July 20, 2008

Cement Industry – Stock analysis

I received a list of companies to analyse based on my earlier post. In order to do a better analysis, I am trying to club all the stocks from the same industry. As there are several cement companies in the list, I decided to take a stab at the cement stocks first.

My earlier analysis of the cement industry is
here and here. In addition I have analysed the industry and updated my analysis in the file business analysis in the google group. Please have a look under the column commodity – cement.

The cement industry is a cyclical commodity industry where the profit and return on capital is dependent on the demand cycle picture. From the mid 90’s to 2002-2003 period, there was an excess of supply and hence prices were depressed. Most companies had poor to non-existent profits and accordingly the stock prices suffered. Since 2003, the demand has increased rapidly and so have the prices. The profit margins are now in excess of 20% for some companies and ROE in excess of 40% for companies such as ambuja cements. I personally think these are fairly high returns for this industry and the best of the companies in the industry would earn around a max of 20% over a business cycle.

Valuation of cement companies should not be done on the basis of peak earnings alone. This holds true for most commodity companies. Case in point – sugar companies. In 2006-2007, these companies appeared cheap based on their peak earnings. However when the cycle turned downwards, the stock prices got wacked. The economics of the cement industry are not as bad (there is lesser government intervention), however the valuation approach should be similar to the sugar industry. One has to be careful in extrapolating the peak earnings and assuming that the stock is undervalued.

Due to the cyclicality and commodity nature of the industry, analysis and valuation of cement companies is more diffcult as one has to figure out where the industry stands in terms of the business cycle . High returns can be made if one can predict the key turnaround points in the business cycle.

Mysore cement –
This is an interesting company. The company was taken over by the heidelberg group and made a tender offer to buy shares from the public at 54 Rs/ share in 2006 . SEBI directed the group to set the price at 72.5 per share. This was
recently overturned by SAT and the heidelberg group can now initiate a tender offer to buy the shares from the public at Rs54 per share.

In addition the company alloted 66.5 Million shares at Rs 54 per share in 2006 to the group. This capital was used to pay off the accumulated debts and wipe out the accumulated losses. The company has also become profitable from 2007 since the new management took over.

In addition a
recent news, indicates that indorama cement would be merging with mysore cement taking the capacity to 2.8 Million tonnes. The company further plans to expand the capacity to 5.9 Million tonnes.

The financial look good, with the company solidly in the black, no debt and cash of almost 180 crs on the books. The impact of the new management can clearly be seen from the P&L account, balance sheet improvement and aggressive plans of the company to expand capacity through mergers and greenfield projects.

So if everything is so good, then one should go and buy the stock? I would hold on that before I can figure out the following
- Cement is a cyclical industry. Currently the industry is on an upswing and hence all cement companies are making good money. How will mysore cement fare when the cycle turns south (supply exceeds demand)
- What is the cost structure for mysore cement? Cost is critical in a commodity industry such as cement.
- Future plans of the management. Scale is important in the industry. Mysore cement is still at 2.8 Million tonnes and even after capacity expansion would still be one of the smaller companies

One interesting development is the tender offer. The stock is quoting at around 30 Rs and the tender offer should be around 54 Rs. The stock may be a good arbitrage opportunity, even if the long term prospects of the company needs a more thorough analysis.

Ambuja cements
Ambuja cements has been one of most profitable cement companies in india and has made money even during the downturns. They have the highest net profit margins in the industry at 30% and ROE of almost 40%. Net profit margins have grown from 10% to around 30% and the profit as a result has grown by 8 times in the last 5 years.

The company sells at around 560 Crs/ Million tons of capacity compared to say 170 Crs/ Million tons of capacity for Mysore cement. The difference is high and understandable as Ambuja cement is a well run company with huge capacity and a very efficient cost structure.

The company is currently selling at a PE of 7 based on last year’s net profit numbers. Based on normalised profit margins of around 12-15%, the company is selling at a PE of around 12-13. I would say the company is undervalued by 20-25% at best.

If you believe that the net margins are sustainable, consider the following fact : Net margins in 2003 and before were around 10% and have expanded to around 30% in the last 2 years.

Grasim, ACC, Ultratech etc
Grasim has a blend of cement, VSF and other businesses. The cement business seems to be doing well in line with industry. The other companies such as ACC and ultratech have also been performing well in the last 2-3 years. Most of the top cement companies now have margins in the range of 18-22%, ROE in excess of 30% and high profit growth rates in excess of 20-30%.

The valuations of these companies are fairly close. Most of these tier I companies are selling at 7-8 times profit in comparison to the smaller companies which are selling at 4-5 times or lesser.

I am reaching the following conclusions after looking at the complete sector

- The cement industry has enjoyed very high growth rates and great profits for the last few years. The profits margins are not sustainable. New capacity, cost pressure and competition are bound to drive the margins to long term averages of around 10-12% in the next few years
- Most of the companies appear undervalued in terms of the last 2 years profits. However on the basis of normalized profits they are selling at 12-13 times earnings. At best, these companies appear undervalued by 20-25%. There may be a bit of undervaluation, but not by a huge amount.
- Considering the level of undervaluation in some sectors such as pharma, IT etc and the better economics enjoyed by those industries compared to Cement, I am personally not too keen on investing in the cement sector. If I had to pick up one cement company to put my money in for the long term, I would prefer ambuja cement (if I had to that is !!)


Rathin Shah said...

Hi Rohit,
In this write-up, you have written about cyclical industry...So we will have to use normalized earnings for the analysis. But how can we find out the inflection points related to uptrends and downtrends of the industry ?

Anonymous said...

Hi Rohit,

Can you tell me why the fixed costs are high in this industry?

Thank you


Mahendra Naik said...

Peter Lynch mentioned in his excellent book beating the street that the time to buy commodity stocks is when they are quoting at extremely high PE ratios as compared to their historical PE's. Conversely they should be sold at low PE's. The logic being that high PE's indicate that the cycle is bottoming out and vice versa. I think that should answer aove query on inflexion point.

Rohit Chauhan said...

Hi rathin
in addition to mahendra's point, you have to track the demand supply situation and also have an idea of the new supply coming up. If the demand exceeds supply and there is no new supply coming up, then you may have positive inflexion. if the reverse happen then you have negative situation. ofcourse doing this is a full time task and diffcult to get right every time, which i why i find commodity company investing more diffcult.

kiran - fixed costs are high due the high amount of assets required in the form of plants and machinery, large investment in inventories, wcap etc and the cost of the distribution infrastucture. In addition due to the commodity nature of industry, companies cannot charge a very high premium based on the brand.


Anonymous said...

It must have been hard for you to study and analyze an industry you always knew you wouldn't invest in. You must have done it as an academic exercise. Looking forward to reading your analyses of the Pharma and IT packs.

Anonymous said...

Rohit / Kiran

Manufacturing costs are also high because of the high energy demand in making cement and this seems to be a key factor in cement profitability. See wikipedia on cement

Anonymous said...

Hi Rohit,

Where did you get the data of these cement companies in the mid 90's?


Rohit Chauhan said...

hi anon1

i currently have no plans to invest in the cement industry. that does not mean i will never invest in it. it all depends on the valuation.
regarding studying the industry, investing and reading up is really not work for me. i do it because i like to do it. in addition i think, it is critical to expand once knowledge base and study industries or companies which one may reject later.

i invested in L&T in mid 90's and was reading a bit on the industry during that time. so i remember the numbers since those days. difficult to forget the numbers as a lot of cement companies were doing very badly ..including l&t cement which was a part of the l&t group then.


Ninad Kunder said...

Hi Rohit

Good analysis of the industry. The key in any commodity business is the ability as you correctly put it, to time the cycle.

I would like to add two more variables to this process. Commodity businesses tend to act as a natural hedge to inflation as the replacement cost of assets go up as commodity business are asset heavy. So if one is able to identify companies with strong balance sheets with low debt then there is a play to be made.

The other variable is that markets tend to overreact on both sides of the cycle. So lets say if u get a good balance sheet at 4 PE then if profits halve, we still are looking at a 8 PE stock.

Cement today factors in all the negatives - slowing demand, excess capacity, price control & increasing inputs costs. The market is factoring all this in the price.

If any of these variable turn (Ex coking coal prices are coming down with fall in oil) then some of the stronger balance sheets available at 3-4 PE will really benefit.

Mysore Cement is a interesting story. It wouldnt surprise me if Heidelberg makes a open offer in a years time horizon after they have wrapped up the amalgamation. Plan to put out a post on Mysore Cement.



Rohit Chauhan said...

Hi ninad
i agree with you first comment on commodity companies being a play on the business cycle.
however i personally dont think that the cement stocks are pricing much of the negative news. Profits for the industry are at all time high. they are more than twice the long term average.
So 10-12 times long term average would at best represnt a 10-20% discount. decent, but i would hardly call it undervalued.
mysore cement looks interesting, but the operating history is too short. the new management seem to have fixed the obvious issues and have had the benefit of an upcycle. need to see how they perform during a downcycle. but the company can be a good arbitrage plan


Anonymous said...

Hi rohit,
Have u analysed JK Lakshmi Cements which is now trading at 2 p/e with eps of around 40.Last quarter results were not that much attractive but their previous 6 quarter results were amazing..


Anonymous said...

Hi Rohit

Interesting comments. I am curretly analyzing a South African cement firm, PPC. The cycle that you discuss is very much at play in South Africa and PPC dominates the market. The return metrics are actually better then Ambuja but you pay for it 9-10x P/E forward.

Question: what is the replacement in UDS for a million tons of cement? PPC seem to think its $400/ton? Seems to high. Cement firms may well trade below replacement value in this cycle?