Stella-Jones: Tying Up A Solid Q2 And On Track For A Good Year

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Stella-Jones is a profitable company in the Materials sector manufacturing railway ties and utilities poles, with consistent sales growth and strong EBITDA margins.The company's core segments of ...

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Introduction I rarely cover companies in the Materials sector. Often, companies in this sector lack pricing power, facing significant challenges due to the commodity nature of their products, price volatility, and intense competitive pressures. These factors can limit their ability to set prices above market rates and protect their margins. They also tend to be highly cyclical, meaning that investors often have to get the timing right in addition to picking the right stocks. However, some companies manage to navigate these difficulties successfully by leveraging cost efficiencies, establishing strong customer relationships, providing an essential service, or finding niche and attractive end markets where they can benefit from long-term organic growth. One such company I think meets these criteria is Stella-Jones Inc. (TSX:SJ:CA) (OTCPK:STLJF). Stella-Jones is a manufacturer of railway ties and utilities poles. While this is a business tied to a cyclical industry (wood products and lumber), Stella-Jones is actually a growing company, having had sales increases for 23 consecutive years. More importantly, it's also quite profitable, with EBITDA margins in the 17-19% range. These two businesses, railway ties, and utilities poles, are benefitting from long-term replacement cycles, where infrastructure maintenance and upgrades drive consistent demand. Railway infrastructure requires periodic renewal to ensure safety and reliability, while utility poles must be replaced regularly to maintain the integrity of power distribution networks. This cyclical need provides Stella-Jones with a steady stream of orders and a strong position in the market. Additionally, the company's focus on cost control, operational efficiency, and strategic acquisitions has enabled it to enhance its market share and profitability, making it well-positioned for sustained growth despite the broader industry's fluctuations. With these factors making up my primary investment thesis back in February, I wanted to review the company again, particularly after its latest second-quarter results. In this article, I'll unpack the latest earnings report, provide an update to my investment thesis, how the outlook has changed, and why I'm still avoiding the company on valuation concerns. Investor Presentation Recent Results When looking at Stella-Jones' latest quarterly results for Q2'24, the company reported sales of $1.05 billion, which was 8% higher compared to last year's quarter. On gross profit, the company reported a margin of 21.5%, indicating 90bps of margin expansion. EBITDA margins also expanded this quarter from 18.0% last year to 19.1%, as EBITDA grew 14% year over year to $200 million. Overall, I'd say this was a pretty good quarter for Stella-Jones. Both revenue and EPS came in line with expectations, with earnings per share coming in at $1.94, up 13% compared to last year's EPS of $1.72. Company Filings I think it's helpful to analyze how the company did by looking at their individual segment results. In the Utility poles business, which makes up 45% of total revenues, excluding currency impact and M&A, sales increased by +16% organically compared to last year driven by higher pricing and volumes (40% of growth attributable to volumes). During the quarter, Stella-Jones secured new multi-year contracts and new customers, which helped drive the gains. In the railway ties business, excluding currency impact, sales increased by +10% year over year organically due to greater volumes for non-Class 1 customers (inventory replenishment) as well as price increases due to cost pass-through clauses. At $265 million in revenue, this segment made up a quarter of the company's total sales. The residential lumber segment is where Stella-Jones saw some weakness. As the name suggests, the segment provides plywood and dimensional lumber for use in outdoor applications, in addition to providing customized services for the residential and construction markets. As repair and remodeling activity have been in a slump lately and lumber prices continue to be depressed, sales for the segment were down roughly 10%. On the earnings call, management noted continued softness in demand, across the building products segment as of late. Given the residential lumber segment's weakness, it was unsurprising to see the Logs and lumber segment' sales down 22% compared to last year, as lower trading/pricing meant less sales for Stella-Jones. Finally, in the Industrial products segment, sales climbed 7% versus last year, as higher volumes led the way forward for the tiny segment. Outlook Altogether, my take is that this quarter was quite strong for Stella-Jones, even in spite of the residential lumber segment. In the company's strong segments, which collectively make up the vast majority of revenue, utility poles, railway ties, and industrial product sales, grew by 17%, so it's clear that the company is performing nicely in its core areas. The resilience in these key segments suggests that Stella-Jones is effectively leveraging its strengths and adapting well to market conditions. Although the residential lumber segment presents a challenge, it appears to be an isolated issue rather than a systemic problem. As mentioned in the outset, some parts of the business have cyclicality, but the company's main segments of railway ties and utility poles have long-term organic growth traits, thanks to the replacement cycle for these products. As a result of the strong quarter, management decided to increase guidance for adjusted EBITDA for the year. The company now expects EBITDA margins of \"close to 18%\" vs. prior guidance of 16% for FY'24). In addition, Stella-Jones also reiterated its expectations for Utility Poles growth of 15% organically year over year for both 2024 and 2025. For the railway tie business, the company is guiding low single-digit organic sales growth for FY'24. Company Filings On residential lumber, with the segment's poor top-line performance, management is expecting 2024 sales at the lower-end of its $600-$650MM guided range. One of the standouts about this is that even though sales and volumes are down, the company is still managing to put up an EBITDA margin of around 18%. So even with lower forecasted sales activity for the segment, profitability-wise, I think the segment looks to be doing okay. Why this matters is because it gives Stella-Jones balance sheet flexibility and enables return of capital back to shareholders. From a balance sheet perspective, Stella-Jones had a Net Debt to EBITDA ratio of 2.5x, down from 2.6x just six months ago. With steady improvements in leverage, Stella-Jones has the balance sheet flexibility and mobility it needs to weather weaker economic periods, have capital to reinvest back into the business, or pursue opportunistic M&A. Company Filings On return of capital, Stella-Jones has been executing very well in this regard. During the quarter, the company's return of cash to shareholders was 40% share repurchases ($22 million) and 60% dividends ($32 million). For the 2023-2025 period, the company expects to be on track to return about $500 million back to shareholders (roughly equal to 10% of the company's market capitalization). With a quarterly dividend of $0.28, the company has a payout ratio of less than 20%, so the dividend yield of 1.2% appears to be well-supported by the company's earnings and cash flow. In my view, this should support further dividend increases and 2024 should mark 20 years of consecutive annual dividend growth. Seeking Alpha Valuation There are currently 8 sell-side analysts who cover Stella-Jones' stock, with 5 'buy' ratings and 3 'hold' ratings. With an average one-year price target of $102.50, this suggests that shares of Stella-Jones have about 12.0% upside, not including the company's current dividend yield of 1.2%. With a total return potential of 13.2%, on the whole, sell-side analysts are relatively bullish on the company. Seeking Alpha In my view, I don't think shares of Stella-Jones are particularly cheap at current levels. Compared to the company's peers in the U.S. like Koppers Holdings (KOP), Trinity Industries (TRN), and Valmont Industries (VMI), shares of Stella-Jones to be right in line with the peer group. As shown in the table below, Stella-Jones trades at a small discount at 9.9x forward EBITDA and 14.1x forward earnings (source: S&P Capital IQ). Author, based on data from S&P Capital IQ However, when we look at where Stella-Jones has historically traded, the company has historically traded within a range of 7.2x and 12.0x EV/EBITDA over the last five years (source: S&P Capital IQ. With the current multiple of 10.1x EV/EBITDA above the historical lows seen during 2022, I don't think shares of Stella-Jones are the bargain they once were. Author, based on data from S&P Capital IQ So while the residential lumber business may be poised for a turnaround, I'd have more concerns around the utility pole and railway tie businesses slowing down. For now, they've shown fantastic growth, however, as we are in the peak capex spend for Class I railway ties, it's likely that they may pull back, rather than ramp up. Recently, it seems that talks of a dual rail strike at both CP Rail (CP:CA) and CN Rail (CNR:CA) don't seem to be getting resolved, and so I suspect CP and CN to pull back their spending. As other Class I rails watch this unfold, I think they could become more cautious on their capex spend, which would hurt demand for railway ties. Conclusion In summary, while Stella-Jones' latest quarter showed solid performance in its core segments of railway ties and utility poles, reflecting its effective operational strategies and long-term growth prospects, I think the company may face headwinds that warrant consideration. In my view, the recent quarterly results highlight the company's continued profitability, supported by strong segment growth in utility poles, railway ties, and industrial, with an overall commitment to returning capital to shareholders. I think the real question is how sustainable these growth rates are, especially in the railway tie segment amid potential reductions in capital expenditure by major Class I rails. Moreover, the residential lumber segment's ongoing weakness poses a challenge to overall performance. Given these dynamics, I don't think shares of Stella-Jones are as attractive as they once were. While I wouldn't be a seller at these prices, I don't feel compelled to buy as most of the positives here are already priced it. So while I like the company and consider it to be one of the best names in the Canadian Materials sector, I'd rate shares as a 'hold' for now and wait for better opportunities.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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