The European cement sector has steadily sold off during the past year, accelerating as the Russia-Ukraine conflict escalated. Even at first glance, the sector’s value credentials are apparent. The major players are paying out a significant amount of cash via dividends and buybacks and have markedly stronger balance sheets than they possessed going into previous downturns.
General investor aversion towards the sector due to its high carbon emissions, accounts for much of their discounted valuations and recent underperformance, with fears that it will emerge from the transition towards a lower-carbon economy as a structurally smaller and less profitable industry.
Our conversations with sell-side analysts have underscored this view, reiterating that investors are discarding cement companies due to energy-transition fears, focusing instead on businesses with renewables and decarbonisation angles.
The cement industry is undeniably a high carbon emitter, accounting for 8-10% of all CO2 emissions globally. Around 90% of this results from the production of clinker – the lumps of fused limestone that are ground and mixed with gypsum and limestone to form cement. With the global ‘benchmark’ product, Portland cement (produced for over a century and often required by regulatory standards), containing 90-95% clinker by weight, these emissions are essentially unavoidable. While there are initiatives to reduce the clinker content in cement, there is limited reduction potential before durability and quality are risked.
Evidence suggests that demand for cement is unlikely to abate. In fact, the various CO2 ‘roadmaps’ for transitioning towards a lower-carbon economy all anticipate higher cement demand, with total demand likely to grow in line with GDP. More cement implies unavoidable CO2 emissions.
Innovative, lower-carbon alternatives are unable to match cement in terms of cost, scalability, quality and durability – and are unlikely to do so for the foreseeable future.
Thus, the best solutions for decarbonising the industry are in the hands of the incumbents, specifically via offering a range of lower-carbon cements, reducing the clinker ratio, and developing carbon capture and storage (CCS) schemes.
Industry leader HeidelbergCement (which has been reducing the clinker content in its cement for years) offers a range of low-carbon ‘Ecocrete’ cements (which use recycled materials). Heidelberg has been shifting towards more renewable energy sources for cement production, is part of consortia developing carbon-capture projects in the UK and Europe and is on track to have the world’s first fully operational carbon-capture plant in the cement industry in Norway, by the end of 2024. The company expects to achieve its original 2030 emissions target five years ahead of schedule.
Nevertheless, carbon costs are set to increase for Heidelberg and its peers as free allowances under the EU’s emissions trading scheme (ETS) expire. The market carbon price has risen sharply in recent years and cement producers will need to pass on significant cost increases to their customers via price hikes.
The indications are that they’ll be able to do so, in fact this is already underway. There have been aggressive price hikes in recent months, with carbon surcharges built into some price agreements between the major cement manufacturers and their customers, and with no signs of discounting in order to maintain volumes, even in the depths of the Covid-induced downturn.
Cement companies operate natural local monopolies, due to the fact that transportation costs are high relative to the low price per tonne of the product. Also, cement generally accounts for a very low proportion of overall construction costs, and with much less price volatility than other building products. All of this supports the sustainability of future price hikes.
As pressures on efficiency, innovation and cost at the smaller plants make them less competitive and economical, we expect the larger, leading European cement producers to advance. Consequently, the overall impact of the energy transition on the profitability and operating margins of leading cement firms could prove to be positive.
So, despite concerns about the cement industry’s place during the transition to a lower-carbon economy, a decline in demand for cement looks unlikely (GDP-type growth is more probable); industry profitability should not suffer as carbon costs can be passed on via higher pricing; and there is the potential for the profit margins of the leading players to improve. Regarding carbon emissions, the leading cement companies can be part of the solution to precisely the issue which has caused investors to avoid the sector, namely the cement sector’s high absolute emissions.
If misgivings on the future of cement provide us with the opportunity to invest in this sector at single-digit earnings multiples and double-digit free cashflow yields, we’ll gladly participate.
Alessandro Dicorrado and Steve Woolley are co-portfolio managers of the Ninety One Global Special Situations and UK Special Situations funds. The views expressed above should not be taken as investment advice.