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Few U.S. investors have heard of Switzerland's Holcim (OTC: HCMLY) and France's Lafarge (OTC: LFRGY), which trade on the pink sheets. But they are quite well-known in Europe, with $40 billion in combined sales in 2013. Back in April, these two cement producers announced plans to merge, creating an entity that will be more than twice as large as its next closest competitor, Mexico's Cemex (NYSE: CX).
Why should you care about this European merger? Because Cemex may soon experience a pitched battle for market share. Despite its south-of-the-border heritage, Cemex has a substantial presence here in the U.S. With 21% market share, it is the leading cement supplier in the U.S. This merger, if approved, would push Cemex to No. 2.
More importantly, market share battles often lead to price wars, and Cemex simply can't afford one. Holcim and Lafarge know that Cemex is in a weakened state and will likely look to press their beleaguered rival in hopes of creating financial distress.
A decade ago, the global economy was quite healthy and construction cranes popped up in almost every major city. Cemex's executives figured demand for cement would keep on rising, so they doled out $18.6 billion on a pair of acquisitions (in 2005 and 2006) to develop a large global presence.
By the end of 2008, Cemex had more than $20 billion in debt on its books, and by the fall of 2011, shares briefly moved below $3 as investors grew concerned that the prolonged global economic slump would keep Cemex from ever escaping its debt load.
As you can see, shares recovered from their extreme lows, yet the financials are still disconcerting. In 2013, for example, the company had $15.2 billion in revenue, $4.7 billion gross profits and roughly $3.6 billion in overhead, leading to operating profits of $1.1 billion. The company reported a net loss of around $840 million for the year.
At the end of last year, the company still had around $17 billion in debt. What's really troublesome is the $1.25 billion in annual interest expense to service that debt. High interest costs are likely to lead to a net loss in 2014 as well. Most of Cemex's bonds carry interest rates in the 7% to 9% range, reflecting the company's weak financial position.
The proposed merger between Holcim and Lafarge, and its implications for a tougher competitive environment, is likely to sharpen concerns about Cemex's financials. Short sellers already smell blood in the water. They now hold 91.5 million shares short, making CX one of the most heavily shorted stocks on the New York Stock Exchange.
The merger between Holcim and Lafarge could ratchet up the competitive pressures in the U.S. market, but the combined entity may also look to make a bigger push into Cemex's home market of Mexico, where the company derives plus-sized profits.
According to UBS, Cemex generates roughly $1 billion in annual operating income in the less competitive Mexican market, compared to a history of operating losses in the more competitive North American market.
To be sure, it will be several quarters before this merger is approved, so the heightened competitive risk isn't an imminent threat. Yet, as the deal moves closer to approval, CX is likely to undergo heightened scrutiny, perhaps starting with a fairly lofty EV/EBITDA (enterprise value divided by earnings before interest, taxes, depreciation and amortization) of around 11.7 (using UBS's 2014 EBITDA calculations).
Heavily indebted companies often sport a multiple close to four or five. Simply applying an EV/EBITDA multiple of seven would push this stock sharply lower, which is what short sellers are expecting, as soon as the changing competitive landscape starts to filter into investors' mindsets.
Recommended Trade Setup:
-- Sell CX short at the market price
-- Set stop-loss at $14
-- Set initial price target at $8 for a potential 38% gain in six months
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