Stella-Jones: Long-Term Contracts Selling Utility Poles and Railroad Ties Add Up to A Predictable, Consistent Compounder that Unfortunately Has to Use Debt to Beat the Market
Stella-Jones mainly provides large customers with pressure treated wood under contractually decided terms. The customers are mainly: U.S. and Canadian railroads, U.S. and Canadian electric companies, U.S. and Canadian phone companies, and U.S. and Canadian big box retailers. Stella-Jones has some other sources of revenue – like selling untreated lumber and logs – that provide revenue but no value for shareholders. The company also has some more niche customers – probably buyers for using wood in things like bridges, piers, etc. – that probably do provide some profit, but not profit meaningful in scale to the categories of customers I mentioned above. The company also sells some stuff that I’d consider more or less byproducts of their main business. Everything they do is clearly tied to either wood or the treatment of wood. Because there is less information about the smallest product categories the company sells and because those categories are either low or no margin or are probably too small to move the needle for making a decision about whether or not to buy this stock – I’m going to pretend Stella-Jones sells only 3 things: 1) Ties to U.S. and Canadian railroads, 2) Poles to U.S. and Canadian electric and phone companies, and 3) Pressure treated wood (for outdoor decking, etc.) to U.S. and Canadian big box retailers.
First, let’s discuss the economics of this business. One: the first two categories – railroad ties and utility poles – are super predictable, because the U.S. and Canada already have basically all the railroad ties and utility poles they’re ever going to need. What these countries need is simply annual replacement of those products. These are long-lived assets. On average: a utility pole can go 65 years before needing to be replaced. Railroads and utilities can defer replacement due purely to age. But, why would they? This isn’t the most expensive form of cap-ex to spend on. Eventually, network performance will degrade if they don’t maintain this stuff. And these are usually very, very creditworthy customers. They don’t have to rely on short-term borrowing from banks. Stella-Jones’s most important customers can all issue long-term bonds to raise the capital needed to fund not only normal maintenance projects but even growth cap-ex. So, there could be some cyclicality here. But, it’s probably a lot less than you’d think. It’s going to be far, far less cyclical than companies like suppliers of newer technology products to utility and telecom customers. It’s going to be a lot less cyclical than suppliers of locomotives to railroads. Although technically Stella-Jones is clearly selling a physical (and pretty much commodity) product to these customers – the economics here are going to look a lot more like they are being paid to maintain something on behalf of their customers. They’re providing a constant supply of replacement parts.
The physical scale of Stella-Jones and their customers is possibly a lot bigger than you might be thinking. What I mean by this is that the company moves a large physical volume of actual wood being sold compared to what you might guess from a company with market cap, revenues, etc. of this size.
I did some back of the envelope type estimating of what a utility pole (basically, what you’d call a “telephone pole”) costs and what a railway tie costs. My best guess was that a utility pole can’t cost more than about $700 to $750 on average and a railroad tie probably does not cost more than $50 on average. If a utility pole costs $700 to $750 on average and lasts 65 year, then the annual spending by a utility on replacing its poles works out to just $11-$12 a pole. For accounting purposes, the Union Pacific (UNP) railroad assumes a 34-year lifespan for its ties. If we assume railroads pay something like $50 to $55 (at most) per tie, we’re talking about $1.47 to $1.62 spent per year per tie. Let’s call that $1 to $2 per tie per year. Of course, I think railroads spend more per tie than that and I think utilities spend more per pole than that – I just think they spend it on stuff like the labor used to remove, replace, maintain, dispose of, etc. the poles and ties.
It’s also worth mentioning that this stuff has to be moved. And it’s not light. So, the location of the wood has to be important in terms of how close the timber is from where it’s going to be treated and then how close the treated wood is from where the customer needs to replace a pole, tie, etc. Stela-Jones includes a map of their facilities. The map looks like what you’d expect to see if a company was siting its facilities near where it was sourcing the timber from. The value of this stuff has got to be low compared to the distances it is traveling. I also think it can’t be all that high versus the labor used by the customer to actually replace its poles and ties once the wood product is on site. So, I don’t think that the cost of what Stella-Jones is charging – setting aside all the freight costs involved – is necessarily as high versus the true cost to the customer as you’d expect with a commodity. The actual “all-in” cost to the customer probably depends mostly on just generally what fuel costs are at the moment (this is the cyclical element of transport costs), the distance the replacement wood has to travel, and the labor and other related costs of removing the old pole, tie, etc. and replacing it with the new pole, tie, etc. The economics for Stella-Jones are a little different. Let’s get into what I think matters most to them.
One, I think it’s important that Stella-Jones be able to pass on inflation to their customers. This is easiest if they have long-term contracts with purchase prices indexed to inflation and where unit demand doesn’t vary much from year-to-year. I think they have this in both utility poles and railway ties. Utility poles are 34% of the company’s sales (and probably more of their profits) and railway ties are 32% of their sales (and, again, probably more of their profits). I don’t think they have this in residential lumber sales (this is selling pressure treated wood to big box retailers). That’s 22% of their sales. It has grown over time. The contracts in that business are short-term (like one year, so not much of a contract at all). And unit demand in that business is more cyclical. Even if it consisted purely of homeowners replacing an existing deck or something – which it doesn’t – homeowners don’t have the balance sheets and rational, long-term outlook that utilities and railroads have. Homeowners are more likely to carry out replacement projects when their confidence is high, their income is rising, home values are rising, they have easy access to credit, etc. It’s a more cyclical business. And, of course, no matter the creditworthiness of the big box retailers – they have no interest in buying a lot of wood inventory they can’t sell this year.
This brings me to what I think are the biggest two determinants of Stella-Jones’s future returns on equity, value creation in the stock, etc. Number one is how much inventory of unseasoned wood the company keeps on hand. Number two is the company’s cost of financing that inventory. It can take up to 9-months to air season the wood Stella-Jones is treating and selling to its customers. This time lag is unavoidable. And the company isn’t going to be able to get its suppliers to extend it more than 9-months of credit to purchase this wood. I say “more than 9-months”, because you have to remember that big utilities, railroads, and big box retailers are going to expect their suppliers – like Stella-Jones here – to extend them some credit. These customers don’t pay in cash upfront. You can see the problem here. It’s entirely possible a company like Stella-Jones could end up owning inventory for as long as 3-4 quarters. That can be very rough from a free cash flow perspective. You need to generate cash to cheaply finance your business. And shareholders need good cash returns on invested tangible assets to drive compounding of the per share value of the stock over time. Stella-Jones has a clear record of compounding its share value, its dividends per share, etc. over time. So, something is working here. But, how?
Stella-Jones borrows money. And I think they have to. They don’t literally have to. The business does generate free cash flow that is perfectly sufficient to finance the company’s growth at rates even faster than the organic growth in the industries they serve. So, Stella-Jones could grow its market share over time and produce a profit for its shareholders every year without ever borrowing. But, I’m not sure Stella-Jones stock can convincingly beat something like the S&P 500 index over time unless the company borrows a bit. Right now, it is borrowing about 2 times EBITDA in net debt. That’s a little on the low side compared to what it’s done in the past. The company has often operated with 2-3 times net debt to EBITDA. Just reading about this company’s business – before getting into how much they are actually borrowing and on what terms – I would’ve told you the right debt load for this company was probably 3 times net debt to EBITDA. I still think that’s true. I have one caveat: the larger the residential lumber business gets, the less comfortable I am with Stella-Jones constantly operating with that much debt. But, if the business was purely one of selling utility poles and railway ties – I’d say permanently targeting a leverage ratio of 3 times net debt to EBITDA would make the most sense.
I’m not sure I’d want to buy this stock if I thought management would operate it without debt. Clearly, management has no plans to operate without debt. But, I just want to make that point here – because, normally, I am writing up a stock where I’d be perfectly happy to own the business if it never used a penny of debt. Here, I think I’d need to feel sure management will use debt. Otherwise, I just don’t think the business will generate enough free cash flow versus the amount of money shareholders have put into the stock to be assured of a good outcome here versus the market. I don’t think you can buy and hold this stock forever and meaningfully beat the market without Stella-Jones using some debt. Which it will. So, this isn’t something to worry about.
But, it does bring me to price. When a company earns relatively low unleveraged cash returns on its tangible invested capital – I think a prospective stock owner needs to be very, very careful about the price he is willing to pay for the stock. Right now, the stock trades at nearly 2 times book value. And some of that book value is goodwill and intangibles from all the acquisitions this company has done. Could it be worth 2 times book value? Or: more than 2 times tangible book value?
Sure. I think it could. In fact, I think that optimally run from a financial engineering perspective – Stella-Jones is worth 2 times tangible book value or more. Still: I’m not sure how comfortable I am paying more than tangible book value for a business that doesn’t actually generate very high returns on its tangible invested capital.
Why am I cautious about that?
Well, Stella-Jones is certainly less cyclical than Monarch Cement (MCEM). They are both extremely durable. Monarch might be a little more durable. But, Stella-Jones might be a little less risky. It faces much less price risk. I didn’t get into that here, but the company is making most of its money under 3-10 year contracts that include automatic price escalations such that close to two-thirds of the company’s business is more like a “cost plus” business except insofar as it has to actually carry inventory. I don’t think a cost plus type business where you have to hold all that inventory is ever going to be as good as a pure cost-plus service business. But, it’s still very good. I think the economics of Stella-Jones are probably better than the overall economics of Monarch Cement. However, I actually don’t know that the economics of Stella-Jones are better than the economics of just the cement plant in Humboldt, Kansas that Monarch owns. I actually think that over a full cycle, the cement plant alone may be a better investment than Stella-Jones. But, I could definitely see how an investor would prefer Stella-Jones over Monarch Cement. And, honestly, at the exact same price-to-tangible book value ratio – I think I’d prefer Stella-Jones to Monarch Cement.
But, we have to ask why? Why would I prefer Stella-Jones to Monarch Cement?
The answer is financial engineering. Which is a fine answer. But, it’s not usually the bet I like to make. I don’t usually like to bet on management achieving good corporate level results for shareholders through making smart decisions about getting a low cost of capital and then making smart capital allocation decisions.
There are really just 2 reasons for preferring a stock like Stella-Jones to Monarch Cement. One: Stella-Jones will use leverage while you own the stock – Monarch won’t. Two: Stella-Jones will continue to acquire more companies in its industry – Monarch Cement won’t. Stella-Jones is obviously the better perpetual motion machine here. The stock is likely to be a better compounder over time than Monarch Cement. However, I don’t think that has as much to do with the actual assets of the business as it does with who is running the business. The strategy at Monarch is extreme conservatism and no expansion. The strategy at Stella-Jones is constant use of debt and constant expansion. In the long-run, I expect Stella-Jones stock to outperform a stock like Monarch Cement. However, I just can’t pay a premium purely on the basis of someone leveraging up a business and acquiring stuff on my behalf. I said this in the Sydney Airport write-up. But, I’ll say it again here. I don’t recommend it. But, if you have a stock portfolio consisting mostly of liquid S&P 500 type stocks and you’re worried Monarch Cement isn’t using enough leverage – you could always borrow against the blue chip stocks you have to finance a stock purchase of Monarch Cement that is done on terms (for you, the shareholder) that aren’t all that different than if you bought the stock outright using cash but it was leveraged at 3 times debt to EBITDA. What I mean is: I think investors tend to ignore the fact one business isn’t using debt and another is in a way they wouldn’t ignore if they were buying one stock on margin and another without using margin.
At the same price-to-book, I’d definitely prefer Stella-Jones over Monarch Cement. At the big premium at which Stella-Jones now trades, I think I’d pass on the stock for now. I’m not sure if that’s wise. But, I think I can find other businesses that will produce similar returns – as stocks – to Stella-Jones while using zero debt to do it.
Geoff’s Initial Interest: 50%
Possible Revisit Price: 19 CAD (down 52%)