We didn't find any surprises in CRH's third-quarter interim update, and the building materials firm continues to suffer from prolonged weakness in the global construction markets. Consolidated revenue fell 19%, a slight improvement from the 21% decline recorded during the first half of the year; however, demand remains well below prior-year levels.
The company's American and European operations continue to experience significant volume declines due to reduced building activity, and the effects of stimulus spending haven't yet hit the firm's top line. In Europe, demand trends for building materials such as aggregates, cement, and asphalt haven't improved upon the declines experienced during the first half of the year. In the United States, margins for materials have benefited from lower energy input costs and price increases despite sustained soft volume. US building product demand appears to have stabilised on the residential side, but the firm expects deterioration from the nonresidential sector to last though 2010.
CRH's update confirms our thesis that although the housing market is in the process of bottoming, slowdowns in commercial construction will provide an additional head wind in the near term. The firm expects pretax income to fall in the range of EUR 730 million-760 million, which is in line with our projections. We are maintaining our fair value estimate of EUR 19 per share.
Fair value estime: EUR 19 ¦ Fair value uncertainty: High ¦ Economic moat: Narrow
Thesis
(Last updated 12-11-2009)
With operations in 31 countries and an acquisition-focused strategy, CRH is one of the largest players in the building materials market. While the current weak global economy will continue to pressure near-term performance, we believe that this narrow-moat firm will be well-positioned when demand in its markets recovers.
CRH's geographically diversified operations haven't been immune to a global slowdown across its markets. The company earns roughly half of its revenue from the United States, and sales have suffered due to the three-headed monster of a collapse in housing, tight credit markets, and weak nonresidential and infrastructure construction activity. The company obtains its remaining revenue in Europe, where the demand picture isn't any brighter. CRH's sizable global footprint is able to offset regional downturns only to an extent; when the net of a weak worldwide economy is cast, all of its businesses find themselves caught up.
That said, we think CRH's expansion strategy through acquisitions may help the firm in the long run. The company's recent forays into emerging markets such as Eastern Europe, China, and India provide ample platforms for the company to grow. In 2008, the company purchased stakes in two cement manufacturers, Yatai Cement in China and My Home Industries in India. The fundamental driver of CRH's sales is construction activity, which is often tied to gross domestic product growth. While the current weak economy dulls the near-term attractiveness of these regions, future infrastructure spending should spur demand over the long term.
Still, CRH's acquisition-heavy strategy is not without significant risks, as simply adding ingredients to the pot is not a guaranteed recipe for success. Making numerous acquisitions requires skill on the part of management to ensure that integration goes smoothly. The company must also choose its investments wisely, taking into account the purchase price and the potential for return on investment. While merger-and-acquisition activity has led to considerable growth during the past few years, the company hasn't been able to improve its returns on invested capital, which average around the low teens. While CRH has certainly beefed up its operations, we'd like to see the added muscle eventually translate into consistent excess returns for investors.
Valuation
Our fair value estimate for CRH is EUR 19 per share. With anaemic
construction activity likely to persist over the near term due to a weak
global economy, we're forecasting top-line erosion of around a midteen
rate in 2009. During the first few months of the year, severe weather
conditions in Europe have delayed infrastructure projects, pressuring
demand for cement. In addition, demand from the American end markets has
worsened, since softness in the nonresidential sector is now adding to
the malaise brought about by a suffering housing market. We're also
projecting profit margin contraction in 2009, as lower input costs may
be unable to completely offset significant volume declines across the
firm's operations. We project a rebound in revenue for 2010, as we think
infrastructure projects and a possible housing recovery should help spur
sales. Over the long term, we're forecasting organic revenue expansion
at around a mid-single-digit percentage rate--future acquisitions would
help boost overall growth. We are also projecting long-term operating
margins in the high single digits, which are in line with midcycle
figures.
Risk
The biggest risk CRH faces is a prolonged downturn in construction
activity. Although the company maintains a large international presence,
a weak global economy may negate the power of its diverse footprint. In
addition, the company may overpay for acquisitions or purchase companies
that do not generate the desired returns on investment. Finally, the
company's numerous foreign operations leave the firm exposed to currency
fluctuations and its bottom line could take a hit due to shifts in
exchange rates.
Management & Stewardship
Company veteran Myles Lee took over the CEO role after Liam O'Mahony
retired at the end of 2008. O'Mahony had served as CEO since 2000,
leading the company's push for acquisitions and international expansion.
We think that Lee will continue this strategy. We like that the company
splits up the roles of CEO and board chairman, as Kieran McGowan
occupies the latter position. McGowan has been a board member since
1998. Compensation is based partly on performance-related targets such
as earnings per share and return on net assets targets. As a group,
directors own less than 1% of all common shares outstanding.
Overview
Growth: CRH posted double-digit growth from 2004 through 2006,
driven mainly by acquisitions and strong global demand for building
materials. However, the company's organic top line declined in both 2007
and 2008 due to weak construction activity. Going forward, we expect
further erosion in 2009 as weak end markets pressure the firm's top line.
Profitability: Profitability is relatively steady, and operating margins have hovered around 9.5% in recent years. Cement, aggregates, and asphalt normally generate 15% profit margins in Europe and 10% in the US. Concrete and construction products produce average operating margins in the high single digits, while distribution has mid-single-digit margins. The largest drivers of profitability are energy costs and sales volumes.
Financial Health: CRH has net debt of around EUR 6 billion, as it often finances its acquisitions through debt offerings. At the end of 2008, EBITDA covered net interest 7.8 times and net debt/EBITDA was around 2.3. The company's primary covenants require these ratios to be above 4.5 and below 3.5, respectively. In March 2008, CRH raised about EUR 1.3 billion through a rights issuance. The company plans to use the proceeds to pay off debt and fund future acquisitions.
Profile: CRH is an Ireland-based global holding company that manufactures and distributes building materials in the United States and throughout Europe. The firm operates three segments: materials, products, and distribution. The materials segment produces cement, aggregates, and asphalt. The products segment makes a variety of materials such as concrete and architectural glass. The distribution segment supplies roofing and interior construction products.
Strategy: The company has expanded through numerous international acquisitions, as it believes global diversification will help partly offset swings in local demand. The company entered the Chinese market in 2007, and in 2008 made its first foray into India; both involved purchases of less-than-majority stakes in cement manufacturers. Both joint ventures include the option for CRH to assume a larger ownership stake in the future, which is a common feature for the company's deals.
Bulls Say
1. CRH operates in an industry with relatively high barriers to entry.
Prospective entrants may have trouble getting access to raw materials at
pits and quarries, and production facilities require significant amounts
of capital to build.
2. The low value-to-weight ratio of cement makes it expensive to transport. CRH's ownership of quarries close to its manufacturing facilities allows it to save on transportation costs.
3. The outlook for long-term demand for CRH's products remains positive, as planned improvements to global infrastructure should help bolster future sales.
Bears Say
1. The company's products segment will likely continue to deal with
lower sales volumes in the near term, as the new construction and repair
and remodelling markets don't appear to be recovering anytime soon.
2. CRH uses significant amounts of diesel fuel in both its manufacturing operations and distribution services. Price spikes could significantly pressure the company's profitability.
3. The company's global acquisition strategy not only poses risks for successful integration, but also leaves it exposed to fluctuating exchange rates.
