Description

Thesis 

I believe that, at 25 British Pounds per share,  the stock of RHI Magnesita (RHIM LN)  is an attractive long term investment. The company is the global  leader in an attractive, albeit cyclical,  niche industry. Barriers to entry are high. The business economics are good. Management has proven to be capable. The company is in a strong strategic position to consolidate a highly fragmented  industry that grows revenues at mid single digits. The stock is currently cheap because of a cyclical decline in earnings driven by the Covid 19 recession.  Leverage is low and liquidity is not a concern even under a draconian scenario. The company does not have any risk of bankruptcy or dilution. The stock should rerate once earnings begin to recover in a year or two and continue to compound value long term. 

Business Description 

RHI Magnesita (RHIM LN) is the global leader in the EUR 20 billion global refractory business.   Refractories come in different forms (bricks, mouldable casts) and are used to protect  the walls of equipment such as furnaces and ladles used in the manufacture of  steel, cement, non-ferrous metals,  glass, and certain chemicals. The primary raw material to produce refractories is magnesite. Magnesite is mined and processed using other chemicals, high temperatures and incredibly high pressure.   Refractory materials are engineered to withstand temperatures of up to 2000 degrees Celsius (3600 degrees Farenheit).  RHI Magnesita is the only vertically integrated, full service provider in the world. It mines 70% of its raw material needs. It manufactures refractory products in various forms, installs the refractories at clients’ sites. It then removes and recycles the used materials. There is a service component to Magnesita’s business.  It provides technological solutions to monitor the performance of the refractory materials and optimize the industrial processes. 

RHI Magnesita  is the global leader in this highly fragmented market. It has 70% of the South American market. It has 30% share of the European, North American, and MEA market. And  it is the market share leader in India, one of the fastest growing markets in the world, with  20% share.  India’s steel production is estimated to grow at 7% a year for the next couple of decades. Annual steel consumption per capita is 63/kg versus a global average of 208kg. 

For an in-depth look at  RHI Magnesita’s business I recommend listening to the November 14, 2019, capital markets day.  

Business Economics

Although  RHI Magnesita’s end markets are composed of cyclical industries with generally lousy economics, the refractory business is quite profitable and more stable than the markets it serves. Refractories are an essential consumable in the manufacture of   steel, cement, non-ferrous metals,  glass, and certain chemicals. The quality and availability of the refractories is critical to the production process. Yet,  refractories represent a very small percent of the overall production cost of the customers, 0.2% to 3.0% depending on the product. There is a level of customization and service which creates switching costs for customers. And, the customer base is highly fragmented. RHIM services over 10,000 clients globally. 

Refractory volumes are closely tied to customers' production levels. However, the price of refractories is quite stable. As depicted on the chart below  Magnesita’s steel related revenues track steel volumes in the regions in which it operates, but not prices. 

The quality of the business is reflected in RHI Magnesita’s margins ROE and ROIC. In 2018 and 2019 which were relatively weak years, though not recessionary,  in terms of  demand, the company generated an ROE of  22% and 17% and a Return on Capital (tax adjusted EBIT/total capital employed) of 12% and 11%. 

Management Quality

RHI Magnesita is led by a strong CEO.  Stefan Borgas was appointed CEO, in September 2016. Prior to to RHI,  Mr. Borgas worked at BASF, Swiss Lonza, and   Israel Chemicals Ltd, where he had a very good reputation, especially for his impressive role in the turnaround of Swiss Lonza.  

In 2017 he led the transformational acquisition of Magnesita Refratorios. By reviewing the analyst day presentations of the last three years,  one can see that the current management has done a very good job of delivering on its promises.  Following the merger, the company set  aggressive targets for deleveraging and for synergies and margin expansion. Since then, the company has met or exceeded those targets. Furthermore, the company has made tangible progress in its efforts to develop more differentiated, technologically advanced products and services to solidify its leadership position. In November 2019, management announced a target to further improve operating margins by 300bps by 2022.  

The fact that  Dr. Herbert Cordt, the Chairman of the board, acquired 350,000 shares of RHI Magnesita at GBP 21.27/share, the  equivalent to US$9.4 million, is an encouraging sign. 

Balance Sheet 

The company has a very strong financial position. Since 2017 it has reduced trailing net debt/ebitda from  2.6x net debt/EBITDA to 1.1x. As of March 31, 2020, the company had EUR 1.2 billion of liquidity, EUR 500 million in cash and EUR 700 million of undrawn credit facilities with no meaningful maturities until 2023. The company has plenty of liquidity and is not at risk of violating any covenants even under current recessionary conditions. 

Capitalization, Summary Financial Information, and Valuation 

RHI Magnesita is listed in both London (RHIM LN) and Vienna (RHIM AV). The London listing, which is in British Pounds, is the more liquid stock.  It trades on average about US$2 million a day. The company reports its financial results under IFRS in  Euros. For simplicity, all the numbers below, including the share price,  are in Euros. 

I am skeptical of “adjusted earnings,” but,  in the case of Magnesita, I think they accurately represent the true profitability of the business in the past two years Following the merger with Magnesita, in 2018 and 2019, RHI Magnesita took significant non cash impairment charges related to the rationalization of its global production footprint.  The difference in adjusted earnings and reported in those two years is driven primarily by  non-cash impairment charges plus amortization of intangibles as opposed to cash restructuring expenses. 

In 2018 and 2019 the company earned EUR 260 million  (EUR 5.31/share) and EUR 273 million (EUR 5.57/share) of “adjusted earnings.” These adjusted earnings numbers are roughly in line with the free cash flow generation of the company during the same period. The company generated EUR 272 million (EUR 5.54/share) of FCF in 2018  and EUR 247 million (EUR 5.03/share) of free cash flow in 2019. I define free cash flow as IFRS operating cash flow minus total capital expenditures. I am using total capex versus “maintenance capex.” The company estimates “maintenance capex” to be $100 million. The company spent EUR 123 million and EUR 156 million in total capex in 2018 and 2019. 

I believe that 2018 and 2019 combined represent “normalized earnings” for RHI Magnesita. End markets in 2018 and 2019 were quite weak, but  it was not a recessionary environment like 2020 will be. However, 2018/2019 are backward looking and do not give the company any credit for the 300bps of margin expansion that it is targeting for 2022. 

In 2020, the World Steel Association expects steel production to be down 18% in developed countries and down 11% in developing countries ex- China. I’m assuming that RHI Magnesita’s volumes and revenues will be down 15% in 2020. Consensus estimates of “adjusted EPS” have declined from EUR 5.35/share at the beginning of the year to currently EUR 3.22/share. 

I think the proper way to value this company is based on “adjusted earnings” which closely tracks free cash flow. Based on adjusted earnings, the company is trading at 5x trailing earnings, 5x trailing free cash flow, and about 9x depressed earnings. I think this valuation is too low for a high quality, well capitalized, well managed cyclical business. There is only one publicly traded comparable company, the number two industry player  Vesuvius (VSVS LN). It is trading for 7x trailing earnings and 16 times 2020 times estimated 2020 earnings, a premium to RHIM LN which is a better business. 

Risks

• I am wrong about the quality of the business. 

• The recession is much deeper and longer lasting than expected. 

• The stock sells off further because operating trends are week. 

• The stock is in a downtrend and  has very negative momentum. The asset class, international cyclical small cap value, is suffering redemptions. The stock suffers a deeper draw down in the near term and takes longer to work. 

Catalyst

• Trough in earnings in 2020
• Progress delivering on margin improvements in 2021