LOMA - Loma Negra: A Speculative Play On Argentinian Income Recovery (Rating Upgrade)

2023-12-13 05:11:06 ET

Summary

• Loma Negra, the largest cement manufacturer in Argentina, has seen its operating income fall due to price repression and currency depreciation.
• The company's profitability might be explained by real estate prices in Argentina, which have been in a downward trend since 2017-18.
• Despite the current challenges, LOMA has strong financials and the potential for income growth, making it an opportunity for investors.

Loma Negra ( LOMA ) is the largest cement manufacturer in Argentina.

I wrote about LOMA in the past, recommending both purchasing the stock ( June 2022 ) and not purchasing it ( July 2021 , October 2022 ). Those articles have a detailed explanation of the company's competitive position and operations.

In this article, I review the latest results and what I consider one of the main drivers behind LOMA's profitability: real estate prices in Argentina. After that, I present a simplified model to show the expectations behind the stock and whether or not there is an opportunity now.

I believe LOMA is a speculative play on a reversion to the mean of its operating margins and revenues, with an upside opportunity if the average income grows in Argentina after being depressed for five years.

Price repression explains this year

LOMA has suffered significantly this year, reaching operating income levels not seen in years.

I believe the main reason for that underperformance has been price repression in an electoral year, coupled with extreme inflation, eroding the company's gross margins, plus currency depreciation (destroying the company's USD-translated revenues).

This is not particular for LOMA but rather something seen across some regulated energy players like Central Puerto ( CEPU ) and Transportadora de Gas del Sur ( TGS ), as covered in recent update articles. Although LOMA is not regulated, the company probably reached some form of agreement on not updating cement prices as fast or above its cost inflation. The previous government repressed prices to hide inflation before the elections via regulations (like CEPU and TGS) and agreements with large companies.

I believe the fall is explained by price repression because cement dispatches at the country level are close to record, according to the industry association. Further, the construction index ( published by INDEC ) shows that materials and masonry have inflated below the index. The COLSECOR Foundation published a national report showing a 100% increase YTD (versus 120% general inflation) and a 124% increase YoY (versus 142% general inflation) as of October.

Property prices explain the long term

I have long thought about what is the driver behind LOMA's revenues and profitability margins, on top of the ARS to USD depreciation versus inflation race.

Indeed, year to year, the company's profitability can be higher or lower depending on whether the country's internal economy is appreciating or depreciating against the USD, but that is something extremely difficult to predict.

Especially before 2018, when inflation and the depreciation rate were smaller, there was less volatility in revenues and margins. The chart is unavailable, but you can see the table format information here in Seeking Alpha .

What I found to be a correlated measure, and intuitively a driver, is the cost of real estate (per square meter below) in Argentina, especially in the capital, Buenos Aires.

We can see a consistent downward trend since 2017-18, coinciding with local maximums in LOMA's revenues and profitability.

I firmly believe in subjective value theory, which states that prices determine costs and not vice versa. That is, if real estate prices in Argentina were higher, developers would be more willing to pay more for supplies, including cement and concrete.

Income and credit

Two measures could explain the destruction of real estate prices since 2018.

The first one is average income. Argentinians have been significantly poorer since 2018, as the crisis led to a real depreciation of the country's costs. A publication by Econometrica shows that the real USD gross salary (measured via the financial rate) was in December 2022 less than 35% of what it was in 2017.

The second one is the availability of mortgage credit (credito hipotecario), which has not been plentiful in two decades but got a small boost during the UVA credit boom in 2016, 2017, and 2018.

Strong(er) financials

As usual with Argentinian companies, the depreciation rate complicates understanding how much companies pay as interest.

As an example, LOMA had about ARS 30 billion in ARS-denominated debt as of 3Q23. That debt pays interest at the inflation rate + 2%. If the inflation rate is 150% a year, then the accounting treats ARS 45 billion as interest. However, converting those interest expenses to dollars would be incorrect because the interest component in such an inflationary economy is mostly inflation to keep the principal constant in real terms.

I prefer, instead, to convert the debts to dollars at the official rate (representing more dollars) and use the dollar interest rate at which the company can issue debt (the latest financing at 6% in November 2023). However, the latest rates seen in Argentina are artificially low because of capital controls (too much capital chasing too little investments). Otherwise, how could an EM company like LOMA finance at SOFR + 1% fixed? I prefer to use a more conservative 10% to calculate the company's potential debt costs.

As of 3Q23 plus subsequent events, LOMA has $135 million in dollar-denominated debt and $96 million in peso-denominated debt. Applying the 10% rate on the resulting $231 million yields approximately $23 million in interest payments. Again, this is not what LOMA reports, but rather what I speculate could be the cost of the debt given a more normal environment (both in terms of inflation, depreciation, and credit availability).

The company also has $40 million in cash. $9 million of those are pesos, but I converted them using the financial rate, 3x higher than the official rate used to convert the debt.

Napkin model and expectations

What is behind the price of LOMA today, based on the above financial adjustments?

Currently, the company is valued at around an $800 million market cap. This is ARS 800 billion in the Buenos Aires market divided by about ARS 1000 per 1 USD using the financial rate. Some sites show a $2.3 billion market cap which is incorrect because it converts the ARS market cap using the official rate.

To obtain a 10% earnings yield, the company should generate $80 million after-tax earnings, translating to $125 million in pre-tax earnings (using the Argentinian 35% income tax rate) and around $150 million in operating income.

This is well below the pre-2023 operating income of the company since 2018, coincident also with a prolonged bear market in real estate prices, which, in my opinion, depress revenue and profitability in the cement industry.

I believe that LOMA's operating income should return to the mean after the repressed inflation is released by the new government, and companies are free to set prices. This process even has a term in Argentinian economic history called Rodrigazo .

In my opinion, LOMA trades at a low multiple of what its mean reversion earnings could be and offers the potential for further income growth via recovery of average income and mortgage credit (this latter is much less probable) in the Argentinian economy.

For that reason, I believe LOMA is an opportunity at these prices.

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