There is much talk of bubbles in the stock and real estate markets due to the extraordinarily accommodative monetary policy of the past 7 years. It would be natural to see excesses in real estate given it is normally heavily financed and therefore linked to interest rates. Although the bubbly storyline may sell papers and increase viewers, is it the correct outlook today? In this write-up, I will provide a simple analysis of the construction data to show the real estate market has recovered from a deep recession, but is only back to ‘normal’ recessionary levels of activity and far from excessive levels characteristic of a market top. Finally, I offer Apogee (APOG) as an attractive investment because it sells architectural glass and therefore levered to construction activity.
CONSTRUCTION PERCENTAGE OF GDP
Construction accounted for 3.7% of GDP in 2014 up from the cycle low of 3.5% in 2011, but still well off the high of 4.9% in 2007. Construction drives growth in many small businesses needed to start and complete real estate projects. Taking a high level view of the construction market through the permits, starts and completions data shows the current level of activity has recovered from a deep recession but is only back to ‘normal’ recessionary levels. Activity could continue to increase by 50% before reaching levels characteristic of past market tops.
Permits are currently 1.1 – 1.2 million on a seasonally adjusted annual basis. Peaks in the early-70’s and mid-00’s had permits well above 2 million. During peaks in the late-70’s and mid-80’s permits ranged between 1.6 – 1.8 million. Permits have recovered from trough levels below 1 million where they hovered from years following the financial crisis, but still have plenty of headroom before approaching frothy territory. In the graph, I have the level of permits represented by the bars and permits-divided-by-population represented by the line and corresponding to the right axis. Currently, the U.S. issues 3.6 permits annually per 1,000 people.
Permits may represent a project about to get underway, but also may be just an idea with little conviction or intent to follow-through. Starts and completions give a better idea of current construction activity taking place.
Starts, like permits, are also between 1.1 – 1.2 million, a level consistent with previous troughs in the late-60’s, mid-70’s, early-80’s and early-90’s. Following the financial crisis, the level of starts dropped below 600,000 and maintained this level much of the time from 2008 - 2011. The level of starts has plenty of room to run above 1.6 million before reaching levels associated with excess. Currently, the U.S. has 3.6 starts per 1,000 people.
Completions are lower than starts and permits, currently just 900,000 – 1 million, This level is well below the trough levels of the early-80’s and early 90’s. Adjusted for population, the U.S. is completing 3.1 homes per 1,000 people. So construction has plenty of dry powder in my opinion. I doubt we’ll come out of a deep recession and just reach back to levels still low by historical standards. I believe it’s more likely the construction market will run for several more years to much higher activity levels. Therefore, I view construction as still in the early stages of recovery.
Another construction metric is the number of people employed in the industry. Today, the construction industry employs 6.3 million people, the same amount of people as 1998. That’s not a bubble. Sounds more like depressed levels to me.
APOGEE LEVERED TO CONSTRUCTION ACTIVITY
This brings me to my stock, Apogee. I have been looking for stocks levered to the U.S. construction market, because I believe construction is one of the stronger parts of the economy and more importantly, still in the early innings of recovery. Apogee fabricates architectural glass windows. Demand for architecture windows has been on the rise with most commercial and residential towers made of a glass exterior. Apogee is the best pure play in the architectural glass space.
LOWERED REVENUE GUIDANCE
Apogee lowered FY16 revenue guidance when reporting 2Q results. This triggered the recent selloff of the stock. Apogee explained some window installations were delayed, pushing revenue out of the second half of FY16 into FY17. The stock had a 20% selloff on this news, and I view this as an overreaction. The revenue has not been lost, rather it has been shifted out a couple quarters. Therefore, I believe the 20% selloff offers an attractive buying opportunity.
Apogee forecasts FY18 (calendar 2017) revenue to be $1.3B which is a 12.3% CAGR from the trailing twelve months revenue of $972M. Apogee forecasts operating margin will increase to 12% by FY18 from the current 9.3% level. Assuming $50M of capex, implies $88M of free-cash-flow. The current market cap of $1.36B is a 15x multiple to FY18 FCF. The high-performance flat glass market is forecast by Freedonia to grow 8.2% annually to $9.2B by 2017. Apogee’s FY15 revenue growth is 21.1%. Apogee has a high share of the architecture glass market, and I view their forecast for 12.3% growth as realistic.
Apogee is levered to the construction market. Construction activity is strong, and I expect it to strengthen further. This means Apogee is well positioned to benefit from high market share of an architectural glass market growing at around 3x GDP growth. The valuation is consistent with the growth prospects of the business.
The S&P's earnings, measured on a trailing twelve month basis, are expected to bottom out this quarter (Q3) down -6.1% from the peak of Q3 2014. The pullback in earnings has spread from the energy sector to materials and staples. Health Care, Technology and Consumer Discretionary Sectors have faired the best without a single down quarter.
The graphs below show the reported and expected earnings of the S&P and selected sectors. This graphic representation makes clear the fact that the economy is partly in recession and partly quite resilient. The performance of the sectors roughly follows their earnings path. The Energy and Materials Sectors down the most while Discretionary and Health Care are up.
Will earnings growth return to the S&P in Q4? The market expects Q4 earnings to be up 14.9% on a year-over-year basis. Q4 would be the first quarter of earnings growth since Q3 2014.
My outlook is for a slow reversion of the weaker sectors back toward growth. I don't see a strong snap back occurring given the current over capacity situation in nearly every commodity. I do expect the strong sectors to remain strong, particularly consumer discretionary. The one thing that would disturb me from my bullish view is if the U.S. consumer starts to show signs of weakness. This is what I am keeping my eye as an indicator the market might have further to go on the downside.
Original Blog Post
Michael Grove, CFA