Description

We last wrote up HeidelbergCement (HEI GY) on August 7, 2015, on the back of its recently announced acquisition of Italcementi, which was poorly received by investors.  We typically wouldn’t re-post the same name within just a few years, but we believe the HEI GY opportunity is perhaps even more compelling today than it was two years ago.  

Despite solid share price appreciation since our last write up (shares are up +21%), recent performance has been lackluster.  Since the election, which marked a period of strong performance for many infrastructure-related stocks, HEI GY shares are actually down just over 1%, while the S&P and DAX Indices are up +13% and +18%, respectively.  To be fair, most of the cement sector has underperformed (LafargeHolcim +3% and CRH +4%, with Buzzi Unicem +26%), though HEI GY is the laggard.

While the underperformance is at least partially explainable by a number of factors—lackluster quarterly results punctuated by a somewhat confusing and poorly communicated Q4 print, a stronger Euro, and continued focus on disappointing results in HEI GY’s Indonesian business (HEI GY owns 51% of publicly traded Indocement/INTP IJ) among others—we think the forward outlook is much more positive and that the current valuation is too cheap on both an absolute and relative basis.

Investment Thesis Update

We should note that the core tenets of our investment thesis as described in the original write-up are largely the same: 1) positive inflection across key financial metrics, in particular free cash flow which in turn drives deleveraging and opens up the potential for more shareholder-friendly capital allocation; 2) improving ROIC at both the HEI GY and industry level, aided by a wave of consolidation; 3) an attractive valuation relative to the underlying assets; and 4) too much negativity around the Italcementi acquisition.  We’ll briefly update a couple of these before elaborating on the current backdrop.

FCF Growth – In addition to margin expansion from synergy realization on the Italcementi acquisition and operating leverage on the legacy assets, HEI GY’s earnings and FCF will continue to benefit from significant reductions in interest expense over the next 2-3 years as they refinance existing debt at very attractive rates (HEI GY raised over €5bn of debt in 2016 and 2017 to fund Italcementi and existing maturities at a blended cost of ~1.6%).  Just last month, HEI GY issued €500m of 10-year notes at a 1.5% coupon.  The company has almost €4.5bn worth of debt maturing in 2018-2020 at average coupon rates of 7.1%, 5.4%, and 5.9%, respectively.  These refinancing transactions alone represent >€200m of pre-tax interest savings over three years.  With net leverage dropping below 2x in 2018, HEI GY is positioned to: 1) continue with its progressive dividend policy; 2) pursue smaller tuck-in M&A transactions; and 3) repurchase shares (competitor LafargeHolcim has been actively buying shares, a relatively uncommon occurrence in the cement industry).  HEI GY’s dividend has already doubled over the past two years, with the payout ratio increasing from ~15% to ~30%.  The Company is aiming for a payout ratio of 40-45% by 2019, which suggests the dividend could double again over the next 3 years.

Italcementi – The early performance of the Italcementi assets has been mixed, with pockets of strength (e.g., U.S.) offset by weakness in selected markets (e.g., Egypt).  Ultimately, the success of the deal will be a function of performance in Italcementi’s core Western and Southern European markets (Italy, France, Spain), which remain depressed.  As we mentioned in our initial write-up, at the time of the acquisition announcement, almost 30% of Italcementi’s revenue base was earning <5% EBITDA margins.  Spain remains cyclically depressed but likely can’t get much worse from a cement perspective.  France, historically a well-structured cement market, has seen limited volume growth which in turn has limited pricing.  Recent data points, however, have turned positive, with housing starts accelerating to +15% in 2Q after a number of quarters in the LSD and construction PMI remaining in positive territory for the eighth consecutive month in July.  As for Italy, HEI GY has signaled a desire to play a part in repairing what has been a structurally broken market for many years through market consolidating transactions.  Buzzi Unicem (BZU IM), the other large Italian cement player, took a small step in that direction recently with its recently completed acquisition of privately-held Cementizillo.  This follows Cementir’s (CEM IM) €125m acquisition of privately-held Sacci last year.  HEI GY and BZU IM also implemented price increases this year for the first time in many years, though it remains to be seen whether they actually stick.  Like Spain, however, it’s hard to see how numbers get much worse in Italy.  When it’s all said and done, thanks to incredibly cheap financing and upgraded synergy targets (latest operational synergy target is €425m, well ahead of initial expectation of €175m), we expect the Italcementi deal to be successful over the long-term.  

Cycle – Putting HEI GY’s overall results into context from a cyclical standpoint is a challenging exercise given its combination of mature, developed markets and secularly growing emerging markets.  Having said that, we feel pretty comfortable that the developed markets are closer to mid-cycle than peak, which informs our financial forecasts and multiple selection.  Western European cement consumption is still >20% below peak.  Using country-level data and weighting those figures according to HEI GY’s capacity mix suggests HEI GY’s Western and Southern Europe business is >30% below peak.  Similarly, U.S. cement consumption of 92mt in 2016 was 25% below the most recent peak of 123mt in 2005.  Barring a global recession, HEI GY’s markets still have plenty of room to run (though the Company is subject to capacity limitations in the U.S., so the majority of growth in that market will come from continued pricing actions and small incremental capacity additions, both organic and inorganic).

Short/Medium-Term Outlook

As for the forward outlook, there are a number of reasons to be optimistic:

• The U.S. business, HEI GY’s largest profit contributor, continues to perform well and enjoys long-term secular tailwinds from increased infrastructure investment.  Recent data points point to strong momentum.  U.S. cement prices rose +7% y/y in May, demonstrating continued strength as utilization remains high and supply constrained.  Volumes are subject to regional and weather-related variability but have generally been good.  U.S. rail shipments of aggregates have accelerated in Q2 and are now up >20% y/y over the past month

• Early indications are that cement prices are moving in the right direction in Europe as demand improves and utilization begins approaching levels at which the cement companies can begin pushing through price increases (current utilization in Western Europe ~68%, whereas rates in the mid-70s are required for price taking).  After 10 months of price declines, Euro area cement prices increased in March and April.  We’re not declaring victory quite yet, but it’s good to see these numbers trending in the right direction

• The strong/improving performance in these large developed markets should also show up more clearly in HEI GY’s financials beginning next quarter.  Q1 results were below consensus as weakness in select African markets and Indonesia outweighed strength in HEI GY’s developed markets.  However, given seasonality (i.e., timing of the construction season start), North America and Europe are only ~25% of EBITDA in Q1 but ~70% of EBITDA in each of Q2 and Q3 and 50% in Q4.  The aforementioned strength in the U.S. and improvements in Europe should lead to accelerating earnings momentum as we move through the year

• Indonesia, a source of intense investor scrutiny over the past few years given deteriorating fundamentals, should be less of a headwind going forward.  Demand growth accelerated in 1Q/2Q, though we have seen a number of false starts and the timing of Ramadan creates a tough Q2 comp so we are realistic about short-term performance.  Nevertheless, we think the amount of focus placed on Indonesia is out of line with its profit contribution (now only a MSD percentage of total EBITDA adjusted for the fact that HEI only owns 51%)

• In addition to Indonesia, another persistent leg to the bear case has been the potential for cement exports out of China.  The Chinese Cement Association has proposed a series of reforms which aim to consolidate and shrink China’s cement industry.  The proposal could require up to a 400mt reduction in clinker capacity, which represents ~20% of China’s total cement capacity.  We were never huge believers in the risk of Chinese cement exports having a major impact on HEI GY’s business—this announcement seemingly supports our point of view

Valuation

Thanks to the aforementioned acceleration in free cash flow, HEI GY is currently trading at a 6%, 9%, and 12% FCF yield on our 2017-2019 numbers, respectively (or a 9%, 12%, and 15% maintenance FCF yield, respectively).  For valuation purposes, however, we’ll focus on EBITDA as that is the metric on which investors have historically focused.  We think the business should be able to generate just under €4.0bn in EBITDA in 2018.  Applying 7.5x to the cement business (ex-Indocement), 11.0x to the aggregates business (seemingly very conservative relative to Vulcan Materials and Martin Marietta’s 13-14x), 5x to the ready-mix/asphalt/other, and 9x to Indocement, implies a blended EBITDA multiple of 8.4x (in-line with HEI GY’s current 2017 EV/EBITDA of 8.3x).  On our 2018 numbers, this implies an enterprise value of €31.5bn.  Adjusted for net debt, minorities, and interim dividends, we arrive at a target share price at year-end 2017 of €112, up almost 30% from current levels.  Extending the time horizon and/or more explicitly factoring in future optionality from capital allocation gets us to bull cases of +50% from the current €87 share price.

For those of you interested in further reading, HEI GY has been subject to a wave of sell-side upgrades over the past month, many of which actually do a pretty good job summarizing the bull case in greater detail.  Despite the sell-side’s newfound interest in HEI GY, the buy-side isn’t yet biting.  While this isn’t a call on a quarter, we think more constructive (ha) Q2 and Q3 results will be well received and should refocus investors on the medium-term thesis of significantly higher FCF generation.

Disclaimers:  

We and our affiliates are long HEI GY. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Quarterly earnings