by GEOFF GANNON
This is my initial interest post for Monarch Cement (MCEM). I’m going to do things a little differently this time. My former Singular Diligence co-writer, Quan, emailed me asking my thoughts on Monarch as a stock for his personal portfolio. I emailed him an answer back. I think that answer will probably help you decide whether you’d want to buy this stock for your own portfolio better than a more formal write-up. So, I’ll start by just giving you the email I sent Quan on Monarch Cement and then I’ll transition into a more typical initial interest post.
I think Monarch is a very, very, VERY safe company. Maybe one of the safest I've ever seen. If you're just looking for better than bond type REAL returns (cement prices inflate long-term as well as anything), I think Monarch offers one of the surest like 30-year returns in a U.S. asset in real dollars.
Having said that, I don't think it's as cheap or as high return as you or I like as long as the CEO doesn't sell it. And the CEO very clearly said: "Monarch is not for sale".
I’m basing a lot of my comments in this email on historical financial data (provided by Monarch’s management) for all years from 1970-2018.
In a couple senses: the stock is cheap. It would cost more than Monarch’s enterprise value to build a replacement plant equal to the one in Humboldt, Kansas. And no one in the U.S. is building cement plants when they could buy cement plants instead. The private owner value in cement plants is even higher than the replacement value. An acquirer would pay more to buy an existing plant than he would to build a new plant with equal capacity. The most logical reason for why this is would be that an acquirer is an existing cement producer who wants to keep regional, national, global, etc. supply in cement low because his long-term returns depend on limiting long-term supply growth in the industry he is tied to – and, more importantly, anyone seeking to enter a LOCAL cement market needs to keep supply down because taking Monarch’s current sales level and cutting it into two (by building a new plant near Monarch’s plant) would leave both plants in bad shape (too much local supply for the exact same level of local demand). Fixed costs at a cement plant are too high to enter a local market like the ones Monarch serves by building a new plant. You’d only get an adequate return on equity if you bought an existing plant. Therefore, I believe that it’s usually the case that the price an acquirer would pay for a cement plant – and certainly Monarch’s plant given its location far inland in the U.S. – is greater than what it would cost to replace the existing plant. So: Acquisition Offer > Replacement Cost. And, in this case, Replacement Cost > Enterprise Value. Therefore: Acquisition Offer > Replacement Cost > Monarch’s Current Enterprise Value. In other words, Monarch’s current enterprise value is less than what any acquisition offer would be. So, the stock is definitely cheaper than what a 100% buyer would bid for the plant.
So, the stock is cheap. However…
This is where things get tricky.
Monarch’s stock price is around $60 a share. An acquirer would pay over $100 a share. Like $100 at the low end and $120 at the high end. Replacement value is also quite high.
However, I don't think YOU (or I) would necessarily want to pay more than about $40. Maybe $50. Basically, close to book value. Why not?
Returns in the cement plant itself are good. But, management here: 1) Doesn't use leverage (Monarch only uses leverage to fund big cap-ex, then pays down the debt - most public companies around the world borrow constantly to finance cement production). The business here would benefit a lot from continual use of a reasonable amount of long-term, fixed cost debt. The company should carry net debt. It actually carries net cash. You can see that in the results. While Monarch would have reported a net loss if it had debt in the bottom of a deep recession - see 2010 or so as an example - the ROE over time would be higher, because this is a company where you could predictably borrow at like 6% fixed and make 9%+ on whatever investment in the plant you financed at 6%. You could keep doing this. The math is favorable and would drive up after-tax ROE over a full cycle (though you would report losses at the bottom of deep recessions because operating income wouldn’t cover fixed charges in those rare, terrible years). 2) Management has bought ready mix concrete businesses. Without getting into how cement works, basically the input for cement is lime (and other stuff) that is then produced at a cement plant and shipped close to where it will be needed where it is then mixed with aggregates like rock to become concrete. Concrete is then used to build roads, bridges, apartments, offices, warehouses, etc. Anyway, the lime business is as good or better than anything (it is probably a bit more competitive than cement, but it has lower cap-ex needs - so lime may be the best business overall). Cement is the next best business (probably the least competitive, but very high cap-ex spending - because of high economies of scale, desire to reduce labor cost component, and meeting environmental regulations - cement is the most technical part of the chain of production). Ready mix concrete is the worst part of the business. Honestly, I think Monarch just bought out its customers in ready mix concrete in certain markets when they got themselves in trouble. Owning ready mix concrete ensures demand for Monarch's production. But, it's not needed. Cement plants only average 80-90% utilization normally, demand is so volatile (much more volatile than price), that even owning the ready mix concrete businesses in an area doesn't insulate you from the cycle. So, the whole ready mix thing just sucks up a bunch of capital for no return over time. The ready mix concrete business literally returns nothing sometimes. And it's not small. Finally, Monarch's CEO just puts the rest of surplus funds into owning other cement stocks (mostly). I think he has a policy of trying to keep roughly similar percents of Monarch's overall stock portfolio in each of the publicly traded cement companies he buys. He's not a value investor. He just keeps averaging into these stocks whenever Monarch has extra money after paying the dividend.
The CEO said "The dividend is sacred". And based on the 1970-2018 figures I have - I think that's true. Monarch will lower the dividend a lot in a total bust in the industry, but then start raising it again the very next year. So, the ROE isn't going to be leveraged and is going to include investments in ready mix concrete (the CEO knows these are not good investments, but I'm not confident he'll swear off these purchases entirely) and publicly traded cement stocks. Publicly traded cement stocks are much, much more expensive (usually) on like a P/B ratio compared to Monarch. Some are good businesses long-term. But, Monarch will buy these regardless of price. So, it's not ideal capital allocation.
Because of these capital allocation decisions: I think Monarch as a company will have a long-term ROE of like 8-12% a year. I think the underlying economics of Monarch’s actual cement plant are at the top of that range (12% unleveraged returns on an accrual - not FCF - basis). And I think actual cement plant returns – in the middle of the U.S. – will only be better over the next 30 years compared to the last 30 years (competition has decreased over time, there are fewer and bigger locations, plants are much larger: Monarch's capacity has probably quadrupled in 50 years at just that one plant, major players in U.S. cement are all bigger and more rational, it's very similar to what we saw in lime).
More accurately I should say: I think ROE will be 5-9% (or maybe like 6-10%) plus inflation. It's probably easier to calculate real returns and add inflation here.
You asked if cement economics are similar to lime as far as transport costs. The answer is yes. You can move cement by ocean going ship, river barge, railroad, or truck. You’ll basically need a cement terminal wherever you take delivery of it. So, if you are shipping across the ocean from East Asia to the U.S. let's say - you'd have to take delivery at a cement terminal in like Seattle or Los Angeles. And then you could ship by truck. The last leg - shipping by truck - is by far the most expensive per mile. So, the U.S. does import cement from other countries (imported cement is the marginal supply, it can drop like 90% from boom to bust), but imported cement is irrelevant to Monarch. Monarch's plant is basically dead center in the middle of the country. It can serve about half of each of several states (so, parts of Iowa and Kansas and so on). It's near the Eastern border of Kansas. So, it can ship to Oklahoma and Arkansas. Cement imports at U.S. ports could never travel far enough inland – due to the high transportation costs per mile once inside the U.S. versus the low value of the cement itself – to ever be worth worrying about foreign competition influencing cement prices in Monarch’s market. Technically, the best way to think of competition would be to imagine supply cascading into adjacent local markets sort of like ripples that dissipate with distance. So, if you can import from Asia into Los Angeles, then ripples of those imports could – through adding supply in the Los Angeles area – also be felt hundred miles inland. But, they wouldn’t be felt a thousand miles inland. Looking at a map of the world – it’s hard to imagine a location for a cement plant that would be more insulated from the risk of chronic oversupply than someplace like Kansas. In fact, looking at margins from 1970-2018, I can see that despite being in the super cyclical industry of cement – Monarch’s variation in margins (0.42 coefficient of variation) and pre-tax return on equity (0.37) is actually lower than many companies experience over 50 years. The only way that can happen in an industry where overall demand is so volatile and fixed costs are so high is if changes in competitive position are much rarer than in less inherently cyclical industries. In other words, you can’t have a lot of new entrants in a cyclical market and have variation that low and you can’t have a lot of changes in who is the low cost producer in a cyclical market and have variation that low. Monarch’s cost position relative to other cement producers in the region must change very, very little over time.
When shipping direct to the customer, you don't ship cement further than you'd ship lime. Lime is an input for cement. Monarch owns lime deposits at its cement plant to supply it for 50+ years. Lime isn't a huge part of the cost of cement. But, it's always a plus to have this low value/weight resource without having to worry about transport costs. I think the plant and lime deposits are on like 5,000 owned acres. However, I don't think land in Humboldt, Kansas is worth much of anything if it wasn’t being used to produce cement. In Iowa: they also own a 250 acre cement terminal and a 400 acre (nearly depleted) quarry.
Nonetheless, the replacement cost and acquisition prices I suggested don't explicitly include any value for the land, the lime deposits, etc. For example, I don't think someone in the U.S. - if they were building new cement plants, which on a net basis they certainly aren't - would really plan to spend less than about $300 million.
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