Cement Sector ROCC Note ; Looking at valuation from 'Build vs Buy' perspective
After the stellar earnings show (+30.5%yoy) in Q1FY10, the cement sector has clearly hogged the limelight. However, concerns over huge capacity addition plans by the industry, continue to daunt the street.
In this note, we have valued cement stocks from a different perspective, modelled on 'build vs buy (the stock)' decision. Our analysis tells us that our cement universe trades at an average discount of 27% to the value, beyond which, a cement maker will decide to build a cement plant over buying the stock. Based on this analysis, our top picks in the sector are ACC, Ultratech, Shree Cement and Madras Cement. While we are not looking at strategic sale by a company, we are trying to build a scenario to determine the premium; a strategic buyer would be willing to pay for an existing facility. We have seen cement stocks enjoy similar valuations during the previous bull phase of 2005-2007.
In our analysis, we have used assumed the time and capital cost, an entrepreneur would take to build a plant with capacity similar to the target company. To this end we have, therefore, assumed its replacement cost + the present value of its earnings over cost of capital (NOPAT (–) WACC), as the basis of valuation. If the stock price is below this value, he will choose to buy the stock, else he will build.
Many market observers have argued about the impact of large capacities (coming up over the next few quarters) on cement prices and therefore, on sustenance of its profitability. Given the low gearing (virtually debt free status by FY11) of large cement producers like Birla group, ACC & Ambuja Cement, Shree Cement, etc, which control 47 % of industry capacity; we do not expect the players to sell cement at unremunerative prices. Hence the pricing discipline could be reasonably strong in the industry.
We have built in a cement price of Rs228/bag (as compared to current prices of Rs253/bag), as this is the price at which, the new capacity will be able to recover its cost of capital (WACC 11.6%). We have built in current operating cost of Rs125/bag.
We remain positive on the sector and believe that the strong demand momentum will ensure that correction in cement prices is moderate and that cement companies will continue to add significant return over cost of capital (ROCC) over the long term. We believe that the street is getting excessively bothered about a possible correction in cement prices and is ignoring the potential of earning ROCC of these cement companies. The sector valuation at 9.3X FY2011E earnings and USD 89.7 per tonne for FY2011 capacity looks fairly attractive. We reiterate ACC, Ultratech, Shree Cement and Madras Cement as our top picks in the sector.
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