It is important that one evaluate their past missteps in order to make sure that the same mistake is not made in the future. In 2007, I held a large highly profitable position in Cemex (CX) which was spread out between taxable as well as nontaxable accounts. All of the profits in my taxable accounts were in the form of long-term capital gains.
When Cemex successfully completed the acquisition of Rinker in April of 2007 the company was trading around $35 a share. Foolishly, I only sold the shares in my nontaxable accounts and continued to hold the vast majority of my position until the late summer of 2008 when I was alerted to the magnitude of the financial crisis. What caught my eye was a news story that said Buffett, though his Kansas Bankers Surety Company, had ordered the company to no longer insure accounts in excess of the $100,000 FDIC guarantee. At that point, I sold all my CX shares; unfortunately the price was now under $20. The move turned out to be prudent as CX steadily retreated to around $5 per share by early 2009. Today, the stock is available for sale at around $3.5 per share and the company is in danger of violating its debt covenants.
For many companies, acquisitions account for the majority of their revenue and income growth. Sometimes the acquisitions provide useful synergies; for instance, the acquisition may allow the business to reduce distribution costs, increase their customer base across complementary product lines, as well as reduce competition.
Unfortunately for shareholders, many acquisitions are ill-timed and frequently never produce their intended synergies. Further, management has a nasty habit of significantly overpaying for the object of their desires. Similar to a scorned suitor, the more the object of their desire resists their advances, the greater the acquiring management longs to consummate the deal. If management is unwilling to walk away when the price becomes exorbitant, then shareholders are best served to jettison their shares promptly. Such was the case for shareholders in Cemex (CX, Financial) in 2007. At the height of the housing bubble Cemex management developed an insatiable lust to take over Ringer without regard to cost. That fascination resulted in one of the poorest acquisitions in the last decade.
The dramatically overpriced acquisition of Ringer took place at the absolute peak of the housing bubble. The mistake was exacerbated by the fact that the takeover was financed by debt rather that equity, bringing CX to the brink of bankruptcy as the U.S. and world housing markets have continued to languish due to oversupply and credit contraction.
The Rinker Acquisition Price
Cemex paid $15.3 billion (cash and debt assumption) to purchase Rinker in mid-2007 after a long period of negotiations. The following is a summary of Rinker's trailing five year financials taken from their 2006 Annual Report:
The price of the acquisition amounted to a lofty 11.3 times peak EBITDA, which occurred in 2006, during the height of the housing bubble. Using a more sensible metric, Cemex paid 22.5 times peak free cash flow to obtain Rinker. Bear in mind I am using a peak multiple, 2006 turned out to be an uncharacteristically good year for Rinker and it appears that the trailing five-year average in terms of EBITDA and FCF were much more representative of the amount of profits which CX could expect to extract from the company in future years.
If we use a five-year average, CX paid the following multiples: 18.3 times EBITDA and 35.5 times FCF. The question was not so much what was Cemex thinking when they purchased Rinker; rather the question was why did I continue to hold most of my shares?
In retrospect, I am certain that I held my shares to avoid paying additional capital taxes for 2007. Additionally I probably felt that CX was still a hold in terms of its price to free cash flow prospects. What ever the reason it amounted to a costly mistake, one which I do not intend to make again.
Not only did CX pay an excessive price for acquisition of Rinker; they also put the company in peril by overleveraging their balance sheet. Cyclical companies which employ high leverage are not the type of companies which a conservative investor should own. By continuing to hold the stock following the overpriced acquisition, I was lucky to escape the situation with the shirt on my back.
Epilogue
At its current level CX shares may now represent outstanding value, although the risk of bankruptcy is now a distinct possibility as well. If I was inclined to invest in CX at this point I would likely opt for the bonds rather than the stock.
Cemex had made a series of smaller highly successful acquisitions earlier in the decade and by the mid-2000s the company appeared to be an outstanding buy in terms of its price to free cash flow prior to the ill-timed Rinker purchase. The acquisition materially affected the value of the stock in terms EBIT/EV and FCF/EV multiples, as well as removing the margin of safety which existed in its previously strong balance sheet. At that point, all prudent investors should have exited the stock.
The crowning blow to CX was the financial crisis of 2008 and its impending impact on the company’s profitability for subsequent years. The ill-fated takeover of Rinker has now put the future of Cemex in jeopardy. If the company survives and does not severely dilute the shareholders, it likely represents outstanding value at its current price. Certainly if it approaches its past levels of free cash flow it currently trades at a discount to its intrinsic value considering its current enterprise value is less than $20 billion. However, the extensive debt Cemex holds as a result of the Rinker acquisition and the ongoing worldwide housing slowdown has turned the company into a risky proposition. Too risky for conservative investors.
Disclosure: no position in CX
When Cemex successfully completed the acquisition of Rinker in April of 2007 the company was trading around $35 a share. Foolishly, I only sold the shares in my nontaxable accounts and continued to hold the vast majority of my position until the late summer of 2008 when I was alerted to the magnitude of the financial crisis. What caught my eye was a news story that said Buffett, though his Kansas Bankers Surety Company, had ordered the company to no longer insure accounts in excess of the $100,000 FDIC guarantee. At that point, I sold all my CX shares; unfortunately the price was now under $20. The move turned out to be prudent as CX steadily retreated to around $5 per share by early 2009. Today, the stock is available for sale at around $3.5 per share and the company is in danger of violating its debt covenants.
For many companies, acquisitions account for the majority of their revenue and income growth. Sometimes the acquisitions provide useful synergies; for instance, the acquisition may allow the business to reduce distribution costs, increase their customer base across complementary product lines, as well as reduce competition.
Unfortunately for shareholders, many acquisitions are ill-timed and frequently never produce their intended synergies. Further, management has a nasty habit of significantly overpaying for the object of their desires. Similar to a scorned suitor, the more the object of their desire resists their advances, the greater the acquiring management longs to consummate the deal. If management is unwilling to walk away when the price becomes exorbitant, then shareholders are best served to jettison their shares promptly. Such was the case for shareholders in Cemex (CX, Financial) in 2007. At the height of the housing bubble Cemex management developed an insatiable lust to take over Ringer without regard to cost. That fascination resulted in one of the poorest acquisitions in the last decade.
The dramatically overpriced acquisition of Ringer took place at the absolute peak of the housing bubble. The mistake was exacerbated by the fact that the takeover was financed by debt rather that equity, bringing CX to the brink of bankruptcy as the U.S. and world housing markets have continued to languish due to oversupply and credit contraction.
The Rinker Acquisition Price
Cemex paid $15.3 billion (cash and debt assumption) to purchase Rinker in mid-2007 after a long period of negotiations. The following is a summary of Rinker's trailing five year financials taken from their 2006 Annual Report:
Millions of dollars unless stated | US$ | US$ | US$ | US$ | US$ |
Year ended 31 March | 2006 | 2005 | 20041 | 20031 | 20021 |
Financial performance | |||||
Trading revenue | 5,108 | 4,310 | 3,704 | 2,954 | 2,576 |
Earnings before interest, tax, depreciation | |||||
and amortisation (EBITDA) | 1,354.50 | 970.1 | 728.8 | 605.4 | 509.7 |
Depreciation and amortisation | 208.9 | 195 | 177.7 | 163.5 | 144.9 |
Earnings before interest and tax (EBIT) | 1,145.60 | 775.1 | 551.1 | 441.9 | 364.8 |
Net finance expense | 20.1 | 32 | 45.2 | 57.5 | 61.8 |
Income tax expense | 381.9 | 244.9 | 154.5 | 121.9 | 102.6 |
Net profit attributable to members | 740.2 | 493.2 | 350.2 | 260.3 | 199.7 |
Net cash from operating activities | 942.4 | 678.8 | 660.6 | 514.3 | 445.4 |
Development capital | 346.6 | 121 | 94 | 581.8 | 148.8 |
Purchase of property, plant and equipment | 383.7 | 281.1 | 224.4 | 129.2 | 165.7 |
Free cash flow | 678.6 | 416.9 | 441.2 | 384 | 293.3 |
The price of the acquisition amounted to a lofty 11.3 times peak EBITDA, which occurred in 2006, during the height of the housing bubble. Using a more sensible metric, Cemex paid 22.5 times peak free cash flow to obtain Rinker. Bear in mind I am using a peak multiple, 2006 turned out to be an uncharacteristically good year for Rinker and it appears that the trailing five-year average in terms of EBITDA and FCF were much more representative of the amount of profits which CX could expect to extract from the company in future years.
If we use a five-year average, CX paid the following multiples: 18.3 times EBITDA and 35.5 times FCF. The question was not so much what was Cemex thinking when they purchased Rinker; rather the question was why did I continue to hold most of my shares?
In retrospect, I am certain that I held my shares to avoid paying additional capital taxes for 2007. Additionally I probably felt that CX was still a hold in terms of its price to free cash flow prospects. What ever the reason it amounted to a costly mistake, one which I do not intend to make again.
Not only did CX pay an excessive price for acquisition of Rinker; they also put the company in peril by overleveraging their balance sheet. Cyclical companies which employ high leverage are not the type of companies which a conservative investor should own. By continuing to hold the stock following the overpriced acquisition, I was lucky to escape the situation with the shirt on my back.
Epilogue
At its current level CX shares may now represent outstanding value, although the risk of bankruptcy is now a distinct possibility as well. If I was inclined to invest in CX at this point I would likely opt for the bonds rather than the stock.
Cemex had made a series of smaller highly successful acquisitions earlier in the decade and by the mid-2000s the company appeared to be an outstanding buy in terms of its price to free cash flow prior to the ill-timed Rinker purchase. The acquisition materially affected the value of the stock in terms EBIT/EV and FCF/EV multiples, as well as removing the margin of safety which existed in its previously strong balance sheet. At that point, all prudent investors should have exited the stock.
The crowning blow to CX was the financial crisis of 2008 and its impending impact on the company’s profitability for subsequent years. The ill-fated takeover of Rinker has now put the future of Cemex in jeopardy. If the company survives and does not severely dilute the shareholders, it likely represents outstanding value at its current price. Certainly if it approaches its past levels of free cash flow it currently trades at a discount to its intrinsic value considering its current enterprise value is less than $20 billion. However, the extensive debt Cemex holds as a result of the Rinker acquisition and the ongoing worldwide housing slowdown has turned the company into a risky proposition. Too risky for conservative investors.
Disclosure: no position in CX
