I’ve been doing a lot of driving over the past couple of weeks. Two things I’m certain of: 1) there is a lot of road construction; and 2) I’m not going long corn as this year’s crop looks very healthy! The first point (a lot of road construction) is good news for Astec Industries, Inc. (ASTE), a market leading manufacturer of road building equipment. Founded in 1972, Astec’s products are used in each phase of road building.
While earnings season so far has been mixed to soft, Astec’s quarter stood out and showed strong growth. Sales increased 10% and EPS increased 55% to $0.79. Backlog improved considerably as well, up 59% to $365 million. Astec is benefiting from the passage of the 5-year $305 billion Federal Highway Bill that was signed by President Obama in December 2015. The passage of the highway bill provides some certainty for Astec’s customers and should benefit Astec’s operating results over the next few years.
The last time Astec’s customers had this type of visibility was after President Bush signed the Safe Accountable, Flexible and Efficient Transportation Equity Act in 2005, which authorized $286.5 billion in funding for federal highway and transit programs through September 30, 2009. Astec’s business performed well during this period as earnings per share (EPS) grew from $1.34 in 2005 to $2.80 in 2008. The program ended in 2009 and was replaced by month to month appropriations. Astec’s business suffered considerably once government funding certainty was replaced with uncertainty – EPS fell to $0.14 in 2009. Astec’s stock collapsed from its high of $57 in 2007 to $22 at its low in 2009.
In the current earnings environment of slow to negative growth, investors are willing to pay a very high price for above average growth and certainty. As investors stampede into anything with growth, Astec’s stock has benefited and is up 58% to $61 (all-time high) over the past year. The sharp increase in its stock price has driven Astec’s P/E ratio to 40x. At such an expensive valuation, investors are most likely valuing Astec based on its future earnings estimates. As earnings continue to increase, EPS could reach mid $2’s later this year and low $3’s later next year. I believe these earnings expectations are reasonable and are not too different from its last earnings cycle peak of $2.80/share.
In addition to being an example of investors’ eagerness to pay a high price for growth and certainty, I believe Astec is a good example of the growing use of peak earnings to value businesses. In Astec’s case, investors are valuing the business not only on peak earnings, but on peak earnings that have yet to occur (an even more aggressive valuation technique).
Although I believe Astec will generate healthy earnings growth over the next two years, a lot of this growth is cyclical, or growth coming off depressed earnings. In my opinion, given Astec’s valuation, investors are valuing the business as if recent growth is sustainable, not cyclical. The fact of the matter is Astec is a cyclical business. There’s nothing wrong with this, but extrapolating cyclical growth and valuing it as sustainable growth is another one of my top ten investment commandments – Thou Shalt Not Extrapolate Cyclical Earnings Growth.
Uncertainty and volatility in government funding is one of the reasons Astec’s business is cyclical. A large portion of Astec’s business is tied to government spending and is reliant on politicians coming to an agreement. Although funding can become tight during economic downturns, I believe during the next recession politicians will agree on providing fiscal stimulus. Furthermore, to fund the stimulus, I believe both parties will prefer the voter-friendly option of printing money, versus the more difficult decision of raising taxes or cutting spending. Therefore, I wouldn’t be surprised if helicopter monetary policy comes to the U.S. during the next recession – directly funding aggressive fiscal spending with monetary policy/money printing.
Unlike Japan, which may simply print money and hand out checks, I believe if helicopter drops come to the U.S. the majority of it will be project-based, such as spending on public projects such as improving roads and bridges. While I don’t agree with policy solutions that rely on getting something for nothing (money printing), I suppose a government induced bubble in infrastructure is better than what we received during the last cycle of malinvestment. After the housing/mortgage bubble popped, we weren’t left with much except for trillions of bad debt and millions of new granite countertops!
If helicopter drops are used for infrastructure and investment I suspect companies like Astec will benefit. Unfortunately, in my opinion, potential benefits have been priced in Astec’s shares, especially if using normalized earnings for valuation purposes, not future peak earnings.