Description

HeidelbergCement AG (ticker: HEI GR, €52.5) (“HeidelbergCement” or the “Company”) is a €10.4 billion market cap, €23.4 billion EV construction materials company, based in Germany.  (Note – I use the ADR for the title above, but the writeup refers to the German shares and all prices are in Euros. Also I wrote this up when the stock was at €52.5). The Company is vertically integrated, producing aggregates, asphalt, ready-mix concrete, and cement.  The business supplies to all facets of construction: infrastructure, commercial, and residential.  The Company was twice previously written up on VIC by krusty75 (last time in July 2017), which provides some useful background.

Despite operating in a generally structurally attractive industry (see CRH, US aggregates players etc) HeidelbergCement’s stock has done more or less nothing for 20 years and is down from €90 just a couple of years ago. HeidelbergCement has been a poorly managed rollup in a structurally attractive industry. Under the previous CEO’s leadership, the Company prioritized growth through acquisitions and investment into new markets.  Overall those capital allocation decisions have not worked out too well, resulting in increased balance sheet leverage and poor returns.

So why look at it now? Looking past the recent macro turmoil, we think that the underlying story has changed, yielding an interesting risk-reward for those willing to take a fresh look. 

•       HeidelbergCement is entering a new chapter in its life.  The old CEO, Bernd Scheifele, stepped down in February after 15 years.  The new CEO, Dominik von Achten, seems focused on operating improvement, but the stock seems priced for “muddling along”.
•    The Company seems committed to an improved capital deployment strategy, more geared towards shareholder value rather than top-line growth, paying down debt aggressively this year.  We’re hoping for more good news in next month’s Capital markets day.
•      Improved competitive dynamics – a return to rational pricing seems to have helped in some of the Asian markets, in spite of recent volume challenges. Major competitor (and equally lousy stock) LafargeHolcim Ltd has also been re-focusing on returns rather than growth
•     The Company should be a beneficiary of the implementation of CO2 regulation that will significantly alter the European cement market competitive landscape.  
•        Likely beneficiary of any construction rebound / infrastructure stimulus spending

There’s a lot of moving parts but the gist is simple: Heidelberg participates in a structurally attractive industry with high barriers to entry.  At ~7x depressed 2020 EBITDA and 6.4x est. 2021, downside is limited.  With basic blocking and tackling we believe the stock will be worth €80 on a two-year horizon, >50% upside (but still below 2017 levels). With a commitment to really good capital allocation from the new CEO, we should see €100+. Near term catalyst in the Capital Markets Day on September 16^th.

Industry and Company Overview

HeidelbergCement operates in a structurally attractive market. Volumes are linked with construction spending.  The industry would be a beneficiary of any pent up demand in developed countries, and any stimulus-based investment in infrastructure and roadways that needs to be addressed.  Volume should also benefit from the general rise in construction spending in developing countries over time.  Competition is limited and localized due to high transportation costs and environmental permitting.  Given the weight of the products such as aggregates, transportation cost is an important variable restricting the number of possible competitors within a given radius.  Aggregates are typically sold within a 25 mile radius, and concrete is sold within a 150 mile radius.  Environmental regulation, as well as a stringent permitting process (not to mention strong NIMBY sentiment) limit new capacity in developed markets.

The Company is globally diversified with 43% of revenue coming from the two European segments, 27% from North America, 18% from Asia and just under 10% from Africa.  EBITDA geographic contribution is skewed slightly as Western and Southern European margins are lower than the others segments.

Operational Upside / Opportunities

Macro weakness, in particular Europe and emerging markets, is always a risk for these stocks, and 2020 has obviously had that in spades. After the COVID shock, recovery has been better than expected in most geographies, though Asian volumes have been slower to recover. The company has done a good job of offsetting volume impact with cost cutting from its COPE program, which should set it up well for improved profitability in the future. Looking out a couple of years, we expect the Company to benefit from improved profitability in North America and Indonesia, as well as a potential uplift from Germany where there is talk of infrastructure stimulus spending post COVID, which would obviously be a nice catalyst for HeidelbergCement’s European business.

https://foreignpolicy.com/2020/06/22/germany-covid19-pandemic-stimulus-spending-savings-glut-europe/

The Company should also get an EBITDA lift in Indonesia, an important region in its emerging market portfolio. The region’s consolidation should help the sector rebound from years of irrational pricing behavior and excess capacity, as current pricing is far from justifying new capacity additions.  Holcim Indonesia, prior to being acquired by Semen Indonesia early in 2019, was very aggressive on pricing but this dynamic has changed post deal completion, with HeidelbergCement noting price increases last year despite volumes being impacted by local issues: 

“If you look through the first 9 months, yes, our results in euro terms in Indonesia has more than doubled. Very clear, pricing is up 10%. India is also clearly up, pricing up 10%.”

 The Indonesia subsidiary’s EBITDA had declined by over 70% (close to €400 million) since its peak and has a lot of room for recovery just to reach mid-cycle levels.

And the new CEO, with experience in North America, is targeting improvements from that market too:

“I know the place quite well, I have been over there 8 years after the last recession so I know the plays quite well. And we have clear ideas how to improve, and we will address the upside potential that we clearly see in our North American result…overall, I think it's fair to say that we see some upside potential in North America”

Capital Allocation

The Company has historically been a serial acquirer of large assets.  Most notably, the Company acquired UK-based Hanson which put its balance sheet in a precarious position in 2007.  The Company piled on more debt when it acquired Italcementi in 2016 in a race to get bigger.  Management has also entered into new country markets and increased growth capex with little to show for it.  The strategy was driven in part by the desire to keep up with Swiss rival LafargeHolcim, as both undertook a “bigger is better” approach.  This thinking turned out to be flawed as the synergies among geographical regions are de minimis and the stock price performance of both HeidelbergCement and LafargeHolcim has been underwhelming in recent years. 

HeidelbergCement is no longer engaging in intercontinental deals of large scope which have proven to be value destructive strategies.  Business development will now focus on bolt-on M&A with Management only willing to pay reasonable multiples with synergy being the underlying driver, rather than size, as exemplified by last year’s opportunistic Keystone cement plant acquisition in Pennsylvania at an attractive price.  In fact, the Company is divesting non-core assets. Management had targeted €1.5 billion in disposal proceeds by 2020, about €1.2B of which have already been completed, though with current market conditions it would seem unlikely to hit the full target in time. 

The Company’s balance sheet has historically weighed on valuation, but that should reverse as de-leveraging continues.  Debt reduction is a top priority now, and with net debt down by €1.4B YTD to €9B, with around €7B possible by year end.

“the consensus currently stands at €7.2 million, yes, and €7.2 million does not make me sleeping bad in the night. So clear ambition to go below that.” (Q2 call).

At those levels Net Debt/EBITDA would be ~2.0x, not far off from peers and conservative given the attractive nature of the business.  The Company has historically valued its dividend highly, but prudently cut it at the outset of the pandemic to preserve cash, and we would expect it to be restored going forward. 

HeidelbergCement is holding a Capital Markets Day on September 16^th where we expect more clarity around future capital allocation. We’re expecting caution in the near term, but hoping for a signal on the dividend and shareholder returns in general. If the dividend is ultimately restored to former levels post-COVID it would be a ~4.5% yield.  Lastly, as the net debt ratio approaches 2x, the Company could contemplate a buyback program if the stock remains depressed .

CO2

The cement industry is a major source of carbon dioxide emissions, accounting for 8% of all global carbon emissions and ranking in the top three (after iron and steel, and agriculture) of all polluters.  In Europe, the cement industry is subject to the European Union Emission Trading Scheme (EU ETS), which is the first greenhouse gas emission trading scheme in the world, with the aim of limiting or reducing greenhouse gas emissions in a cost-effective way.  Because of the complexity of the endeavor, EU ETS requirements are implemented in phases (currently in phase III).  So far, the impact from EU ETS has been minor for the cement industry.  However, we expect this will change with Phase IV of the EU ETS, commencing in 2021, and the impact could be seismic.  HeidelbergCement expects around 40mt of cement capacity (17% of total) in Europe to be shuttered over the next decade.  The brunt of it will be borne by small players, most of which have not invested in efficient technology.  The Company has invested heavily in reducing their carbon footprint and should benefit at the expense of smaller peers who have not. Overall, Phase IV will result in higher capacity utilization and cement pricing should jump, potentially significantly, which, to be conservative, we have not modelled into our base case scenario. 

Valuation

Consensus EBITDA for 2021 and 2022 are €3.4B and €3.6B EBITDA.  We think this year’s cost cuts and a focus on operational improvements may offer upside but we’ll use those numbers. At 8-9x EBITDA (discount to CRH, Cemex, US aggregates etc) that would correspond to €80-€100 per share. I’d argue that there’s a strong argument for multiple expansion if the company can show operational improvements. HEI has big exposure to aggregates which is a much higher multiple business – look at VMC and MLM.  Also, the CO2 thing could be a huge tailwind for pricing in Europe, which is not really captured in 2021 EBITDA yet. Add it all up and you can justify a multiple >9x 2021 EBITDA, and over €100/share for the stock (bear in mind it was at €90 in 2017).

I estimate corresponding recurring FCF/share of €4.8 to €6 (calculated after lease capex and provision payments, so more conservative than Company version). I expect the dividend to be restored to offer a ~4.5% yield, which would offer further support. That would still leave significant cashflow for investment in tuck-in deals or share repurchases to drive further upside. 

In summary, if the CEO is bang average and the Capital Markets Day doesn’t offer much, I think the stock should still be worth in the €60-70 range. If the CEO commits to good capital allocation and the world returns to something approaching normal, I can see value to the €100+ range.

Risks

•     Continued macro weakness, in particular Europe and emerging markets. We would expect any effects to be possibly counteracted by government infrastructure stimulus programs.
•      Competition. The industry has generally rational competition, with Indonesia until recently having been an exception. The recent acquisition of Holcim Indonesia seems to have brought some sense to that market.
•       Balance Sheet. HeidelbergCement is levered but with reduced M&A and Capex and the dividend cut, we expect Net Debt to EBITDA to fall significantly over the next couple of years
•      Management. Meet the new boss, same as the old boss? Dr. von Achten has a background in consulting with BCG but he’s an insider, having been at HeidelbergCement since 2007. We’re not betting on some “outsider” type leader for our base case, just competence. To some degree, the market is forcing discipline on the industry, so we anything better than “more of the same” should give us upside.

Catalyst

• Capital Markets Day Sept 16
• Possible stimulus bill benificiary
• Improved capital allocation and restoration of dividend