US Stimulus: American Waste And Beguilement Plan

There has been a lot of hype about the Obama stimulus package scheduled to complete its course through Congress in mid February. There is no doubt the economic plan will provide some sort of relief to a contracting domestic economy, but given the multiples of some of the popular construction materials companies, you would think this would not only address our economic problems, but also launch the economy back into full swing. I am skeptical how much this stimulus plan will actually affect the economy, America’s global competitiveness, and more relevant in this sense the bottom lines of construction materials companies within the Materials sector. When looking at what Obama has announced as his priorities, I believe many investors will be sorely disappointed at the lack of stimulus this package really provides.

The price tag for the economic stimulus package is exceeding $800B. Much of this will go to social security, food stamps, and health care spending. In reference to infrastructure spending, approximately $90B will be spent on specific projects while various accounting principles are temporarily adjusted to the benefit of companies. To break down infrastructure even further: $30B is slated for transportation spending, $31B allocated for the construction and repair of federal buildings, $19B in water projects, and $10B in rail and mass transit projects.

The adjustments of accounting principles are as follows: companies will now be able to claim tax credits from the past five years instead of the past two effectively decreasing the income tax expense that companies will realize on a yearly basis. Bonus depreciation will be used for certain assets of specific construction companies. Lastly, construction companies will be able to double the write offs for their capital investments.

As for the rest of the American Recovery and Reinvestment Act, $275B will be spent on tax cuts ranging from $500 to possibly $8,000. Education investments total $141.6B focusing on local school districts, and the modernization and repair of higher education. Welfare and unemployment spending consists of a walloping $102B of which $20B is food stamps. Finally, the energy portion, a total of $58B,  focuses on stemming growth in the renewable energy segment through $20B of tax cuts and $32B for funding an electric smart grid. I want to mention that I don’t believe this package is all bad, I’m in favor of the education and energy spending, but I don’t believe this will have the speculated results on the bottom lines of Materials stocks that are currently being priced in by the market.

President Obama has mentioned numerous times that he is focused on combating unemployment, and keeping families in their homes. “Spending is the whole point of a stimulus” and by providing Americans with work on America’s infrastructure we can begin the arduous climb back to economic expansion. However, the projects highlighted will prove to be little more than window dressing for the economy.

There was approximately $300B spent on infrastructure in 2008. So all things equal, the stimulus package represents approximately a 30% increase in spending, but spending is clearly not forecasted to be equal this year. According to the National Association of State Budget Offices (NASBO) general state fund expenditures are expected to be down 4.1% on a real basis after $12B of budget cuts. A report from Keybanc Securities believes governmental infrastructure spending could be down between 4% and 8% in absence of a 2009 stimulus package. So with these facts in place already a portion of the stimulus package is being used to replenish scrapped capital projects instead of reviving America’s infrastructure as advertised.

In regards to other scrapped spending plans, an important piece of legislation called the SAFETEA-LU, or New Freedom Program expires in September 2009. The New Freedom Program is geared towards the support of new public transportation services and public transportation alternatives. Approximately $40B was spent on transportation under this program last year. Now what is the likelihood of this legislation being renewed seven months after an unprecedented spending plan is passed in congress which has already been criticized by both parties for its price tag?  You can do the math.

So to make a quick recalculation with me, $300B was spent on infrastructure in 2008. We will project a 6% drop in spending so that total projected spending for 2009 is now $282B. Now lets assume that the SAFETEA-LU legislation is not renewed in September, now we are looking at $242B. Add in the stimulus package and the total is $332. What started as a 30% increase infrastructure spending has been downsized to a mere 10.67% increase, not quite as revolutionary when you put it that way.

Another important point to keep in mind is that President Obama has placed increased pressure on Congress to complete the bill, but I would be hard pressed to see anything but the usual delays that occur with major pieces of legislation. Just take a look at the recent bickering of Republicans and Democrats on the auto bailout. The age-old ideological differences remain in tact. Who can spend your money better, you or the government? As for the timelines of the projects themselves, typical capital projects span over 2 to 4 years. However, this is not consistent with the Obama initiative. Jobs need to be created now.

The American Association of State Highway and Transportation Officials (AASHTO) has identified 5,000 “ready-to-go” projects which by definition means they can be started in 180 days or less. The U.S Conference of Mayors has identified 15,000 similar projects. Based of past infrastructure spending, most RTG projects usually include road resurfacing, and lane additions. This is probably not what the American public was expecting. Let’s assume that the bill is passed and completed in late Februaryor early March. Approximately half of the AASHTO projects should be completed by 2009 ($45B). Then include the regular stimulus spending including forecasted declines ($242B). This totals $287B which is actually decline of 5% decline in total construction. Infrastructure spending will not increase year over year with the stimulus package included.

When looking at the EV/EBITDA ranges of some of these companies compared to the earnings expectations their common stock prices seem a little out of kilter. Below I have highlighted some numbers from a recent Keybanc Securities industry note released in late January of the two companies most likely to benefit from this plan.

Vulcan Materials (VMC)

Forward P/E Ratio: 29.8x

2009E EPS: $1.75

Forward Trading Range: 14x - 18x

Implied Earnings: $3.74 - $2.91

Forward EV/EBITDA Ratio: 10.7x

2009E EBITDA: $850

Forward Trading Range: 6x - 9x

Implied EBITDA: $1,535 - $1,023

Martin Marietta Materials (MLM)

Forward P/E Ratio: 20.6x

2009E EPS: $4.00

Forward Trading Range: 14x - 18x

Implied Earnings: $5.89 - $4.58

Forward EV/EBITDA Ratio: 9.2x

2009E EBITDA: $498

Forward Trading Range: 6x - 9x

Implied EBITDA: $763 - $509

The numbers above are more attuned to the 30% increase in spending previously advertised, but once investors catch on to the reality of the situation these stocks will plummet. Increased volumes for these companies will be incremental in nature (5% or less) and sooner rather than later their stock prices will have to come back in line with their valuations.

With these numbers in mind, it’s pretty clear what to do with this sub-sector. Short these stocks immediately! If you are looking for some real stimulus in the economy, focus on unemployment, inventories, housing starts, and CPI as determinants of a market recovery. It’s human nature that we all prefer easy solutions to our problems, but let me assure you that this stimulus package is not one of them.

Disclosure: None

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Comment by Wayne Moore

2009-02-12 15:06:13

In addition to the massive spending and individual tax cuts, the value of which could be debated forever, a stimulus package needs to cause broad business investment for recovery and growth. A week ago I sent my 5-page recommendation to the White House and to key Democratic and Republican Congressional leaders via UPS overnight letter. The first and fourth recommendations would be opposed by the GOP; the second and third recommendations would be opposed by the Democrats. However, all four taken together would actually stimulate the U.S. economy and would require the bi-partisan compromise that I believe Obama and the American public want. In summary, the four recommendations were:

1. Discourage executive compensation excesses by a change in IRS Code Section 162(m) that uses a ratio to median company pay and by adding SEC rules requiring full and easily accessible disclosure (transparency).

2. Make American firms more competitive in the global market by reducing corporate income tax rates to a level near the lower end of the middle range of OECD nations.

3. Make corporate dividends paid to shareholders deductible for corporate income taxes.

4. Pay the cost of the corporate tax reduction and dividend deductibility by:

a. Eliminating the special tax treatment of dividends and capital gains enacted in 2003.

b. Imposing a 35% corporate excise tax on excess compensation beyond the new Code Section 162(m) limit, in addition to it not being deductible for corporate income taxes.

A corporate income tax rate reduction from the current 35% to about 24% would place U.S. corporations in a far better position for competing in the global marketplace - it would place U.S. companies in the lower middle range of industrialized nations instead of at the top end – THIS WOULD CREATE JOBS! During Monday night’s press conference, the phrase “attracting private capital” was repeatedly used by President Obama. This could be accomplished quickly with a corporate tax rate reduction AND allowing dividends to be deductible by corporations. A major reason that the financial crisis is impacting investment is the fact that the interest paid on debt financing is tax deductible, while dividends paid on equity financing is not. This has also created some of the present Wall Street problems. The investment mindset is now oriented toward appreciation of investment rather than true return on investment, driven by the tax code bias that taxes dividends twice. I would be willing to give up the 2003 individual tax cuts (Item #4) as a way to pay for these changes (I am retired and nearly all my income is from investments).

This would probably have to be separate legislation. Do you think the Average Joe would support or oppose this type of tax change? What about elimination of the special tax treatment of dividends and capital gains enacted in 2003 (which benefit individuals) as a way to pay for the corporate tax cut?

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