Peru is one of the best performing economies in Latin America. The country is expected to grow GDP at 5.5% annually through 2016. This is higher than the expected GDP growth rates of Chile, Colombia, Mexico, and Brazil, which are 4.5%, 3.8%, 3.6%, and 2.1% respectively. The above average GDP growth rate in Peru should benefit small-cap concrete producer, Cementos Pacasmayo (NYSE:CPAC).
Cementos Pacasmayo is the only cement manufacturer in the northern region of Peru. This gives CPAC a monopoly status in that region of the country. Cement consumption has been growing in the northern region of Peru at a CAGR of 11%. APOYO Consultoria's survey in July 2013 shows that 30% of households are planning to expand, remodel, or finish building their homes over the next year. This situation provides investors of Cementos Pacasmayo with a compelling risk/reward scenario. The company has an attractive undervaluation with high expected earnings growth.
CPAC's products include: concrete blocks, pavers, cement bricks, quicklime, and ready mix concrete. The company operates three segments:
1. Cement, Concrete, and Blocks, which had net sales of $972 million in 2012 and comprised 83.1% of 2012 net sales. Last year's gross profit margin for the segment was 45.3%, or $440.5 million. This large segment matters the most for the company, which experienced a 14.7% increase in sales for Q3 2013, driven by strong demand in northern Peru. The gross margin for the segment also increased from 44.8% in Q3 2012 to 46.3% in Q3 2013. Margin expansion was achieved by allowing a modest 11.5% increase in cost of sales which was lower than the percentage increase in sales. The Cement, Concrete, and Blocks segment should continue to experience growth in sales as households in northern Peru continue to expand & remodel their homes. The company's concrete blocks and cement are needed to build homes, additions, garages, and other structures, walkways, driveways, etc. Peru's strong above average GDP growth is driving and should continue to drive this segment and CPAC's earnings higher.
2. Quicklime, which is used in mining operations, had 2012 net sales of $52.7 million and comprised 4.5% of 2012 net sales. This segment has a profit margin of 24.5% with gross profit of $12.9 million. Quicklime experienced a 43% decline in Q3 sales as a result of lower demand. However, this does not heavily affect the company as the segment comprises a small percentage of sales.
3. Construction supplies, which had 2012 net sales of $143.2 million and comprised 12.2% of net sales. This segment has a gross profit margin of 3.4% on 2012 gross profit of $4.9 million. Sales in the Construction segment declined 19.2% in Q3. This is not as impactful for the company as the segment comprises a small portion of total sales. Despite the decline in sales, gross margin expanded in the segment from 2.7% to 3.3% as a result of decreased fixed costs and lower energy consumption.
Overall, CPAC expanded its gross margin from 38.8% in Q3 2012 to 41.9% in Q3 2013. This was driven largely by sales and margin gains in the Cement, Concrete, and Blocks segment. As households continue to expand and remodel their homes, CPAC should continue to achieve increases in sales and gross margin as its concrete products remain in demand. This will positively impact earnings, which is likely to drive the stock price higher over the long-term.
Undervalued When Looking Forward
CPAC is undervalued as its future annual earnings growth is higher than its PE ratio. This is evident in its PEG ratio of 0.44. With a PEG under one and 40% expected annual earnings growth for the next five years, CPAC is priced well and poised for strong future stock growth. The expected growth is based on high demand for the company's concrete and cement products being driven by many households in northern Peru performing home remodeling and expansion projects.
The company also trades with a low price to book ratio of 1.74. This shows that CPAC is priced well in terms of its balance sheet. The company has over 4X more total assets than total liabilities and it has over 9X more current assets than current liabilities. I typically like to see companies priced less than 3X their book value per share and CPAC fits the bill.
CPAC's stock remains undervalued largely as a result of being an underfollowed company. There are only four analysts covering the stock and the company is just not currently on investor's radars. However, I think that as the company continues to grow and achieves positive results, CPAC will become more of a widely owned stock
With such high earnings growth expectations for an unknown company, I think that CPAC is likely to remain undervalued even if it does achieve those expected results. I think that it will take time for investment managers to get know and to embrace the company. Since stocks typically trend toward earnings growth over time, I do think that the stock will increase faster than the S&P 500, perhaps doubling the market's performance. However, due to the fact that the stock is not well known or covered extensively, I think that CPAC will not exactly match its earnings growth over the next few years. The stock currently trades with an average daily volume of 26k shares. For this reason, the stock should remain undervalued until the company becomes more well-known.
How High Earnings Growth Can Be Achieved
Peru's economy is expected to grow at an above average rate to the tune of 5.5% annual GDP growth through 2016. This high growth rate is fueling construction and remodeling projects among Peru's consumers. Many of these projects involve the need for CPAC's concrete and cement products. The northern region of Peru accounts for 23.2% of the country's population and 14.8% of its GDP. The area still has significant infrastructure and housing deficits. Since CPAC is the only manufacturer of cement in northern Peru, the company is likely to see higher revenue growth going forward to satisfy the growing demand. Revenue is expected to be $480 million this year and grow to $528 million for 2014.
In addition to revenue growth, the company is likely to achieve gross margin expansion as a result of cost efficiencies. For the first 9 months of the year, CPAC increased its gross margin from 44.9% for the first nine months of 2012 to 47.2% for the first 9 months of 2013. CPAC benefits from being vertically integrated, where it owns the quarries and the plants, and has a distribution network of 218 independent retailers and 318 hardware stores. The company's quarries are located close to its plants, thus minimizing transportation costs. CPAC also works diligently to lower operating costs on a regular basis, which leads to expanding gross margins. CPAC was able to reduce energy costs by securing its own source of coal. This entire network from quarry to retailer keeps operating costs down and acts as a competitive moat for the business. It would not be easy for a competitor to penetrate this already established network in the northern region of Peru.
CPAC does a good job with product innovation, which has led to gross margin expansion. For example, the company developed cement products that are suitable for coastal construction. This specialized cement withstands erosion from sulfate better than standard cement. CPAC is able to charge more for this differentiated product, which allows for higher margins. The company was also able to reduce the amount of clinker required for cement production by using natural minerals and additives without sacrificing product quality. This reduced use of clinker decreases costs, which also contributes to higher margins.
The downside for the company is protected by CPAC's competitive moat which includes its vertically integrated business system and its monopoly in northern Peru. This system gives the company a high degree of control over its costs and operations. With control over its quarries, plants, and distribution network, CPAC operates efficiently and has an established system with respected products to satisfy consumer's demands. High earnings growth can be achieved as Peru continues its above average economic growth in Latin America. Peru's strong economic growth should also protect the company from the downside. CPAC's cement and concrete products should continue to experience higher demand, which should lead to higher revenue growth. Furthermore, the company's operating efficiencies and specialized products allow for expanding margins. The higher revenue growth combined with expanding margins should lead to above average earnings growth. Given the attractive valuation and above average earnings growth, CPAC' stock could be trading 25% to 50% higher within a few years.