High Costs And Macro Worries Drag Cemex Down

Summary

• Cemex has underperformed, with investors fretting about both a weaker demand environment in 2023 and underwhelming profitability at this global cement giant.
• Management continues to talk a lot about environmental/sustainability and growth initiatives, but I want to hear what they intend to do about underwhelming cost/profitability that increasingly seems structural and long-standing.
• Next year is likely to see U.S. volumes contract on weaker housing and non-residential, but the long-term combination of housing, non-residential, and infrastructure demand and limited new supply is bullish.
• Underwhelming profitability remains a key risk, but even with more conservative assumptions, Cemex shares appear undervalued.

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My bullish call on Cemex (NYSE:CX) in February was predicated on strong volumes and pricing in the U.S. driving better profits and cash flow, with a healthy outlook for increasing infrastructure spending supporting the longer-term view. While U.S. demand and pricing have both been healthy, the market has become considerably more nervous about 2023 and Cemex has fallen short on profitability, leading to a 20% drop in the stock price and underperformance in an admittedly lackluster cement sector (though Eagle (EXP), GCC, and Martin Marietta (MLM) have held up better).

I’m increasingly concerned about what look like structural cost issues at Cemex that seem likely to lead to longer-term underperformance in profitability. That said, I do think infrastructure demand is likely to remain quite supportive and today’s price seems to reflect an overly bearish outlook for the company. Management has most definitely not earned the benefit of the doubt here, but if the company can manage something on the order of 4% long-term EBITDA growth, I do think there is some value here.

The U.S. Market Will Get Tougher, But Cemex Should Be Relatively Better Off

U.S. demand/consumption of cement has definitely slowed in the second half of the year, and next year is likely to be even more challenging. With U.S. housing likely to decline around 10% or so, I believe U.S. cement volumes could contract by around 4% in 2023. And if the economy sees an even harder landing in the wake of significant rate hikes, there could yet be downside risk to that range due to even weaker non-residential building activity (I’m relatively bearish on non-resi compared to the Street).

Offsetting that, at least to some degree, is a healthier outlook for infrastructure projects. Federal infrastructure stimulus should start kicking in more meaningfully in 2023 (and in subsequent years), and high single-digit growth in infrastructure demand (roads, etc.) should help mitigate the weaker demand from housing and non-residential construction. I’d also note that while I expect housing to be weak in 2023, there is still a meaningful shortage of housing and I expect good long-term growth in housing (particularly non-residential).

Cemex could also see some relative benefits from its footprint. Housing declines aren’t likely to be equal across the country, and I expect relatively stronger housing markets across the Southern U.S., where Cemex’s operations are concentrated (California, Arizona, Texas, and Florida are major Cemex markets, as well as North Carolina to a lesser degree). I also see relatively stronger non-residential and infrastructure activity in these markets, so it is plausible to me that Cemex could outperform overall reported volumes in the U.S. in 2023 and beyond.

Mexico has had a rougher year than the U.S. in 2022, with volumes trending down around 5% so far and likely to end the year down around 7% to 8%. Higher rates have hurt informal housing demand and Cemex has lost some share due to aggressive pricing. On a more positive note, headwinds tied to the pandemic/pandemic recovery shouldn’t be an issue in 2023 and while the country is vulnerable to a U.S. recession, nearshoring has been driving more demand from commercial and industrial customers. I’d also note that the proposed federal budget for Mexico in 2023 is the largest it's been in a decade, with infrastructure projects like Riviera Maya helping to drive demand for cement and other materials.

Management Needs To Address Costs More Meaningfully

Cemex’s November Investor Day had a lot of content regarding sustainability and growth initiatives. That’s fine to a point, and both are important. I applaud Cemex’s aggressive environmental/sustainability targets, including a significant reduction in CO₂ from cement production (with the company targeting a roughly 30% reduction by 2030).

Likewise, I’m bullish on the company’s Vertua product line (a more environmentally friendly product line that already accounts for about 33%-40% of ready-mix and cement volumes) and Regenera efforts (harnessing industrial and municipal waste). I also support the company’s plans to use organic capacity additions and bolt-on acquisitions to increase its production base in Mexico, the U.S., and EU and drive higher sustainable potential EBITDA.

What I would have liked to hear more about, though, is the company’s cost structure. Cemex has been aggressive all year on pricing, but it hasn’t been enough to preserve margins, with EBITDA margin down 320bp to 16.4% in the last quarter. Cemex isn’t alone, as many companies are struggling to offset inflationary cost pressures, but this isn’t a new issue.

Cemex’s EBITDA/ton in the U.S. market is about $10 to $20 below average and more than $60/ton below the sector leaders (at around $20-$30 for Cemex and $80+ for the leaders). This isn’t a new phenomenon, and inflationary cost pressures have made it worse. I don’t have the detailed information it would take to know exactly what Cemex is doing differently (worse), but it seems as though Cemex’s energy and maintenance costs are both meaningful contributors. This may speak to an overaged asset base and/or the challenges of operating near capacity (Cemex has had to import from Mexico, where its cash production costs are even higher), but whatever the cause, I’m disappointed that this isn’t a front-and-center part of management’s plans to drive better performance.

Looking at Street estimates for 2022-2024, Cemex is expected to generate EBITDA margins of 17.5%, 17.7%, and 18.5%. By comparison, expectations are for GCC to generate margins of 31%, 31.9%, and 31.9%, while Cementos Argos is expected to improve from 17.9% to 18.2% to 18.9%. Martin Marietta is expected to improve from around 26.5% to 29%, while Eagle should stay in the 33%-34% range. Even allowing for issues of comparability (this isn’t “apples to apples”), Cemex stands out and I think this is something management needs to start addressing more forcefully.

The Outlook

I’m still looking for over 4% long-term revenue growth from Cemex, as I believe the company remains well-leveraged to what is likely to be a period of sustained above-average cement demand growth in the U.S. and relatively healthy demand in Mexico as well (driven largely by reshoring and infrastructure spending).

I’m clearly not as bullish on margins as before, though I do think EBITDA margin should get into the 19%s over time. That, in turn, should allow for free cash flow margins in the 6%s and healthy long-term free cash flow growth. The near-term priority for cash will be improving the company’s leverage position and credit rating, followed by growth projects and then returns of capital to shareholders (management has committed to growth projects irrespective of achieving an investment grade rating, but has said capital returns are dependent upon achieving an IG rating).

Discounting those cash flows back, I do still think the shares are meaningfully undervalued today. Likewise, using my weighted EV/EBITDA approach (using a 5.5x multiple on 12-month EBITDA and 6x on long-term full-cycle EBITDA), I get a fair value close to $6. Cemex has traded at higher multiples in the past, but given the shortfalls in profitability in the U.S., management’s growth plans, and the elevated leverage, I’m more comfortable with discounted multiples.

I’d also note that there has been a stronger historical correlation between the rate on the 10-year Mexican bond and Cemex’s forward EBITDA multiple. With a current rate of 9.3%, a 5.25x forward multiple would be appropriate and would drive a fair value of around $4.75 on my 12-month EBITDA estimate.

The Bottom Line

Cemex looks undervalued, perhaps meaningfully so, and I think the macro outlook for cement demand in the U.S. and Mexico beyond 2023 is healthy, and possibly very healthy in the U.S. given demand from housing, non-residential, and infrastructure growth and limited new supply coming online.

I do have real concerns about the cost structure and management’s ability (and willingness) to really address those in a comprehensive way, but I also think the valuation reflects a lot of those issues. This could prove to be a value-trap, but given how strong the cement market in the U.S. could be post-2023, and given how strong commodity markets tend to actually benefit less-efficient producers more, I think there’s an opportunity here.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.