Edited Transcript of ELEMENT*.MX earnings conference call or presentation 20-Feb-20 3:00pm GMT

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Fernando Benjamín Ruiz Jacques, Elementia, S.A.B. de C.V. – CEO [6]

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Perfect. And apology for the technical difficulties. So I was saying about the major initiatives we launched in the last 18 months. So the first 1 was the overhaul of our Building Systems business unit. The other 1 was the development of noncore operations and expansion into underserved markets in our Cement business, and of course, the reformulation of our Metal business strategy. So all of this has helped us to put us on a better footing. Our spin-off process remains underway, and during the call, we will give you some color on where we stand. But let me give you a quick reminder of our rationale behind this major change.

So first, over the years, we have heard from many of you regarding our stock price. And we have watched our shares trade at a discount for being perceived as a conglomerate. We believe the spin-off will release this lost value of our shares and give each business the chance to have access to resources under better terms to more effectively continue their growth strategies. And second, we will have more focused management teams, which will be able to carry out their respective strategies and in the end help to deliver more value to all stakeholders.

However, we don’t need to rush this process. We want to make sure we do it under the best terms and conditions for all parties involved. So today, we are operationally and strategically ready, and we are just waiting for the right timing. We believe today is still not the best time since we still don’t have the best financial conditions to carry on with the spin-off process. We first want to complete the sale of our Cement plant in Pennsylvania for $151 million and then use the proceeds to pay down debt. After this happens, we will have a lower leverage ratio, which will certainly help us find better conditions to carry out the spin-off. In other words, we will wait for the right window frame.

So now turning for — on the subject we’re here for. Let’s begin with the materials, which is the way we call now the sum of Building Systems and Metal business unit. So the spin-off will return the company to the structure it had 10 years ago. These businesses have the capacity and the strategic drive to create the Cement division and build it from ground up. We see a world of opportunity in the construction sector. It is without question one of the least industrialized sectors in the world, and there’s still much to do. Therefore, materials has launched its new strategy called Terranova, with the model from [Great Green]. It’s based on 3 pillars: innovation, sustainability and customer centricity. For this purpose, we are reorganizing the business in 4 channels: distribution U.S.A.; which is Allura; distribution Latin America, which is Mexalit, Eternit, Plycem among many others; the builders channel; ‘and then industrials metals, which is Nacobre. Very soon, we will be sharing the details of this strategy with you and the vision, which is already underway.

So let me now review the fourth quarter and full year 2019 results for each business, starting with materials. In Building Systems or distribution LatAm, we proved to be on the right path, registering a remarkable turnaround for the full year, with a 41% increase in EBITDA and a 180-degree turn in net income. Our strategy proved to be successful last year, as we concluded the turnaround of the operations with the technology change and SKU reductions, resulting in incremental profit levels for all our companies in 2019. Our volume for the full year declined due to the optimization of SKUs. However, this initiative made us more productive and helped us to reduce the SG&A expenses.

Selling expenses increased due to the ramp-up of the new line in Cali, Colombia, in which we invested close to $10 million to expand our capacity in flat panels. We expect this effect to normalize in the second quarter 2020. We had several achievements in the year. Let me share some of them with you. In terms of new products, we successfully launched a new plastic roofing that has been gaining ground versus galvanized roofing. The new plastic format is made of recycled materials, has excellent performance quality, at a very competitive cost. Likewise, we launched a new fiber cement roofing, which has helped us to better compete in many South American markets given its value proposition to the end user and customer.

In terms of new markets, Peru, for instance, where we launched the sale of water tanks and fiber cement panels and roofing or Bolivia where we began producing and selling flat fiber cement panels. And last but not least, in terms of new channels, we launched a project called Advance, which we have been working on for the last 3 years. So far, we have delivered construction kit to 6 projects and have over 50 projects in our pipeline. With this kit, we delivered close to 75% of the materials needed to carry out a construction. Without a doubt, Advance B1 will be 1 of the main growth avenues for Elementia in the coming years. For 2020, we will continue entering and maintaining profitable markets while stabilizing operations to pursue financial growth.

Now turning now to Building Systems U.S. or distribution U.S. We made important adjustments in our commercial strategy and structure, and they proved to be successful. We posted 4% volume growth and 6% revenue growth for the year, thanks to our products with high value proposition such as prefinished. Allura has not delivered the results expected after the reopening of our plant in Ghana. However, we expect to reach a breakeven point in the second half of 2020.

Also, in the fourth quarter of 2019, we registered a special charge that is mainly related to the class action filed against Allura. The lawsuits comprising the class action alleged that Allura siding is defective because it is manufactured with fly ash. This has been disputed by Allura. Fly ash has not been used in Allura since February 2015. In 2020 and following our strategy, we will continue to grow faster than the market, while we enter underserved markets and better serve our existing customers with higher value-added products. We are working very hard towards optimizing our costs and expenses, and we expect to see the results of these efforts in the second quarter 2020.

Moving now to industrial market — to industrial metals. This business suffered last year due to headwinds in sourcing. Normativity change and market and other conditions reduced the availability of raw materials, which drove steep cost increases, which, given worldwide market conditions, we haven’t been able to translate this incremental cost to the market. We are still unclear as to when the situation will improve. Therefore, our focus will remain on reinventing ourselves, increasing operational efficiencies and cash flow generation.

Due to these challenges, we have been changing the way in which we operate this business. In the commercial arena, we are seeking new opportunities abroad through our U.S. commercial operation. We are simplifying the business and focusing our operation through the reduction of SKUs. We are building our commercialization business, which has had triple growth in the last 2 years. Likewise, in the operations arena, we are working to improve the yields of the raw materials. We are working very hard to reduce our inventories. We’re increasing operating efficiency through the reduction of headcount, SG&A and COGS, among many, many others.

The CEO of this division recently retired after more than 33 years in the company. We will be seeking a new head with a fresh perspective and ideas to help us in this important turnaround. In the meantime, we are working on best exploiting the properties of copper in areas such as thermal and electrical connectivity, anticorrosive and anti-microbe properties. So the spin-off will certainly give us more flexibility and resources to reinvent ourselves in this business. This is a mature industry, but with an enormous potential. We have the brands, the channels, the know-how and the capabilities to make this a success.

Last but not least, turning to our Cement business unit. Let’s begin with Mexico that, despite a slowdown in the economy, Fortaleza posted the same revenue levels as in 2018, thanks to an aggressive sales strategy and strong commercial network. We anticipate that 2020 will remain weak in terms of the construction sector in Mexico. However, we have been awarded 2 major public projects for ready-mix concrete that will contribute to our current operations, and we’ll also be starting operations at our refining facility in Yucatan. Our plan is to keep our plants working at full capacity and improve productivity to drive strong free cash flow from operations throughout 2020.

Mexico’s GDP contracted by 0.1% in 2019. For 2020, we estimate and the government estimate our return to growth in the 1.5% to 2.5% range. However, economists are targeting more of a 1% level on the back of a global economic slowdown. In terms of our Cement business in the U.S., thanks to incremental volumes and improved operating efficiencies, we registered a 51% increase in EBITDA for the full year 2019 and a 24% increase in the fourth quarter.

Regarding our initiatives to improve return over invested capital in this division, on September 27, we announced the sale of our Cement assets in Pennsylvania to Lehigh Hanson. We expect to conclude the process by mid-2020, at which point we can utilize the proceeds to reduce our leverage levels and achieve better ROIC metrics by focusing on our core operations and improve our overall returns for the Cement business in the U.S. Last, but not least, our Cement business in Costa Rica achieved full capacity at our grinding facility and successfully placed the Fortaleza brand in the market.

With this, I conclude my remarks. And now I turn the call over to Juan Francisco Sánchez Kramer for further details on our financials. And after that, we will go to the Q&A questions where Jaime Rocha will join us as well, so he can answer whatever you need to know about the Cement business unit. Thank you very much. And Juan Francisco, please go ahead.

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Juan Francisco Sánchez Kramer, Elementia, S.A.B. de C.V. – CFO [7]

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Thank you, Fernando. This quarter was heavily impacted by nonrecurring effects. So let me begin by explaining their nature. First, Metal, by year-end, and according to our regular processes, we did mainly 2 things. The first one was on inventory revaluation to market value. In this sense, we analyzed the several layers of inventory which we bring to current market value. By doing so, we are limiting the mark-to-market impact in accordance with IFRS. The second one was according to our internal policies where we tried to keep the inventory at a scalable value. Any inventory that is classified as obsolete, and therefore, with very limited chances to sell or use is canceled from inventories and added to the cost. In a similar way, but with a preventive focus, the inventory that is classified as a slow-moving and has begun to age is canceled from inventories again and added to the cost. In 3 stages, we canceled 50% of the inventory value when it exceeds 91 days, another 25% to reach 75% when it exceeds 121 days and the remaining 25% to reach the 100% when it exceeds 180 days.

Moving to Building Systems U.S.A., as Fernando mentioned, in 2018, a class action related to Allura siding sold between 2014 and ’15 was filed in South Carolina. This lawsuit triggered other class actions in different states. The lawsuits are now consolidated in 1 process that is being handled by the federal court in South Carolina. We hope to be able to reach a settlement with the plaintiff, subject to a court approval within the first half of 2020. We have created a provision to face this contingence. Also, in the fourth quarter last year, we released or canceled a warranty provision that became in excess facing claims made.

For Building Systems LatAm, at the beginning of 2019, we find out that there was a total flow that impacted the quality of our products, mainly during the first quarter of 2019. We corrected the flow and recovered the quality. In order to minimize the impact on our customers and our image, we decided to put it in plant in this product to analyze if it was risk-free sealable. Once those tests were concluded, we decided to destroy the product to prevent it from reaching our customers. We managed to reprocess parts. We are reflecting the net impact in our figures. For 2018, we excluded the discontinued operations, and this process mainly has to do with the old technology.

Lastly, on Cement U.S. and given that we have reached a binding agreement to divest the Pennsylvania facility, we must comply to reclassify the assets from noncurrent assets for property, plant and equipment to current assets or assets held for sale. And by doing so, we also booked the impairment that is expected from the difference between the book value and the divestment value, including the goodwill that created — that we created when we concluded the 50% uncontrolled acquisition of Giant. It is important to mention that this impact is a noncash item and, therefore, it does not impact EBITDA and/or leverage ratios. As we have mentioned in previous quarterly reports, one of the main objectives for 2019 was to deleverage the company. This objective continues into 2020. So in line with this, the plan is to use most of the proceeds of the transaction to repayment of debt.

Moving to financial cost. It remains fairly the same when compared to 2018. Interest paid was 6% lower but was offset by currency fluctuations impact. Moving to cash flow. It was MXN 1.1 billion before CapEx or 31% of the EBITDA, mainly because of a working capital consumption due to a combination of inventories and receivables in the U.S. operations for both Cement and Building Systems, while we prepare for the winter and yearly outages. Cash taxes were 27% lower for the year. Capital structure operations, including debt repayment and stock buyback, consumed MXN 573 million, and CapEx totaled MXN 1.1 billion. As a result, free cash flow was a consumption of MXN 659 million (sic) [MXN 629 million].

In terms of our balance sheet, 44% of our gross debt is in U.S. dollars, while 74% is at fixed rates. This offer us a better stability with regards to potential fluctuations. Additionally, close to 92% of our debt is long term. And I want to point out that Elementia’s total net debt was reduced by 50 — $550 million in a combination of debt repayment and cash consumption. Our leverage ratio, considering the last 12 months of EBITDA, was 3.89x, while the interest coverage ratio was 2.45x. During the fourth quarter, revenues were 2% lower than the fourth quarter 2018. The impressive 53% growth in Building Systems LatAm and 60% in Cement Costa Rica were close to offset the 7% decline in Cement Mexico and 16% decline in Metal. Just as a reminder, during the fourth quarter of ’19, we faced headwinds in 4 out of the 7 LatAm countries in which we operate, like Bolivia’s President removal from offices, Peru’s Congress removal, Colombia’s nationwide transport’s strikes, and the Mexican demand decline for the construction industry, making our top line growth in Building Systems LatAm even more remarkable.

For the full year, consolidated revenues declined 9%. Nevertheless, Cement U.S.A. and Building systems U.S.A. posted a 9% and 5% increase, respectively, while Cement Costa Rica showed a 137% increase, given that the operations began mid-June 2019. In terms of EBITDA, consolidated and normalized figures showed a 4% growth when compared to the fourth quarter last year, driven by a 24% increase in Cement U.S.A., a 435% increase in Building Systems LatAm and 18% in Cement Costa Rica, which were enough to offset the decline in Cement Mexico, Metals and Building Systems U.S.A. For the full year, normalized consolidated EBITDA showed an 11% increase versus 2018, led by increases of 291% and 57% in Building Systems LatAm and U.S.A., respectively; 260% and 51% in Cement Costa Rica and U.S.A.; which offset the declines of 11% and 62% in Cement Mexico and Metal.

With this, I conclude my remarks, and I ask the operator to please proceed with the Q&A session. Thank you.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We’ll take our first question from Nikolaj Lippmann with Morgan Stanley.

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Nikolaj Lippmann, Morgan Stanley, Research Division – Equity Analyst [2]

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Sorry, I don’t have much of a voice. First, on the class action lawsuit, if you don’t mind. Can you mention how many claims you have in how many states? And also, if any of these claims relate — I think you mentioned 2014, ’15. If anything is from later than that period? And if this is something that you think could — if you can give any color on whether you think it could grow over time? So that’s question number one. Question number two relates to Jaime and Cement. If you can give a bit of color on how you see the outlook for the Mexican both volume and pricing in 2020?

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Juan Francisco Sánchez Kramer, Elementia, S.A.B. de C.V. – CFO [3]

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Thank you, Nikolaj. Regarding the class action, it is 14 plaintiffs and 6 states. And as I mentioned, they have all been consolidated in 1 lawsuit now that is handled by the South Carolina courts. The product that is related to this class action is all from 2014 and ’15, nothing further in time, and it’s just for one of the facilities.

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Jaime Emilio Rocha Font, Elementia, S.A.B. de C.V. – Director of Cement Division [4]

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Nikolaj. Here’s Jaime. I believe that we were in the same party last night because I have the same problem. So for 2020, our projection is short growth. We don’t see the volume of the markets will change from what it was in 2019. The — maybe the evolution of the volumes will be a turnaround. That means that last year we had a very good first half and was a decrease in the second half. And I believe that this year we’re going to continue with the trend we had in the second half of 2019 with a better performance in the second half and doing at the end of the year like a flat situation from 2019 in terms of the market volumes. For pricing, we project that we are going to have some slight increase in prices, something between 2% and 4% and something that will be for sure and settled by a better performance as long as the year performance is better than months per month. So that’s the answer.

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Operator [5]

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(Operator Instructions) And our next question comes from Vanessa Quiroga with Crédit Suisse.

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Vanessa Quiroga, Crédit Suisse AG, Research Division – Head of Mexico Equity Research & Co-Head of the Housing & Infrastructure in LatAm excluding Brazil [6]

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My question is regarding Mexico Cement and the construction market. How do you expect those markets to perform in 2020 in terms of housing, informal or bag market and your views on being — potentially winning more projects related to infrastructure?

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Jaime Emilio Rocha Font, Elementia, S.A.B. de C.V. – Director of Cement Division [7]

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Well, as I already answered, we expect that more or less flat performance of the year compared to 2019. But splitting it into bag and bulk markets, we — at Fortaleza, we start moving on infrastructure projects seeing that is the commercial and industrial construction that needs also these ready-mix bulk products are — is not performing as well as it was doing the first half of ’19. So we — by the second half of last year, we start moving on the infrastructure projects, and that’s the reason why we get into 2 important projects, 1 is the new airport — new international airport of City of Mexico and also we won a new highway that goes from Mitla to Tepic. So in general terms, the bulk market was more contracted than the bag market. Bag market normally is more stable and is — has less fluctuations according to the economy. We expect for 2020 to keep this about 70-30 ratio between both for the market and also for us.

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Operator [8]

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And we take a follow-up from Nikolaj Lippmann with Morgan Stanley. Mr. Lippmann, your line is open. So we will take our next question from Coleman Clyde with HSBS (sic) [HSBC].

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Coleman Lee Clyde, HSBC, Research Division – Analyst, Global Consumer and Luxury Brands [9]

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I was just wondering if I could get a little bit more color on the reorganization of the materials business. You mentioned that you were reorganizing the business into 4 different channels. If you could remind me what those 4 channels were and what the rationale for that is? And then as a follow-up to that, what your outlook is for both Metals and the Building Systems divisions in 2020?

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Fernando Benjamín Ruiz Jacques, Elementia, S.A.B. de C.V. – CEO [10]

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Thank you for your questions. So reminding you the 4 channels. The 4 channels is distribution USA, which is Allura. The second 1 is distribution LatAm, which is the firm of the other companies we have throughout Latin America, which is Mexalit, Plycem, Eternit, Duralit, among others. The third channel is builders and the fourth channel is industrial metals. So the rationale for this is to be closer to the customer. Remember that as part of the Terranova, the Terranova has started. One of the pillars is customer centricity. So what we want here is to be closer to the customer, give them a better service.

Today, for instance, in distribution LatAm, and let me give you an example. If we go to our customer, we go to them with Fortaleza — with a salesperson from Fortaleza, salesperson from Mexalit, a salesperson from Plycem or from Eureka. So what we’re doing here is only 1 salesperson approaching to the market, presenting the whole portfolio. In that sense, we will have a — we will give a better service, so on and so forth. Regarding the builders, for instance, it’s a totally complete different market. So distribution is our traditional way of doing business. The builders is more a specification market. So we need other kind of salespeople. So we need more technical people, architectures, engineers so on and so forth. So we believe it is — this will give us a value-added for our customers. And the second question was?

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Juan Francisco Sánchez Kramer, Elementia, S.A.B. de C.V. – CFO [11]

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Outlook for Metals and Building Systems.

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Fernando Benjamín Ruiz Jacques, Elementia, S.A.B. de C.V. – CEO [12]

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Okay. So for Building Systems, I think that we — as I said in the beginning of the conversation, I think that we already went through the learning period of the new technology. We are on the right track. This year in Latin America, we had an interesting growth. I believe we will have another good year regarding that and mostly in Central and in South America. In Mexico, I believe there are also good opportunities. So I would say that we have a nice outcome for distribution Latin America.

Likewise for distribution U.S.A., I also believe that there will be — it’s going to be a good year. The market is there. We have a great value proposition. Unfortunately, last year, we had the — this class action thing, which I think has been taken care of. So having solved that almost, we will be able to focus on our business, and the outlook looks quite positive. And regarding the Metals business, that one, we are still struggling with the sourcing of the raw materials, no. There’s a very volatile environment worldwide. Many things are changing, and Mexico is not the exception. So we will keep looking for ways to get better sourcing of our raw materials.

Nevertheless, as I talked about, we are reinventing ourselves. We are making many changes in all the ways, commercial-wise, operational-wise, HR-wise. So I’m sure that these changes will bring good news for the near future. So I would say that we — definitely, we will have a better year than last year, without a doubt. But my most important concern is to solve the sourcing of the raw material, and we are on the way of doing that.

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Operator [13]

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(Operator Instructions) We have no further questions at this time. I will turn back the program back to CEO, Fernando Ruiz Jacques, for any closing remarks.

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Fernando Benjamín Ruiz Jacques, Elementia, S.A.B. de C.V. – CEO [14]

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Okay. So thank you. Thank you, operator, and thank you all once again for your interest in Elementia. We will do our best to keep you updated on the spin-off process. So let me just close with these final remarks. First, 2019 was challenging — was a challenging year with downturns in the macroeconomics for several countries that affected our business and the construction sector as a whole. Nevertheless, we were able to improve our results on several fronts. Second, we had many onetime hits that affected our results. And third, we will continue developing strategies and alternatives to turn headwinds into opportunities. So we will complete an important transformational process that will create value for all our stakeholders. So that concludes our call. So please feel free to contact me, Juan Francisco or Jaime, if you have any further questions. Have a nice rest of the day.

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Operator [15]

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This does conclude today’s conference. You may disconnect your lines and have a good day.