Friday Morning Coffee Nr. 120 : Big is not always beautiful

170920 Friday Morning Coffee

Friday Morning Coffee Nr. 120 : Big is not always beautiful

What if we were to tell you that this large cap company operating in the cement industry has grown its revenue two and a half times in last five years and has EBITDA margins of +30 percent? Exactly, even we did not believe our senses at first. We are talking about Anhui Conch, a Chinese cement manufacturer. It is hard to digest a hyper growth cement manufacturer when we have grown accustomed to mature, low margin and value destroying profile of cement businesses.

In a study published by Mckinsey, titled “The cement industry at a turning point: A path towards value creation”, authors claim that Big has not been beautiful for the sector. In the table below, we show Total Shareholder Return (TSR) for European building material names for the period 2010-2019.

Source: ECP, Bloomberg

As per the authors, the top quintile of the players capture almost the full economic profit of the industry, whereas the remaining players create returns just above or below the cost of capital. Moreover, top-quintile companies are almost exclusively composed of leading regional companies. On the opposite end, the bottom quintile includes all five large global players. The divergence in the performance is a result of combination of revenue growth and capital efficiency, suggested the authors.

Source: Mckinsey

In their quest of growing big and beautiful, these global players overpaid for acquisitions and entered markets that had some country specific challenges or continued to remain heavily invested in mature markets. To give you some perspective, for a similar scale of operation while Anhui Conch has 3% of its balance sheet in intangible assets, Heidelberg Cement has 32% of its balance sheet in intangible capital, almost entirely made of Goodwill. Hence, we are talking about a sector that has quite a bit of cyclicality, frequent periods of supply-demand imbalances and high capital intensity. Add to it, bloated balance sheets and inefficient management teams, one can easily zero in on European building material names, No-go pocket to consider for an investment in this liquidity awash world. Although, after being aware of the shortcomings of the industry, earlier this week we did start building our position in a Swiss cement manufacturer, LafargeHolcim.    

“The only constant in life is change”-Heraclitus

By investing in LafargeHolcim we are not taking a bet on the eventuality of it staying away from new acquisitions, in fact we want them to continue doing M&As. Our thesis is that going forward, Lafarge would undertake more rational portfolio positioning under its new leadership. As per Lafarge, a typical cement plant has economic radius of 300 km. It is a regional/local industry with each individual geography having its own pricing and supply-demand dynamics. Cement businesses being capital and energy intensive, having advantageous raw materials access is equally important. Factoring in the geopolitical red tapes and nature of the business dynamics, if LafargeHolcim, or any global player would want to grow, then acquisitions has to be part of their story, as seen in the last decade, and in coming time it has to be in the emerging markets because of urbanisation and increasing GDP/capita theme. Moreover, a cement business with a rational portfolio positioning global footprint turns out to be a boon to insulate the group against extremes in cyclicality that regional champions face.     

But what made us more optimistic on LafargeHolcim is its current management and the Keynesian tail winds that we expect to see in coming times, some with the tag “Green” attached to it. The current CEO of Lafarge, Mr. Jan Jenisch, is an industry veteran. He joined Lafarge in 2017, prior to that he headed Sika, another European name in Building materials sector. Under his leadership Sika grew its revenue at 5% CAGR, however in the same period EBITDA grew at 13% CAGR which proves his focus on profitable growth. In his three years at LafargeHolcim, he has already started showing results; be that CHF 400M annual cost savings concluded in 2019 or staying disciplined in acquisitions or shedding underperforming assets in south-east Asia. We can continue to talk about savings on interest costs, repositioning the business towards more profitable end markets and products, launching of carbon efficient products etc but that would be beyond the scope of these brief notes.

Source: ECP

In the end, what made the decision easier for us was our proprietary Quality-Value tool, which shows continuously an improving quality score, whereas the value score is still in line with historical average.