ARM Cement has space to push up its gearing ratios

The corporate debt issuance market is still expected to be busy as the year draws to a close, despite the current elevation of the shorter end of the yield curve.

Total corporate issuances this year, including three planned issuances, will hit Sh40 billion, which will then represent a 25 per cent year-on-year growth over 2014.

One of the largest planned issuances in this last quarter of the year is ARM Cement, which is seeking up to Sh9 billion, split into an issue size of Sh6 billion with a green shoe option of Sh3 billion, through a private placement.

ARM makes an interesting case because of its already elevated balance sheet gearing with debt-to-EBITDA (earnings before interest, tax, depreciation and amortisation) multiple hovering at six times in the first nine months of the year, which makes the balance sheet look a little bit congested.

I know, to a certain extent, this doesn’t make a good investment case especially for the money managers.

But this extent could be overplayed and before I get into the details, let me put some two key cases forward: first, the cement business is always a capital intensive business.

It’s not always possible to internally generate the required capital for capacity enhancement purposes, hence the need for leverage.

Second, the best way to look at the financial health of a capital-intensive cement business such as ARM is through cash generation capacity—which is proxied by EBITDA; forget about profit after tax, because this is one line item that is always subject to a lot of distortionary accounting treatments.

EBITDA, simply speaking, is the operational (not free) cash flow pot out of which a company meets its financing costs, among others, the most important line item for the company’s debtors.

As shown by the 9-month results, indeed, EBITDA margins have come under pressure this year due to high gearing levels, which has since unnerved prospective institutional participation in the company’s upcoming debt issue, and rightly so.

But there is a genesis to this. If you look at ARM’s revenue charts over the last decade, revenues have hit a plateau especially between 2013 and 2015.

Generally, this is often a dangerous phase for any company because the revenue chart-line can easily nose-dive, or significant investments have to be made for the chart-line to nose-up.

As a company, you always have to do something urgently about this, or you’ll become extinct.

And in ARM’s case, it looks the company noticed this some three or four years back and decided to ramp up capacity through leverage.

They put up two investments in Tanzania, a 1.2 million-tonne clinker plant in Tanga and a 750,000-tonne cement plant in Dar es Salaam, at a total cost of $200 million (Sh20bn).

Since then, and because of debt-cash flow mismatch, a characteristic of new projects, the company has built up significant capex and working capital borrowings (overdrafts and commercial papers), with $183 million (Sh18.3bn) in total debts outstanding, out of which 95 per cent of it have a tenor of below five years, hence the urgent need for a longer-tenor refinancing to create some breathing space in as far as cash is concerned.

This balance sheet congestion is temporary for three reasons. First, with the company now fully non-dependent on imported clinker, EBITDA margins will incrementally swell to 32 per cent, which means that the company will be able to generate Sh7 billion in operational cash by 2016 from a possible Sh4 billion in 2015.

With this kind of margin, ARM will be able to bring down its debt-to-EBITDA ratio to 2.5 as early as 2018.

Second, with clinker sales expected to pick up strongly, alongside other dollarised sales, dollar revenues could rise to $20 million (Sh2bn), which implies the company will now be able to match most of its dollar debts.

Finally, the company has frozen new expansion projects until 2019, which is good news for cash flows. So, without the risk of understating the extent of margin pressures, I think ARM hasn’t lost its ‘premium-borrower’ status.