• Buy AfriSam Secured FRNs due 2/4/2012 for an expected annual return of ~15% for 3-4 years

• Loss of principal is a low probability because of seniority to junior debt and equity, property, plant & equipment collateral, and attractive valuation: AfriSam's FRNs are levered 4.5x through the face claim and at the market price of 75-80 the FRNs are 3.5x LTM EBITDA of $2.2B --Pretoria Portland Cement (PPC SJ), another South African cement producer, trades at 7.1x LTM EV/EBITDA and the trading range for publicly traded cement producers across developed and emerging markets ranges from 6-8x LTM EBITDA

• The South African cement industry has high barriers to entry due to: a) limited access to limestone and mining permits, and b) the South African Black Economic Empowerment (BEE) program aims to promote black equity ownership and management representation of greater than 26% among companies that compete for government contracts

BACKGROUND/HISTORY:

AfriSam is the 2nd largest producer of cement in South Africa. The company was founded in 1934, however, the current ownership structure was formed in Jun-07 when Holcim Ltd, a CHF 20B market cap Swiss multi-national building products, cement and aggregates producer, and Aveng Ltd, a $17B market cap South African construction and engineering company, sold their respective 54% and 46% ownership stakes in the company (formerly known as Holcim SA) to a consortium including South Africa's government run Public Investment Corp which renamed it AfriSam.  

AfriSam's FRNs are trading at depressed levels for three reasons.

1) Sharp decline in operating rates.  Demand for cement has been in decline since late 2007 which has put downward pressure on industry demand and AfriSam's volumes.  So far, price increases have offset declines in volume so that revenue and profits have been flat, but there are concerns that price discipline could collapse.  In June-09, the South Africa Competition Commission launched an investigation into anti-competitive pricing behavior among cement producers and the investigation could result in stricter price regulation.  

2) New supply.  At the same time, Sephaku Holdings, a publicly traded South African mining and exploration company has entered into a joint venture with Dangote Industries, the Nigerian manufacturing conglomerate, to invest R3B in a project that will add 2.2 tons per annum of production (12% of industry supply) at two new cement manufacturing facilities.  (Industry operating rates were over 100% at the time of the announcement.)  Construction is expected to be completed by the second half of 2012.

3) High leverage.  The buyout transaction by the AfriSam consortium in Jun-07 left AfriSam with high leverage (currently 7x debt-to-ebitda) that carries floating rate interest and foreign exchange rate exposure.  The company promptly hedged its exposure by swapping its floating Euribor commitment into a fixed rate obligation based on the forward curve at the time.  As the economy softened and interest rates fell, AfriSam's swap kept its interest rate high.  A likely short-term catalyst for the credit will be a restructuring to deleverage and extend debt maturities because liquidity could get tight as interest costs are scheduled to increase (because of deferred swap payment obligations - discussed later) and cash flow may decline if price discipline is not maintained.  The government is highly motivated to avoid an embarrassing bankruptcy on such a high profile equity investment for the government's Public Investment Corp. 

INVESTMENT SCENARIOS:  

• Base case = 14-15% annual return for 4 years. The most likely outcome is for the Secured FRN holders to negotiate out of court with the Public Investment Corp to extend their maturity by two years until Feb-2014 (versus Feb-2012) and for the principal to be repaid in full by a refinancing for the capital structuring after a rebound in the South African economy.  In the event that the FRN holders agree to a 20 point haircut on their claim, the return on the FRN s would fall to 9% per year for four years.

• Negative case = 5% annual returns. I'm sure there are scenarios of lower returns.  But consider this "negative" scenario.  First, assume that owing to new supply, a prolonged economic downturn, government price regulation, or otherwise, EBITDA fell 50% (it has been +/- 10% for the past four years).  Second, assume that the capital structure were restructured at 5x EV/EBITDA (peers trade tightly around 7x 2010 EBITDA, but of course this would change in the negative scenario) with a debt load such that that interest expense at a 10% coupon was 25% of EBITDA.  Third, assume that the secured FRNs got 100% of the debt and 25% of the equity (perhaps the sub-debt got 50% and the government/current equity holders got 25%).  In that case, the annual cash return for the secured FRNs would still be 5%.  (€29m of interest plus €8m of FCF for an annual cash return of €39m on an investment of €815m, all in euros)  

• Positive case = 27% annual return for 1.5 years. If AfriSam repays the FRNs in full in Feb-12 with the proceeds of an equity infusion from the Public Investment Corp or from the sale of the company then the annual return is 27% for 18 months. Perhaps more upside is possible if the notes are exchanged for equity or equity-like securities and the equity value increases substantially as the economy improves and the commensurate increase in commercial construction spending creates a strong rebound in demand for cement. 

INDUSTRY STRUCTURE

Cement production in South Africa has been an oligopoly comprised of Pretoria Portland Cement (42% share of capacity), AfriSam (24%), Lafarge (18%), and Natal Portland Cement (9%). Demand increased by 10-15% per year during 2006-08, and industry production was greater than aggregate nameplate capacity, suggesting that operating rates exceeded 100%.  The economic contraction has reduced utilization rates to about 85%.  The managers of various producers have an incentive to portray industry fundamentals poorly given the threat of new supply and the investigation by the competition commission.

Despite barriers to entry (time, licenses, capital), strong fundamentals attracted the first new entrant in decades: Sephaku is constructing a plant that will add 12% to capacity in 2012.  Moreover, the No. 2 cement producer in China, Jidong Cement, is exploring a second new plant that would add 5% to capacity, but the plant is not under construction yet and financing remains uncertain.

While I do not have a detailed cost curve, engineering firms estimate that new kilns have a 20-30% cost advantage. Meanwhile, transporting cement and clinker 200-300km in South Africa doubles the delivered cost, so the cost advantage of a new plant that isn't well located is quickly diminished. 

AFRISAM'S LIQUIDITY PROBLEMS

AfriSam's operating earnings have remained fairly stable despite the decline in volumes and operating rates because of price increases.

And as the table below illustrates, the company's interest coverage and leverage have remained stable so far during the recession. 

(ZAR-mm)        Jun-07  Sep-07  Dec-07  Mar-08  Jun-08-us">  Sep-08  Dec-08  Mar-09  Jun-09  Sep-09  Dec-09  Mar-10  Jun-10 
EBITDA  504     632     590     435     474     571     4230    559     556     617     584     480     515    
Cash interest   17      355     396     271     564     615     369     323     340     323     396     413     430    
Capex   68      91      216     145     129     143     195     88      111     121     50      93      58     
EBITDA/Interest (LTM)                   2.8x    2.1x    1.3x    1.1x    1.1x    1.1x    1.3x    1.6x    1.7x    1.5x    1.4x   
Debt/EBITDA (LTM)                               8.0x    8.2x    7.9x    9.8x    8.9x    7.8x    7.6x    7.4x    7.8x    7.6x   

But continued volume declines, new capacity, and an investigation by the South Africa Competition Commission could threaten AfriSam's pricing power and profitability (the penalty situation may not be devastating because the government owns 25% of the AfriSam equity) and make it difficult for the company to service debt. Another problem is an interest rate swap with Citi that fixed the "floating" interest rate on the Floating Rate Notes. Citi agreed to defer payments on the swap until 2010 and 2011, so catch up payments are required and AfriSam's cash interest obligation increases by R300m in 2010 from R1.4b in 2009 to R1.7b in 2010.

There is a positive to a payment default or restructuring event that would surprise many US bondholders because of the type of swap that Citi and AfriSam negotiated.  The swap is called an extinguishing swap (common in Europe but not permitted in the US).  According to the company, the contract is torn up in the event of a default.  This aspect of the swap contract significantly reduces Citi's leverage because in the event of a default they would have no claim against AfriSam for damages under the swap contract and annual cash interest would fall by approximately R325m, which explains why Citi was willing to allow AfriSam to defer payment on its swap obligation from 2008 and 2009 into 2010 and 2011. 

50-90% DISCOUNT TO CONSTRUCTION COSTS

The FRNs currently trade at up to a 50% discount to replacement cost.  At 79% of €1,029m, the market price of the FRNs is €815m.  Since AfriSam has 4.6m tons of capacity, the FRNs trade at €177 per ton of capacity.  Both Lafarge and Pretoria Portland Cement expanded production at existing plants in 2009, adding 1m and 1.25m tons of capacity at estimated costs of €200 per ton. Engineers report that construction costs for Greenfield plants cost €345 per ton, and for Brownfield run €200-250 per ton.  Sephaku is constructing a very large new plant and budgets costs of €155 per ton, though the plant is scheduled for completion in 2012 and so that estimate may prove high or low.  The most reliable data seems to be the recent expansions that cost €200 per ton, and the FRNs trade at 90% of that metric.  In a best case, the FRNs trade at 50% of estimated Greenfield costs.  In a worst case, they trade at 115% of estimated cost for a plant which has a planned capacity equal to 12% of all current domestic capacity.

OPTIONAL HEDGE

An investment in the AfriSam FRNs may be hedged by a short in the equity of Pretoria Portland Cement (PPC SJ) which trades at 7.1x LTM EV/EBITDA.