Trade

Thesis

• Italcementi (IT) is facing a challenging operating environment and will likely see earnings/cash flow continue to decline 
  • Core/large markets (Italy, France, Egypt) to remain weak for the foreseeable future. Downside to consensus earnings estimates
  • Underwhelming free cash flow generation to continue for the foreseeable future
  • Multiple layers of minorities within IT’s organizational structure result in “economic” results being lower than published consolidated results
• High Valuation versus peers
  • Valuation versus peers does not reflect IT’s more challenging operating outlook
  • EV/EBIT multiples imply ~40-50% downside from current valuation
• High leverage & potential debt covenant breach
  • Net Debt / EBITDA (30-Sep-12): 3.5x on a full consolidation basis (3.9x on a proportional consolidation basis)
  • Debt Covenants currently set at 3.75x (on a full consolidated basis). 7% decline in EBITDA will result in a debt covenant breach
  • Company generates minimal free cash flow – deleveraging without operational improvements not possible
• “Savings shares” (non-voting preference shares) trade at a material premium to ordinary shares (~2x currently) despite being economically equivalent
  • Voting rights attached to ordinary shares have little value as a controlling shareholder owns 60% of IT
  • Savings shares have a higher dividend, a dividend preference and a preference in liquidation
• Expressing a short position via a long savings share / short ordinary share position creates better risk/reward than an outright short position
  • Current savings share discount to ordinary shares is toward the wider end of historical observations 
  • The dividend differential between the two share classes (savings shares have a higher dividend) becomes more meaningful at lower share prices (current share prices are lower than historical).  Savings shares are currently entitled to EUR0.134/share of preference dividends (~7% of current value) before any dividend can be paid to ordinary shares (explained in more detail below)
  • Current equity value as a percentage of enterprise value is low (~29%) and ordinary shares represent 77% of equity market value. Further reductions in enterprise value should be disproportionately borne by ordinary shares (i.e. the closer the equity market value goes to zero the more the discount between the two share classes should narrow.  In fact, the savings shares should arguably trade at a premium if the probability of bankruptcy is very high – i.e. if equity value was to fall significantly – given the preference they enjoy in a liquidation)
  • If we are wrong about fundamentals and equity value increases there is protection to the short from the long position in the savings shares
• Potential Outcomes (selection of savings share (long) vs. ordinary share (short) ratio will influence this – i.e. market value neutral would be ~2:1).  Assuming a moderately short leaning market value position:
  • Business deteriorates (base case)
    • Profit on market value decline via short position
    • Benefit from “carry” on dividend differential between savings shares and ordinary shares (assuming dividend continues to be paid)*
    • Likely profit on narrowing of saving share vs. ordinary share discount (per comments above)
  • Business improves (fundamental analysis proves to be incorrect)
    • Loss on market value increase via short position
    • Benefit from “carry” on dividend differential between savings shares and ordinary shares*
  • Business muddles through and equity value remains similar to current
    • Benefit from “carry” on dividend differential between savings shares and ordinary shares*

* Note: “carry” on dividend differential is threefold: (i) savings shares are required to pay higher dividends than ordinary shares; (ii) savings shares currently have accrued “catch-up” dividends that need to be paid before any dividend can be paid to ordinary shares; and (iii) (depending on your ratio) this trade will have you owning more savings shares than you are short ordinary shares)

• Potential for corporate actions to simplify/collapse the share structure.  This is not the base case but is possible.  There are economic reasons and recent precedent suggesting this is not zero probability.
  • Economic rationale: the current discount between the savings shares and the ordinary shares means a share simplification could be very accretive to both classes of shares
  • Precedent: Fiat Industrial collapsed its savings share / ordinary share structure in 2011/12 (http://www.4-traders.com/FIAT-INDUSTRIAL-SPA-7054290/news/Fiat-Industrial-SpA-Fiat-Industrial-proposes-to-convert-its-saving-and-preference-shares-into-ordi-13863089/)
  • Argument Against: main argument against a share simplification is that it would dilute the the controlling shareholder’s voting interest in the company (although they would still effectively control the company and would create economic value for themselves in the process)

Risks

• Better operational performance than expected
• Widening of the ordinary share / savings share discount (for technical or other reasons)

Business Overview

• 5^th largest cement producer globally (by capacity exc. China) and 7^th largest ready mix producer globally (exc. China)
• Global footprint but concentrated in Western Europe (36% of cement capacity and 75% of ready-mix plants) and EMEA (28% of cement capacity and 11% of RMC plants)
  • Within Western Europe the company’s core markets are Italy and France/Belgium (87% of Western Europe cement capacity and 94% of RMC plants)
• Complex organizational structure
  • IT 60% owned by the Pesenti family via Italmobiliare, a listed holding company with interests in industrial companies, banking and publishing
  • IT owns 83% of Ciments Francais (which is publicly listed).  Ostensibly all of IT’s non-Italian operations are owned via Ciments Francais
  • Ciments Francais in turn owns majority stakes in a number of other companies. All of these stakes are consolidated by Ciments Francais. Major stakes:
    • Suez Cement (Egypt): 55% (remainder listed on the Cairo stock exchange)
    • Ciment Maroc (Morocco): 63% (remainder listed on the Morocco stock exchange)
    • Thailand: two stakes  (i) Jalaprathan Cement (59%) and (ii) ACC Cement (40%) (consolidated b/c CF controls the board) (remainder not listed, owned by private investors)
  • IT fully consolidates Ciments Francais which in-turn fully consolidates its various majority stakes. I highlight this because when I talk about cash flow, leverage, etc. this is reported by IT on a consolidated basis whereas the “economic” interest is much lower as it is diluted by multiple layers of minority interests
  • IT share structure comprised of both ordinary shares and “savings shares” (non-voting preference shares) (more detail on share structure below)

Operational Performance – Likely to Remain Challenging

• IT’s core (largest) markets/geographies (heavily exposed to the Eurozone) are currently experiencing challenging operating conditions.  Profitability and cash flow generation is likely to continue to decline going forward 
  • Italy (18% of LTM Revenue)
    • Very fragmented market with historically poor industry discipline (e.g. price war in 2009/10). Significant market oversupply. Utilization currently running at <60%
    • Demand remains very weak and cement market volume is down >20% YTD.  Continued declines expected in 2013 =>  housing market remains weak, austerity impacting government spending
  • France/Belgium (32% of LTM Revenue)
    • Utilization running at ~70%. Weakening housing demand impacting demand. Cement market volume down 6% YTD. Continued weakness expected in 2013
  • Egypt (12% of LTM Revenue)
    • Significant political instability and a weakening economy. Cement volumes down 8% in Q3’12. Political instability becoming more acute.  Continued market weakness expected with downside risk if political tensions escalate
• IT also has exposure to peripheral Europe where market conditions continue to weaken
  • Greece/Spain (3% of LTM Revenues): YTD cement market volume declines of 40%+.  These geographies continue to be loss making and cash consuming for IT
• We believe market consensus remains too bullish for IT’s earnings in 2012 and 2013

Leverage

• LTM Net Leverage (Net Debt / EBITDA) has increased from 1.4x in 2004 to 3.5x at 30-Sep-12. LTM Net Debt / (EBITDA-Capex) at 30-Sep-12 was 8.2x
  • This is based on full consolidation of both net debt and EBITDA (note comments above on minorities)
• LTM Net Leverage (Net Debt / EBITDA) on a proportional consolidation basis was 3.9x
  • This is based on proportional consolidation of Ciments Francais Net Debt and EBITDA (it does not adjust for minorities & debt of CF’s minorities)
• EUR381m of Debt is subject to a 3.75x Net Debt / EBITDA covenant. A 7% decline in LTM EBITDA (based on 30-Sep-12 debt) will result in a covenant breach
• IT generated EUR15m of Free Cash Flow After Capex in 2011 (EUR198m including asset disposals). YTDFCFis negative EUR24m (+EUR86m including disposals)
  • Without an improvement in operations IT cannot organically deleverage (i.e. it doesn’t generate sufficientFCF)

Valuation

• IT’s valuation is in line with comparables on an EV/EBITDA basis but significantly higher on EV/EBIT (a better proxy for cash flow) and P/E (a better proxy for eliminating the various layers of minority interests)

Source: Bloomberg Consensus

Background on IT Share Classes

• Share capital is comprised of 177m ordinary shares and 105m “savings shares” (preference shares)
• Votes: ordinary share have votes, savings shares do not
• Distribution of Reserves: ordinary shares and savings shares are entitled to the same if there is any distribution of reserves
• Priority in Liquidation: In the case of a dissolution of the company savings shares have priority in the repayment of the share capital for the full nominal value of the savings shares
• Dividends:
  • Minimum Dividend: savings shares are entitled to a dividend of EUR0.05/share.  If the dividend paid to savings shares is lower than the minimum dividend, the difference between the actual dividend and the minimum dividend is paid as an increase to the dividend on the savings shares in the next two years (i.e. the dividend accrues for 2 years forward if it is not paid)
  • Dividend Calculation: savings shares are entitled to a dividend of EUR0.03/share greater than the dividend paid to the ordinary shares
• Dividend Payments:
  • Distribution history below => EUR0.03/share additional dividend paid to savings shares for each year 2001 – 2008 (per description above)
  • Importantly, the distributions paid in 2009 and 2010 were returns of capital not dividends (insufficient profits to pay dividends). As such, savings shares were entitled to “catch-up” dividends of EUR0.10/share (EUR0.05/share per year for each of 2009 and 2010) (per description above)
  • In 2011 the distribution was part capital return (EUR0.12/share) and part dividend
    • All profits were paid as dividends.  The “catch-up” payment to savings shares is required to be paid before any dividend can be paid to ordinary shares
    • EUR0.066/share of dividends was paid to savings shares (EUR0.05/share “catch-up” for 2009 and EUR0.016/share “catch-up” for 2010). This represented 100% of profits
    • Zero dividend was paid to ordinary shares
    • Currently savings shares are entitled to EUR0.084/share of dividend (EUR0.034/share “catch-up” for 2010 and EUR0.05/share “catch-up” from 2011) before any dividend payments can be made to ordinary shareholders.  Savings shares are also entitled to a minimum dividend of EUR0.05/share in 2012.  A total of EUR0.134/share. This amount is material relative to the current share price (~7% of the current share price)

IT 10 Year Dividend History

• Continued deterioration in operational performance
• Debt covenant breach
• Equity raising
• Share consolidation or other corporate actions