Madras Cements: What is it worth? - Views on News from Equitymaster

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Madras Cements: What is it worth?

Apr 2, 2008

In one of our previous articles we analysed investor expectations that were embedded in the then stock price of ACC. In this article, we have tried to analyze investor expectation with regards to the share price of southern major, Madras Cements. The company has presence only in the southern region, which had in the past witnessed excess capacity problems leading to lower realisations as compared to the other regions. However, the company being one amongst the lowest cost cement producers in the country, has been able to sustain its margins at around 25%.

The company is setting up a cement plant in Tamil Nadu and also setting up additional clinkering facility in the state by installing a 4,000 TPD kiln to take its total production capacity to 10 MTPA at an investment outlay of approximately Rs 15 bn.

In the past: In the past 7 years, the company has added capacity at a CAGR of approximately 8%. On account of it being one of the largest cement producers in the southern region and owing to its strong presence within the region, the company has witnessed 11% CAGR in production and dispatches. Net realisations on the other hand, have witnessed a subdued growth of 5.5% as the southern region has always witnessed excess supplies in the past.

Assumptions: To find the expectations of investors at the current price, we have considered free cash flow projections till FY10 and a terminal value component (cash flows in FY10 and beyond). Cash flow projections till FY10 are based on the following assumptions, while for terminal value, we have considered the same to grow at a sustainable growth rate of 4%.

  • We have considered cost of capital, a discount factor to arrive at net present value as targeted weighted average cost of capital (WACC) till FY10 and to discount the terminal value we have considered FY10 WACC.

  • The company is planning to expand its capacity from 6 MT in FY07 to 10 MT in next two to three years (expected to be completed by the end of FY09), i.e increasing at a CAGR of almost 19%. We expect the sales volumes to grow at a CAGR of 17% between FY07 and FY10, an assumption that we believe is rather reasonable.

  • We expect the company to achieve almost 10% CAGR in net realisations in the coming three years, an assumption we believe that is slightly on the optimistic side as a lot of capacities are likely to come on stream in the medium term.

Now after drawing major assumptions for the next three years with respect to margins and growth rates and assigning an appropriate terminal growth rate as mentioned above, we sum up the present value of free cash flows for the next three years and the terminal value to arrive at the enterprise value. After completing the whole exercise, we have come to a conclusion that the current stock price largely factors in the growth prospects and there is little margin of safety at the current valuation.

Even after taking into account an optimistic scenario, the current market price seems to be expensive. Now investors’ should make a note of this that cement ultimately is a commodity and has to face cyclical ups and downs. Post FY04, the industry has witnessed an upturn in cycle resulting in favourable pricing scenario, which has led to improved financial position of the companies. On account of improved cash flows and strong demand expectations, cement manufacturers have lined up huge capex plans. The additional capacity expected to come on stream is over 100 MT in two to three years and the bulk of it will start flowing in by the end of FY09. Once the capacities come on stream, the current high realisations may witness downward pressure impacting margins and in turn returns to shareholders.

We believe that the current good times will continue in the medium term. While the southern region is expected to witness demand growth in line with industry growth rate, once the lined up capacities come on stream as per schedule, the current high realisations may not sustain in future. Hence caution needs to be exercised, as while the medium term scenario is favourable, from a long-term standpoint, the stock is fairly valued.

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