U.S. Lime (USLM): A High Longevity Stock in a Low Competition Industry
This is the second article in my new approach to writing for Focused Compounding each week. I will give you a look into my initial thoughts on a stock that I may then research further. At the end of this article, I will tell you my interest level (0% means there’s no chance I will follow-up with additional research on this stock; 100% means it’s already at the top of my research pipeline). This is my first article on U.S. Lime & Minerals (USLM). So, the question I have to answer here is not “should I buy the stock”, “what is the stock worth”, etc. Right now, the question is simply: should I research USLM further.
Charlie Munger is a fan of flipping how you frame a problem by “inverting”. If everyone is looking at a problem the same way – maybe looking at it upside down will give you a different but equally correct way of seeing things. Today, I’m going to “invert” the problem of finding a company with a high return on capital. Actually, what matters for us investors is a company’s incremental return on capital while we own it. What the stock earned on its capital before we invested in it and what it earns after we sell the stock isn’t what we care about. We care about the return on money put to work while we own the stock.
That’s a more difficult question to answer, though. So, let’s just start by asking if we think U.S. Lime will can earn an adequate unleveraged return on equity for a long-time into the future. Here, I am focusing on the “long-time into the future” part.
First, a confession. I personally don’t think in terms of return on equity when making my own investing decisions. Instead, I always “invert” ROE. I think of capital not as something you earn a return on but something which is a bit of a “tax” on growth. The reason I wrote about a stock like NIC (EGOV) is that if it does grow – that growth will have a very low owner’s equity tax. Maybe the stock will grow and maybe it won’t. But, if it does grow, it isn’t going to need to retain earnings to do it.
With a commodity like lime, it’s possible that the “inflation” part of any growth won’t require much capital investment. If you already own plenty of lime deposits, then it shouldn’t cost you much more to produce the same tons of lime each year – and yet, if the dollar gets 3% less valuable each year, you may be able to charge 3% more for your same quantity of lime produced.
This is the aspect of a commodity producer that’s attractive. There are other less attractive aspects to commodity producers that often make me shy away from them. But, maybe we’ll learn lime doesn’t share those qualities.
My interest in U.S. Lime is a little odd. On the one hand – as we’ll see – running lime quarries is an asset heavy business. On the other hand, U.S. Lime already has more reserves than it needs to produce earnings for a long time. And, as I said at the start of this article – it’s the return on incremental capital while we own a stock that matters. As investors, we don’t want to pick a stock that is going to buy many tons of proven lime reserves the day after we buy the stock. We want to pick a stock that already owns lime reserves and then exploits them – without buying new ones – while we hold the stock. We want high cash flow from operations and low cap-ex.
Can U.S. Lime deliver that for us?
Let’s start by inverting the “return on capital” problem. Instead of asking what allows a company to earn a high return on capital – like it’s abnormal to earn a high return – let’s ask what stops a company. Every company out there is managed in a way that’s supposed to deliver high returns on capital for the long-term – that’s the goal. But, most businesses fail.
Why?
I think five “birth defects” explain why most businesses naturally fail to earn very high returns on capital:
- Their business requires a lot of capital investment (asset levels are too high)
- They face a lot of rivalry from competitors (prices are too low)
- They get a lot of pushback from suppliers (costs are too high)
- They get a lot of pushback from customers (prices are too low)
- The government confiscates a lot of their profits (taxes are too high)
So, what we want to do is find a company with “market power” as I defined it in my article on that topic:
“Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.”
I think every lime quarry in the U.S. – not just the ones U.S. Lime owns – has market power. There is no market for the supply of lime outside of buying it from a local (usually within 400 miles) quarry. You can produce it yourself – and some big consumer do that – or you can buy it from your local (usually within 400 miles) quarry. But, there aren’t stockpiles kept in inventory and traded by wholesalers. So, sellers of lime must secure a deposit and mine it. Imports and exports of lime are immaterial. And it is believed – there is no data on this – that annual production and annual consumption of lime are nearly equal. Lime is short-lived and reactive with water, so all reports I’ve seen on lime assume no one would store meaningful quantities of it.
I’m going to spend a lot of time talking about the lack of price competition (“rivalry”) in the lime industry. I hope this doesn’t bore you, because it is the main attraction here for me. If you can be very sure that some business you buy won’t face price competition for a very, very long – perhaps perpetual – period of time, you can be secure paying a much higher price for that asset. This is less obvious today when we are in the midst of about 10 straight years of low inflation. But, it’s always useful to own a business that can maintain the same real price per quantity far into the future without causing any decline in unit volume.
Let’s start our discussion of how competitive the lime industry is with a quote from U.S. Lime’s 10-K. I have bolded words that I highlighted on my hard copy of the 10-K:
“The lime industry is highly regionalized and competitive, with price, quality, ability to meet customer demands and specifications, proximity to customers, personal relationships and timeliness of deliveries being the prime competitive factors. The Company’s competitors are predominantly private companies.
The lime industry is characterized by high barriers to entry, including: the scarcity of high‑quality limestone deposits on which the required zoning and permitting for extraction can be obtained; the need for lime plants and facilities to be located close to markets, paved roads and railroad networks to enable cost‑effective production and distribution; clean air and anti‑pollution regulations, including those related to greenhouse gas emissions, which make it more difficult to obtain permitting for new sources of emissions, such as lime kilns; and the high capital cost of the plants and facilities. These considerations reinforce the premium value of operations having permitted, long‑term, high‑quality limestone reserves and good locations and transportation relative to markets. Lime producers tend to be concentrated on known high‑quality limestone formations where competition takes place principally on a regional basis.”
That part of the 10-K’s description of competition is concerned with competition on a local or regional basis. In the last part of U.S. Lime’s “competition” section, we get some info about the structure of the industry nationally:
“Consolidation in the lime industry has left the three largest companies accounting for more than two‑thirds of North American production capacity. In addition to the consolidations, and often in conjunction with them, many lime producers have undergone modernization and expansion and development projects to upgrade their processing equipment in an effort to improve operating efficiency.”
I included the last sentence, because of a trend I seem to detect in the industry long-term. It may be uncertain, difficult, time-consuming, or expensive to acquire and develop truly new quarries. For example, kilns pollute. So, it may be easier to upgrade an existing kiln than get government approval for a new kiln. In addition, if competition is localized, exploiting a new quarry near an existing one – within sort of the “circle of competitiveness” for an existing quarry would have negative long-term consequence for the industry. Basically, return on capital would be lowered, because you would either introduce price competition between two local players or you would need to invest heavily in capital at first to get up to the production cost economics of the existing quarry or you would shrink the local market the existing quarry (and the new quarry) each had to themselves. If the 3 largest companies in the U.S. lime industry are long-term, private players in this industry – they might seek to make more rational long-term decisions than a lot of little players would. For example, they might favor committing capital spending to the expansion and modernization of larger, successful existing quarries and not opening – or even shutting down – some of the more marginal sites. A trend like that would be a very good sign. In fact, once you have a trend like that things like environmental regulations, permitting processes, etc. can become a benefit to the industry because it raises the bar for what a truly new competitor would have to attain in terms of how much time and capital they’d need to start a new site. What I’m saying is: fewer and fewer production sites is always better for an investor than more and more production sites. And it’s possible that fewer and fewer big players on the national scale would try to shape the industry toward fewer and fewer sites on the regional level.
Our next source of information about the competitiveness of the lime industry in the U.S. is the USGS. The USGS is the Unites States Geological Survey. It’s referred to as a “scientific agency” of the U.S. government. However, when it comes to commodities, some of the work the USGS does is really economic in nature. The USGS prepares annual reports on commodities like lime. Here is the opening to the 2018 yearbook on lime.
Again, I am showing you what I highlighted on my hard copy of the PDF:
“In 2017, an estimated 18 million tons (20 million short tons) of quicklime and hydrate was produced (excluding independent commercial hydrators), valued at about $2.3 billion. At yearend, 28 companies were producing lime, which included 18 companies with commercial sales and 10 companies that produced lime strictly for internal use (for example, sugar companies). These companies had 74 primary lime plants (plants operating quicklime kilns) in 28 States and Puerto Rico. Three of these 28 companies operated only hydrating plants in five States. In 2017, the five leading U.S. lime companies produced quicklime or hydrate in 21 States and accounted for 76% of U.S. lime production. Principal producing States were, in descending order of production, Missouri, Alabama, Ohio, Texas, and Kentucky. Major markets for lime were, in descending order of consumption, steelmaking, flue gas treatment, construction, chemical and industrial applications (such as the manufacture of fertilizer, glass, paper and pulp, precipitated calcium carbonate (PCC), and in sugar refining), water treatment, and nonferrous mining.”
We can now make some estimates about the size of the lime industry, the degree of concentration of market share, and U.S. Lime’s relative position. There are only 18 companies with commercial sales of lime. To me, that means there are only 18 true lime producers in the U.S. We know the top 5 of these 18 control 76% of lime production. So, the market share breakdown is that something like 3 players probably have at least 65% of the market, the next two might have as much as 10% of the market, and then 13 others have the remaining 24% of the market. In other words, there are probably 3 producers with around 20% of the market and about 13 producers with about 2% of the market. So, the relative size difference between the 3 biggest and 13 smallest producers is something like 10 to 1. I am, you’ll notice, combining info from U.S. Lime’s 10-K with info from the USGS. And I’m rounding numbers off and making some guesses. But, I think what I laid out here is a pretty good summary of what the level of consolidation may be here. You have 3 companies with at least 67% of the industry and 5 companies with 76% of the industry. I think we can say that the number of “big” players here is somewhere in the 3-5 range and the amount of market share in the hands of the big players is two-thirds to three-quarters. On top of that, a “big player” is probably about 10 times the size of a small player. Also, it is often stated that the top 10 producers have about 90% of production. So, it’s likely that the 8 smallest producers have market share of 1% or less each. Concentration might look roughly like this.
Three biggest producers: >= 65% of the market
Five biggest producers: >= 75% of the market
Ten biggest producers: >= 90% of the market
Eighteen biggest producers: 100% of the market
Because the USGS provides the number of lime plants – including non-commercial plants – in the U.S. in each year’s report, I can paint a picture of whether the number of plants and number of tons produced has been growing or shrinking over time.
Here are snapshots of the U.S. lime industry taken at 5-year intervals (except for the last snapshot which is today):
1994: 18 million tons produced by 64 companies at 114 plants in 33 states.
1999: 19.6 million tons produced by 45 companies at 115 plants in 33 states.
2004: 20 million tons…at 94 plants in 32 states.
2009: 15.8 million tons…at 90 plants in 29 states.
2014: 19.5 million tons produced by 29 companies at 77 plants in 29 states.
Today: 18 million tons produced by 28 companies at 74 plants in 28 states.
The above numbers overstate how widespread and fragmented the production of lime is because I included: 1) Companies and plants engaged in lime production for their own “non-commercial” uses 2) Lime plants incapable of certain types of lime production and 3) Plants that did not produce any lime during the year.
The best piece of information about the reasons for the trend toward consolidation and potential lack of competitiveness in the lime industry is laid out in the 2014 report from the USGS:
“The U.S. lime industry is characterized by high barriers to entry, which include an industry dominated by a few large-scale producers with nationwide supply and distribution networks, a scarcity of high-quality limestone deposits on which the required zoning and mining permits can be obtained, the need for lime plants and facilities to be located close to markets with access to suitable transportation networks to allow for cost effective production and distribution, environmental regulations making it difficult to permit new lime kilns, and the high capital cost of the plants and facilities. Production capacity increases are usually met by retiring older kilns and using the existing air quality permits for new, more efficient, higher capacity kilns that have reduced air emissions. In 2014, the U.S. lime industry consisted of 29 companies…Of the 29 companies, 14 companies produced lime products for sale, 10 companies produced lime that was used entirely for internal company purposes, and 5 companies did both. Owing to its reactivity and short shelf life, lime is not stockpiled in large amounts and data on stocks are not collected.”
I think we can say that the trend in the lime industry is toward fewer and fewer producing sites controlled by fewer and fewer companies. This means capital allocation must be focused on upgrading and modernizing existing sites and acquiring other lime producers.
Finally, in that same USGS report (for 2014), U.S. Lime is listed as the sixth largest producer of lime in the U.S. The other companies listed ahead of U.S. Lime are either private or are a small part of a public company that produces other commodities as well. The only public peer of any kind shown ahead of U.S. Lime is a subsidiary of Martin Marietta Materials (MLM).
Martin Marietta trades for 18 times EBITDA while Vulcan Materials (VMC) trades for 19 times EBITDA. USLM trades for 9 times EBITDA. I wouldn’t call Martin Marietta or Vulcan peers. Limestone production is – I suppose – quite similar to aggregate (gravel) production. But, the main uses of lime are not in construction. Lime is used in everything from steel mills, to coal power plants, to water treatment – all of which have nothing to do with construction. It’s also worth mentioning that – over the last 25 years – U.S. Lime stock has far outperformed both Martin Marietta and Vulcan Materials. So, the stock’s history points to this being at least as good a business as the more expensive Martin Marietta and Vulcan.
Overall, I would say that USLM appears to be cheap enough to consider researching the stock further. The competitive position of a lime producer might have some similarities to aggregate producers. And yet, U.S. Lime is probably half the price of some construction related quarry owners.
Finally, what does U.S. Lime actually own? What are you getting when you buy this stock?
Here are the company’s key assets:
- $82 million in cash (against no debt)
- Texas Lime: 33 million proven tons plus 53 million probable tons. Estimated life of reserves at current production level: 70 years.
- Arkansas Lime: 13 million proven tons plus 76 million probable tons. Estimated life of reserves at current production level: 60 years.
- Clair: 12 million probable tons. Estimated life of reserves at current production level: 20 years.
- Land ownership: The land is being used to produce lime, so it’s important not to double count this. However, U.S. Lime owns 3,450 acres at Texas Lime and 3,550 acres at Arkansas Lime. St. Clair is an underground mine and some of that land is leased. U.S. Lime has some mineral rights on land it doesn’t own.
Let’s assume the land has no value. That’s not a very extreme assumption. Although we’re talking 7,000 to 8,000 acres here, we need to keep some things in mind. One, it’s being extensively mined and will be for a long time. There will be costs to closing any lime quarry and using any of the land for anything else. Any non-lime monetization of land would be very, very far-off. So, let’s cross “land ownership” off the list. But, it’s an asset that might be enough to offset unexpected future liabilities that can be associated with mining operations. For example, U.S. Lime has earned royalties for the extraction of natural gas on some of its land.
The $82 million in net cash works out to more than $14 a share.
As far as reserves, let’s say the proven reserves are to be counted at 100% and the probable reserves are to be counted at 50%. This is arbitrary. If we blend that together we get 33 million tons plus 13 million tons equals 46 million tons to be counted at 100%. Then we have 53 million tons plus 76 million tons plus 12 million tons equals 141 million tons to be counted at 50%. That’s 70 million more tons. So, that’s about 116 million tons of reserves (assuming proven means 100% certainty and probable mean 50% certainty).
We know two other facts about U.S. Lime. One, it used up about 3 million tons of lime from its reserves last year. And, two, the company was producing at about 62% of its capacity last year. Let’s assume capacity is 5 million tons of lime and – for the sake of argument – U.S. Lime starts producing at 100% of capacity and keeps producing at that level forever.
At that rate, U.S. Lime would deplete all its proven reserves in 9 years. It would deplete all its proven and probable reserves (assuming probable reserves turn out to be 50% real and 50% not) in 23 years.
So, that would say that U.S. Lime doesn’t need to acquire more limestone deposits for 10-25 years even if it produces at close to 100% capacity and even if probable reserves turn out to be only 50% real.
Those are extremely aggressive depletion assumes. You need to make kind of outlandish assumptions to get to the point where U.S. Lime would be out of reserves in 10-20 years.
The reality here is that U.S. Lime isn’t going to produce at 100% capacity. The stock is priced like it’s going to produce at about 60% capacity forever. And, at this rate, U.S. Lime won’t need to acquire more deposits for something much closer to 15 – 45 years. It would be 15 years if 100% of probable reserves turn out to be non-recoverable and 45 years if 50% are recoverable and 50% aren’t. If 100% of probable reserves are eventually exploited and U.S. Lime only produces at its current annual unit volume in tons – the company would have 60 years of production left in it without acquiring new deposits.
I think we can pretty safely guess U.S. Lime won’t run out of deposits sooner than 15 years from now and its deposits won’t last more than 60 years. Between those two numbers, your guess is as good as mine. But, my guess is that the company has ample reserves compared to many commodity producers.
So, the attraction here is pretty simple.
One, I think the lime industry isn’t very competitive and isn’t going to get more competitive in the years ahead.
Two, I think the thing that is the most expensive part of getting into this business – acquiring a working lime quarry – is something U.S. Lime won’t have to pay for in the foreseeable future. It’s entirely possible you could buy this stock and hold it for 10 or 15 years without the company using its cash to acquire another quarry.
And then, the price looks okay right now. It’s hard to know what normal free cash flow looks like, because the company will go for years without spending much of anything on cap-ex and then it’ll suddenly invest in a new kiln or something. But, if we use the free cash flow figures from the years after the financial crisis (lime production plunged more than 20% in tons in 2009), we have free cash flow being pretty steady in the $20 million to $25 million range. Let’s call it $23 million in average free cash flow.
That gives the company a market cap to free cash flow of 18. The enterprise value to free cash flow is 15. This is before the tax cut. So, I’m fine assuming the stock is not trading for more than a cash P/E of 15 to 18.
The important question here is re-investment. So, normally a typical U.S. public company grows about 5% a year to 6% a year (at around the rate of nominal GDP growth) while retaining about half its earnings. So, if you buy a normal stock at a P/E of 15, you are really paying something like 30 times the payout from the company (cash piling up, stock being bought back, and dividends being paid out). The other half of your reported earnings are funding the 5% to 6% growth rate. You never see that part of the cash – you only enjoy the growth it funds.
The question here is whether we might be paying closer to 15 times the actual distributable cash flow. U.S. Lime’s balance sheet is mostly cash and equipment. Land and mineral rights are held at a low valuation on the books – but then, we don’t expect more investment in that. What we expect USLM to invest in is upgrading and modernizing the existing sites it controls.
Imagine production in tons is held steady. Meanwhile, the price of each ton of lime rises 3% a year. How much of the company’s earnings are really cash that doesn’t need to be put back into the business?
If the number really is around $23 million – that is, about $4 a share – this stock is a buy. It has net cash on hand. It has more reserves than it needs. And then you have a $4 cash coupon coming off the stock. It’s a real yield (the price per ton of lime won’t fall due to inflation). So, what is the right fairly certain, very long-term real yield on a security these days?
If we’re talking appraisal value – what it’s worth, not what I’d pay – it’s probably 25 to 33 times the real cash coupon. If you know competition is limited and you know you’ll keep earning the same real profit regardless of inflation – that’s worth a lot. Furthermore, if you know the lifespan of this security is of the same sort of lifespan as say a 30-year government bond – that’s worth even more. For example, the 30-year U.S. Treasury Bond yields 3.13% right now. So, could something that is producing at two-thirds of capacity (it might produce more one day) and indexed to inflation (this is basically a TIPS not a normal 30-year bond) be worth a starting yield of something close to that 3% nominal yield on a government bond (like 33 times free cash flow)?
The right yield on something like this is probably 3% to 4%. A 5% yield (P/FCF of 20) seems too high for something with such a wide moat and such ample reserves relative to production levels.
So, does that mean U.S. Lime shares are worth something like 25 to 33 times free cash flow?
Maybe.
Assume free cash flow is $4 a share. Assume a 25 to 33 times multiple. That gets you to an appraisal value of $100 to $132 a share. There’s also just under $15 in net cash. That would give an appraisal value of $115 to $147 a share.
That could be too high.
But, the stock’s at $76.30 a share as I write this. That’s about two-thirds of the bottom end of this appraisal range (where I used a P/FCF of 25).
Is the stock worth a P/FCF of 25?
Probably. I mean, it’s difficult to find things with as long-term and safe as U.S. Lime with a REAL yield of 4% or higher. Many stocks that face serious competition and definitely wouldn’t be able to pass on 100% of inflation trade at 25 times reported earnings – not free cash flow – already.
My guess is that the stock won’t underperform the S&P 500 even if bought at about 25 times free cash flow. Would I consider buying it at 15 times free cash flow or less?
Yes.
Right now, I rate my interest level in U.S. Lime at a 5 out of 10.
If the stock dropped even 5% to 10% in price, down to say a $70 price – I’d bump up my interest level to at least a 6 out of 10 here.
As it is, I’m about as likely as not to put this stock at the top of my research pipeline.
Geoff’s interest level: 50%