Investing in all about outperforming expectations. A stock that strengthened its balance sheet with significant de-leveraging might outperform another stock with a debt-free financial position. Similarly, the market is more likely to reward a turnaround story with improved valuations than a consistent performer with all the positives already factored into the stock price.
An improvement in balance sheet strength and the eventual recovery in global infrastructure demand will be the catalysts for a re-rating of Cemex SAB de CV (ADR) (NYSE:CX), one of the largest cement producers globally.
Why cement is a great business
Houses made of steel sound like a good idea, but the high cost of steel vis-à-vis cement will push construction costs and home prices through the roof. Also, the “not in my backyard” mentality of residents limits where new cement plants can be located, which adds to the difficulty of getting the relevant regulatory approvals from the authorities to start new plants. Moreover, every cement plant is equivalent to a natural geographic monopoly, due to the weight of cement that makes transportation over long distances uneconomical.
Lessons from the past
The nature of Cemex SAB de CV (ADR) (NYSE:CX)’s business lends itself to strong free cash flows, with cement plants typically requiring minimal maintenance capital expenditures once the plants are up. But Cemex chose to act like a leveraged buyout (LBO) firm. Historically, Cemex used its free cash flow to borrow heavily to finance acquisitions. Put debt and acquisition-driven growth together and you have the perfect recipe for disaster. The music eventually stopped playing for Cemex SAB de CV (ADR) (NYSE:CX) during the global financial crisis (GFC) in 2008. Cemex had to refinance its huge debt load at higher interest rates and with more restrictive debt convenants to stay afloat.
The future will reward patient investors
There are two major reasons why I am positive on Cemex for the mid-to-long term.
Firstly, based on its most recent 20-F, Cemex SAB de CV (ADR) (NYSE:CX) has improved on its key financial health indicators. Its leverage ratio fell from 7.4 in 2010 to 5.4 in 2012; while the coverage ratio also increased from 1.9 to 2.1. Current ratios are well inline with debt covenants.
Refinancing risks are also mitigated with average debt maturity having increased from an average of 3.8 years in 2011 to five years in 2012. I am cautiously optimistic on Cemex meeting its targeted leverage ratio of below three times by 2016, which will reduce cost of capital and lead to a re-rating of the stock.
Secondly, infrastructure is something that can be deferred in the short term, but needs to built or rebuilt for developing and developed markets respectively at some point in time. Being globally diversified with operations in the U.S., South America, Europe and Asia, Cemex is the best proxy for the long-term secular trend of global infrastructure growth.
Cemex’s peers include Martin Marietta Materials, Inc. (NYSE:MLM) and Vulcan Materials Company (NYSE:VMC). On a trailing-12 months EV/EBITDA basis, Cemex SAB de CV (ADR) (NYSE:CX) is the most undervalued with a EV/EBITDA of 10.5 times. In contrast, Martin Marietta Materials, Inc. (NYSE:MLM) and Vulcan Materials Company (NYSE:VMC) are valued by the market at 18.6 and 24.2 times. Using the debt-to-equity ratio as a gauge, Martin Marietta Materials, Inc. (NYSE:MLM) and Vulcan Materials Company (NYSE:VMC) have gearings of about 70%, half that of Cemex SAB de CV (ADR) (NYSE:CX).