Thesis Summary

At the current price of €46.50, investors in Lafarge can realize a 14% compounded return (IRR) over the next four years using very conservative assumptions, and up to a 37% IRR over the same period if the recovery picks up more quickly. More immediately, if shares re-rate to early 2010 levels of €60, investors would realize a 30% upside.

To bet on Lafarge is to bet that the world will continue to build things made out of cement such as buildings, roads, and other such structures. The company is rebounding from the severe slump of the past two years with North America leading the volume recovery. While the upturn develops, the stock pays a €2 dividend for a yield of 4.3% (included in the IRR calculation, detailed below).

Business Description

Lafarge is the world leader in cement production, #2 and #3 in aggregates and concrete, and #3 in gypsum (wallboard). The company is based in France but derives 46% of its revenues (and 66% of operating income) from the Middle East, Africa, Latin America and Asia. The balance comes from North America, Western and Eastern Europe. Its main competitors are Holcim and Cemex. The company has been around since 1884 and its shares have traded on the Paris Stock Exchange since 1923.

For the purposes of this discussion, we'll focus on Lafarge's cement segment, which accounts for nearly 60% of revenues and 90% of operating income. The other products, aggregates, concrete and gypsum, are exceedingly low margin (around 4.5% operating margin compared with cement's 24%).

The production of cement and related products is essentially a mining operation. Limestone, sand, alumina and iron ore are heated to 2,700°F, producing "clinker" (lumps of material), which is then finely ground with gypsum (a common mineral called calcium sulfate dihydrate) to make cement powder. There are many varieties of cement produced using different ingredients, and some components of basic cement have substitutes that can be used depending on local availability.

Orascom Acquisition & The Recession - Why Lafarge Became Cheap

On January 2008 the company completed the ill-timed acquisition of Orascom Cement for €10.2 bn, gaining 45 million tons (mt) of installed capacity. This represented a total acquisition price of $300 of enterprise value per ton, likely a peak multiple on peak margins. By way of comparison, Lafarge currently trades at $180 EV / ton of cement capacity, right at its 12-year average of $180 / ton according to JPM Cazenove research.

On the other hand, the acquisition was funded with €6.0 bn of debt and the issuance of 22.5m new shares at €125 per share to Nassef Sawiris. From that perspective, the issuance of inflated stock and cheap debt (~5.3%) at the peak was a brilliant move.

Since then, revenues in every region except Middle East, Africa and Asia have crumbled, and in 2010 we are finally witnessing a tepid recovery with nearly every region except Western Europe posting year over year growth.

With the addition of acquisition debt and the subsequent decline in revenues, Lafarge was forced to conduct a rights offering in 2009 to strengthen its balance sheet. The stock declined from over €135 in 2007 to a low of €31 in 2009. It has since focused on deleveraging by cost cutting, selling assets and expanding in higher margin emerging markets. Earlier this year the ratings agencies were looking at downgrading Lafarge's debt into junk status, which would've triggered higher payments on some of its debt issues. Combined with worries about the Euro and the sovereign debt of Greece and Ireland, this caused the decline of the shares from €60 to under €40. Lafarge's credit downgrade never came as the company passed that inflection point with good Q3 results and progress on debt and cost reduction.

Cement Volumes

According to Lafarge's 2009 annual report, global cement volumes have grown at 5% per annum between 1991 and 2009. A chart on page 28 of its annual report shows that as countries increase their GDP per capita, cement consumption grows and then levels off. With 66% of its installed capacity and operating income derived from emerging markets, Lafarge is probably in the best position of the large cement producers to capture that trend.

In 2009, Lafarge had 203 mt of installed capacity and produced 141 mt of cement. At that production level, Lafarge had over 40 years of permitted reserves available.

Valuation - How Returns Are Achieved

We are going to outline two scenarios for Lafarge: a base case and an optimistic case. The base case is probably too pessimistic, but the idea is to build enough margin of safety into the numbers to allow for the unforeseen. Here are the assumptions for the base case:

• Lafarge's revenues have grown at 3.1% compounded from 2001 through 2009, and are on track to grow 2.5% from 2009. I assume 2.5% revenue growth over the next four years, which is probably understated for two reasons. First, this growth is off the depressed 2010 numbers (which are only 2.5% above 2009 revenues, which declined 16.5% from 2008). Secondly, faster growing regions are now a larger portion of Lafarge's results. In 2007 only 34% of its operating income came from emerging countries. That nearly doubled with the acquisition of Orascom and growth in other regions.

• Lafarge likes to report its own free cash flow numbers, giving us an implied maintenance capex figure (which you can calculate off their financial statements). In 2011, the company has guided to €1 bn in total capex, and has stated that maintenance capex should be 80-85% of D&A because newer, modern capacity addition means less maintenance capex. As a percentage of sales, D&A has hovered around 5.5-5.7% and jumped to 7.1% in 2009. It's trending at 7.2% in 2010. For conservatism, in calculating free cash flow I'm using 6% of D&A going forward and a full €1 bn in capex. Using the high end of the maintenance capex guidance gets us to about €850m, but we'll use the full €1 bn number instead since we're focused on deleveraging the balance sheet.

• Operating margins have averaged 15.1% between 2001 and 2009. They peaked at 18.7% in 2007 and hit a seven year low of 14.2% in 2009. There aren't any structural reasons for margins to remain depressed; instead, with higher utilization of its processing plants, the company should be able to lift margins. But we'll model depressed 14.2% margins going forward for conservatism.

• In 2009 the company's effective tax rate was 20%. In 2010 so far it's been 23%. The company attributes this to the "progressive withdrawal of temporary tax holidays." We'll model a step function jump to the 35% French statutory tax rate in 2011 and beyond, which is probably unreasonable but again, conservative.

• Interest expense is calculated at 5.5% of the €17,040m in gross debt, which is about where the company is today. Diluted share count remains flat at 286m shares, as does the dividend at €2 per share.

Where does this leave us? Because the company's stated goal is debt reduction and earnings growth, we'll allocate all residual free cash flow (fully taxed, after dividend cash flow) to debt reduction. With less interest expense, there is an increase in free cash flow each year. So with top line growth of 2.5% we get free cash flow per share growth of about 8% per year. By 2014 we have €4.2 in free cash flow per share.

Let us say that an investor in Lafarge in 2014 would like to earn a 10% return from the shares, and that the terminal growth rate is 3.0% (for comparison, operating income grew at 7.4% between 2001 and 2009 and net income grew at 4.1% since 2000). This would mean our investor would pay a 7% yield for Lafarge, or a 14.29x multiple on the €4.2 in free cash flow per share. This gets us a stock price of €60. Add the €2 dividends received in July of 2011-2014 and the IRR foots to 14%.

A More Optimistic Scenario

Let's alter our base case assumptions now to reach a more optimistic (perhaps realistic) valuation. The only two variables we are changing now are:

• Revenues grow at 3.0% annually instead of 2.5%
• Operating margins increase from 14.2% in 2011 to 15.0% in 2012 (still below the 15.7% of 2010), 16.0% in 2013 and 17.0% in 2014 (still below the peak of 18.7% in 2007 or the 17.7% of 2008).

Now we get €5.6 in free cash flow per share in 2014 compared with €4.2 previously, and our stock price target is €81 for an IRR including dividends of 26%.

Capacity Addition

Lafarge is working on expanding capacity in emerging markets and has estimated there will be an additional €750-850m of EBITDA in 2012. Let's take the bottom of that range and assume it's delayed by 1 year. Adding €750m of EBITDA to 2013 and 2014, fully taxed at 35%, increases free cash flow per share to €7.4 and our target price to €105 for a total IRR of 37%.

A side note on free cash flow per share: using the new diluted share count, the average of the past three years' free cash flow per share would be €7.3 per share. So it's reasonable to expect that if the effective tax rate stays lower, margins improve and the announced structural cost savings materialize, we could have materially higher returns from this stock.

Management

One of the features that attracts me to Lafarge (as opposed to its competitors) is the presence of Albert Frère and Paul Desmarais as long-term, ~20% shareholders in the company. Gerald Frère and Paul Desmarais Jr (their respective sons) are on the board of directors, and the two families participated in the rights offering Lafarge conducted in 2009. Together they have a long history of shareholder value creation and it's not a bad thing to invest alongside them.

Risks & Uncertainties

• Competition - It is easier to add capacity in emerging markets than in mature markets, and this could drive down pricing and cause Lafarge to lose market share.
• Input costs - Energy is a large cost (about 31% of total production costs) for cement plants so higher fuel prices could depress margins. Most of Lafarge's fuel is coal (44%), petcoke (20%) and gas (17%).
• Double dip recession or other economic weakening - Cement volumes may decline again in such a scenario.
• Collapse of the Euro - Even though Lafarge earns most of its money in other currencies, it is still a European cyclical company whose shares are denominated in Euros. Fluctuations in the currency may affect the stock in the short term. I believe we at the beginning, not the end, of the European debt crisis, so I fully expect the shares to be volatile in the short term.
• Underfunded pension fund - currently to the tune of €1.2 bn.

Lafarge estimates for 2011-2014. The differences between the optimistic and base scenarios are shown in bold.