High valuations demand higher performance
During the week of November 1, construction materials industry leaders U.S. Concrete and Martin Marietta released their 3Q 2015 earnings reports. Each company delivered strong growth in both revenue and earnings, but the market response to each’s results could not have been more different. While U.S. Concrete shares realized a 9 percent increase in pre-market trading following its earnings release, Martin Marietta’s stock dropped 8.5 percent following its announcement.
The discrepancy in market reaction directly correlates with market expectations. Martin Marietta did not deliver weak results. It grew revenue 7.9 percent and its earnings increased 119 percent year-over-year. However, what Martin Marietta failed to deliver was performance on par with its lofty valuation.
At the time of Martin Marietta’s earnings announcement, its enterprise value totaled nearly 15 times EBITDA. To use a term preferred by CNBC’s Jim Cramer, Martin Marietta’s shares were “priced for perfection,” which the company did not deliver. Further, the company reduced its earnings guidance for 2015 and 2016, stoking fear that the aggregates industry was seeing a broad slowdown and was yet another sign of a slowing economy. As a result, Martin Marietta’s shares dropped precipitously, and the share prices of most other construction materials companies were dragged down with it.
Conversely, when U.S. Concrete announced similarly strong results—49.4 percent revenue growth and 85.8 percent earnings growth year-over-year—the market responded favorably. The reason: U.S. Concrete’s performance exceeded analyst expectations.
U.S. Concrete’s enterprise value totaled approximately 12 times EBITDA at the time of the announcement, which is still high by historical standards but not as lofty as Martin Marietta’s.
Surely U.S. Concrete benefited from reduced expectations set by Martin Marietta’s results and guidance, which drove more pronounced share price gains in reaction to the earnings beat. U.S. Concrete also benefited from its geographic footprint, with operations focused in markets that showed continued strength and limited exposure to regions within the U.S. showing some weakness (notably those regions in which the economy is very energy dependent). In addition, the company got a large boost from the success of its continued acquisition program.
Still, the most important factor that drove favorable market reaction to U.S. Concrete’s earnings announcement is the fact that its valuation heading into earnings season was low relative to that of Martin Marietta, and analyst expectations were correspondingly low.
U.S. Concrete and Martin Marietta are both solid companies, led by talented management teams that are delivering strong revenue and earnings growth. Yet their respective share prices went in different directions when reporting similar performance. The reason is simple. One was priced too high, the other not high enough. Valuation will ultimately revert back to the mean. Sure, it is great to be “priced for perfection,” but it is important for companies and shareholders to understand that performing to perfection is rarely sustainable. In the end, market expectations drive results, and when performance does not align with expectations the market will adjust and correct.