Major Market Recoveries Can Take Cemex Further

| About: Cemex, S.A.B. (CX)
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Summary

Housing and government spending are growing again in Mexico, and state budgets in the U.S. are starting to improve.

Cemex margins should see significant positive leverage from better capacity utilization and cost/efficiency moves made during the downturn.

Assigning a 10x multiple to 2014 EBITDA and/or an 8.5x multiple to the mid-cycle EBITDA estimate both suggest a $15 fair value and the potential for low-to-mid teens annual returns.

Conditions are looking better in core Cemex (NYSE:CX) markets like the U.S., Mexico, the U.K., and Germany, but there's still quite a bit further to go before conditions are back to normal. Improving construction trends in the U.S. and increasing public spending in Mexico should boost cement and ready-mix demand, helping pricing, capacity utilization, margins, and cash generation. The process of valuing Cemex is a little convoluted, but if Cemex can reach management's goals for mid-cycle EBITDA in 2016/2017, low-to-mid teens appreciation over each of the next three years doesn't seem unreasonable.

Leveraged To Construction And Public Spending

One of the largest cement companies in the world, Cemex has a global operation spread across Northern Europe, the Mediterranean countries, the U.S., Mexico, South America, Africa, the Middle East, and Asia. Cemex sells cement, ready-mix concrete, and aggregates, and has an installed capacity of around 95 million tons. About 30% of that capacity is in Mexico, and nearly 20% is in the U.S., accounting for about that much of Texas's cement capacity and close to a third of market capacity in the southeastern U.S.

Housing and infrastructure is the driving force behind concrete and ready-mix demand. Around one-third of Mexico's demand ties back to housing, with another quarter or so tied to infrastructure spending. The Mexican government has been accelerating its spending since late in 2013, and has laid out a fairly aggressive plan for infrastructure spending. On the housing side, starts were up more than 5% yoy from January to April, but still down one-third from the levels seen in 2010 and 2011.

The U.S. story is similar, albeit even more tied to infrastructure spending. Residential construction is about one-quarter of U.S. cement demand, while infrastructure accounts for around 50% to 60%. With job growth improving state revenues and budgets, spending on roads and highways could climb back from its sub-2% level (as a percentage of state budgets) to the long-term average of 2.25%. That may not sound like a lot, but it's a roughly $160 billion pool, and while not all of that is cement, a return to more normalized spending levels can mean significant improvements for the company's U.S. operations running at around two-thirds capacity.

The story is a little different in Latin America, where Cemex is, in many cases, looking at markets where it holds a considerable share of capacity and where cement usage is low compared to more developed emerging markets.

Will Lafarge And Holcim Help Out Cemex?

Holcim (OTCPK:HCMLY) and LaFarge (OTCPK:LFRGY) are looking to merge, creating a global cement giant with over 400 million tons of capacity (dwarfing Anhui Conch and Heidelberg). A bigger, more efficient rival is a threat to Cemex's operations, but also a potential source of benefits. The two companies are going to have to shed assets to get regulatory approval for the merger, with Bloomberg recently speculating that up to $7 billion in asset sales could be in the works.

Management at Cemex has made a point of shoring up the balance sheet, but they still have the capability to participate in these sales. These acquisitions could add some high-quality assets in areas that the company believes are strategic for it, helping cushion the blow of dealing with a large, more competitive rival.

New Management, But A Consistent Vision

With the passing of Cemex's long-time CEO earlier this year, Cemex now has a new CEO and chairman in place. Both have long associations with the company, as the new CEO was formerly the CFO, and has been with the company since 1989.

Not much is new about the approach recently laid out by the new CEO, Fernando Gonzalez Olivieri. The company is looking to get an investment grade rating by virtue of EBITDA growth, and it is prioritizing expansion in emerging markets and improved utilization and margin in more established markets. Global utilization was only around 60% in the first quarter, with Mexico and the Mediterranean region both below that average, and the U.S. only a little bit above. In Mexico and the U.S., improved utilization can feed directly into better margins, but the company has been making progress on taking costs out of the operations and driving operating efficiencies that should hold up as the demand grows.

I've already touched a bit on the growth potential in Latin America, as many countries are likely to use more cement as their economies grow. Utilization is close to 80% in South America, but with utilization of 84% in Asia, this may be another emerging area where Cemex can grow through expansion.

Free Cash Flow Should Be On The Way

Management, and most of the sell-side, believe that the company is going to hit its mid-cycle EBITDA figure of around $4.7 billion in 2016/2017. Along the way, Cemex should see a small free cash flow deficit this year but $1 billion or more in 2016, and that should help facilitate expansion, debt repayment, and capital returns to shareholders.

Given the cyclicality of the industry, I'm not a big fan of free cash flow modeling, and even an EV/EBITDA approach is a little convoluted. Valuing Cemex based on expected 2014 EBITDA is pretty tricky, as the company is just coming out of a long trough. A 10x multiple doesn't seem outrageous relative to what should be mid-teens growth over the next three years, and that works out to a $15 target today. Alternatively, assigning a mid-cycle EBITDA multiple of 8.5x to that $4.7 billion estimate for 2017, adjusting the debt, and then discounting back to today at 13% works out to almost the same number (slightly more than $15).

The Bottom Line

At $15, Cemex should be priced to generate annual gains in the low-to-mid teens over the next three years. That's a respectable return, with upside if the company sees a faster/stronger recovery in Mexico and the U.S., better growth in emerging markets, and/or outperformance in terms of margins. With Mexico's economy looking like it's on the way back, Cemex may yet have some worthwhile upside, even after a 40% move this year and a 130% move over the past two years.

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