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ACC: Are investors expecting too much? - Views on News from Equitymaster

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ACC: Are investors expecting too much?
Sep 10, 2007

Cement industry has witnessed all time high realisations in past few quarters on account of demand running neck and neck with supply. In terms of operations too, the industry has been operating at optimum level, manufacturers have been and are improving blending ratio so as to cater to the incremental demand and have also outlined huge capex plans to expand and upgrade exiting capacities. The improved cash flows on account of improved realisation has helped companies improve their financial position and has also enabled them to fund their capital expenditure plans. However, in case of commodities, historically and quite logically too, capacities have come up when the cycle is at the peak. Planned capacities take 12 to 18 months to commence operations. As mentioned, manufactures incur capital expenditure during peak and since all of them jump onto the expansion bandwagon, supply is enhanced significantly, putting downward pressure on prices. This is the time when industry witnesses a phase of high volumes and poor realisations, which impacts their profitability.

Cement prices are a factor of demand and supply, but another important factor that can help firm up prices is the extent of consolidation in the market. However, even if industry witnesses further consolidation, the current scenario is likely to reverse once the planned capacities come on stream, exerting downward pressure on current high realizations and in turn, affect shareholder returns.

Now, even if we take into account a rather optimistic scenario, there seems to be very little upside potential left at the current valuation.

Generally, we project cash flows to arrive at the stock value. Here, we turn the situation around to find out what are the investors’ expectations that are embedded in the current stock price.

In the past: In the past 10 years, the company has added capacity at a CAGR of approximately 7%, has witnessed 8% growth in production and despatches and net realisations grew by 4% for the same period under consideration.

Assumptions: We have divided the analysis in two parts. Free cash flow projections till CY09 and a terminal value component, which will take care of cash flows in FY10 and beyond. We have projected cash flows till CY09 based on the following assumptions.

  • We have considered cost of capital, a discount factor to arrive at net present value as 15%.

  • The company is planning to expand its capacity from the current level of almost 20 MT in CY06 to 27.5 MT by the end of 2009, i.e increasing at a CAGR of 11% in the next 3 years.

  • We expect company to achieve 4% CAGR in net realisations in the coming three years, considering that realizations are at peak level and substantial industry wide capacity additions.

  • The industry is expected to grow at the rate of 10% annually and we expect company to grow in line with the industry over the next three years.

While we have outlined major assumptions for the next three years, this is not going to be enough. Since the total value of the enterprise is the sum of the present value of the company’s cash flows over the next three years and the terminal value, we will have to plug in an appropriate growth rate for the cash flow for CY10 and beyond. We have come to the conclusion that for the stock to give returns in the region of 15% over the next three years, the cash flows of the company will have to grow at a CAGR of 9% in CY10 and beyond. It should be borne in mind that the growth rate of such a magnitude is not usually taken even for non-commodity companies let alone the commodity companies. Further, if we look at historical growth rates in cash flows for ACC over the last 8-9 years, it has remained in the region of 7% and this is despite the fact that the industry is currently going through one of its best periods ever. Thus, it will take a very brave soul to assume that the company’s cash flows will consistently grow at 9% or more over the distant future.

Now, let us take a look at replacement cost method, which we use to value a commodity company like cement.

Under this method, at the current price of Rs 1,089, the stock is trading at an expensive valuation of over US$ 150 on the enterprise value per tonne (EV/tonne) basis as per our CY09 estimates. This is nearly 50% higher than our fair value replacement cost of US$ 100 per tonne.

We believe that the current good times will continue in the medium term. However, amidst this euphoria, there is a big concern staring industry in its face. This concern is regarding the lower prices of cement once the planned capacities come on stream. As risks outweigh rewards, we suggest investors to exercise caution.

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