Cemex: Positive Drivers Undermined By Worries Around Mexico And Capital Allocation

seekingalpha07-10

Cemex stock has underperformed peers, in large part due to bearish sentiment on Mexico after the recent presidential election.Demand and margins have stayed healthy in Mexico, and Q2 should see double...

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GDMatt66/iStock Editorial via Getty Images There are certain stocks where it just feels like there’s always some spanner in the works that limits the upside relative to what you otherwise think it should be. Cemex (NYSE:CX) very much looks like one of those, as the company was supposed to be on the front end of a U.S. cement super-cycle driven by limited capacity and growth in infrastructure spending, healthy demand in Mexico, and a more responsible management where capital allocation is concerned. While those positive drivers have largely come through, the shares are only up about 17% from my last update, meaningfully underperforming Holcim (OTCPK:HCMLY), Heidelberg (OTCPK:HDELY), CRH (CRH), and Buzzi (OTCPK:BZZUY), though doing better than Mexican peers like GCC (OTCPK:GCWOF) and Moctezuma (OTC:CMZOF). Therein lies some of the problem, as investor sentiment on Mexico has definitely soured since the presidential election. I do believe that Cemex remains undervalued, and I also believe that the worries about the U.S. and Mexico markets will prove transitory relative to the longer-term potential. That said, capital management (balancing M&A, organic reinvestment, debt reduction, and shareholder returns) remains a concern and Cemex has never been a top-flight operator in terms of operating efficiency. Fear Dominates Everything Tied To Mexico Even though the results of the recent presidential election in Mexico weren’t exactly a major surprise, the market has made its feelings about the new administration very clear – the IPC Mexico index dropped 6% immediately and hasn’t recovered much and the iShares MSCI Mexico ETF (EWW) is still down about 10%, with currency explaining some of the difference. In addition to a slate of proposed constitutional amendments proposed by the new administration, analysts and investors are worried about the high fiscal deficit in Mexico, the impact of high interest rates, and how the administration will sort out its spending priorities. This latter point could be the biggest issue for Cemex and the broader economy, as a lot is riding on the ongoing growth of reshoring/nearshoring of manufacturing to Mexico, but the country desperately needs investment into electricity, water, and human capital (education, et al). At 20% of revenue and around 40% of EBITDA (50% in the last quarter), Mexico is inescapably important to Cemex’s prospects. “On the ground” conditions are still decent, though. Revenue rose 20% year over year in the first quarter (and fell 1% quarter over quarter), with better EBITDA margins, and management upgraded its full-year guidance on a healthy informal sector and a still-strong pipeline of infrastructure projects that are likely to continue or complete through the end of the year. To that end, I expect mid-teens growth in this upcoming second quarter report, with further margin leverage, but I do wonder if the company is going to warn of deceleration in the second half, as that has been the pattern after elections in Mexico. While I do understand these worries about Mexico’s fiscal priorities, I am guardedly optimistic that the government realizes how important both fiscal discipline and public works projects are to supporting economic growth. Softer Near-Term Trends In The U.S., But Still A Good Fundamental Setup When I last wrote about Cemex, I mentioned my out-of-consensus view that Cemex could be vulnerable to weaker construction spending trends even as infrastructure projects ramped up. That has played out, with a low-to-mid single-digit decline in housing starts, a double-digit decline in multifamily starts, and much weaker spending in some areas of non-residential construction like warehouses undermining demand. With residential markets accounting for about a third of cement demand, it seems as though pricing power is fading. Realized cement prices were up 4% yoy in the first quarter and down 1% qoq, and it sounds as though price realizations are getting harder to come by. At the same time, Cemex has been hit by bad weather and higher transportation prices, leading to softer than expected volumes and sluggish margins. I don’t think these factors derail the longer-term story. Infrastructure projects are still moving forward and will keep cement producers in markets like California and Texas busy for several more years. As a reminder, there isn’t enough cement to meet demand right now, leading to higher imports of cement into the country. Greenfield capacity additions have been fairly limited (companies seem more interested in M&A), and I think the outlook for supply and demand is still quite positive for Cemex and other major U.S. players like Holcim, CRH, and so on, particularly when considering that housing demand and non-residential construction will bounce back. Capital Allocation Is Still A Talking Point  Management’s most recent investor day (back in March) made it clear that they are still looking to grow the business and are more willing to pursue M&A and brownfield expansion than in the past. Growing the U.S. business is the top priority, with management looking to take this business from 29% of EBITDA in 2023 to 40% over the next few years. The company is looking for bolt-on deals in aggregates and urbanization (a catch-all business that includes admixtures, precast pieces, and waste management), but is also looking to expand its cement capacity in the United States. While investing in U.S. capacity arguably makes sense given constraints to the aggregates and cement businesses, past M&A left the company with a bloated, ill-managed collection of assets and a lot of debt that the company then unwound through sales. At a minimum, I think the Street would like a more balanced allocation of capital across debt repayment, capital returns to shareholders (dividends and buybacks) and reinvestment/growth. With Holcim, CRH, and Heidelberg all offering dividend yields in the neighborhood of 3%, I can’t say it’s an unreasonable request. The Outlook Management is investing in renewing its asset base (recently completing an expansion at Tepeaca in Mexico), but I do believe the company’s infrastructure and locations do limit its margin expansion – the company has long been on the wrong side of average for cement cost curves, and I don’t think there’s much they can do about that in the near term (they certainly don’t have the capital for a mass-renovation cycle). I am a little below the Street for FY’24 and ’25 revenue and margin expectations, but still within a few percentage points of average, so it’s not like I’m notably bearish. Longer term, I expect around 3% to 4% annualized revenue growth, and I feel as though I am more bullish on the company’s opportunities in Mexico and the U.S. relative to the current zeitgeist. On margins, I note that the company did exceed my EBITDA margin expectations in FY’23 by close to two points. I’m looking for a modest improvement in FY’24 (less than half a point) to around 19.5%, followed by modest improvement thereafter. With that, I think EBITDA growth is more likely to be in the “mid-to-high single-digits” versus management’s high single-digit growth target. At the free cash flow line, I expect mid-single-digit margins, which supports around 5% long-term growth, as the company will continue to spend on modernization, capacity growth, and decarbonization. Discounted free cash flow leads me to a fair value estimate of around $8.50. I could argue for $8 to $9 a share on EV/EBITDA, but with rates where they are in Mexico and challenges to near-term pricing and volumes, I think a 5.25x multiple (a fair value a little over $7) is reasonable for the near term. The Bottom Line Given that I’m bullish on longer-term drivers like infrastructure spending in the U.S., a housing recovery, and further construction to support reshoring, as well as long-term public works/infrastructure and near-shoring opportunities in Mexico, and the shares are below even what I regard as a low-ball fair value of $7, it’s hard not to be at least somewhat bullish on this name. That said, this has been a frustrating stock many times in the past, and I do recommend it only with those reservations noted.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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