Summit Materials Inc

NYSE:SUM

Earnings Call Transcript 2018-Q2

[Operator]

Greetings, and welcome to the Summit Materials Second Quarter 2018 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Noel Ryan, Vice President, Investor Relations. Thank you. Mr. Ryan, you may begin.

[Noel Ryan, executive]

Good morning, and welcome to Summit Materials Second Quarter 2018 Results Conference Call. Leading today's call are Summit's CEO, Tom Hill; and CFO, Brian Harris. We issued a press release before the market opened this morning detailing our second quarter results. We also published an updated supplemental workbook highlighting key financial and operating data, which can be found in the Investors section of our website at summit-materials.com. This call will be accompanied by our second quarter 2018 investor presentation, which is available on the Investors section of our website.

I would like to remind you that management's commentary and responses to questions on today's call may include forward-looking statements, which by their nature are uncertain and outside of Summit Materials' control. Although these forward-looking statements are based on management's current expectations and beliefs, actual results may differ in a material way. For a discussion of some of the factors that could cause actual results to differ, please see the Risk Factors section of Summit Materials' latest annual report on Form 10-K and subsequently filed quarterly reports on Form 10-Q, each is filed with the SEC. Additionally, you can find reconciliations of the historical non-GAAP financial measures discussed in today's call in this morning's press release. Today's call will begin with remarks from Tom Hill, who will provide an update on our business and market conditions through the first half of the year, followed by a financial review and outlook from Brian Harris. At the conclusion of these remarks, we'll open the line for questions.

And with that, I'll turn the call over to Tom.

[Thomas Hill, executive]

Good morning. Thank you for joining us on the call today. Turning to Slides 4, 5 and 6 of the deck. While the construction season got off to a slow start this year, we generated organic volume growth across our aggregates, ready-mix concrete and asphalt lines of business in the second quarter, resulting in a 14.8% year-on-year increase in net revenue, consistent with the pace of top line growth in the prior year.

Despite solid demand trends in our public and private end markets, adjusted EBITDA was flat year-on-year in the second quarter given lower sales volumes in our Cement segment and Houston operations together with an increase in variable costs.

While we remain optimistic on business trends heading into the second half of the year, there are a finite number of days remaining in the construction season. And with this in mind, we have reduced our full year outlook.

On Slide 5, we bridge from $505 million, the midpoint of our old adjusted EBITDA guidance range, to $470 million, the midpoint of our new range. The revised guidance is attributable to an incremental $30 million of variable costs and approximately $25 million in combined reductions to our Cement and Houston operations.

Offsetting these factors are $16 million of incremental price and volume acceleration in the second half of 2018, together with $4 million of partial year contributions from the 4 acquisitions we've completed since our last update in May.

In Cement, organic sales volumes declined 4.8% due to poor weather during April and May, together with continued price-driven competitive pressures. We generated a disappointing low single-digit increase in Cement prices so far this year. We anticipate an acceleration in Cement sales volumes in the second half of the year.

Turning to Houston, a slow post-Harvey recovery, together with significant rain in June, impacted our results in the first half of the year. While Houston ready-mix generated year-on-year organic volume growth year-to-date 2018, Houston aggregate volumes declined due to delay in several large highway projects.

Importantly, we continued to see Houston aggregates and ready-mix volumes accelerating in the second half of the year as project work that was delayed from the first half begins to pick up.

To that end, for the company as a whole, per-day aggregate shipments in July were 13% higher than in June and also higher versus the prior year period.

Pricing has begun to gain momentum heading into the back half of the year. We believe Houston is well positioned for a steady cyclical upturn consistent with our prior outlook.

Finally, with regard to variable cost increases. On Slide 6, we show that variable costs increased $33 million year-on-year in the first half of 2018 due to a $20 million increase in recurring costs, $6 million of nonrecurring costs, together with $7 million in higher pass-through input costs. This $33 million of cost increase was approximately $20 million higher than we had expected.

Key recurring costs include transportation, materials inputs, labor and fuel. Trucking and transportation costs are moving higher given limited availability of drivers and trucks.

Materials inputs such as product additives and fly ash are higher as well. We've experienced increasing labor costs in some of our faster-growing market as of late, particularly within our product lines of business.

We do not anticipate this trend will abate any time soon and will likely carry with us into 2019 given the high level of activity in the regions we serve.

With regard to fuel exposure, we consume approximately 30 million gallons of diesel each year. For 2018, we have entered into forward contracts on approximately 60% of our 2018 diesel consumption at an average of $1.85 per gallon.

The remaining 40% of our required diesel fuel is purchased in the spot market. The year-to-date average spot price for diesel fuel is $2.07 per gallon on Nymex but has been as high as $2.29 per gallon.

As a result, we absorbed higher fuel costs on 40% of our consumption, which represented a modest headwind in the period. To help remove uncertainty from our 2019 fuel exposure, we intend to be 70% hedged on our diesel consumption by year end 2018.

Moving into nonrecurring costs, poor weather in our Cement markets during the second quarter resulted in significant inventories of undelivered Cement that were held in third-party floating storage, contributing to an increase in our demurrage cost. With weather now cooperating, we have since begun to sell these inventories, thus reducing our demurrage.

Further, with the loss of our Pelican liquid asphalt terminal in Houston due to Harvey last year, we were unable to store liquid asphalt during winter fill season at lower prices. Pelican is now up and running, which will allow us to avoid this issue come the 2019 winter fill season.

Input costs on cement and liquid bitumen that we purchased from third parties for our ready-mix concrete and asphalt lines of business increased at a faster pace than we were able to pass along to our customers during the first half of the year. Importantly, our average selling prices on both materials and products have gained traction entering the third quarter. While this lag between rising cost and corresponding price increases is not unusual, the pace of increase impacted our margin during the second quarter, a trend that should reverse in the second half and into 2019.

In summary, while our first half performance fell short of expectations, we see the opportunity for recovery into the second half given a seasonal acceleration in demand, increased traction on announced selling price increases together with solid backlogs.

Given our newly revised guidance, we now expect 8% growth in adjusted EBITDA in 2018 at the midpoint of guidance.

Turning to Slide 7, 8 and 9. Net revenue increased 14.8% in the second quarter and is up 15.5% on an LTM basis given a combination of price and volume growth in our markets. Although second quarter EBITDA was essentially flat versus the prior year period, LTM EBITDA is up nearly 8% from the prior year.

Organic aggregates sales volumes increased 2.3% year-on-year in the second quarter, driven by broad-based strength in our East region, Northeast Texas and parts of the Intermountain West.

Excluding our project-driven sand business in Vancouver, organic aggregates volumes increased 4.3% in the second quarter.

Organic aggregates ASPs increased 3.6% year-on-year, with West region ASPs up 5.5% in the period.

Organic sales volumes of Cement declined 4.8% in the second quarter due to rain in April and May, together with price-driven competitive pressures. Organic Cement ASPs increased 1.9% in the second quarter, below our expectations.

Organic sales volumes of ready-mix concrete increased less than 1% in the second quarter, with 10% organic improvement in the East region being partially offset by weather impact volumes in the Salt Lake and Houston markets.

Given higher Cement prices in our largest ready-mix markets, we raised our ready-mix prices on April 1. These price increases are sticking and will benefit the second half. In Houston, we announced a second ready-mix price increase effective October 1 given plans for a second $6 per ton Cement price increase by local producers.

Organic sales volumes of asphalt increased 2% in the second quarter, driven mainly by increased paving work in the West region, and in particular, within Utah, Colorado, Nevada and Wyoming.

Turning to Slide 10. Gross profit margin declined year-on-year in the second quarter across all lines of business. While volumes and prices were positive in the second quarter, ex Cement and Houston, higher variable costs were a headwind. Our announced price increases are catching up with these higher costs, positioning us for a return to margin growth in subsequent quarters. Importantly, the LTM trend remains intact, particularly within our materials lines of business.

Turning to Slide 11. Cement segment EBITDA declined 17.5% in the first half of the year given poor weather, a more modest year-on-year price increase, competitive pressures and higher freight and demurrage costs.

Looking at the USGS monthly Cement data year-to-date through April, each of our top state markets were impacted by heavy rainfall that contributed to a year-on-year decline in sales volumes.

While Cement had a challenging first half, our outlook for the business remains positive heading into 2019 for several reasons.

First, we expect the river market to return to 3% growth. Cement producers on the river are currently operating at utilization rates in the mid-90% range, with no new capacity expected over the near term.

Looking ahead, we think stable demand growth, inflationary cost pressures, together with no additional capacity in the market should result in a more favorable cement pricing environment.

Turning to Slide 12. The public funding outlook remains positive heading into next year. At the Federal level, the House and Senate Appropriations Committees have both approved proposals that serve to further increase funding for the Highway Trust Fund into fiscal 2019.

Following the 2-year budget agreed upon earlier this year, transportation programs received a total of $5.3 billion in supplemental general funds in fiscal year '18 and are on track for a similar level of supplemental funding in fiscal year '19.

Total Federal highway funding is expected to approach $50 billion in fiscal 2019 versus $43 billion in fiscal year 2017.

At the state level, Texas continues to increase funding for public infrastructure. In July, the Texas state Comptroller's office indicated that through June of fiscal 2018, sales and use tax collections are up 10% from June of fiscal 2017.

As a result, the comptroller increased the state's revenue projection for fiscal 2018 by more than $2.8 billion.

Importantly, Proposition 7 provides that the first $2.5 billion in sales tax collections, exceeding $28 billion in any fiscal year, be deposited to the State Highway Fund.

Sales tax collections in fiscal 2018 are likely to exceed $30.5 billion, meaning that the comptroller will allocate the full $2.5 billion to the State Highway Fund from fiscal 2018 collections.

In -- TXDOT's fiscal year ended August 2018, we estimate our TXDOT awards have more than doubled versus the prior year period. TXDOT currently expects total lettings via the State Highway Fund for fiscal 2018 to be nearly $7 billion, with August lettings expected to exceed $1.4 billion.

In Kansas, the public funding outlook is improving as the state continues to get its financial house in order. In July, Kansas Department of Revenue indicated that fiscal year-end tax receipts were $1.2 billion, above the previous fiscal year, while state tax receipts were above expectations for every month during the fiscal year.

In Missouri, a statutory referendum to fund the Missouri State law enforcement and maintenance for highways, bridges, roads and streets, known as Proposition D, is on the statewide ballot in November. If passed, Prop D could add more than $120 million annually to local governments for road construction and maintenance.

Turning to Slide 13. All 3 of our largest metro housing markets are growing in excess of the national average. Months of housing inventory also remain near historically low levels, while single-family permit growth remains healthy.

John Burns Research forecasted single-family permits in Houston will increase by merely 30% in 2018 to 2020, consistent with our view that this market is in the early stages of a multiyear expansion.

Ultimately, we think our housing markets will benefit from what remains a slow, grinding recovery given positive underlying demographic trends.

Turning to Slide 14. We've completed 11 acquisitions on a year-to-date basis, including 4 transactions that have closed since our last quarterly update.

Total investment spend across the 11 acquisitions was approximately $228 million, including $75 million for the 4 bolt-on acquisitions completed since May 8.

The Olathe assets in Kansas comprised 2 quarries, 2 asphalt plants and 2 construction landfill sites. These assets expand our existing operations into the growing southwestern Kansas City metropolitan area.

Virginia-based Buckingham Slate is an aggregates acquisition that expands our market position and reserve base near Charlottesville. Buildex is a lightweight aggregates business based in western Missouri that provides a complementary product offering to our existing portfolio in the region.

XIT is an aggregates company that provides further vertical integration of the company's aggregates, asphalt and paving operations in northwest Texas.

Of the 11 acquisitions we've completed this year, we've added more than 300 million tons of aggregate reserves to our portfolio, further expanding our presence in the upstream while leveraging our presence in the downstream through our vertically integrated business model.

Looking ahead, the acquisition pipeline remains active, consistent with the trend in recent quarters.

With that, I'll turn the call over to Brian for discussion of financial results.

[Brian Harris, executive]

Thank you, Tom. Good morning to everyone. Demand conditions are improving in our markets as we transition toward 2019, with selling prices increasing to offset cost inflation. From here, our focus remains on controlling fixed overhead costs, mitigating commodity price risk through our forward purchase program, all while optimizing productivity metrics.

Turning to Slide 16. Consolidated net revenue increased by 14.8% in the second quarter. In the West segment, net revenue increased 17.5%, while in our East segment, net revenue was up 20.4%. Growth in both West and East segment net revenue was supported by a combination of organic and acquisition-related growth. Net revenue in the Cement segment declined 2.8%, mainly due to high precipitation levels and competitive dynamics along the river system during the second quarter.

Turning to Slide 17. As of 30th June 2018, we had $270 million in cash and availability under our revolving credit facility to support our ongoing acquisition strategy and the general growth of the business. We anticipate net leverage to be approximately 3.5x by year-end 2018, assuming the midpoint of our revised adjusted EBITDA guidance and subject to the pace of acquisitions.

For modeling purposes, including the impact of all 11 completed acquisitions on a year-to-date basis, SG&A is running in a quarterly range of $67 million to $68 million. DD&A is running in a quarterly range of $49 million to $50 million, and interest expense is running in a quarterly range of $29 million to $30 million.

All analysts should also model for approximately $2 million per quarter of transaction-related expenses, an amount which can vary depending on the volume of potential acquisitions under review. We anticipate paying $3 million to $5 million in state and local cash taxes and no U.S. Federal income taxes in the current year.

Finally, with regard to total equity interest outstanding, as of June 30, 2018, we had a weighted average of $111.6 million Class A shares outstanding and 3.5 million LP Units held by investors, resulting in total equity interest outstanding of $115.1 million. In calculating the adjusted diluted earnings per share, this is the share count that should be used.

And with that, I'll turn the call back to Tom for his closing remarks.

[Thomas Hill, executive]

Thanks, Brian. Turning to Slide 19, 20 and 21. In summary, we are seeing broad-based demand growth in the majority of our markets, a trend that has already begun to contribute to increased average selling prices across our lines of business. As the year progresses, we expect an acceleration in our Houston business together with a recovery in our Cement segment.

Looking ahead to 2019, we see a continuation in demand growth across both our public and private end markets, coupled with the opportunity for improved year-on-year growth in average selling prices, particularly within our Cement business. Even after lowering our full year guidance, Summit remains on pace to achieve record full year adjusted EBITDA in 2018. Since 2013, our adjusted EBITDA has increased at a compounded annual growth rate of more than 27%, supported by a combination of organic and acquisition-driven growth.

In an inflationary climate, our leadership in local markets positions us to pass along price increases, resulting in superior margin capture through the cycle. Moving forward, our business has begun to gain momentum as demand fundamentals remain strong, leading into the second half of 2018 and into 2019.

With that, I'd like to open the call for questions. Operator?

[Operator]

[Operator Instructions] Our first question comes from the line of Rohit Seth with SunTrust.

[Rohit Seth, analyst]

My first question is on your 2018 guidance. It looks like you moved your midpoint down, about $35 million. Can you just bifurcate how much of this is the first half? And how much of that is the second half? And if you can provide any color on your price, volume and cost assumptions in the second half and any color on how you plan to defend your margins going forward? My second question is - let me just get in my second question. Second question is, in the prior quarter, you mentioned there were some larger deals you expected to do or at least that you're looking at in the pipeline, I mean, are you still considering those deals at this point given your leverage profile?

[Thomas Hill, executive]

Okay, Rohit. Thank you. I'll take the second one first. We have nothing imminent on the larger deals. In fact, a couple of them have fallen off. We just couldn't find value, or, in fact, they decided not to sell. We do remain pretty busy on the small- to medium-size add-ons that have sort of been our bread-and-butter for the last few years. So -- but we certainly have nothing imminent on the larger platform deals. So turning to our first half performance, we, obviously, were very disappointed with our first half. We've lowered our guidance by $35 million. Bridging from our prior guidance midpoint of $505 million to the new guidance of $470 million, there's $30 million in variable costs above what we thought would be in our initial guidance. And that's $24 million recurring costs and $6 million of nonrecurring costs. We also have $25 million in lower contributions from our Cement and Houston than we expected. And these are somewhat offset by $4 million of acquisition contributions and $16 million of incremental price, volume acceleration in the second half more than we were expecting. So this turns into the second half, we're expecting mid- to high-single-digit volume growth and low- to mid-single-digit price growth.

[Operator]

Our next question comes from the line of Trey Grooms with Stephens.

[Trey Grooms, analyst]

So first off, I just wanted to make sure we all have a good sense of really what's going on with the Cement business. So Cement volume is down. You mentioned competitive behavior. So I guess, first off, with manufacturers apparently operating in this mid-90s type utilization range in the market, first off, why are we seeing competitive behavior there? That's the first thing I'm not getting. Secondly, with your volume down, but it looks like you're pushing a little bit of price, sounds like you got $3. I didn't see it in the quarter sequentially. But sounds like you got $3. Is that implying that you guys may have given up a little bit of share in the quarter due to this competitive behavior? Really just summing up the situation with Cement.

[Thomas Hill, executive]

Yes, Trey. Yes, the 2 major elements to the lower volumes and a disappointing price increase in Cement were we had a very late spring and a pretty wet summer, especially the early part of the summer, and this reduced demand as you saw on the USGS data that we have in the deck. And it also increased cost because in a Cement business, you're running 24/7. And if your sales are too slow, we have to put the Cement somewhere. So we put it in barges and had to pay demurrage. And I would say that this probably also contributed to the weak price performance as that -- most price increases go in in April. As everyone's silos are full because of the weak demand, that probably makes it harder to implement the price increase. As far as the competitive pressures, there was one large player who aggressively took back share with price that they considered that they had lost the year before and yes, most definitively, we've lost share to them in 2018. But look, both of these things are behind us, and we expect volume to improve in the second half, and volume and price to both increase in 2019. In fact, one large multinational has announced their 2019 price increase of $15 per ton. So we are very optimistic about looking forward in our Cement business.

[Trey Grooms, analyst]

So the volume and price you mentioned in response to the prior question, was that across all of your segments? Or was that specific to Cement or...

[Thomas Hill, executive]

That was specific to Cement. Everything I -- I thought your question was on Cement, so I answered specifically on our Cement business.

[Trey Grooms, analyst]

Yes, mine was. I'm responding. Earlier you mentioned some price and volume in that $16 million bridge, just -- kind of just making sure...

[Thomas Hill, executive]

Oh yes, that is inclusive of Cement where we see volume increasing. We don't see price improving in the second half in Cement. But we do see volume improving. As the weather has cleared up, the competitor seems to have stopped its aggressive behavior. And we're optimistic for volume in Cement in the second half.

[Trey Grooms, analyst]

Okay, that's helpful, and then my second one, it would be, looking at the guidance, the revised guidance, $470 million -- or $475 million, I guess, would be excluding that onetime cost, in that neighborhood. I think during the first quarter, you guys announced or said that your acquisitions that had been announced year-to-date at that point should be adding something like $22 million? Is that -- and I know you added another $4 million here. So is reduction in guide is -- I guess, is there any change in that $22 million or I guess the $22 million contribution from the first acquisitions done in the first quarter? Or -- just trying to get a better sense for what's going on with the core business expectations in the back half excluding that piece?

[Thomas Hill, executive]

Our acquisitions are roughly hitting plan year-to-date, and we expect for the full year to be roughly as expected. So it's really the core business that's been impacted.

[Trey Grooms, analyst]

Okay, got it. And If I can sneak one last one in on Houston aggregates, I think I heard you say it was down in 2Q. I just want to make sure I heard that right. And is there something specific about your kind of portion of Houston that you participate in that was going on? Or was that more of the entire market being down?

[Thomas Hill, executive]

Again, we're disappointed in our Houston performance. There, certainly, demand has been less than we anticipated, both in ready-mix and in aggregates, it's much worse in aggregates. And we think it's probably due to some post Harvey impacts that are hard to quantify. But there are several large highway projects that have been delayed. The Northeast section of Grand Parkway, which is a multibillion-dollar project, has just gotten underway. And several other large highway projects have been delayed and are hopefully going to get started in the second half. And I don't think there's any doubt that we've probably lost some aggregate market share as we tried to raise price. And also our homebuilders are saying that they see great demand, but they are having trouble getting things built due to lack of -- shortage of labor. So I -- we think the fundamentals in Houston in all segments are very positive. These highway projects are going to start, like I said, the Grand Parkway has actually started, single-family permits are very strong. I think starts are being delayed because of the labor shortage but permits, the backlog and pent-up demand is building months of new -- of home inventory is way below the national average. So -- and light commercial is starting to be built out around the recently completed section of the Grand Parkway in the northwest part of Houston. We're -- again, we're optimistic. Aggregate price increase, we've announced 6% effective October 1. And we've also announced a ready-mix price increase effective October 1, which is the second this year. And follows the local Cement producers announcing a $6 per ton price increase. So first half, disappointing. We do see some pent-up demand in Houston. And we do really believe that Houston is at the early stages of a new upcycle. And we think it's a great place to do business. And again, we're optimistic going forward.

[Operator]

Our next question comes from the line of Kathryn Thompson with Thompson Research Group.

[Kathryn Thompson, analyst]

First on Cement, just wanted to flesh out the drivers. So you had some nice year-over-year increase in Cement pricing, but sequentially, it was a little bit flattish even in light of the price increase this spring. Could you flesh out to what extent geographic mix, customer mix or just a more tepid pricing realization factored into the optics of Cement pricing in Q2?

[Thomas Hill, executive]

Yes, Kathryn, I do believe that it's the latter. I don't see a lot of customer or regional variation. It's really an impact of the market got destabilized with a major player taking share back. And they did that through price. We defended our share where we thought appropriate, but it did, overall, affect the pricing. And I think also, as I mentioned earlier, that the wet spring and -- or late spring and wet summer also contributed to less courage in keeping the price up. So again, we think that's all behind us. Certainly, that major player that we talked about, we believe, is getting very, very close to our capacity and optimistic for pricing going into '19.

[Kathryn Thompson, analyst]

So just to clarify understanding that the price increase was implemented in April, and knowing you have a certain amount in backlogs and you aren't getting the full quarters effect, it would imply that really no pricing was realized with that spring price increase. Is that what you're implying?

[Thomas Hill, executive]

No, I mean, we're going to get a couple of bucks overall for the year. But I do think that it's -- that we'll get between $2 and $3 overall, which I find very disappointing.

[Kathryn Thompson, analyst]

Okay. Moving back to Texas lettings, knowing that the Houston market is more of a residential market, particularly, in the western part of Houston. But moving into Austin and in the northern part of the state with your RK Hall business, we have seen trailing 3 months $1 billion with the lettings May, June, July average for Texas. But if you could give any color in terms of what you're saying with boots on the ground in terms of real bidding for projects? And how that may be flowing through for your business? And also clarify, to what extent those regions are exposed to and benefit from infrastructure build-out?

[Thomas Hill, executive]

Yes. Thanks, Kathryn. Our Austin and our North Texas businesses are very highway dependent. And in fact, I think our TXDOT awards are twice this year what they were last year. So in Austin, we have an aggregate and asphalt business that is recovering from a new entrant a few years ago. We're making steady progress there. Their TXDOT business is very strong. In North Texas at RK Hall, they have picked up quite a bit of work and been very active in the last couple of lettings. Big letting coming up next week. And overall, we are seeing that strength in awards. And in West Texas, where we had some TXDOT work, but we're more aggregates and ready-mix there, the Permian Basin and Midland/Odessas are just on fire. And we're doing extremely well there and that should continue to improve as the year goes on.

[Operator]

Our next question comes from the line of Scott Schrier with Citigroup.

[Scott Schrier, analyst]

I'm curious if you could elaborate a little more on how you get confidence in the second half of this acceleration in pricing and volumes? Particularly, in Houston, you made your point about labor shortages may be slowing down some of the rate of construction there. I'm just trying to reconcile these 2 somewhat conflicting statements? Also it sounded like you made a little commentary that you might have given up some share. So I mean, do you see more disciplined behavior by market participants that would enable for this pricing to move forward?

[Thomas Hill, executive]

Well, I think the fact that a number of these large projects are getting going will certainly soak up a lot of the supply in the market, which we're confident we can then increase our volumes. That and the fact on the aggregates side, we've picked up a couple of new customers and our backlogs are up. And actually overall Summit, our backlogs are up. So that's probably the best forward-looking indicator metric we have in our business. And our backlogs are up and we're very confident going into the second part of the year.

[Noel Ryan, executive]

And Scott, this is Noel Ryan. I would also offer that, that $16 million is not inclusive of any benefit that we might receive from a 6% aggregates price increase in Texas effective October 1, which would be the second price increase of the year. And it does not include another rate mix price increase effective October 1, which that too would be the second price increase this year. So we're building in some cushion there. And we want to make sure that we're in a position where we can run according to expectations.

[Scott Schrier, analyst]

Thanks for that color. And for my follow-up, so some of your largest peers that participate more in a larger infrastructure market have talked about a lag in between the timing it takes to implement price increases, and when it starts to actually ship, coupled with a backlog of older, longer-dated projects, since you don't really participate in those really large projects in the infrastructure market, I'm curious if you could speak to the timing and how fast that you could actually implement and see upper momentum in some of these pricing measures you're taking?

[Thomas Hill, executive]

Thanks, Scott. Because we don't have large projects in backlog at fixed prices. But what happens is when those projects start, and it takes some of our competitors' supply out of the market, it enables us on the smaller projects to get price probably quicker than if we had it in backlog. I don't know if that makes sense, Scott, but it's -- we don't like big projects pretty much across all of our businesses. We like the small- and medium-size projects that don't have the year, 2-year or 3-year lag to them. We don't -- we just have never liked those and don't pursue them. So we feel that we can probably get our price increases in a -- in quicker because of that. Because we become the excess supply in the market. And if a job comes up, the bigger players don't have the capacity and we can supply.

[Operator]

Our next question comes from the line of Stanley Elliott with Stifel.

[Stanley Elliott, analyst]

Can you talk a little bit more about the cost side and the creep in the quarter? And did I hear that it was kind of $30 million higher than what you would have thought heading in?

[Thomas Hill, executive]

Yes. We had $33 million more variable costs than we -- well, overall, we had $33 million of increased costs. That's broken down into $20 million of recurring, $6 million of nonrecurring and $7 million of what we call pass-through. The pass-through is basically Cement and liquid asphalt, which we are able to get through to our customers fairly quickly. The nonrecurring consists of, we had our liquid asphalt terminal in Houston that we actually supplied liquid asphalt to our Austin business with was wiped out in Harvey last year and we were unable to buy winter fill last winter and as a result, our liquid asphalt costs are higher in Austin this year. We also had a once-off concrete issue in Western Colorado, where it was at an airport that we actually had to remove and replace that is nonrecurring. And the $20 million of recurring is freight, materials.

[Brian Harris, executive]

Labor.

[Thomas Hill, executive]

Labor and fuel. The biggest issues there were materials and fuel. We really didn't have any material wage increase. And we -- this is probably, we estimate, $15 million to $20 million more than we expected in variable costs in the first half. And we don't feel going into the second half that we'll see much more than this. And we think that price and volume will offset the already elevated variable costs.

[Stanley Elliott, analyst]

And when you talked about kind of the Cement on the river and competitors being aggressive, is the same competitor that was aggressive the one that came out with the $15 per ton increase for next year?

[Thomas Hill, executive]

No. Different multinationals.

[Operator]

Our next question comes from the line of Garik Shmois with Longbow.

[Garik Shmois, analyst]

You're talking about volume and price improving and maybe the pace of cost moderating in the second half of the year into next year. Just wondering if you can help frame up how we should think about incremental margins moving forward? And in Cement, if revenues do increase in the second half of the year, is it not unreasonable to think that your gross margins should improve as well?

[Brian Harris, executive]

Garik, it's Brian here. Thank you for the question. Yes, we would expect to see incremental margins improve. Obviously, if you look at the trend line there, it's been a little bit disappointing. Incremental margins on the aggs in second quarter were 50%. But our overall margins should improve in the second quarter as we get more traction on volume and price to offset some of those cost increases. So it's really going to be a combination of volume and price improvement that will drive those margins higher in the second half.

[Garik Shmois, analyst]

Okay, and then, Brian, on the cost increase in the quarter, the $20 million variable cost that could be recurring, I might have missed it, but did you break out how that divides up between your main business segments, aggregates, cement, et cetera?

[Brian Harris, executive]

We did not break it out that way, Garik. But just to give you a sense of some of the things that are in those variable costs that are increasing, you've got things like electricity. Costs are up this year by about 9%; coal, costs are up by about 10%. We've talked about diesel. But on-road diesel is up about 13% and off-road is up by about 23%. So even though we hedge a good portion of those costs by buying them forward and we know what the costs are going to be, we still do buy a portion about 40% over the course of the year, which we buy as spot in the market. So there's been price escalation there. Tom talked about liquid asphalt pricing. Again, we've been forced to buy liquid asphalt at spot prices this year as opposed to being able to buy forward, which we will be getting back to when our -- now that our asphalt terminal in Houston is up and running. So there's been a few things there that are in there what we would call recurring, underlying input costs. We talked a little bit about freight and trucking costs, of course, which are also higher. So that's what's in those recurring ongoing variable cost items.

[Thomas Hill, executive]

And if you look historically, the great part about our business is that price is fairly elastic and you can recover those costs through price. And in fact, most of the time, you recover more than the costs. But there is a lag of a quarter, 2, 3 quarters to get it. But historically, if I look back over the last 30 years, we've always been able to get the costs back and then a little bit more.

[Operator]

Our next question comes from the line of Phil Ng with Jefferies.

[Philip Ng, analyst]

Can you add a little color -- provide a little color on how volumes actually trended interquarter for Cement? And any update on how July has progressed?

[Thomas Hill, executive]

I don't have the monthlies in front of me. Brian, do you have that?

[Brian Harris, executive]

I mean, I can tell you basically that the trend has been one of improvement throughout the quarter. We still suffered from a slow start to the season. At the beginning of the year, there was a lot of weather-related delays, as you saw from the USGS statistics that we produced in April. Many of the markets were down year-on-year, in fact, virtually all of them north to south along the river. But we did see progressive improvements in volumes as we went through the year, and we'll continue to see that general trend over the second half as well.

[Philip Ng, analyst]

And I guess, on the second half, how are you thinking about growth? I mean, can you get back to that mid-single-digit run rate? And part of the reason why volumes reaccelerate, is that driven in part due to pent-up demand? And I guess you made some comment that competitive behavior had actually toned down a bit? Any color on that front would be helpful.

[Thomas Hill, executive]

Yes, and we definitely see some pent-up demand out in the marketplace. And in fact, our markets are healthy. And we would see mid- to high-single digits volumes in the second half of 2018. I think the first half was below expectations due to a combination of weather and certainly some limited share loss in several markets. But we do anticipate an acceleration. If you look at our businesses starting from the west, Vancouver, which is really an infrastructure market for us, projects are coming through. We are getting ready to complete the largest capital project in the company's history at the Cox quarry, which will come online on October 18. It's on time and on budget, and actually it looked very well timed as a lot of these big infrastructure projects are coming onstream in the second half of this year and next year. The Western Slope of Colorado is extremely strong. Our business on the Western Slope is doing very, very well. The front range of Utah is also very strong. Our volumes and price are up very strongly there. And as I mentioned earlier, Odessa/Midland is basically sold out. Austin is continuing to recover slowly. We've talked a lot about Houston. In the east, our Kansas, Kentucky and Missouri businesses have seen decent volume growth, but probably ready-mix has also been quite strong there. But what I like about those three markets. Although their sort of underlying private construction is sort of low growth, all 3 of those states are working on funding mechanisms to really ratchet up their highway spending, and we would be very optimistic that at least in 1 or 2 of those states, that will have an impact in '19. And then, we've talked about Cement. We're very encouraged going into the second half that the competitor that we talked about is basically at capacity. So certainly, we see our volumes picking up in the second half. So overall, demand going into the second half, there is strong pent-up demand. The market fundamentals are there, and we see us picking up momentum on the pricing side also to offset some of these underlying cost increases.

[Operator]

Our next question comes from the line of Mike Dahl with RBC Capital Markets.

[Michael Dahl, analyst]

I have a couple of questions related to just the M&A comments on the balance sheet. One, you made a comment that several large deals have fallen off the radar a bit for a variety of reasons. But just wanted to get your sense of kind of the composition of the deal pipeline as it remains. And relatedly, I guess this is more conceptual, but if one of the concerns that we hear voiced pretty consistently from investors is there has been a lot of sensitivity in the market around leverage today than there was, call it, 6 or 12 months ago. You've got the outlook for 3.5x by the end of this year, but that's dependent on getting on how the acquisition pipeline comes through. With your stock where it is today, are there -- it's probably less appealing to issue equity. So just kind of conceptually, how are you thinking about the M&A strategy or capital allocation as you look forward?

[Thomas Hill, executive]

Yes, I'll let Brian handle the leverages. In our deal flow, we're very busy on the small, medium-sized bolt-on acquisitions, which have been sort of our mainstay. The larger deals, we evaluate on a deal-by-deal basis. And obviously, as your equity goes down, your cost of capital goes up. And -- but we certainly -- I can say right now there is nothing imminent. And in fact, the number of larger platform deals has diminished since the last quarter. So with that, Brian, on leverage?

[Brian Harris, executive]

Yes, so on the leverage. Our thesis has always been -- has been pretty consistent over the long term that our goal is to drive the leverage down lower. We are, obviously, very mindful of where we are in the cycle in that context. And we -- the pace of acquisitions and M&A goes hand in glove with the cycle and our goal to reduce our leverage over the long haul. We're quite comfortable getting to 3.5x. You've seen that short-term spike up in the first half of the year as a result of the acquisitions that we've done. And we've always been able to bring that back down with organic growth. We think that's still the position that we're in today, and we have significant free cash flow with which to pursue those smaller single and double bolt-on acquisitions that Tom just mentioned that we have in the pipeline. So the goal long term, reduce leverage over time and we'll manage our capital allocation based on where we believe we are in the cycle.

[Michael Dahl, analyst]

Okay. My second question is -- it's somewhat housekeeping related. You talked about the fuel spend and the hedging strategy heading into next year. If you look at kind of where spot is and what you've got under contract already for beginning of next year and looking at the curve, do you have any ballpark of what you think blended costs could be for you in fiscal '19 versus '18, at least on the hedge portion?

[Noel Ryan, executive]

Yes, so -- so far -- it's Noel. So far, we've hedged about half of our diesel consumption for '19 at an average per gallon price of $2.23. So it's slightly higher year-on-year, but the goal is not to time the market, the goal is to have certainty within your outyear budget. And so again, we're going to be 70% hedged by the end of this year for '19. And we're buying ratably on a month-by-month basis. This isn't as if we're buying 70% all in one monthly outyear. It's ratable throughout the year.

[Operator]

Our next question comes from the line of Brent Thielman from D.A. Davidson.

[Brent Thielman, analyst]

Tom, a clarification on that prior answer, but the inflationary pressures and the price lag taken as much in the quarter, should we take that as agg margins could take the 4Q to rebound versus prior year or could it happen sooner?

[Thomas Hill, executive]

Well, you have some operational leverage as your volumes increase that will help to boost the margin in Q3 and in Q4. But your price increases typically go in effect April 1. And you don't get all that price April 1. You have protected jobs. You have some larger customers, and it really flows through in April and May. We would expect on aggregates and on ready-mix that by the start of the third quarter, they have been fully implemented. It's really Q2 that we saw the lag because you don't get it immediately as Q2 starts out. So no, I would think you'll see some decent margin improvement in Q3.

[Brian Harris, executive]

And at this point in time, Brent, we'd anticipate with $330 million of EBITDA required in the second half of the year to hit the midpoint, we think of a Q3, Q4 phasing of kind of a 55 for Q3 -- 55% for Q3, 45% for Q4.

[Brent Thielman, analyst]

Okay. Tom, is there any historical precedent that when you see this large hole in Cement volumes and what sounds like a decent market and, I presume, it's created a buildup in backlog. Has that tended to create some bubbles in price in the past as customers get scrambled for product going forward?

[Thomas Hill, executive]

Yes, I mean what's happened in 2018, there's probably a number of projects that are -- because of the wet weather, that are going to shift into 2019. If we return to our normal underlying 3% demand plus projects moved into 2019 from 2018, you should see a very healthy supply and demand dynamic, where pricing should be quite good. Now we can't predict the weather. I think our -- the competitive pressure should ease. So what you want in the Cement business is to be on allocation. You want capacity to be fully utilized and you want the excess to be serviced by imports, which we actually have the capacity to do. So I think we're getting very close to that. Whether that happens in '19 or '20, we'll see. But I think the underlying fundamentals of the Cement business remain quite healthy except for a couple of bumps in 2018.

[Operator]

Our next question comes from the line of Jerry Revich with Goldman Sachs.

[Jerry Revich, analyst]

Can you talk about on the products' gross margin outlook, what are the puts and takes as we think about the back half, as you think about what's better in guidance? Do we get back to getting margin expansion in products or the pressures that we saw to input costs in the first half enough to drive year-over-year margin compression for products in the back half?

[Brian Harris, executive]

Hey, Jerry, so in the products, we have the ready-mix and we have asphalt. In the ready-mix, we will start to see the price increases in the Houston market take hold. As we said, we're contemplating a second price increase in October, which will further boost those margins. So we would expect to see a return there. And liquid on the asphalt side, we should also see improved margins as the jobs that are bidding in the second half now contemplate higher prices. So I think you see a recovery in the underlying products margins over the second half.

[Jerry Revich, analyst]

On a year-over-year basis, not sequentially, but we're talking year-over-year?

[Brian Harris, executive]

Yes, on a year-over-year basis, you will see an improvement probably as well. Keep in mind that in the second half of last year, we had Harvey, was a huge impact. So notwithstanding another 500-year storm, we should see an improvement there. Harvey was a significant drag on margins from the standpoint of lost volume, lost productivity and incremental costs incurred. So year-on-year, I would expect the ready-mix margins to improve.

[Thomas Hill, executive]

Yes, and I also suspect that Harvey had an impact on price as there was virtually no activity for a couple of weeks. And as people were trying to get back up and running, I think some of the smaller players might have been a little aggressive on to get back some of the volume lost due to Harvey.

[Jerry Revich, analyst]

Okay. And then in terms of from a predictability standpoint, some of the cost items we're talking about in terms of not being able to buy liquid asphalt earlier and other factors, feels like we had some visibility on that earlier in the year. So can you just talk about what really changed regarding those factors compared to the initial guidance? And how should we think about potential cost items in the back half of the year versus guidance? How do we build comfort that we've taken a conservative enough view around cost in the back half?

[Thomas Hill, executive]

Well, the recurring cost that we saw where freight, labor, materials inputs and fuel. I mean, we've talked about fuel. We're pretty well hedged on that. The materials inputs, they are a little bit like our business, where they get price increases early in the year and they don't tend to get a second one in the second half. So I think those costs are where they are. Labor, we've had a -- not really a material increase in our labor costs, we've had some. And freight, surprisingly enough has been probably the smallest of the recurring costs. We don't have a lot of rail or we have no -- outside of Cement, we don't barge any aggregates. We have very little rail. Our freight cost is primarily trucking, and there's been some increase, but again, not material. The biggest elements have been materials inputs and fuel, both of which we really feel we have a handle on what the costs are going to be in the second half.

[Brian Harris, executive]

And the liquid is -- just to add to that, the liquid is a pass-through in virtually all markets other than in Texas. So that's the one where, obviously, the Houston terminal had an impact in our Austin asphalt business. But that's now behind us. So that headwind should be a one-off.

[Operator]

Our next question comes from the line of Nishu Sood with Deutsche Bank.

[Nishu Sood, analyst]

Just sticking on the topic of costs. Just wanted to get some clarification on some of the numbers. On Slide 6, the first half, the $33 million in cost inflation, Tom, I think you said $20 million was not expected or was greater than expected. Can you walk us through across those 3 different buckets, how that...

[Thomas Hill, executive]

Yes, on the recurring costs, we had in our initial guidance about $8 million. So $12 million of that $20 million was unexpected in half 1. Obviously, the nonrecurring was not expected. And then the $7 million of the pass-through we had, the Cement was expected, the liquid asphalt has been a little bit higher than we expected, but because it's a pass-through, it's not really relevant to margin. So does that clear that up a little bit, Nishu?

[Nishu Sood, analyst]

Yes, that's perfect. And then on the bridge on Slide 5 has a markdown of the EBITDA guidance by $30 million. Does that tell us then that you expect an additional -- there was an additional kind of $10 million -- you're expecting kind of $10 million more than you originally expected in the back half of the year? I mean, thinking...

[Thomas Hill, executive]

No really, on the on variable costs. And actually it’s a $35 million decrease in -- to a midpoint $505 million to $470 million. The variable costs, as I said, $12 million were unexpected in the first half of the year, and we expect those to continue in the second half. So that's $24 million. The nonrecurring, we don't expect any new nonrecurring. And our Cement in Houston operations are $25 million, less than expectations in our initial guidance. And then we have that partially offset by the 4 new acquisitions and the $16 million of price, volume acceleration above the initial guidance, which really results in volume in mid- to high-single digits and price in low- to mid-single digits in the second half.

[Operator]

Our next question is a follow-up question from the line of Stanley Elliott with Stifel.

[Stanley Elliott, analyst]

Just for a point of clarification. Did you all say kind of the cadence of this remaining $330 million would be 55% Q3, 45% Q4?

[Thomas Hill, executive]

We did.

[Stanley Elliott, analyst]

And what is driving the big -- I mean, if you guys did, let's call it, 110 last year Q4 kind of implies like 150 in this Q4, what are some of the big drivers? Is it really just the reacceleration on the pricing and the volume piece plus some of the acquisitions? Or does the margin environment getting better? Just trying to help kind of frame out that jump?

[Thomas Hill, executive]

Well, I think the major element there is the pent-up demand from the late spring/wet summer that we -- as long as the weather stays strong, we're very, very busy. So I think that's the primary reason for Q4 being strong.

[Noel Ryan, executive]

We also have the Harvey benefit coming through. So recall that we lost about $15 million in Harvey last year. And so you're going to see a lot of that come through in the back half.

[Operator]

[Operator Instructions] There are no further questions in the queue. I'd like to hand the call back to management for closing comments.

[Thomas Hill, executive]

Thank you, operator, and thank you all for joining us. That concludes our call. I hope everyone has a good day.

[Operator]

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.