Description

CX ($39.54) – Cemex (6/12/07)

 

 

Cemex is a combination of a good global business with great management and value (10% FCF yield, 27-52% upside). With the expiration of the tender offer for Rinker on June 22^nd, restricted analysts (especially JP Morgan one) should resume coverage with a bullish tone. After the acquisition completion, the company should set up an Investors Annual Meeting and present higher targets for synergies at Rinker. Due to the strong reduction in imports and the oligopoly of the sector, there should be a sizable price increase in US cement in 2007 or maximum January 2008. This is not contemplated in the market expectations which focus on the weak US housing demand. Finally, the US comps will start to improve in the next few quarters and when the street start looking into 2008 they should see a good momentum picture (overly biased by US news) increasing the attractiveness of an already great  business, management and value story.

 

Business Analysis

 

The building materials sector has been consolidated into 3 major global cement players: Cemex (Mexican), Holcim (Swiss) and Lafarge (French). All 3 have global presence and present an organized oligopolistic behavior.

 

Cemex is present in 3 main businesses: cement, aggregates and ready-mix concrete. Cement and aggregates are inputs in the production process of ready-mix concrete.

 

Cement (72% of EBITDA pre Rinker, 57% after Rinker)

 

Cement is a low value-to-weight product at around $100/ton. Therefore competition and demand drivers are mainly local, generally restricted to 100-150 miles. It is hard to import/export cement because of transportation cost, humidity and the need of port infrastructure and grinding facilities (most imports are done through clinker which is grinded into cement at destination). As a consequence, global trading accounts for only 7% of consumption. The majors Cemex, Lafarge and Holcim control most of global trading, which is very important in the United States, where imports represented 24% of consumption in 2006.

 

In developed countries, it is very hard to expand supply due to difficulties in getting the environmental license and permits for new quarries and plants. Community resistance (NIMBY) is also strong. Holcim, for instance, gave up on a plant expansion in the US after many years of unfruitful efforts.

 

In developing countries, most of cement is consumed by the informal economy through the sales of bags (vs. bulk). Clients are very small and pulverized and distribution and brand become strong barriers to entry. Margins are higher than in developed countries.

 

In summary, the combination of high transportation cost, licensing/permits/NIMBY restrictions, pulverized distribution and oligopolistic behavior present strong barriers to competition in the cement business.

 

Aggregates (9% of EBITDA pre Rinker, 13% after Rinker)

 

Aggregates are even more expensive to transport ($10/ton). In the US, reserves are even scarcer and consolidation is creating a secular shift in pricing with margins expanding 200bps per year. This business should be as good as or even better than the cement business. The market currently trades pure US aggregates stocks at P/Es higher than 20x..

 

Ready mix concrete (15% of EBITDA pre Rinker, 20% after Rinker)

 

Contrary to cement and aggregates, ready-mix-concrete is a much less capital-intensive business. Barriers to entry are much smaller and profitability much more cyclical. Some exceptions happen in market where vertical integration is the norm, as Florida and California in the US. In these cases, it is harder for non-integrated players to compete because of the difficulties in guaranteeing supply of cement and aggregates. In these situations, margins may be more resilient and less cyclical.

 

Geographic Exposure

 

Cemex sometimes is excessively discounted for being listed in Mexico and for being exposed to US housing.

 

Mexico represented only  33% of EBITDA in 2006 (and this should fall to 24% after the acquisition of Rinker. They are truly as global as Holcim and Lafarge, but analysts generally attach a higher WACC for them because of its Mexican listing (and perhaps its name). The acquisition of Rinker may help change this risk perception.

 

Many American investors use Cemex as a vehicle to play US housing. However, US was only 29% of EBITDA in 2006. Moreover, most of cement sales are to infrastructure and non-residential construction. US housing probably represented less than 10% of EBITDA in 2006. With Rinker acquisition, this number should grow to a bit more than 15%. This misperception may help explain the stock being flat in the last 12 months. For example, in 1Q07 US EBITDA went down by 34% YoY (weather and housing effects), but total EBITDA was up 6%. Company guides a 5% growth in total EBITDA in 2007.

 

Management, Taxes and Acquisitions

 

Cemex has a great management, probably the best in this sector. They are also very aggressive and have almost eliminated its taxable income in Mexico. They benefit from loopholes in the Mexican tax system for multinationals. Many of their companies have R&D expenses paid to its Switzerland subsidiary, where R&D is not taxed. The overall effect is an accounting tax rate of 17% in 2007 of which only 11% are related to cash taxes.

 

Cemex tax rate should increase over time. A change in tax legislation in Mexico is reducing the alternative net asset tax rate but limiting the deduction used for net asset calculation. This should have a negative effect on Cemex. Over time as the company grows through acquisitions, it should be more difficult to maintain a low tax rate which has grown in the last 3 years.

 

The problem of having no taxable income in Mexico is that it makes no sense for them to pay dividends of make buy backs, since this would be taxed at full tax rate. Therefore Cemex is a cash flow machine which needs to use its cash in acquisitions to avoid worsening its capital structure and tax planning. The good thing is that management has created a lot of value in the acquisitions. They have a 10% ROCE target which needs to be achieved in 3 years after any acquisition. They also have a great experience in integration and the implementation of best practices across the organization. Cemex has historically presented a ROIC 200-300 bps above its WACC.

 

Rinker Acquisition

 

The most recent corporate event is the acquisition of Rinker, an Australian company with strong presence in the US markets (mainly Florida). The risk of overpaying has been a drag in the stock performance in the last 12 months. Cemex, however has recently obtained the support of Rinker’s management and last week the deal became a sure thing as Cemex achieved the 50% minium acceptance level in the tender offer. The tender offer expires on June 22nd.

 

Rinker is being acquired at a 5% FCF Yield (no leverage). With the announced operating sinergies of $100mm/year, this increases to 5.6%. If one assumes tax rate being reduced to 17%, FCF Yield becomes 7.1%.

 

The acquisition (US$14.3bi) is totally debt-financed at an estimated rate of Libor + 40bps. Therefore, I estimate that the new Cemex is trading at around 9.8-10.5% of Equity FCF Yield after maintenance capex (depending on tax savings potential). Even on an operating basis the FCF Yield would be 7.4-7.8%. Since this is a great business where WACC should be around 8%, it is easy to see that even by assuming CPI growth only the stock presents a substantial upside.

 

The conclusion of the Rinker acquisition should bring some positive triggers to the stock. Restricted brokers (UBS, JP Morgan and Citibank) should resume active coverage of the name with a bullish tone. Unfortunately, I was lazy in publishing this recommendation and Citigroup resumed coverage recently with a $42 target price ($56 on DCF) and the stock went up 10%. However, the most influential analyst in this sector is the one from JP Morgan who he should resume coverage only after the tender offer conclusion. Analysts as a whole should start making projections for the new company, probably with a lower WACC. The company should also set up its annual investors meeting, which should give the market more color on the acquisition, Mexican taxes and US market trends. After Rinker due diligence, they will probably announce a more aggressive target of synergies for the transaction.

 

US Market

 

The US cement market was definitely down in the last 12 months. As the table below shows, the housing slowdown which started in April/06 led to annual volume reduction of up to 8% YoY in 2006. The 1Q07 presented and even lower annual reduction of 16%, but this reflects the abnormal good weather presented in 1Q06. Since US housing permits are down 30% YoY and represent 30% of the market, it is expected that total market should be running at an 8% annual decline. Infrastructure and non-residential segments are growing.

 

Cement	Sales YoY	Import YoY	Import/Sales
Jan-06	27%	44%	24%
Feb-06	12%	33%	25%
Mar-06	8%	24%	25%
Apr-06	-4%	4%	25%
May-06	1%	11%	25%
Jun-06	0%	11%	25%
Jul-06	-2%	4%	25%
Aug-06	-4%	-2%	25%
Sep-06	-8%	-6%	25%
Oct-06	-3%	-4%	24%
Nov-06	-8%	-15%	23%
Dec-06	-6%	-16%	22%
Jan-07	-19%	-31%	21%
Feb-07	-18%	-27%	22%
Mar-07	-11%	-26%	20%

Source: USGS

 

The good side is that comps will start to improve in the 2Q07 and definitely should be much easier in the 2H07. Even more important is that the cement majors are implementing a substantial cut in import levels. As I said before, they control cement imports in the US. Imports are done through long term contracts, however, and could not be accommodated to the demand reduction at once. Throughout the year, however, the import reduction should become a fact as is evidenced by the 28% reduction rate of the 1Q07. As soon as they are able to reduce the excess supply through import reduction, there will be 2 major positive effects: (1) margins will improve with the shift from imported material to locally produced cement as imported cement has an almost neutral profit contribution and (2) the majors will implement substantial price increases even with the demand slow down. It is important to bear in mind that the cement players have been using their bargaining power to introduce price increases in the last few years, improving profitability. This process was only interrupted in 2007 because of a temporary adjustment of supply x demand, which depends only on the reduction of import contracts. The analysts are not counting with any cement price increases in the US for the near future and should be positively surprised with this move. I believe that such price increase will happen in 2H07 or at most in January 2008. Lafarge mentioned in its conference call that they expect a 6% average price increase in US in 2007 and that they reduced imports in 40% in 1Q07. Holcim mentioned that they will zero their US imports.

 

Valuation

 

The New Cemex is expected to generate an Equity FCF after maintenance capex of $3.0bi in 2007. This is comprised of $2,700mm from legacy Cemex, $700mm from Rinker, $675mm of additional after tax financial expenses, $85mm from after tax operating synergies and $214mm from potential tax synergies. This means $4.06 per share or 10.3% of yield based on current stock price. Even without tax synergies, there would be $2.8bi FCF ($3.77share) and 9.5% yield.

 

On an operating basis the FCF yield would be between 7.3% and 7.7% depending on taxes. Assuming a target 6% yield (8% WACC – 2% CPI growth), Cemex target price should be $55-60 (depending on taxes), giving an upside of 39-52%.

 

I also ran a DCF scenario where Cemex tax advantages are eliminated after a 5 year period. This leads to a target price of $50 or 27% above current level.

 

Cemex EV/EBITDA of 8.7 is slightly above those of its global peers Holcim (7.6) and Lafarge (7.7). However, this multiple does not capture Cemex higher FCF/EBITDA due to lower taxes and maintenance capex (which is now even lower due to a higher ready-mix-concrete in the mix).

 

Cemex P/E of 11.8 is substantially discounted to Holcim (14.5) and Lafarge (14.1). Their P/E is distorted because of Mexican GAAP which overstated depreciation and has a non-cash monetary correction line which overstates true earnings.  Besides, Cemex low effective tax rate may not be considered sustainable by some investors.

 

Therefore, the best way to look at Cemex is on a cash flow basis. My analysis shows an upside of at least 27% to $50 even assuming a phase out of tax advantages in 5 years. It is important to bear in mind that we are valuing the company on the trough of the US cycle whose reversion should not only bring momentum, but make the company even cheaper. I believe there are triggers in the short-medium term to help bring its valuation to a more appropriate level.

Catalyst

Conclusion of Rinker acquisition (June 22nd)
Resumption of coverage from restricted brokers. Citi has already resumed coverage this week which led the stock up 10%, but JP Morgan is the most respect analyst and should resume coverage together with UBS.
Reduction of US cement imports and consequent US price increases.
Improvement of comps (US housing started to fall in 2Q06, 1Q06 had extraordinarily good weather).
Cemex Investors Annual Meeting - higher synergy targets for Rinker.