Description

PPC is the largest cement company in South Africa with operations in two other sub-Saharan nations and projects nearing completion in two more.  Financial disclosure is clear and thorough. What makes this stock so interesting right now is that you can’t screen for it.  They have just completed a rights offering, so on a cursory look or a screen the share count is very wrong, and the balance sheet is wrong.  An analyst needs to do some work here.  I will present later in the text the case for an intrinsic value of two times the current price.

Over the summer the company was flirting with “going concern” risk, but that risk has been mitigated.  I would also suggest that earnings power is misunderstood if you are looking at current or historic numbers as 1) their core market has had a lot of issues, and 2) they have spent about 40% of their current market capitalization on new projects at various stages of completion that are not earning anything yet.    

It is not a bad business at all, but has suffered with the South African troubles the last few years.  Although cement prices in South Africa are down year over year, management has commented several times this year that “The downward pricing trend in the South African cement market seems to be slowing.”  A big part of this was dumping duties imposed on Pakistani imports, driving imports down by 50% late in 2015 – pricing stabilized since then.

Management’s stated strategy is three-fold.  1) Leadership position in the South African market, 2) Invest in new capacity in less developed nations in Africa, 3) a new one since they brought in a new CEO last year – aggressive cost management. 

Previous management got a little too aggressive with expansion when capital was being thrown at emerging markets, committing to four big projects at the wrong time.

In 2014, just as capital began to exit the emerging markets, especially South Africa, past management committed to over $300 million U.S. of spending including new facilities in Rwanda, Congo, Zimbabwe and Ethiopia.  It probably looked like a good idea at the time, and still might be.  These countries are growing at 7% off a very low GDP/capita base and need a lot of cement.  In early stage emerging markets, every 1% of incremental GDP growth usually means significantly more than 1% cement growth.

I am no expert on sub-Saharan Africa, but with the company’s disclosure and a map you can piece together a lot of what is going on here.   Growth around 4% in the region (and that is being dragged down by the biggest economy South Africa below 2%) looks better than other emerging markets.  Growth in Democratic Republic of Congo (DRC), Ethiopia and Rwanda, where PPC is building new capacity, is in the 7-8% range. 

Cement is imported into some of these countries by land routes – incredibly inefficient – which is why cement prices in Rwanda, Congo and Zimbabwe are twice what they are in South Africa.  For example, Congo, a country of 82 million people (GDP/capital is about $500) is a 3 million ton domestic market but only has one tiny 400,000 ton cement plant.  Prices are $250 per ton as compared to $120 in South Africa.  The other countries they are in or going into with the exception of Ethopia which is geographically in a different region are tiny populations and small enough geographically to make domestic capacity vs. demand irrelevant as they are importing or exporting to nearby neighbors.

PPC is already exporting into these new countries, presumably from South Africa and to a lesser extent from Botswana.  This is important as it indicates that the brand and distribution has been established so they are not going into these countries cold start.  Cement is sold in bags in Africa through retail channels.

The South African economy is still growing at 1.5%, but that might as well be negative as it has been a huge disappointment.  We consider the political situation there to be the biggest risk.  We think the risk is well reflected already in the currency and the real yield of bonds, and we will stay long the currency and expect to make money there too.  The South African cement market has been very soft, though demand is still growing at 5%.  That’s much less than it was supposed to grow, so new capacity that was planned several years ago has hurt pricing inland and until late 2015 when import controls were imposed, Pakistani imports were putting even more pressure on pricing on the coast.  The imports have fallen 50% since then and pricing has stabilized.  PPC sells at a long-standing premium to the market in South Africa with their Surebuild brand of redi-mix.  60% of the cement in South Africa is sold through the retail channel – think bags, not trucks.  Distribution really matters and PPC has been the market leader forever.

In May, S&P cut PPC’s credit rating.  This accelerated 2 billion rand of debt, which compounded the problem they were already going to have with a 1 billion maturity.  So they needed 3 billion rand and the capital markets were closed.  They were unable to file financials without a “going concern” statement from their accountants.  This was, needless to say, quite scary and the stock is down about 30% (adjusted for the dilution of the rights offering) since May.  The liquidity problem has been solved. 

The option they chose is a rights offering at 4, which was a 55% discount to the preannouncement price.  Draconian to existing shareholders, but there are two kinds of problems in investing, mine and somebody else’s.  If you bought after September 1^st this is very much in the category of somebody else’s. The offering was completed on September 14^th, the stock is trading at its ex-rights price and everybody has their shares.

Long story short, through the rights offering we can buy the stock for a pro-forma market capitalization of just under 10 billion rand.  There will be about 5 billion of debt left after the proceeds of the rights offering go to pay back 3 of it and leave 1 on the balance sheet.  So an equity value of 10 and an enterprise value of 15.

But its not that “simple”.  The debt on the new projects is non-recourse at the project level.  For the consolidated entities which they don’t fully own, this debt is overstated on the balance sheet.  And these projects, which I have no reason to think are impaired, are not earning anything yet.

I appraise this security in two ways, earnings power and replacement cost.

First earnings power.  The existing earning assets (mainly in South Africa) have established earnings power of about 1.6 billion of EBIT, 2.2 billion of EBITDA.  16 billion would be 10x EBIT, 7.3x EBITDA which seems reasonable for the leading cement player in a major emerging market.  Global comps trade at 13x/8x.

To this 16 billion I am going to add the equity value to PPC of the projects they are building outside of South Africa.  They give enough disclosure to back into what they have spent on them to date (6.7 billion).  Adjusting for the project debt and the percentage of each project they own I calculate PPC’s equity value in these projects to be about 3 billion at cost.

Because that 3 billion valuation for the projects is an equity number, I have already accounted for the part of consolidated debt (consolidated on PPC’s balance sheet) that is at the new project level.  Subtract that from the 5 billion of consolidated debt and that leaves 1.3 billion of debt against the legacy assets.

16 billion enterprise value of the legacy assets less 1.3 of debt plus 3 billion equity value of the projects being built equals 18.7 billion, or 11.50/share, nearly double the current price.

The second way to approach valuation is replacement cost.  If we look at their currently operating capacity, they have 9.6 million tons.  Let’s add pro rata for both their share and how finished it is the almost finished three plants in other countries.  That’s another 1.3 million tons for a total of 10.9 million tons.  The stock is trading at enterprise value of $13.3 billion after adjusting for minority interest in project debt, or $85 U.S. per ton of capacity. 

Replacement cost for cement around the world is in the $200-250 range.  We might apply some discount to the other African countries, but I don’t see why we would have to apply a discount to the leading player in South Africa.  If we use $200, the stock is a triple.  If we use $150 it’s a double. 

Management in the 2015 annual report wrote “on the continent, companies can expect to pay US $300 million for a 1 million ton plant.”  That would be $300/ton replacement cost.  I’m not going there, but if emerging markets got popular again who knows? 

Another data point would be PPC’s new investments where they are not adding to an existing plant.  These are in the range of $225-250/ton with the exception of Ethiopia which is at $140/ton and I don’t know why.  Management calls out that number in their annual report that they got a big bargain here. The stock is priced at less than $100/ton which looks like a huge margin of safety.  Replacement cost in Africa does not look that much different than anywhere else I’ve seen in the world and is somewhere in the range of $175-250/ton.

Capital spending will step down big after 2016 and could be at maintenance levels by 2018.

I would note there was a takeover attempt on PPC two years ago at clearly a much higher price by another South African company.  Maybe they come back, but I would also consider it quite possible that this leading South African player could be attractive to Holcim and the other big players who have been consolidating globally.  By my analysis, private market value should be 2-3 times the current stock price.

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.

Catalyst

1) Numbers become better understood following major balance sheet change and shareholder turnover

2) South Africa gets a little better

3) Takeover