Description

While multiples have contracted across many industries, there are a few gems out there that have seen dramatic stock declines despite improving operational performance.  I believe Vicat is one of these companies, trading at a rock bottom multiple and with 50% earnings growth over the next few years.  To get straight to the point, Vicat is a global cement manufacturer that essentially did not publicly exist until mid 2007.  If you have followed the cement industry, you might have heard of the Heidelberg Cement acquisition of Hanson.  The significance of this transaction is that Heidelberg was forced to divest its ownership in Vicat to finance the deal, thereby resulting in a secondary for 35% of the company at 86 euros per share.  While the company & Vicat family used the offering to buy back stock, the deal served to increase the float (5% to 30%) and ADV substantially ($50k to $4mm ADV).  Shortly after the offering, the increased volatility in the equity markets as well as concern over US and European construction growth led to multiple compression across the cement sector.  Such declines in the group took a greater toll on Vicat due to its new investor base, illiquidity, and limited analyst coverage.  It is for these reasons that investors are presented with the opportunity to own a high quality growing business at less than 8.5x trailing earnings.  Amongst the cement sector, Vicat has one of the lowest multiples (6.2x trailing EBIT v 8.5x TMT EBIT for group), favorable end markets, and the highest organic growth in the group.  Based on my earnings projections and analysis of the company’s core markets, I believe this stock has 100% upside over the next two years. 

Vicat is a global cement manufacturer with a presence in France, Switzerland, Italy, the US, Turkey, Senegal, & Egypt.  Roughly 47% of its profits come from France, another 24% from mature markets (Western Europe excluding France and the US), with the remaining 29% in emerging markets.  The thesis here is actually quite simple.  While Vicat’s core businesses in France and emerging markets are growing both pricing and volume, the company is also adding 50% in capacity additions through 2010.  These expansions should result in a significant acceleration of earnings growth over the next few years.   While I will go into the growth markets in greater detail below, the simple math is this: Current trailing earnings of 6.65 + new markets of 2.24 = 8.89 in EPS = 5.8x P/E for a business growing earnings at ~10% prior to improvements in the existing business.

Key Valuation Stats (TMT):

Mkt Cap – 2.4B euros

EV - 3.1B euros

EV/Rev – 1.4x

EV/EBITDA – 5.0x

EV/EBIT – 6.2x

P/E – 7.8x 

Cement Industry – Before diving into the individual markets, I want to highlight a couple key points on the industry as it has certainly changed in the past decade.  Many investors believe cement is a global business, but due to the increased cost of logistics in recent years, shipping/transporting across international borders has become cost prohibitive.  In fact, less than 5% of global cement is exported making this very much a regional market.  This has been driven by 1) freight rates, which have effectively doubled in the past year (30-40 to 60-80 per tonne, often representing between 50%-100% of FOB prices) and 2) rising crude prices, which has made it very difficult to transport cement more than 150 miles once the product makes it to port (for example, Vicat has commented that it costs 35 euros or roughly $55 to transport cement from the South of France to Lyon).  If you run the analysis of the increased costs to transport for exporters in recent years, you will find that margins for those exporters have actually declined, despite higher prices in the end markets.     

It is interesting to note that the global market has grown at a 5% CAGR over the past 20 years and has never seen a single down year from a volume perspective.  While an individual market can experience a material downturn in volumes, it is the portfolio of many different markets that has supported this global growth story.  If one looks at earnings across the industry during the 2001-2002 period, most companies posted flat EBIT, indicating a business that is economically sensitive, but by no means cyclical.  The market has also become increasingly consolidated as global players such as Lafarge, Holcim, and Cemex have been rolling up the industry and now have a presence in virtually every market.  This presence reduces the propensity to expand into new markets and has resulted in a focus on pricing over volume.  I would urge you to speak with the major cement manufacturers and look at historical examples of cross border competition.  You will see that this industry is much more controlled than anyone would like to admit.

New Capacity – The company is in the process of increasing capacity by 50% through 2010.  From a capital standpoint, Vicat is estimating an investment of 90 euros/tonne of capacity, implying a total investment of 750mm (7.5 million tonnes of capacity & 75mm in WC).  At a 14% after tax return (mgt’s target), these additions should generate 2.24 euros per share in earnings.  It is worth noting that Vicat has a solid track record of organic growth and is targeting returns in line with its historical average.  These expansions have been carefully planned out and generally do not rely on growth in market demand.  Instead, the additions eliminate cement bought on the local market and sold as a pass through or displace imports required to meet local demand.  These projects are brownfields, relatively low risk, and will have a dramatic impact on the cost efficiency of the business (Mgt is targeting reduction of cash costs per tonne by 7%).  The forecasted increases include the following:

France – 400k

Turkey – 1,600k

Egypt – 1,700

Senegal/Mali – 2,000k

US – 1,800

French Market (47% of Earnings):

The French market is likely the most protected market in the world such that cement operators can earn fantastic returns on capital and are not at risk to new competition.  This can be attributed to the following: 1) France is highly consolidated market, with only four cement players (Lafarge at 35%, Italcementi at 25%, Vicat at 21% and Holcim at 17%).  On a regional basis, Vicat is positioned in the Southeast with a 50% market share and effectively operates as a duopoly.  2) There is no real cross border competition.  While many acknowledge that France is consolidated, investors miss the fact that all of French manufacturers have a significant presence in every bordering market and are unwilling to jeopardize their own profitability within France (Vicat has strategically acquired assets just over the Italian & Swiss border in an effort to provide a buffer for the economics in France).  Further, most of the neighboring countries are import markets (Spain, Italy, etc.) with the exception of Germany, which I do not believe can economically reach deep into France due to the logistic costs.  3) All four cement players are vertically integrated.  They mine their own aggregates (Vicat has a 30 year reserve life) and operate downstream ready-mix plants.  This provides incumbent players with a large barrier to entry as imports into the market would find it difficult to locate a ready-mix plant willing to even buy their product.  4) Like the US, there is little possibility to build a greenfield plant in France.  The permitting process is a disaster and the market is already in balance (unlike the US where new capacity additions can displace imports).  5)  There is only one major deep water terminal to bring cement into France, which is effectively controlled by the major cement players.  This is further complicated with the “buy French” mentality that puts a premium on working with a Lafarge or Vicat over a new entrant. 

Net net, I do not believe one can economically ship product into the French market, leaving the cement industry to benefit from higher prices and growing margins.  While volumes in France for 2008 are expected to be in the range of -1% to 1%, Vicat’s markets have the highest growth prospects due to favorable demographics and should see 100-150bps of above average growth over the next number of years (mgt is projecting 0%-2.5% volume growth in 2008).  In addition, Vicat just added a small 400k tonne line in December (on base of 4.2mm tonnes) which is immediately accretive to 2008 earnings as it does not rely on incremental volumes, but rather eliminates logistic costs the company incurs transporting cement from the South of France.  On pricing, the majors have pushed through a 5% increase in December, which combined with the capacity expansion should lead to another strong year in 2008.

Regarding cyclicality, the French market is very different from Spain or Germany.  The country has not benefited from a construction bubble or has shown substantial volatility in the past.  Historically, France has grown cement volumes at roughly 1% per annum with moderate levels of volatility (worst year in last decade was -.2% while best year was up 6.5%). The country also benefits from numerous public infrastructure projects and one of the highest population growth areas in Europe. 

US Market (12% of Earnings):

While I am quite bearish on the US market from a volume perspective, Vicat’s US presence is rather small and not the key driver to the thesis.  I am modeling profitability to decline in 2008 as pricing improvements do not compensate for continued volume weakness.  That being said, the US is actually a relatively attractive market longer term due to its significant import volumes (close to 20% of total) and severe constraints on new supply.  While permitting is practically impossible for new entrants, the government will allow new capacity to be brought online if it 1) replaces some existing capacity and 2) if it is environmentally friendly.   While Vicat is targeting a capacity expansion of 1.8 million tonnes in 2010, the net addition will be only 700k tonnes as the expansion will be offset by the closure of 1.1 million tones of high cost capacity.  This addition should provide a return well in excess of mgt’s 14% target and is easy to quantify given much of the improvement will come from savings in cash costs per ton between a low and high cost plant.  Overall, I believe Vicat can increase profitability in the US by roughly 45% once the capacity comes online (Current EBITDA is 83mm euros; with incremental EBITDA of 15mm euros (1.1mm tonne replacement at 25USD/tonne savings converted to Euros) + 22mm euros (700k tones at 50USD/tonne in cash profits converted to euros).

Egypt, Senegal, and Mali (17% of earnings):

These growth markets have been a significant driver of earnings in 2007 and are showing no signs of abating.  EBITDA grew by 35% last year and should see another strong year of both pricing (company is guiding to 2.5%-5.0%) and volumes, especially as the new cement line comes on in Egypt in 2008.  The Egyptian market is highly consolidated and is currently experiencing high levels of organic growth (10% in 07).  It is worth mentioning that Lafarge recently bought Orascom, the largest manufacturer in the region (23% market share) and expects to continue with its strong pricing strategy over the next few years (Vicat is a clear beneficiary of this acquisition as it further consolidates the Egyptian market).  Net net, I expect the new capacity in Egypt will add roughly 30mm of EBITDA once fully ramped up in 2009 (using mgt’s targeted return metrics) as compared to the region’s EBITDA of 101mm in 2007.  Senegal should deliver similar returns as its capacity ramps up at the end of 2008 early 2009. 

Other Positive Factors:

-          Significant Cash Generation: Despite spending close to 1 billion euros in cap ex from 2007-2010, the company should have a net cash balance by the end of 2010.  If you look at this business on a maintenance cap ex basis (115mm euros), TMT FCF implies a low teens yield.

-          Strong dividend: Company recently increased its dividend by 15%, to 1.50 euros per share (3% yield).

-          New Management: The family-run CEO, Jacques Vicat, just retired at the beginning of the year.  The new CEO represents a shift away from family control, brings a greater focus on operations, and increases the likelihood for a strategic catalyst down the road. 

-          Underfollowed: The company has never focused on investor relations historically and is starting to improve its communication to the street.  This would include setting up a full investor relations department, reporting numbers quarterly (currently semi-annual), participating at conferences, etc. 

Catalysts:

-          Significant earnings beats in 2008 as new capacity comes online

-          Further pricing increases in core French market and volume growth in emerging markets

Catalyst