Businessman Investor

Touching base with the rational business psyche of stock market investors

Sunday, September 25, 2011

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.


  1. I think the free cash flows and net income are interchanged.:)
    "Year: Net income vs Free cash flow (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"

    4,190 is 2010 net income.:)

    three years? you probably have doubled your holdings through capital appreciation. Congrats!:)

  2. Whoopsss.... Thanks for notifying me about that! =D Just corrected it.

    It has more than doubled, actually =P Way back then, I wasn't yet as conscious about that cash flow discounting theory and all; I'd say my way of thinking has evolved substantially since then. The acquisition was based on the stock's price being in a deep discount to book value. And seeing the ROE hovering more than 15%, I deemed it as a screaming buy! lol =D

  3. Would you like to consider net operating profit after tax (NOPAT) instead? Free cash flows is relatively easy to distort in accounting.:)

  4. Hmmmm, lemme see...
    I'm curious, for Republic Cement, what is it's 2010 NOPAT?
    How would this be better than Net Income or Free Cash Flow?

  5. NOPAT is simply operating cash flows before working capital changes net of tax.

    In regards with RCM:
    Cash flows before working capital changes 7,704
    Less: income tax paid 1,787
    NOPAT 5,917

    Its basically converting net income from accrual basis to cash basis.:)

  6. Well I guess that can also be used. It's a matter of preference.

    Time-value-of-money-wise, though, receivables just collected is as valuable as cash profits (likewise, sales made on credit doesn't have any value, cash-wise). So I have more inclination towards using Operating Cash Flow less Capital Expenditures (i.e. Free Cash Flow). After all, changes in working capital has a lot of bearing on cash value; the same thing actual, out-of-the-pocket capital outlays.

    Anyhow, valuation-wise, our assumed Php4B above is still way below the 5,917m NOPAT, so margin of safety is well maintained.

  7. Yup. You have a HUGE margin of error in your calculations.:)

    The NOPAT formula that I gave you was from Stern Stewart & Co's book. They are an advocate of cash basis accounting.

  8. hey, huge margin OF error OR huge margin FOR error? hehehe =P

    But let me ask: why would you want to discount/disregard changes in working capital AND capital expenditures? Don't you think that's a lot of disregard with respect to the principle of the time value of money?

  9. *margin for error.hehehe

    Stern Stewart & Co's NOPAT is not used for DCF calculations. Its for economic value added (EVA) calculations.

    I was suggesting you use NOPAT for your yield instead of FCF.:)

    "We then arrive at a safe free cash flow yield of 12.47% (Php4B/32.07B)"

    Their argument is that NOPAT is the actual cash that shareholders receive in the normal course of business. Cash flows from investing activities are not cash generated in the normal course of business and cash flows resulting from changes in working capital is just a timing difference.

    Its not really a big difference. I too don't use NOPAT in my valuations.:)

  10. It's a good thing that RCM did not sold any huge investments in the past years or you would find yourself a huge FCF to base your assumptions with.

    Huge current liabilities incurred can also distort the FCF calculation.:)

  11. "Cash flows from investing activities are not cash generated in the normal course of business..." I'm actually more particular with just capital expenditures. Because no matter how much cash a business can generate from its operations, if all or most of these are just ploughed back to depreciable fixed assets to maintain operations, what does that leave the shareholders?

    "Cash flows resulting from changes in working capital is just a timing difference" The timing factor is precisely why I consider it.

    "... I too don't use NOPAT in my valuations.:)" Which do you prefer and use?

  12. Regarding sold assets: True, true. That's why abnormal, extraordinary transactions such as that has to be weed out. And that's also why the comparison between net income and free cash flow (and I think that also somewhat tempers the effects of huge current liabilities incurred.)

  13. Thank you for sharing your thoughts.:)

  14. You're always welcome Renzie! =D I appreciate your comments and thoughts as well. Always do drop by and leave something! hehehe, Thanks!

  15. I'm not that familiar with the industry.:)

    Do you think DCF can be applied in mining stocks?

  16. At first thought, I'd say yes. Because compared to banks/financials or real estate companies--whose underlying value cannot be easily determined by looking at free cash flow; net asset value or book value measures maybe more appropriate (but I'd appreciate if someone can further enlighten me on this)--the value of mining businesses is only worth the cash they generate.

    Then again, the speculative nature of the prices of the metals they produce (such as gold, silver, copper, etc.) subjects them to even more uncertainties. It's really hard to predict unless the metal's intrinsic value do have productive utility or function (that way, demand for them would have a stabilizing effect)--and that's gonna mitigate (or somehow stabilize) the fluctuations in their prices. What do you think?

  17. Why not assume a conservative price and forex rate for the metals in the calculation?

    What industries do you like and have investments in?

  18. "Why not assume a conservative price and forex rate for the metals in the calculation?" I think that's an excellent MOS assumption! =D

    I have school, cement, media, beverage, greenergy, real estate, etc. you?

  19. I'm on real estate. I am optimistic in the Philippines' tourism industry.^_^

    Regarding DCF, how do you weed out abnormal transactions in cash flow from investments?

  20. I'm on real estate. I'm bullish on Philippine tourism.^_^

    Have you studied the oil company OV? I think it fits all your criteria in selecting a stock. They just started commercial operation in mid 2009.

    Regarding DCF, how do you weed out the unusual cash flows in investing?

  21. Checked out OV. Initially, 2010 results looks promising, but still has a lot to prove (prior years have measly returns). If it's able to maintain 2010 profits (and cash flow) for the succeeding years, then we're anticipating around 15% just in perpetuity return--that is not counting prospects for growth. With P/E ratio currently standing at 6.33x, earnings yield is 15.80% (i.e. 1/6.33)

    With regards to weeding out unusual cash from investing, these abnormalities can usually be attributed to "capital expenditures used for growth" OR "proceeds from sale of major PP&E assets". I have to concede I don't have an exact, almost automated method in going about this, but it helps sifting through the notes to FS. I've read somewhere that for use to arrive or at least have an idea of "maintenance capex", we just have to look at depreciation...

    I still tend to raise an eyebrow on this approach, however. Tips from you or anyone, perhaps? Would appreciate it =D

  22. "I've read somewhere that for use to arrive or at least have an idea of "maintenance capex", we just have to look at depreciation... "

    Looking only at depreciation expense would ignore future spending on fixed assets.

    In my opinion, knowing the management's business plan (might be specified in the sec 17-A filings), industry and regulatory factors would be a great help.

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