Event Update

Toll of a Functioning Democrary - Not the End of Story

Industry : Cement

Analyst: Rajan Kumar +91 22 22836307 rajan@networthstock.com

Price Freeze Issue

After a week of parleys with Finance and Commerce Ministry over price issue, cement manufacturers agreed to hold the cement prices at current level for one year even if the input cost rises. Besides they also agreed to pass on the benefit to the consumers in case the government revokes the additional Rs 200 per/ton excise duty announced in the recent budget. Before that the government has removed the import duty on cement and some other commodities in pretext of controlling inflation. The move did not have any impact on cement prices as higher landed cost of imported cement and lack of infrastructure facility made import unviable. But the industry met with its worse fear when in FY08 budget, FM imposed dual excise duty on cement raising excise duty by Rs200/ton for cement sold in retail above Rs190/bag. The move backfired as cement manufacturers immediately passed on the excise duty by raising prices Rs 12/bag across India. This led to serious spat between FM and Cement Industry leading to the said decision to freeze the prices at existing level. The street has viewed it as a capitulation by cement manufacturers over government dictat that would serve electoral interest of the ruling coalition at the cost of the profit of the Industry. We view the event just as a toll of a functional democracy where by agreeing to price freeze, Cement Industry was able to get out of current imbroglio in return for possibly some hard bargain. Lets look at what the industry got in return Price cap when the cement prices are ruling at historic high. No roll back of a kind that would impact existing realization/ margin. No adverse measures like ban on cement export or worse, harsh measure like imposition of government levy on cement to be sold at subsidisized price. True it takes away the possibilities of immediate hike in cement price but Industry was not expecting a runaway price hike any way. Cement companies to pass on the benefit of excise duty roll back: But dont be surprised that in case of duty reversal benefit may be passed on partly by the cement companies as consumers have already tested the higher prices. Meanwhile the cement players would be in position to affect marginal increase in realization through squeezing the dealers margin. Room For Negotiation On Govt Controlled Input Cost: Besides by conceding to the demand to freeze prices at current level, the cement companies have kept enough leeway to negotiate when it comes to the issues like Coal Linkages.
Sector Update

Prices as on 16.03.07 ACC CMP: 730.0 Grasim CMP: 2017.0 Ambuja Cement CMP: 106.0 India Cement CMP: 160.0 Shree Cement CMP: 917.0 Ultratech CMP: 764.0 Kesoram Industries CMP: 330.0 * Target for FY08E

Reco* ACCU 810.0 Buy 2420.0 ACCU 120.0 Buy 200.0 Buy 1120.0 Buy 920.0 Buy 450.0

All India Cement Price

(Source : CMIE)
Movement in Cement Prices
250 200 Price 150 100 50 0
20 04 20 .04 04 . 30 20 .07 04 . 31 20 .10 05 . 31 20 .01 05 . 31 20 .04 05 . 30 20 .07 05 . 31 20 .10 06 . 31 20 .01 06 . 31 20 .04 06 . 30 20 .07 06 . 31 20 .10 07 . 31 .0 1. 31

March 19, 2007

Event Update

Impact on Earning Not Significant

So what implication does this have on the earnings of cement companies . Very little in terms of profitability .. Yes prices would not rise.. But on the cost front the cement companies are not expected to see any major cost inflation as most of the major cost component (Freight, Coal/ Pet Coke) has stabilized and efficiency gains through savings in power and logistics cost (Gujarat Ambuja, Ultratech, Grasim and JK Cement and Mangalam Cement) still leaves room for margin expansion... Good enough to sustain an all time high margin. In fact many companies would see robust expansion in margin on account of cost saving measures underway. Besides the higher level of consolidation and maturity of the Industry would ensure that capacity roll out would be in phases maintaining pricing power. As far as reversal is concerned it is certainly not in sight in FY09. As per the timeline announced for the roll out of the cement capacity expansion, the industry would still have to operate at above 90% capacity to meet the annual consumption growth of 9% (Except for possibly north region). Besides some possible delay due to land acquisition and Equipment supplies could further delay the capacity addition. Further goal of 8-9% growth in Indian Economy and concomitant thrust on infrastructure would ensure that the cyclical reversal would be short-lived and that price decline might not be as severe going ahead.
FY 04 FY 05 151 150.1 85 127.6 121 6.4 3.4 4.1 20.6 0.2 2.4 FY 06 160 157.2 90 141.8 136 12.0 6 46.3 0.2 FY 07 172 165.7 92 152.9 150 10.5 6 0.0 -2.9 FY 08 191 180.6 90 162.5 163 9.0 5 -16.7 -5.8 FY 09 235 208.5 90 187.7 178 9.0 5 0.0 4.7 FY 10 247 244.0 90 219.6 194 9.0 5 0.0 20.6

Cement Capacity Add On Effective Capacity Capacity Utilization Production Domestic Demand Growth % Export Growth % Surplus (Deficit)

144 142.2 83 117.4 114

Correction a right opportunity to buy:

So does the current correction is an opportunity to buy cement stocks. We risk saying yes. The street is justifying the lower valuation on PE, EV/EBIDTA in anticipation of cycle reversal. But certainly cycle reversal is not in sight before FY10 and recent correction have made the cement companies a pure asset plays when most of them are trading either at slight premium or discount to replacement cost when their earning are at an all time high.

March 19, 2007

Sector Update

Event Update

The table gives the valuation of the companies post correction taking Q3FY07 cement prices as price for FY08.
Valuation CMP INR ACC Gujarat Ambuja Ultratech Grasim Shree India Cement Kesoram 730 106 764 2017 917 160 330 M-Cap Rs.bn 137 160 95 184 31 41 23 Realization Assumption CY07/FY08 3118 3200 3114 2950 2900 2800 2880 Y-o-Y 6.1 5.0 6.0 3.3 2.7 2.8 2.4 FY08 (RSM) EPS 74.6 10.5 75.9 239.0 134.5 26.0 68.7 PE 9.8 10.1 8.5 8.4 6.8 6.2 5.0 EBIDTA 897.3 2295.5 1741.0 4653.3 787.7 897.3 5213.2 FY08 (X) EV/EBIDTA 6.5 6.4 6.8 5.5 4.8 5.4 3.3 EBIDTA/Ton 1031.7 1304.6 969.9 926.5 1258.2 922.4 1060.0 96 97 63 EV/ton 125 142 146 FY08

Valuation near Replacement Cost

Asset

What should be the right way to value the cement stock when price hike would contain the profitability growth to the capability of cement players to expand volume and the possibility of cyclical reversal lurking after two years? Looking at asset values should help. Take for example ACC trading at @730 means the stock would be valued at 9.8 x CY07 earning and 6.5 x CY 07 EV/EBIDTA at a time when its earning would show a growth of 31%. Even on asset valuation the stock trades at $150/ton of its existing 19.91 million tons while with current earnings the company would have Free Cash flow of INR 46 bn over CY06-CY08 translating into an USD 51/ton premium on account of three years earning only. We have attempted to see the current valuation of the companies in terms of Asset Value adjusted for cash flow of three years (07 to 09) which throws up interesting facts about the companies.

Asset values of adjusted for cash flow of three years.

Capacity Replacement Cost (1) ACC Gujarat Ambuja Ultratech Shree India Cement Kesoram 19.9 16.3 17.0 6.0 11.0 4.5 80.0 80.0 80.0 80.0 80.0 80.0 FCF per/ton for FY07-09 (2) 51.4 68.2 45.7 56.7 43.3 41.7 131.4 148.2 125.7 136.7 123.3 121.7 1+2 Current EV/ton (FY07) (USD) 150.9 192.9 146.7 128.0 110.0 74.2

The analysis shows that the frontline cement companies are either trading at slight premium or at discount to their replacement cost adjusted for 3 years Free Cash Flows. This valuation is at a time when the operating profit per ton of cement sold is in range of 21 to 30 USD per ton, companies have unrevealed balance sheet, are undergoing efficiency enhancement drive and are able to finance their expansion through internal accruals. Besides any delay in roll out of fresh capacity would extend the cement cycle beyond FY09 which would make the Cement majors like ACC and Gujarat Ambuja trade below their asset replacement cost and that makes us see the cement space an attractive opportunity to enter in this phase of correction.

March 19, 2007

Sector Update

Event Update

Some more Asset Plays

CMP Capacity Replacement Cost 80.0 80.0 80.0 80.0 80.0 80.0 80.0 80.0 EBIDTA/ TON 1077.2 998.9 1205.4 1034.0 881.1 862.1 1041.9 603.2 Fair Asset Value 127.9 124.4 133.6 126.0 119.2 118.3 126.3 106.8 Current Value USD/Ton 59.0 67.2 109.4 72.3 102.0 141.1 132.8 65.3

Birla Corp Mangalam Cement Prism Cement Orient Paper Century Textiles Chettinad Cement Madras Cement Mysore Cement

200.0 148.9 32.4 410.3 531.0 415.0 2750.0 39.1

5.8 1.5 2.0 2.5 6.3 2.2 6.0 2.1

March 19, 2007

Sector Update

Event Update

Networth Research: E-mail- research@networthstock.com Research Kanan Shah Rajan Kumar Sumit Gupta Rati Pandit Rishi Maheshwari Brijesh Rajvanshi Surya N. Nayak Shashin Shah Taral Mehta Viral Doshi Amar More Sector Banking / Metals / Shipping Cement / Pharmaceuticals Macro Economy / Capital Goods Hotels / Aviation Information Technology Telecom / Media Associate Mid Caps Associate Equity Strategist Production E-mail id kanan@networthstock.com rajan@networthstock.com sumit@networthstock.com rati@networthstock.com rishim@networthstock.com brijeshrajvanshi@networthstock.com suryanarayan@networthstock.com sdshah@networthstock.com taral@networthstock.com viral@networthstock.com amar@networthstock.com Telephone nos. 022-22836307/8/11 022-22836307/8/11 022-22836307/8/11 022-22836307/8/11 022-22836307/8/11 022-22836307/8/11 022-22836307/8/11

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Networth Institutional Sales: E-mail- dealing@networthstock.com Raj Bhandari / Jignesh Desai / Rameshwar Singh 022-22633020/1/2

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March 19, 2007

Sector Update