When I wrote about Cemex (CX) the other week, I mentioned Cementos Argos (OTCPK:CMTOY) [CCB.CN] as a name to consider for investors who wanted better leverage to volume growth in Colombia and the U.S. Cementos Argos ("Argos") has the advantage of not being burdened by less productive assets in less appealing regions, though the company has plenty of debt, and the company's "value over volume" strategy in Colombia is uncomfortably similar to a strategy pursued unsuccessfully by Cemex in Mexico. On the other hand, Argos is a leader in a Colombian market that is seeing construction spending just starting to grow again, and is likewise benefiting from a strong strategic position in the U.S.
Valuation is mixed, but there is significant operating leverage in this model, and a modest outperformance on the top line would translate into not-at-all modest leverage in earnings and cash flow. My base-case suggests around 15% to 20% undervaluation, but over 30% if the business can accelerate to COP 10B or better in 2020 (7.5% or better year-over-year growth).
Looking To Leverage Volume Growth Across Its Footprint
Cement is a volume-driven business; the industry usually starts seeing some pricing power and margin leverage when capacity utilization is better than 60%, and a much more significant ramp around 75% utilization. For the whole of Colombia's cement industry, capacity utilization is likely to end the year around 73%, but Argos is well below this (in the 40%'s). Likewise, the company's U.S. operations are operating somewhere in the mid-50%'s, offering meaningful upside to volume growth.
In Colombia, Argos is the volume and capacity leader, with around 40% volume share (Cemex and LafargeHolcim (OTCPK:HCMLY) are both significant participants). In recent times, Argos has chosen to forego volume to get better pricing, leading to a 2% decline in cement volume in the third quarter against 7% market growth but a better than two-point improvement in EBITDA margin.
With recent developments in Colombia, I believe Argos might be ready to turn the tap back on with respect to volume, without having to compromise much on pricing, given robust industry capacity utilization. Housing has finally started growing again in Colombia after several years of contraction, and money is likewise flowing back into private non-residential construction and public infrastructure projects. The new Bogota metro project alone could consume about 4% of Colombia's annual cement capacity, and with 3% GDP growth forecast for both 2020 and 2021, the cement and ready-mix segments of Argos should do well.
Argos also has attractive growth opportunities in the U.S., largely leveraged to above-average growth in the Southeast. Argos' footprint extends from Texas up through New York, but the core of the business is really in the area from Texas to Virginia. Helped in part by the FAST Act, public spending on roads increased at a high single-digit rate in 2019 and should continue to grow in 2020. Non-residential and residential construction activity should also be a positive driver, with the Southeast U.S. continuing to see net population inflows and an ABI above the national average (52.3 in September versus the national average of 49.7; any number above 50 means expansion).
The Caribbean operations of Argos are harder to assess at this point. While demand has been strong in the Dominican Republic, political instability has hurt demand in Honduras, and demand in Panama has been weaker than expected. Still, with margins in the mid-20%'s, this is hardly a bad business for the company, with capacity utilization above 80%.
In addition to looking to leverage volume growth and improved capacity utilization in both the U.S. and Colombian operations, Argos management is pushing on with its "BEST" efficiency program. While I don't want to minimize the importance of improved operating efficiency across the business, there's not much here that's particularly novel, nor are there much in the way of easily-measured deliverables that can help investors hold management to account.
Above all, this program is targeting leverage reduction to 3.2x net debt/EBITDA by mid-2020, which seems ambitious. Not unlike Cemex, Argos is trying to reduce debt by selling non-core assets, and Argos recently announced the sale of 28 ready-mix plants to SRM Concrete for $95 million, or about 9x EBITDA. These plants accounted for a small part of the U.S. business, and they weren't strategically located for Argos, so the sale looks like a net positive to me.
Management is also targeting ongoing improvements in working capital efficiency, improvements in procurement, and optimized use of capacity and the overall network. About one-third of Argos' U.S. cement production is used in its own ready-mix operations, and the company has done a good job of locating its plants with respect to transportation (rail, ports, etc.).
While most of the margin/FCF margin leverage I expect from Argos is tied to capacity utilization, an incremental half-point here or there is still significant.
Ambitions And Appetite Versus Prudence
One aspect that is both a risk and a potential driver for Argos is the company's appetite and ambition for further growth and scale in the U.S. There were rumors in the summer that Argos had approached Summit Materials (NYSE:SUM), and while there is strategic rationale for such a move, it's not a move I would favor, given the company's outsized present-day leverage.
Perhaps, it's unfair to compare Argos to Cemex, while they compete in Colombia, the U.S., and the Caribbean, there's not all that much overlap otherwise, but Cemex did something similar - using debt to fuel an aggressive M&A campaign that has since dragged significantly on the company and forced management make decisions motivated more by liquidity needs than optimal long-term strategy. That said, perhaps Grupo Argos, the construction conglomerate that controls Cementos Argos, could find novel ways to structure the deal, and Argos could perhaps use this as a way to gain a U.S. listing.
How the next year or two develops for Argos in Colombia is critical; management's decision to prioritize price and margin over volume is what Cemex did when it enjoyed similar market leadership in Mexico, and it really didn't work out well for Cemex. Minding the margins is, of course, important, but losing too much share in the preservation of margins is self-defeating in the long-run, particularly in a business where plant-level capacity utilization is so important to profitability.
I'm looking for 5% long-term growth from Argos, as it leverages growth in the Colombian market, as well as in its Caribbean region and the U.S. I'm not looking for dramatically higher FCF growth, but I do expect FCF margins to improve from the mid-single-digits of recent years into the high single-digits and, possibly, the double digits in particularly good years.
Valuation is mixed. Argos is a somewhat borderline buy call in my base-case on the basis of discounted cash flow (a prospective return in the high single-digits), but a more solid call on the basis of an 8.5x forward multiple. In a more bullish scenario where healthy (if not strong) demand for cement and ready-mix drives capacity utilization into the sweet spot in both Colombia and the U.S., the upside moves considerably higher.
The Bottom Line
I believe 15% to 20% upside in my base-case is enough to make Argos worth a closer look, but these shares are not particularly liquid, and that could be a dealbreaker for some investors. It's also worth repeating that this is a high-reward/high-risk setup - while better volume growth could drive significant margin leverage in 2020 and 2021, volume shortfalls (whether from disappointing end-market demand, share loss, or what have you) would drive considerably worse numbers, and the shares would almost certainly underperform.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.