Investment story

LafargeHolcim (OTCPK:HCMLF) (OTCPK:HCMLY) is the global leading cement company. The company is exceptionally well-run and can be acquired cheaply at today’s prices (25bn CHF market cap). Even in the crisis year 2020, the company plans to deliver over 2.75bn CHF, which is an 11% FCF yield at current prices. Finally, LafargeHolcim should produce even greater cash flows in the future, providing further upside.

An in-depth write-up about the business, its competitive advantages and great management can be found here and an assessment during the height of the first COVID wave can be read here.

At the time of writing, 1 Swiss Franc = 1.09 USD.

Navigating the pandemic

As I mentioned in my April article about LafargeHolcim, the company was entering the COVID crisis in a position of strength with a record 2019 performance, low debt and ample cash reserves. To navigate the pandemic, CEO Jan Jenisch focused on preservation of cash with the “HEALTH, COST & CASH” action plan. Now, 7 months into the plan, all financial targets of the action plan were exceeded. Fixed costs were reduced by almost 400mn CHF, capex was reduced by another 400mn CHF and net working capital was reduced at a faster pace than the sales declined.

Source: LafargeHolcim 2020 Q3 PresentationSource: LafargeHolcim 2020 Q3 Presentation

Thanks to the action plan, LafargeHolcim achieved an impressive act for such a high-fixed-cost business: defeating negative operating leverage. While like-for-like (LFL = adjusted for scope and FX changes) sales decreased by 2.6%, LFL EBIT increased by 10% in Q3 2020. If a company with such a high operating leverage can increase EBIT during a period of revenue decline, one can only start to imagine how earnings might develop when sales growth returns. CEO Jenisch attributes the strong results to the strict cost management as well as a higher share of branded, higher-margin, bagged cement (compared to lower-margin bulk cement).

Source: LafargeHolcim 2020 Q3 Presentation

Source: LafargeHolcim 2020 Q3 Presentation

The result of the exceptional management effort can be seen in the FY 2020 FCF outlook, which was lifted by 37% in Q3 2020. The company expects now to deliver FCF above 2.75bn CHF, which is an 11% FCF yield at current prices. Given that 2020 is a year with extreme economic contractions across the globe, this is a very strong result.

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Future FCF growth

Since the value of a company is determined by its future Free Cash Flows, one needs to assess how these over 2.75bn CHF will develop over the coming years. Therefore, the different FCF drivers and their outlook for LafargeHolcim are discussed below.

Revenue growth

While 2020 sales suffer(ed) significantly due to the COVID pandemic, this year also provides a relatively low base for future revenue growth. Jenisch mentioned during the 2020 Q3 call several infrastructure programs across the globe, which are designed to support economic recovery after the pandemic. All of all these projects should drive significant demand of cement and aggregates. Some selected projects are: A EU-wide infrastructure & green renovation program, an extension of the US FAST Act (Fixing America’s Surface Transportation Act) until September 2021, a €7bn program for building refurbishments in France, a 10-year infrastructure program in Quebec, Canada, a $5bn housing project in Brazil, a Housing for All initiative in India, etc.

The full list of projects should be published in the coming days on the LafargeHolcim website. On top of the organic growth opportunities from a “return to normal” and infrastructure programs, there is also the option of inorganic growth. Having over 8bn CHF in liquidity, levered only 1.6x EBITDA and led by a highly M&A-experienced leadership team, LafargeHolcim is ready for a (major) acquisition. While the BASF construction chemicals business was too expensive for Jenisch to buy, an extended duration of the COVID pandemic will likely lead to more attractive opportunities in the quarters to come. Overall chances are very high that sales will be substantially above the 2020 level in the coming years.

Margin expansion

When sales increase in the coming years, it is very likely that margins will increase due to the high operating leverage in the business. Additionally, a stronger push towards CO2 reduced building will probably increase demand of the higher-margin ECOPact products, which have a significantly reduced CO2 need (-30% to -100%) compared to conventional cement. So overall, margins are likely to expand in the near future.

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Capex development

LafargeHolcim aims at reducing capex in 2020 by over 400mn CHF compared to the 1.4bn CHF of 2019 (of which 900mn are declared as maintenance capex). Jenisch expects medium-term capex to be below these 1.4bn CHF from 2019. This should be achieved through greater standardisation of equipment and processes as well as savings from stronger use of global sourcing systems. If the company manages to achieve their low capex targets, one of the key bear arguments (cement is a too capex-intensive industry) is invalidated and significant future FCFs are likely.

Working capital changes

The H1 2020 cash flow from operating activities benefitted by 650mn CHF from improvements in net working capital. Days Sales Outstanding decreased from 54 to 46 YoY and Days Inventory Outstanding decreased from 42 to 35 YoY. In the Q2 2020 call, the CFO stated that these improved net working capital (NWC) ratios are expected to be sustainable for the future. This means that NWC will probably grow over time in line with sales, but no over-proportional drag on cash flows is expected.

To sum up all the FCF drivers: Sales will likely grow from infrastructure programs across the globe and potential acquisitions; margins should expand due to high operating leverage and higher-margin eco products, capex is expected to remain low, and working capital should only increase in line with sales. So overall it looks likely that FCF will be materially higher in the coming years than the one of 2020.

Valuation

Since 2020 FCF is expected to be above 2.75bn CHF and there are several drivers supporting further FCF growth, it is easy to imagine 3-3.5bn CHF FCF p.a. in the coming 1-2 years. Applying a 15 FCF multiple on a 2021 FCF of 3bn CHF results in an intrinsic value of 45bn CHF. Compared to today’s market cap that’s a margin of safety of 44% or an appreciation potential of 80%.

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Risks

Overall I see a long-term investment in LafargeHolcim as a relatively low-risk investment. The company produces a product with no real substitutes (cement), has a favourable competitive positioning, low debt and is exceptionally well-run. A second round of strict lockdowns (with closure of construction sites) would have a negative sales impact on the company. As LafargeHolcim has ample liquidity (over 8bn CHF as of September 2020), it should manage this period relatively well and would probably not incur any long-term damages.

While many people see the high CO2 intensity of the cement industry as an inhibitor in a greener future, I believe the push towards a more sustainable economy is actually benefiting LafargeHolcim. Being the clear industry leader, they have the financial resources to research, develop, pilot and globally distribute green solutions such as CO2 reduced cement or partially recycled cement. Already, (private builders) are willing to pay higher prices for higher-margin CO2 reduced cement.

I believe governments will also push in the same direction, leading to a favorable, higher-margin product mix for LafargeHolcim. CEO Jenisch mentioned in several calls that he’d prefer higher prices of CO2 certificates, since this would increase overall cement prices and LafargeHolcim’s costs would increase by a smaller amount (than the prices), as the company’s plants are more efficient compared to competitors.

Summary

LafargeHolcim manages the current “pandemic year” extremely well as cost savings exceeded sales reductions and the company expects strong cash flows for 2020. Looking into the future, it seems like there are several drivers supporting even higher levels of FCF, providing current investors with up to 80% return potential.

Disclosure: I am/we are long HCMLF. 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.



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