Cemex's Prospects Improving

We think the market underestimates

U.S. cement consumption collapsed amid the financial crisis and has mustered only a halfhearted recovery due to disappointing residential construction spending. We expect U.S. cement demand to improve over the next five years, driven by a recovery in cement intensity as residential construction spending normalizes. We forecast U.S. cement demand growth of 4%, on average, from 2015 to 2021. Rising capacity utilization should set the stage for robust price increases and margin expansion.

We anticipate a considerable improvement in Mexican cement demand over the next five years. Compared with average growth at less than 1% per year from 2010 to 2015, we forecast cement consumption will grow roughly 5% per year, on average, through 2021. Capacity utilization assuming today's production footprint would approach 100% by 2019, supportive of materially higher prices.

Although President-elect Donald Trump's campaign included a great deal of rhetoric on immigration and protectionist trade policies, we expect little impact on Mexican cement demand. First, tariffs on Mexican imports could spark a trade war that would negatively affect the U.S. economy. The potential short-term gain of protecting U.S. jobs could come at the cost of lower employment over the long term. Second, we expect a minimal impact on Mexican fixed-asset investment, given construction spending’s minimal reliance on foreign direct investment. Third, most of the principal transportation projects in Mexico's national infrastructure plan have little to do with international trade, minimizing the risk of trade barriers eroding fixed-asset investment spending.

Advantages in Cost and Barriers to Entry We assign Cemex a narrow economic moat rating based on a low-cost advantage and high barriers to entry. These competitive advantages stem from the low value/weight ratio of cement and aggregates, difficulty obtaining permits for new quarries and cement plants, and operational efficiency in its Mexican and South American and Caribbean operations.

Cement and aggregates have low value relative to their weight. This creates local markets rather than global markets, as high shipping costs relative to the weight of the materials creates a low-cost advantage for local producers and high barriers to entry for outside competitors. The additional costs make it unlikely for imports to enter the local market, except in periods of excess demand. We believe this advantage is supported by high barriers to entry: Permits for new quarries and cement plants are difficult to obtain. Local residents tend to be opposed, and regulations make it difficult to build new facilities close to populated areas, which are the primary sources of strong demand.

Government and corporate customers constitute the majority of demand in developed markets. The Mexican market is different, with retail constituting 65% of demand, of which 35% is self-construction. Similar market dynamics exist in many of Cemex’s South American markets. To exploit the heavy retail demand, Cemex employs its Construrama distribution network to sell its cement to individual builders at more than 2,200 locations throughout Latin America. This distribution channel allows it to dominate the retail market. For example, 6 out of 10 bags of cement solid in Mexico and Colombia are sold at Construrama stores. Given the low customer concentration of the retail market, we think Cemex enjoys bargaining power over its customers, giving it more control of prices. Further, we believe a competitor attempting to recreate Cemex’s distribution channel would face high capital costs, creating high barriers to entry.

At current production levels, Cemex has more than 70 years of raw materials reserves for cement production and over 30 years of aggregates reserves. Because we do not anticipate the importance of cement and aggregates in construction to diminish, transportation costs to fall, or new permits to become easier to obtain, we think Cemex’s competitive advantage is sustainable for more than 10 years.

Construction Downturns a Concern Construction activity is the single-most important driver of earnings power. Given the high fixed costs of cement production and the fact that almost half of the firm's revenue comes from cement, we believe downturns in construction demand are particularly risky to Cemex's earnings, compared with peers with less exposure to cement.

Some key operating cost components are largely beyond Cemex's control. Energy costs are a threat to margins. Kilns require significant energy to reach the extremely high temperatures necessary for cement production. Cement production is fairly pollutive, and new requirements for emissions control technologies at kilns could add costs.

We think the firm faces some geopolitical risk. In 2008, Venezuela seized Cemex’s cement assets. While Venezuela eventually paid Cemex, we think this event served as reminder of the geopolitical risk the company faces. However, we believe this risk is somewhat mitigated, as Cemex’s current footprint does not include countries with a significant historical tendency to appropriate assets.

Given its global footprint, Cemex faces material currency risk. The company earns revenue in local currencies, while nearly 85% and more than 10% of the company’s debt is denominated in U.S. dollars and euros, respectively. Any depreciation in local currencies relative to the dollar, and to a lesser extent the euro, could have a material impact on the company’s ability to service its debt. With Cemex’s Mexican operations serving as a main source of operating income, we believe depreciation of the Mexican peso relative to the dollar is the biggest currency risk the company faces.

We believe all of the company’s risks are intensified by its high leverage. Even the slightest impact on earnings can threaten Cemex’s ability to service its debt and has a significant effect on the share price. If the company can continue to manage upcoming maturities through refinancing or repayment through asset sales, we think it will be in a position to improve its financial health.

Investors should take note of special voting rules for Cemex. Shares consist of Series A (Mexican shares) and Series B (free subscription shares). The company’s securities are listed on the Mexican Stock Exchange as ordinary participation certificates, or CPOs, consisting of two Series A and one Series B share. Cemex is listed on the New York Stock Exchange through American depositary shares, consisting of 10 CPOs. Whether they invest directly in CPOs or indirectly through ADSs, non-Mexican national investors have no voting rights through underlying Series A shares. In effect, they have one third the voting rights relative to economic rights.