Africa is not only big, but bigger than most Americans can probably easily imagine. China, the U.S., India, and Western Europe would fit within Africa's borders with some room left to spare. It's also a very underdeveloped area, as the best-ranked country in terms of roads is Namibia at #35 and much of the bottom quartile of the rankings is made up of African countries. As a leading cement producer, this means opportunity for South Africa's PPC Limited (OTCPK:PPCYY).
Poor infrastructure has emerged as a key issue in maximizing the value of Africa's mineral and resource exports, to say nothing of facilitating better food production and trade. It remains to be seen whether African countries will invest the needed resources in infrastructure development, but PPC has big plans to benefit not only from improving conditions in South Africa, but underserved markets throughout Africa.
The only fly in the ointment is valuation. Down more than 10% over the past year and about midway between the 52-week high and low, investors are nervous about the company's ability to withstand increasing supply and low utilization in South Africa and continue to invest in the capex needed to expand into other African countries. The shares are not necessarily overpriced today, but they don't appear to offer that extra margin of safety I prefer in emerging market infrastructure plays.
A Large Player In A Tough Market
PPC boasts over 60% of South Africa's cement capacity at present, and over 90% market share in the Western Cape province (home to Cape Town). That market presence doesn't really translate into a real moat, though, as rivals like Afrisam, Natal Portland Cement, and Lafarge (OTCPK:LFRGY) have shown themselves willing to take 10% to 20% discounts to maintain their volumes.
Demand has been improving in South Africa recently, mostly due to private customers buying for housing and construction projects. Building permits have been rising at a double-digit clip, but public works spending has not kept pace. South Africa has an ambitious National Development Plan on the books, and could certain use the job creation boost offered by construction projects, but actual budget allocations and spending have lagged targets by 70% to 80%. Cement companies like PPC could be looking at significant demand growth in the coming years if the national and provincial governments try to catch up with the plan, but that appears to be a significant "if" at this point in time.
It's also true that market dynamics in South Africa are challenging. Not only does PPC lack pricing power, but competitors are increasing supply. Sephaku, a subsidiary of Nigeria's Dangote Cement, is finishing up new facilities in South Africa that will add about 16% to 20% to the country's annual supply. With utilization rates already around 70% across the industry, that's not going to be helpful for pricing or margins.
The South African government is also hurting the cause. In addition to arguing underspending on infrastructure projects, the government has proposed a carbon tax that would see PPC's cost rise by around 4%. More troubling for PPC, cement importers would be exempt from the tax, making it even harder to compete with imports from Pakistan.
Fueling Growth Through Expansion
PPC currently gets about 20% of its revenue from outside South Africa, and management has stated its goal of doubling that percentage by the end of 2016. With that, the company has taken stakes in established cement companies in Ethiopia and Rwanda and is looking to build new plants in Zimbabwe and the Democratic Republic of the Congo in short order, and enter markets like Kenya and Tanzania a little later.
Ethiopia, the DRC, Kenya, and Tanzania are among the largest countries in Africa and the quality of their roads and infrastructure is generally poor. At current rates of GDP growth and infrastructure spending, though, the annual cement demand from these areas (and additional countries like Zambia) could double PPC's current markets. Longer term, PPC also considers most of western Africa, from Angola up through to Senegal, to be target markets for expansion.
The demand growth in these expansion markets does indeed look impressive, but there are risks all around. First, the company has to spend hundreds of millions of dollars in capital investments to get plants on the ground. Then management must hope that economic growth and government policies remain conducive to the sort of projects that will demand that cement. Last and not least, there's the question of competition - Dangote, Lafarge, and other global cement companies are seeing the same conditions as PPC and planning their own future growth and expansion projects.
Limited Scope For Margin Improvements Outside Of Growth
By the standards of other publicly-traded cement companies like Lafarge, Cemex (CX), and Holcim (OTCPK:HCMLY), PPC has very good operating margins despite middle-of-the-road gross margins. As an already efficient operator, then, there would seem to be only limited opportunities for additional cost improvements. Management could shift around some clinker production to more efficient plans, but closing lagging plants is compromised by the fact that many of the laggards are in strategically important regions.
I do expect significant annual revenue growth for PPC, on the order of 9% to 10%, as the company benefits from the growth of South Africa and its greater African expansion plans. I also believe that the company can post solid free cash flow margins, though it remains to be seen if the company can replicate its superior margins outside of its current markets of South Africa, Zimbabwe, and Botswana. I'm optimistic, and I'm looking for greater than 20% long-term free cash flow growth as the company leverages capex investments in the years to come.
The Bottom Line
Even with better than 20% free cash flow growth, PPC looks like no particular bargain on a DCF basis. This is not uncommon for materials companies like cement producers, but the EV/EBITDA methodology doesn't offer huge upside either. While emerging market cement producers are trading at an average multiple of 8x forward EBITDA, I'm willing to give PPC a 10x multiple for its higher expected growth rate. Even a 10x multiple to sell-side 2014 EBITDA targets only results in a target of $6.30, about 10% above today's price.
Granted, a fair value of $6.30 does still suggest that PPC is undervalued. I simply question whether that is enough margin of safety to invest in a company that is operating in a challenging part of the world, particularly with a lot of supply coming into the market in its home country. I need a bigger discount before putting my own money to work here, but I do like the idea of a well-run infrastructure play in Africa.
Disclosure: I 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. (More...)