Valuations of stocks quite expensive
We are quite flummoxed by the market’s unshaken faith in the cement sector despite disappointing financial performance over the past four years. The Street has high hopes of an imminent recovery in cement prices and profitability, as it has had over the past four years.
The cement sector has seen large earnings downgrades over the past three years as the much-awaited recovery in prices and profitability has proved elusive. In fact, the financial performance of the sector has been quite disappointing over the past few years.
With stock prices holding up well and even rising sharply in a few cases over this long period of middling financials, stocks have seen tremendous re-rating of their multiples. The sector seems to be immune to all negative developments and thus, reincarnation as the cement sector may not be a bad idea.
The Street seems to be perennially optimistic about an imminent recovery in cement prices and profitability with the usual arguments of improved supply-demand balance, industry consolidation, limestone shortage and price discipline.
We do not see any great merit in the first three arguments as supply-demand balance will stay unfavourable over the next two years even with a pickup in demand, the industry is fragmenting with smaller entities buying capacities of their larger rivals and India has enough proved limestone reserves for the next few decades.
The fourth argument seems rather self-serving. Price discipline cannot be an investment thesis. Investors hoping for greater price discipline in the cement industry need to view this against
n Increasing fragmentation in the industry with several small players achieving ‘critical’ size,
n The government’s potential tough stance against further misdemeanors; the industry is already in the crosshairs of the Competition Commission of India with two judgments against the industry for alleged price cartelisation, and
n Their own principles and values about investing with the expectation of price collusion; this is a subjective issue though.
Valuations are super-rich on historical earnings. Even after factoring in a steep recovery in cement prices and profitability over FY17-19E, we find valuations of the cement stocks quite expensive. We struggle to understand the rationale of paying 3-6X FY18E BV for largecap cement stocks and 2.5X FY18E BV for smallcap cement stocks.
These are and will remain commodity businesses, irrespective of the Street’s attempts to colour them as branded consumer businesses.