Minimizing Bond Risks through Diligent Credit Analysis
At Diamond Hill, our intrinsic value-based investment process applies to corporate bonds as well as to equities. One key difference is that corporations typically have a single common stock but can have many different bonds available for investment. Selecting the right bond for investment involves diligent credit analysis and a focus on minimizing additional bond risks. When we evaluate corporate bonds we ask:
1. How did the company arrive at its current position? We want to understand the business’s competitive position as well as management’s intentions for the balance sheet.
2. Will the company generate the cash flow and/or maintain the assets backing debt to reasonably assure repayment of principal and interest? Cash flow is the primary means to protect our investment, but tangible assets that can be remarketed in a worst case scenario provide an additional margin of safety.
3. Are we being compensated for the risks we are bearing? We want the long-term value of the business to adequately cover our bonds. We hone in on the bond structure (including coupon, maturity, ranking in the capital structure) and liquidity to make sure we are adequately compensated for the risks of rising interest rates, illiquidity, volatility, calls, extension, and restructuring.
As an example of these concepts, I will review our decision to invest in one particular Cemex SAB de CV corporate bond.
Cemex is one of the three largest cement companies in the world. Cement is combined with water and aggregates to make concrete, which is the second most consumed product on earth after water. Cemex is vertically integrated and engaged in the production, distribution, marketing, and sale of cement, ready-mixed concrete, and aggregates. The core business of cement production requires large amounts of invested capital and, given its high energy usage, has commodity exposure. Its products have a low value to weight ratio that leads to regional rather than global markets. At the same time, environmental regulation and access to aggregates in close proximity to production facilities lead to stiff barriers to entry. In many regions, particularly those that are landlocked, incumbents have good pricing power. In Mexico, a key market for Cemex, the firm has long-term and low-cost fuel and electricity contracts that provide the company with a low-cost advantage leading to historically higher earnings before interest, taxes, depreciation, and amortization (EBITDA) margins in this region.
Under the 20+ year term of then CEO Lorenzo Zombrano, Cemex grew rapidly both organically and through acquisitions. At year-end 2006, the company had revenues of $19.6 billion and generated nearly $3 billion of free cash flow, with leverage (net of cash) of less than 2.5 times EBITDA and investment grade credit ratings. At the height of the housing bubble management recklessly, in our opinion, purchased Rinker Group, a heavy building materials company with approximately 80% of sales and EBITDA coming from the U.S.
Rinker had grown rapidly with EBITDA compounding at approximately 24% per year from 2002 to 2006 due to the company’s heavy exposure to the U.S. housing bubble. However, Rinker U.S. had already experienced slowing EBITDA growth during 2006, and growth turned negative in 2007. It seems clear to us that Cemex should have walked away from its original bid, which was rejected by Rinker. Instead, Cemex increased its offer in 2007 by 22% to $15.3 billion or 10.4 times trailing EBITDA, a peak multiple on cyclically elevated profits.
The deal was consummated and funded entirely with debt. Cemex’s leverage prior to the transaction was less than the company’s target of 2.7 times EBITDA net of cash but ended at more than 4.5 times net of cash. As the U.S. housing market cratered and the financial crisis hit, Cemex’s leverage ratcheted up to over 7 times EBITDA, and the company was downgraded to high yield. Management spent years refinancing over $15 billion of bank debt into high coupon corporate bonds, loosening restrictive covenants included in its bank facilities and paying down over $3 billion of debt through cash generation, asset sales, and swaps. Management has been laser focused on shoring up the company’s precarious balance sheet in its longer-term quest to return to investment grade credit ratings. Cemex’s funded debt leverage as of September 30, 2014 stood at 5.4 times EBITDA. By comparison, large competitors like Lafarge and Holcim, who are set to merge, and HeidelbergCement typically try to maintain net leverage between 1.5-3 times EBITDA.
Prior to the merger, Cemex had historically converted a high percentage of its earnings into free cash flow. While the firm has been unable to consistently generate positive free cash flow, excluding asset sales and swaps, over the past several years, we expect the company to start generating cash in 2015. We forecast revenue growth in the mid- to high-single digits over the next five years as Cemex’s two largest markets, the U.S. and Mexico, are set to improve.
We like to invest in the bonds of companies that have hard assets with strong market values. As of year-end 2013, the book value of Cemex’s net property, plant, and equipment was nearly $16 billion and working capital was $2.7 billion. This understates the value of the assets because they are costly to replicate due to a multitude of factors including environmental regulations and proximity to end markets. Assets include 55 cement plants (plus 12 cement plants with a minority participation), 1,784 ready-mix concrete facilities, 362 aggregate quarries, 222 land-distribution centers, and 63 marine terminals. While the company’s leverage gives us pause, the hard assets combined with the ability to generate cash, the focus on debt reduction, and valuations of comparable public (approximately 8 times EBITDA) and private (10 times EBITDA or higher) companies give us reasonable assurance of receiving principal and interest.
While we are comfortable with the inherent credit risk in Cemex, we want to minimize our interest rate risk as well as liquidity risk. Bonds come in many different flavors depending on coupon, tenor, size, placement within a capital structure, and covenants. Below is a list of Cemex’s current U.S. dollar denominated bonds. Several bonds including the 9% of 2018 (which we owned and tendered back to the company above their first call price), 9.875% of 2019, and 9.25% of 2020 have been partially tendered for, as Cemex seeks to reduce its interest costs. We anticipate these bonds will be fully tendered for in the next few years as the company continues to address its high cost debt. Each bond with a coupon below 8% has been issued since March of 2013 to take out higher coupon bonds as the company opportunistically refinanced bonds. Coupons below 8% in the Cemex structure do not interest us because they represent cheaper funding sources and will have a higher probability of remaining outstanding until final maturity. Thus, they carry moderate to significant extension risk. This leaves the 9.5% bonds due 2018 and the 9.375% bonds due 2022 highlighted in Chart 1 below.
We prefer the 9.375% bonds for a couple of reasons: First, the issue size is much larger and more liquid. Second, both the yield-to-worst and yield-to-maturity compensate us for additional interest rate risk if the bonds were to extend beyond their first call dates.
Our absolute return objective of generating inflation plus 3% is always front and center in our minds when purchasing a bond. By selecting the right bond in a capital structure, we are not just compensated for credit risk in the form of yield. We also look for the right structure to mitigate interest rate, volatility, and liquidity risk. In the case of the Cemex 9.375% bonds, we believe a 5.57% yield-to-worst provides an attractive risk-adjusted return prospect considering Cemex’s diverse and improving end markets, focus on deleveraging, significant hard assets, reasonable equity cushion, and access to global capital markets. The high 9.375% coupon, combined with Cemex’s emphasis on lowering its cost of capital and a call date in three years, provide us with a structure that we believe mitigates some of the interest rate risk inherent in much of the corporate bond market today.
Originally published on November 19, 2014
The views expressed are those of the credit analyst as of November 2014, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.