Harnessing north India's growth | Value Research Shree Cement, north India's leading player, is poised to benefit from this region's strong demand momentum. Buy on dips, reports Anindya Bera
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Harnessing north India's growth

Shree Cement, north India's leading player, is poised to benefit from this region's strong demand momentum. Buy on dips, reports Anindya Bera

Shree Cement is north India's leading cement manufacturer. Given the strong demand for cement in this region, it is expected to maintain its growth momentum of the last five years.

Sectoral overview
Being related to the core sectors of the economy, cement has both benefited and been adversely affected by the boom and the subsequent slowdown in real estate and infrastructure. Residential housing is the major consumer of cement (accounting for approximately 65 per cent of total consumption) while infrastructure and commercial construction are the other major consumers.

The sector's growth drivers are well in place: revival in residential and commercial real estate, the government's commitment to infrastructure development backed by allocation of more funds, and India's lower per capita consumption of cement compared to some of the other developed and developing nations.

However, the cyclical nature of this sector and the regional fragmentation of the market make the stocks in this space high-risk bets. Further, due to the fractured nature of the market, pricing disparity exists between the four regions of the country. A handful of companies have cross-country presence while each region has its own leading player. In recent times, many cement manufacturers have tried to minimise business risk by investing in captive power units and selling their excess power. This has helped boost the stability of their earnings.

The short-term outlook of the cement sector is relatively bleak. The post-budget hike in freight rates and the roll back of excise duty to pre-crisis level mean that companies will have to either pass on the burden through higher prices or take a hit on their bottomlines. Over the past six months, cement prices have risen by Rs 20-60 per kg, but it is unlikely that prices will sustain at these levels, more so in the light of the current over-capacity in the segment and the new units that will come online.

The company
Shree Cements (SCL) is among India's top 10 cement producers. It is one of the more efficient players in the industry with an operating margin of over 39 per cent (Q3FY10). SCL's advantage over its peers arises from its early capacity additions that have enabled it to fulfil rising demand. Moreover, SCL's presence in the power generation business augurs well for the company as it provides additional support to its earnings.

Strengths
Presence in high-growth market. SCL serves mainly the northern (65% of revenue) and the central (24%) Indian market. It is the market leader in this region with 19 per cent market share. The north Indian market's comparative advantage over south Indian market is that it is less fragmented, with strong demand coming from the Commonwealth Games and from ongoing infrastructure activities.

Operational efficiency. The company is self-sufficient in meeting its electricity requirement, which otherwise would have cornered a major chunk of its operating expenses. Its operating margin for Q3FY10 stood at 39.30 per cent compared to 33 per cent in Q3FY09. Compared to its peers, SCL is one of the most cost-efficient cement companies.

Diversified business. SCL plans to raise its power generation capacity to 300 MW by FY11 from 119 MW currently. The new capacity additions will allow it to sell its excess power. This will further boost its bottomline.

Weaknesses
Regional concentration. Cement is a cyclical industry. Currently the northern region seems to be at an advantage compared to the south. But with time this could change. Then localised players such as SCL could face margin pressures.

Rise in input costs. The price of coal, a key ingredient, has been rising for some time. And with the revival in the international economy imported coal prices will also go up. This will contract the company's operating margin.

Fresh capacity additions. Approximately 100 million tonnes of new capacity will be added to this sector in the next three years. In the medium term, this will weaken SCL's ability to set prices.

Management
The company is promoted and managed by B. G. Bangur. With 56 years of experience and nearly two decades at the helm of SCL, he is entrusted with all the major policy decisions. According to Gaurav Dua, head of research at Sharekhan, “SCL's management is competent and is capable of growing the business at above-industry rate.”

Growth opportunities
SCL's earnings growth in the past five years has been spectacular. Its bottomline has expanded at an annualised rate of 81.84 per cent.

According to estimates by Sharekhan, SCL is expected to post a 33 per cent revenue growth and 54 per cent growth in net profit in FY10. However, Sharekhan also expects the company's pace to slow down in FY11 on account of the expected decline in price and higher input costs. But post FY11 it is expected that demand will improve and SCL will be able to regain its pricing power.

SCL's debt situation is also at a comfortable level. Over the past three years, its debt-equity ratio has more than halved from 1.9 to less than 0.9. With an interest coverage ratio of 12.7, there will not be a material impact even if interest rates harden.

Valuation
Currently the stock is trading close to its 52-week high price (Rs 2,261). At this level it is trading at 7.96 times its trailing four-quarter earnings. This is long way off the peak valuation (PE of 28.7) that was reached in the middle of 2007. At the current level it is even trading at a discount to the industry average PE of 10.86.

Should you buy?
Year till date the stock has gained 18 per cent while over the same period the gains of cement stocks have been in the range of 58 to -22 per cent (average 4.88%). The Sensex meanwhile has gone up by just one per cent. Though the stock is trading much below its peak valuation, still the recent run-up and the near term prospects of the sector call for a cautious approach. The right way to go about this stock would be to buy it only when it dips.




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