Description

HeidelbergCement offers an opportunity to buy one of the leading global players in cement and aggregates at a cheap valuation relative to mid-cycle earnings power, much less the company’s longer-term earnings potential.  We believe the company’s recently announced acquisition of Italian cement company Italcementi, which has been poorly received by the market and adds additional inefficiency to the situation, makes a cheap investment even cheaper, and provides an attractive entry point.

Business Description

·      HeidelbergCement (HEI GY) is the second largest cement producer in the world after LafargeHolcim, with 129 mt of cement capacity, and the largest holder of aggregates reserves with 18 bnt

·         The company is exposed to an attractive combination of developed and emerging markets and does business in 40 countries.  Key geographies prior to the recently announced Italcementi acquisition are: North America (~24% of revenue), UK (~10%), Western Europe (~14%), and Indonesia (10%).  In addition, HEI’s portfolio includes various countries in eastern Europe, Africa, as well as Australia

Thesis Summary

Positive inflection point along various vectors—free cash flow, leverage, and capital returns (note: the numbers in this section are pre-Italcementi)

·         As a result of the poorly timed Hansen acquisition that left HEI highly leveraged heading into the teeth of the recession, the company has spent the last 5-6 years focused primarily on debt pay down

·         This has been accomplished through a combination of cyclical recovery in certain markets (and secular growth in others, e.g., Indonesia), significant expense reductions, working capital improvements, and the sale of the non-core Building Products business

o   Leverage has declined from 6.0x in 2007 to 2.5x today (by year-end 2015, we expect it to be ~2x)

o   EBITDA has increased from €2.1bn in 2009 to €2.9bn in 2014 on a like-for-like basis

o   Working capital days have declined from 65 days in 2009 to 35 today

·         The company’s improved financial footing positions it to generate significant FCF over the next 4-5 years, which is no longer required to pay down debt but can instead be used to increase the dividend, repurchase shares, and to make organic/inorganic growth investments

·         HEI management has laid out a long-term plan (2019 targets) that assumes the following (note: these numbers are all pre-Italcementi):

o   EBITDA growing to >€4bn from current €2.3bn and annual FCF growing from €1.2bn to €2.3bn

§  The delta between the €2.3bn of starting EBITDA directly above and the €2.9bn of like-for-like EBITDA in the 2009 vs. 2014 comparison is FX, dispositions, and changes to IFRS

§  Note that HEI benefits from large tax shields that mean it pays limited taxes for the foreseeable future in the U.S. and U.K., two if its largest, most profitable, and fastest growing markets

o   Cumulative FCF in 2015-2019 of €8.8bn, of which ~€1.0bn will be used to pay down additional debt, ~€2.5bn will go towards growth capex, and ~€2bn will be used to fund a progressive dividend (target 45% payout ratio)

o   Assuming they do not relever the business and adjusting for dividends paid to minorities, that leaves ~€2bn of capital for additional shareholder returns whether through share buybacks or special dividends equivalent to ~15% of the market cap

o   If they hold leverage at a reasonable 2.0x, it generates an additional €5-6bn of cash for deployment, representing another 30-40% of the market cap

o   The following presentation from the company’s recent capital markets day does a good job laying out the historical performance and go forward expectations (see “Building Shareholder Value, presentations Capital Markets Day 2015” at http://www.heidelbergcement.com/en/investor-presentations)

Improving industry/company ROIC

·         The cement industry and HEI in particular has historically been characterized by low returns on invested capital, driven primarily by overpriced/poorly timed M&A

·         Over the last few years, management has made it a top priority to generate sustainable returns on invested capital above the company’s WACC (~6.9%).  After bottoming at ~3% in 2009, ROIC has steadily increased and will be above HEI’s cost of capital in 2015

·         Importantly, the other large global cement players are increasingly emphasizing returns on invested capital as a key metric.  We think the transition to better ROIC will have major implications for industry valuations, which currently reflect significant discounts to replacement cost

Cheap valuation

·         We think HEI screens as one of the cheapest names in cement across a number of metrics before accounting for the Italcementi deal

·         On a sum-of-the-parts basis, we believe the implied value of HEI’s “core” cement business (excluding publicly-traded Indocement and HEI’s aggregates business, which we value at 11x EBITDA, well below industry comps) is only 5x EV/2015 EBITDA

o   Inversely, if you assume a peer multiple on the combined entity, it implies that HEI’s aggregates business, which is almost of the same scale as VMC or MLM in the attractive U.S. market, is valued at a deep discount.  We think the value of HEI’s aggregates business is underappreciated by investors

·         HEI current valuation also implies a value of ~$70 per ton, a >60% discount to our calculated replacement cost of ~$187 per ton

·         As a couple points of comparison:

o   In 2014, MLM paid ~20x forward EBITDA to acquire Texas Industries, an implied value of $290 per mt of capacity

o   In 2012, Eagle Materials acquired 1.6 mt of capacity from Lafarge at ~16-17x EBITDA, or $275 per mt of capacity

o   In 2010, Holcim constructed a new plant in St. Genevieve at a total cost of $1.6bn for 4 mt of capacity, an implied cost of $400 mt

o   Comps Holcim-Lafarge and Buzzi Unicem trade at 7.7x and 9.2x 2015 EBITDA, respectively

Underappreciated M&A transaction: Italcementi

·         It is rare to see a business in today’s environment announce a transaction that we think is at least 15-20% accretive to FCF per share and trade down almost 7% on the news (though it has since recovered to pre-deal levels)

o   We believe this is a reflection of investor/sell-side frustration with HEI’s management team, stemming all the way back to the ill-fated Hanson acquisition, as well as a perceived about face from management’s capital allocation commentary at the recent Capital Markets Day

§  On the latter point, we would note that management made of point of re-emphasizing their long-term strategic and capital allocation targets (including shareholder returns) after the Italcementi announcement

o   We are not saying that the HEI CEO is the next [insert your favorite CEO here], but we tend to look at the last 5 years of performance and believe that large, value-destructive corporate actions are a thing of the past.  It is also our understanding that the Hanson acquisition was largely driven by the Merckle family, which controlled the company at the time but is now only a 25% owner

·         Rather than go into the strategic rationale in detail in this points, we would direct you to the following linked presentation and the related call transcript, in which management does a good job articulating the strategic and financial rationale for the transaction (see “Presentation on the Acquisition of Italcementi” at http://www.heidelbergcement.com/en/investor-presentations)

·         Our view is that this is an opportunistic deal that builds on HEI’s positions in the U.S., Canada, and India, exposes them to cyclically depressed markets in western Europe, and adds a basket of emerging markets that diversify their “growth market” exposure away from Indonesia a bit

o   Almost 30% of Italcementi’s revenue base is earning <5% EBITDA margins on cyclically depressed volumes, so additional risk to the downside should be limited

o   This is also a significantly smaller deal than the Hansen acquisition, which limits execution risk and leaves HEI with more manageable levels of leverage

·         Furthermore, Italcementi is an Italian family-run business with >€80m in central costs (almost half of the HEI synergy target) and below industry average margins.  HEI’s management team has proven that they are excellent operators of cement assets, and we are confident that they can operate the Italcementi assets much more efficiently than the current owners

·         Our modeling suggests that the deal is accretive to FCF/share to the tune of >20% in the first full year of ownership (2017, assuming a 6/30/16 close)

·         Pro forma for the Italcementi deal, we think HEI currently trades at a 13% FCF yield, and ~6x EV/pre-synergy EBITDA on 2017, the first full year of ownership

Valuation

·         Assuming revenue growth and EBITDA margins that are essentially in line with consensus and giving credit for management’s €175m synergy target, we think HEI can generate ~€4bn of EBITDA and €9.40 of free cash flow per share in 2017, on its way towards management’s revised 2019 targets

·         Assuming a reasonable blended 8x EV/EBITDA multiple (11x on aggregates, 7.5x on cement excl. Indonesia, 9x on Indocement, and 5x on everything else), we arrive at a ~€100 discounted target price including dividends, up more than 40% from the current share price

o   This implies only ~12.5x earnings and a 10% FCF yield

·         This assumes excess cash flow is used to pay down debt, which will be

·         This gets us to a year-end 2015 target price of €110 per share, +55% from today

·         Looking out further to 2019, we think the combined business can generate over €13 of FCF per share on just under €4.8bn of EBITDA

Risks

·         We think the primary risk is macro given the cyclicality of the cement business

·         Some market-specific risks, though the company’s diversification should mitigate the impact of extraordinary headwinds in any one market

Risks related to the recently announced Italcementi deal, e.g., execution on synergies, regulatory (HEI expects divestitures in two markets)

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 results, which should show accelerating reported earnings growth (FX headwinds masked underlying growth in 2014)

• We expect particular strength in the U.S., where demand is very strong (and could get stronger with passing of new federal highway bill) and HEI and its competitors have been aggressive on pricing

• Start of currently delayed infrastructure projects in Indonesia should also help drive strong performance in 2016

• Closing of Italcementi deal