Wednesday, May 11, 2005

Cement Industry – Differentiation Illusion or High Price Collusion?

On September 2004, Cemex announced its agreement to acquire RMC Group Plc, the world’s biggest ready-mixed concrete maker and Europe’s leading cement producer. The transaction, worth $5.8 billion will be financed cash and debt by Goldman Sachs and Citigroup. The acquisition increases Cemex sales by over 100%, maintaining its number three position in cement capacity, but giving it a boost No.6 to No.1 in ready-mix volumes. The acquisition which was positively received by analysts was recently completed and approved by the anti-trust authorities on the condition that Cemex divests RMC assets in Tucson-Arizona - less than 0.5% of the acquired company -to avoid unfair competition in this segment. The main concern for the US regulatory agency was a potential “coordinated interaction” between Cemex and the remaining competitors in the market. This worry is in line with alleged accusations against the cement industry and Cemex in particular related to price setting agreements with other producers.

Cemex S.A. was founded in 1931 after the merger of two Mexican cement companies. The RMC transaction is by far the largest acquisition it has ever conducted as part of its expansion strategy. In 1982, the company doubled its exports volume and started implementing an international expansion strategy through acquisitions. Its first move was into Spain, acquiring the two largest cement companies and initiating a multi-market contact structure in the cement industry. Cemex continued acquiring companies or interests worldwide targeting those markets where it could buy close to 100% control on companies that would give it a leadership position of at least a 25% share of the new market. As a consequence, Cemex continued to increase its multi-market contact with other major industry players.

Cemex is by far the fastest growing firm in the industry and it has the highest profitability margins. It has been argued that Cemex expansionist strategy is based on some firm-specific capabilities in terms of cost reduction such as efficient post-merger integration, scale economies and superior technology combined with its expertise in emerging markets. In addition, its geographical diversification helps Cemex to achieve overall more stable cash flows offsetting the cyclical nature of the industry.

Cemex comparative lower costs seem to corroborate to an extent the capabilities abovementioned. Notwithstanding, the price behavior does not correlate as one could expect. In a preliminary paper written by Ghewamat and Thomas at Harvard Business School, the analysis of data for the main world producers of cement seems to support the idea that the largest players’ profitability is rather affected by price than by cost.

Moreover, in general increased margins and prices seem to happen in those markets in which Cemex alone or with the other international firms held an important stake of the market. The strong presence of few of the major firms in the same region seems to be common, for example of the 56 plants acquired in Asia (excluding China), during the period 1996-2002, 38 were located in Indonesia, the Philippines and Thailand which is surprising given that those countries had only 58 of the 391 plants in the region. It can be argued that concentration on specific countries is due to particular characteristics of those countries, to a mimicking strategy by peers or also to a strategy to coordinate prices by working together as a dominant producer. Either way, this joint entry in the market clearly increases multi-market contact.

From as far back as 1959 (Harvard University Press, Imperfect Collusion in the Cement Industry, Loescher) the cement industry has been under scrutiny due to both, the development of factors that facilitate collusion in the industry and to informal and legal complaints against price behavior. From a theoretical stand point, two factors that greatly facilitate collusion, tacit or not, are consolidation of an industry and multi-market contact of the same players. Both characteristics are clearly present in the cement industry today. On one hand, during the past couple decades a chain of mergers and acquisitions triggered a trend of consolidation which the recent Cemex acquisition of RMC significantly reinforces –currently there are about 6 relevant players in the worldwide industry- on the other hand, these few players coincide in most of the markets they participate in.

We believe that the collusion allegation against the industry players and particularly against Cemex, have some ground given that prices have increased despite proven low cost capabilities. Yet, none of the accusations have been proven because industry players have been able to support their claim that quality, service and innovation standards, have continue to develop according to competitive market conditions. Likewise, they have been able to argue that these same characteristics represent valued added that relates to their customers willingness to pay.

In the particular case of Cemex, there are some particular factors which could explain, at least in part, the higher prices with which it leads most of the markets it enters: 1) Its focus on emerging markets allows it to reach smaller consumer by offering smaller sized packaging which normally carry a higher margin due to reduced consumer negotiation power (as per Bloomberg analyst, Thomas Black). 2) The company has managed to create some value for its brand, “de-commoditizing” the product by generating an association between quality and Cemex. 3) Cemex attempts to offer differentiated services to cater specific needs of their customers. For example the “tanda clubs” in Mexico which targeted low income families.

The quandary that this argument brings is that if Cemex prices correspond to an actual premium resulting from some sort of differentiation, this could explain the price differential between Cemex and its competitors. Yet, it would not explain the higher prices that the industry presents as a whole once the biggest players have a substantial share of a market. Whether collusion or coordinated interaction are occurring is still up for debate, what is clear is that for as long as the industry players continue to improve quality and service, they may continue to resort to this as an argument to counteract collusion allegations. It is also clear that more consolidation and more multi-market contact, in any industry, facilitate collusion to a point where it may be impossible to prove it, even if it were to take place.

Leccia, Lopez and Villamil

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