Republic Cement as an Equity Bond with an Expanding Coupon

It's just a cement bag. No! For me, it's an equity bond with a powerful compounding/expanding coupon!

This is Part 2 of a Series. Go to Part 1: How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

We turn ourselves to Republic Cement (PSE: RCM), a company I was able to purchase three years back then (and still holding) when it was still selling below book value.

Fast facts: It’s been in the business of manufacturing and selling cement for decades. It’s currently the market leader; majority holder is that worldwide leading French cement company called Lafarge. Catastrophe risk is almost minimal.

So let’s try to apply the simple appraisal steps noted earlier...

Review of the Company’s Historical Net Income, Cash Flow and Return on Equity

First, we go over Republic Cement's key financial figures below and form some quantitative opinions about them:

Year: Free cash flow vs Net income (in millions of pesos)
2004: 699.80 vs 793.30
2005: 1,825.10 vs 900.40
2006: 2,397.60 vs 2,629.30
2007: 3,365.10 vs 1,615.50
2008: 3,794.40 vs 2,830.20
2009: 7,035.43 vs 3,875.52
2010: 5,091.34 vs 4,190.73

Year: FCF growth vs NI growth vs ROE
2005: 13.50% vs 160.80% vs 12.72%
2006: 192.01% vs 31.37% vs 32.96%
2007: -38.56% vs 40.35% vs 15.55%
2008: 75.19% vs 12.76% vs 24.57%
2009: 36.93% vs 85.42% vs 28.85%
2010: 8.13% vs -27.63% vs 26.24%
Geometric Mean: 31.97% vs 39.2% vs 21.86%

Compounding Power (i.e. Expanding Coupon Capacity).The geometric growth rate (from 2005 to 2010) of  free cash flow and net income are 31.97% and 39.2%, respectively. Return on equity, meanwhile, yielded a geometric mean of 21.86% in the same period. It is therefore safe to assume that the company’s compounding power (the equity bond’s capacity to expand its coupon payments) is at double digits around 20 to 30%. Using geometric mean growth rates for free cash flow, net income (and ROE) are useful because while these are reasonably predictable in excellent businesses, they are still not prone to fluctuations.

Ascertaining a Safe Perpetual Cash Flow. Reviewing Republic Cement’s historical net income and free cash flow above, I'd say a Php4B perpetual free cash flow assumption would be safe and conservative. Why? Last reported free cash flow is Php5.09B and net income is Php4.19B; historically, it's been growing cash profits at around 30%. But I'm good and will settle for a flat, perpetual Php4B (mind you, there's a hell lot of margin of safety built-in to this very key perpetuity assumption).

Market Capitalization Net of Cash Hoard. Being bias on accumulated free cash, we can subtract the Php1.3B cash hoard from the current market capitalization of Php33.37B, netting us Php32.07B.

Free Cash Flow Yield as the likely Long-term Rate of Return. We then arrive at a safe free cash flow yield of 12.47% (Php4B/32.07B). That is to say, if we paid Php33.37B (or Php5.72 a share, the current doing/traded price of the company at the stock market) for Republic Cement, our likely rate of return should be 12.47%, and that’s assuming the business will be producing flat cash flows forever.

Republic Cement's Batangas Plant. The company has been producing clinker and cement products mostly for the domestic market since 1955. It directly operates 4 cement plants in Luzon and operates a fifth cement plant in Mindanao through its subsidiary, Iligan Cement Corporation. It also has another subsidiary, Batong Angono Aggregates Corporation, which operates a basalt aggregates quarry in the province of Rizal.

While we conservatively view flat earnings and a perpetuity return of 12.47%, we know by hindsight, through observation of its return on equity, and growth in net income and free cash flow, that the company—as an equity bond—has an expanding coupon, and can thus offer more than the 12.47% perpetuity return.

12.47% perpetuity rate of return? I’d say I’m satisfied with that.

At the least, we’re satisfied with 12.47% returns. And given its observable 20 to 30% compounding power (through ROE, earnings and cash flow growth), we know we’d be receiving more, but we’d rather not delve elaborately or make forecasts on that—because at what the business is already very capable of delivering, we’re happy with a 12.47%! And should it earn more, the compounding power will take care of that.

That’s the decision. I’d say we’ve got a lot of margin of safety in our assumptions throughout the process. And we didn’t do any fancy projections.