valmont’s top-three businesses benefit from the sweet spot of major economic trends:

• Aging and obsolete electric grid in North America

According to the American Society of Civil Engineers (pp. 6-7), the amount of investment in electricity infrastructure that is needed for repair and growth totals $107 billion by the year 2020 and $732 billion by the year 2040. America’s report card for energy infrastructure in 2013 is a miserable D+.

The world will consume twice as much electricity in 2030 as it does today (slide no. 10). Right now, 1.6 billion people in emerging markets live without any electricity. Worldwide, an estimated $606 billion will be spent on electricity transmission infrastructure during the decade 2010-2020.

• Road transport infrastructure requirements

According to the Organization for Economic Co-operation and Development (OECD) (p. 186), between $220 billion and $290 billion of investment in surface transportation is needed globally per year between 2010 and 2030. This is due to global population and economic growth, as well as increasing vehicle ownership in emerging markets and rising per capital roadway miles driven in developed economies.

• 4G wireless expansion due to increased usage of smartphones and tablet computers

According to the Paragon Report, global capital spending on 4G/LTE infrastructure will nearly triple in a single year, growing from $8.7 billion in 2012 to $24.3 billion in 2013.

• Irrigation equipment feeds a hungry world that lacks sufficient water

According to the Food and Agriculture Organization (FAO) of the United Nations (p. 208):

A very small proportion of the planet’s water is available for human use. Of the 2.5 percent of the world’s water that is freshwater, more than two-thirds is locked in glaciers, ice caps and permafrost, about one-third is groundwater. The remaining 1.3 percent of the world’s total freshwater is surface water in rivers, lakes and swamps and in other forms such as ice and snow. 

Of this 1.3% of available freshwater, 70% is used for irrigation, 20% is used for industry, and only 10% is used for drinking water. With water use growing at twice the rate of population growth, it is critical for human health that countries devise ways to irrigate crops more efficiently by using less water. Right now, 84% of all global irrigated acres utilize the grossly inefficient “flood” method. Whereas less than half of the water used in flood irrigation actually benefits crops, Valmont’s “center pivot” irrigation equipment achieves a 98% efficiency of water usage.

With these mega-trends of global infrastructure investment acting as huge tailwinds for any company involved in providing the infrastructure, Valmont almost can’t help but make significant profits in the years ahead!  Based on historical data, Valmont is quite adept at making money and increasing its share price. Since 1993, investors in Valmont have enjoyed a compounded annualized return of 17.6% — 2.6 times greater than the 6.6% annualized return of the S&P 500 over the same 20-year period. In fact, an investment in Valmont has beaten the S&P 500 over the past 15, 10, 5, and 3-year periods as well:

 Valmont Outperforms Over the Long Term

Source: Bloomberg

Growth and profitability have been stellar as well, with earnings per share increasing at an annual clip of 20.4% over the past ten years and revenues up 13.5% annualized. Return on equity (ROE) is currently 21.4% and has been above the 20% level in five of the past six years. Debt is reasonable at only 26% of total capital and the company has zero “net” debt ($491 million in cash is larger than $488 million in debt).

The good times keep rolling. Second-quarter financials were excellent, with earnings up 48% and sales up 15%, both beating analyst estimates. Record highs were reached in quarterly sales and operating profit margin. Every business segment reported sales growth, with the irrigation segment the largest gainer. In April, Valmont raised its dividend by 11.1%, marking the 12th consecutive year that the dividend has increased.

Irrigation appears to be the most important growth-driver looking forward as well. The 2012 U.S. drought underscored the importance of efficient irrigation and has continued to spur sales. Internationally, food and potable water demand will also continue to spur sales, with Brazil and Argentina very strong markets for Valmont’s irrigation products right now. Although farm equipment analysts have voiced concern that lower food prices and a significant shrinkage in U.S. tax incentives will cause farm equipment spending to decline throughout 2014, one of the few exceptions is spending on irrigation equipment, which is expected to continue growing. According to an August 30^th report from Blueshift Research, irrigation equipment will be “exempt from the sales decline and remain in high demand.”

In the conference call, Valmont CEO Mogens Bay said that Europe is the weak spot, but the company has done such a masterful job with cost cutting and restructuring that even in Europe all of Valmont’s businesses are profitable. The company expects full-year earnings to exceed $11.00 per share. At the stock’s current price of $140.50, that’s a P/E ratio of less than 13! Mogens Bay is a great CEO and was recently inducted into the Omaha Business Hall of Fame.

On August 2^nd, Moody’s upgraded Valmont’s investment-grade debt to Baa2 from Baa3. The rationale for the upgrade is very complimentary, citing Valmont’s “leading position in its core markets”:

The Baa2 rating incorporates Valmont’s durable capital structure, multi-segment revenue base, consistent profitability and favorable industry fundamentals underlying the majority of the company’s key end markets. Valmont generates solid operating results on top of a fairly conservative balance sheet which has produced modest leverage and good coverage metrics. Although its principal operating segments have discrete business cycles and demand drivers, the portfolio of basic manufacturing activities along with its geographic footprint have produced beneficial aspects of diversification as their respective cycles have exhibited limited correlation. Moody’s believes the long-term demand fundamentals for global infrastructure and irrigation investments, driven by population growth and the scarcity of fresh water worldwide, will sustain modest expansion.

Despite the company’s high profitability, strong growth, and reasonable debt levels, Valmont Industries remains inexpensive with an EV-to-EBITDA ratio of only 7.0 and a price-to-earnings ratio below its five-year average earnings multiple of 15.4. Valmont Industries appears to be a rare opportunity to buy a growing and profitable company at a bargain-basement price.

Valmont Industries is a buy up to $155; I’m also adding the stock to my Momentum Portfolio.

Value Play: Stewart Information Services (NYSE: STC)

The home mortgage market may have caused the global financial crisis in 2008, but that is so . . . yesterday! Today, the housing market has come roaring back and is expected to remain strong for years to come. Consider the following data points:

• August existing-home sales increased to an annual rate of 5.48 million units, the highest level since February 2007 (a 6½ year high)  
• August new-home sales were up 7.9%, the largest monthly gain since January.
• July home prices rose 12.7% year-over-year, the largest gain in seven years.
• August homebuilder confidence highest in eight years.

The rise in long-term interest rates (including home mortgage rates) since May has not stopped the housing juggernaut for two main reasons: (1) mortgage rates were so low to begin with that they remain very reasonable (4.5% for a 30-year fixed) even after the recent increase; and (2) the economy continues to recover, providing potential homebuyers with the employment and income needed to afford a home.

Homebuilders are reporting very strong quarterly earnings. In conjunction with the release of third-quarter earnings on September 24^th, CEO Stuart Miller of Lennar – the 3^rd largest U.S. homebuilder — stated:

We continue to see long-term fundamental demand in the market driven by the significant shortfall of new single-family and multi-family homes built over the last five years. While there may be bumps along the road that may impact the short-term pace of the recovery, the long-term outlook for our business remains extremely bright.

Fears that the housing market is in an unsustainable bubble ready to pop are unfounded. Yale economics professor Robert Shiller, who correctly called both the stock-market bubble of 2000 and the housing-market bubble of 2007, recently wrote that the current housing market is not in a bubble despite the fact that U.S. housing prices have risen 18.4 percent in real, inflation-corrected terms in the 16 months ending in July:

In summary, Americans are still relatively sober about housing. They aren’t showing “irrational exuberance” about home investing to the degree they did in the past, at least not yet.

New York Fed president William Dudley, in explaining why he voted to delay tapering monthly bond buying under the Federal Reserve’s quantitative-easing (QE) program, noted that one of the economic bright spots was the housing market:

Another sector in which the fundamentals have improved is the housing sector.  Most importantly, the excess supply of housing created during the boom appears to have been largely worked off.  As a result, house prices are now rising in most areas of the country and homebuilding activity has strengthened.  Moreover, there is further scope for gains in homebuilding.  After all, the current annualized rate of housing starts—around 900,000—is considerably below the rate consistent with the country’s underlying demographic trends and the expected long-run rate of household formation.  By these metrics, housing starts should ultimately climb back to about a 1.5 million annualized rate.

This housing optimism coincides with the views of Goldman Sachs, Mr. Dudley’s former employer:

Over the medium term our confidence in the basic math of recovery remains high. In the near term, some further reductions in excess supply are likely, but the 2-3 year outlook is still a big increase in housing starts from the current 900k level.

Given the likelihood that the current good times for housing are not a fluke but a long-term, sustainable trend, an investment in a small-cap stock that benefits from the housing market appears to be a good idea right now.

My housing pick is Houston-based Stewart Information Services, a 120-year-old real-estate business founded in 1893 that is still owned and managed by the founding family. As I wrote in Founder CEOs Are the Best Leaders of Small-Cap Companies, I am attracted to the passion and long-term focus of founding families that love their companies and wouldn’t do anything to jeopardize their future success in order to make a quick buck. Stewart CEO Matt Morris is a fifth-generation member of the founding Stewart family to run the company. The Morris/Stewart families collectively own about 95 percent of the company’s Class B shares (page 3), which are given the exclusive right to elect four of the company’s nine-member board of directors. Beneficial insider ownership (economic interest as opposed to voting power) is around 3% of total shares outstanding.

Stewart started off as a title insurance company that focused on performing the due diligence necessary to ensure that real estate being sold was owned by the purported seller and did not have any undisclosed property liens that diminished the value of the property. In addition, the company provided escrow and settlement services to facilitate the actual sale of the property. Although the company’s title-insurance business is focused on the U.S. market, Stewart has earned the #1 market share in Canada.

Over the years, Stewart has expanded into several types of mortgage outsourcing services, including evaluation of the riskiness of individual mortgage loans and mortgage-backed securities for lenders and investors, mortgage loan modification, post-closing support, and foreclosure/short-sale consulting. Non-title services (i.e., mortgage services) now account for 13% of total revenues and the corporate goal is to achieve 25% non-title revenues within five years (slide no. 9). Title insurance is subject to state rate regulation, so profit margins are limited. The good news is that the state of Texas raised title insurance rates for the first time in 22 years, but Stewart wants more exposure to non-rate-regulated businesses. Only about 35% of Stewart’s mortgage-servicing business is related to refinancings – compared to 70% on average for its competitors – so higher interest rates and the likely reduction in refinancing work will not hurt Stewart anywhere near as much as most of its competitors.

In 2012, the company was honored by Forbes Magazine as one of America’s 100 “most trustworthy companies” and generated the highest growth in earnings per share of any of the 100-largest publicly-traded companies in the Houston metropolitan area, according to the Houston Chronicle. This excellent performance was good enough to get Stewart added to the Barron’s 400 Index, which measures the performance of “the most fundamentally sound and attractively priced stocks.” Only six percent of all North American publicly-listed companies make the cut and the index has outperformed the general market by more than five percentage points per year over the past decade.

Stewart is a company in the later stages of a complete transformation that has greatly improved profitability and growth prospects. As CEO Morris stated at a June investment conference, the Stewart of today is a much-improved version of its former self:

I think the real story of Stewart has been the transformation that we’ve undergone over the last several years. And I think the results we’re seeing now in incremental improvement in our margins, more focused direction is really what is creating some interest in the stock and building some trust with the investment community.

Historically, Stewart has been a very decentralized, almost a parent company operating model, causing a lot of duplication. Our company was organized by geography in nine regions, each region operated independently known for different things, and we embarked several years ago really to become more of an operating company and pull all the back office functions together in a centralized, shared services environment, consolidate hundreds of legal entities, accounting systems, data centers, etc.

After we really took a lot of the efficiencies on the back office away, we really started focusing on front of house and reorganizing our business lines by customer segment and by channel rather than geography. And what this allowed us to do is be much more deliberate in our strategies around what our reputation and presence would be in the various markets that we would serve. We’re probably 85% of the way through this transformation.

Given this transformation, I’m not concerned that the company’s financial performance over the past decade has been spotty. For the four fiscal years from 2007 through 2010, the company lost money each year, but earnings have come roaring back under the corporate restructuring and the improved housing market:

I believe the current state of high profitability is not only sustainable, but capable of significant growth under CEO Morris, who is largely responsible for the recent successful restructuring. One exciting area of future growth (besides mortgage services) is expanding title insurance services to the commercial real-estate sector. The title work for a commercial transaction is virtually identical to the work for a residential transaction, but commercial transactions involve much-larger dollar amounts so receiving a profit percentage based on commercial work is much more profitable than residential work. CEO Morris has stated that commercial title work would generate “huge incremental margin to the bottom line.” Up until recently, Stewart has been constrained from winning commercial title business because its insurance rating has been below A, but in August Fitch Ratings upgraded Stewart’s insurance rating to A- from BBB+. This insurance upgrade promises big profit improvements for Stewart in future quarters.  Fitch’s reasons for the rating upgrade are very positive:

Fitch’s upgrade of Stewart’s ratings reflects a continued improvement in operating results, sustained solid capitalization, and increased reserve stability. The ratings also reflect strong debt servicing capabilities as a result of low financial leverage and solid earnings. Fitch believes pretax profit margins will remain attractive near 20% and will be further boosted by significantly improved title insurance margins.

Despite the company’s high profitability and a debt-to-capital ratio below 5%, Stewart remains extremely inexpensive with an EV-to-EBITDA ratio of only 3.4 and a price-to-earnings ratio below six times. Curiously, the company’s short interest-to-float ratio is elevated at 13%, which suggests some skepticism either about the housing recovery and/or the sustainable success of Stewart’s corporate restructuring. I’m confident about both, so I view the high short interest as a positive catalyst based on a possible short squeeze in the not-too-distant future.

Stewart Information Services is a buy up to $36; I’m also adding the stock to my Value Portfolio.