Shree Cements rating: Reduce — Stock’s expensive valuations unjustified

The rise is even more surprising considering the demand outlook has deteriorated, as the economy continues to grapple with COVID-19. (Representative image)

India’s cement sector has witnessed a sharp run-up QTD with the top 5 companies (HSBC coverage) up 25%. SRCM has slightly outperformed the sector (+28% QTD) and significantly outperformed the benchmark (Sensex up 19%). It currently trades at a record forward EV/Ebitda multiple of c24x and PE of c60x, making it the costliest cement stock globally. The rise is even more surprising considering the demand outlook has deteriorated, as the economy continues to grapple with COVID-19.

SRCM’s valuations unjustified
While SRCM benefits from low-cost operations, a history of industry outperformance, low capital intensity and relatively high ROCEs compared to peers, we think expensive valuations point to where the lines between a good company and a good stock are getting blurred. The view has been captured well by value investor Howard Marks in his book The Most Important Thing, where he says “no asset is so good that it can’t become a bad investment at too high a price”.

SRCM trades at an FY22e EV/Ebitda of 18x. Simply put, at the FY22e rate of Ebitda, it would take 18 years to return the investment. The period will increase materially if we account for sustaining capex, working capital requirements, taxes and the time value of money.

The stock also trades at an EV/t of $265 — significantly ahead of replacement cost as well as industry average. At 80% capacity utilisation, SRCM needs to generate an Ebitda/t of $33 to give a paltry 10% return. This implies SRCM’s Ebitda/t would have to surge by 74% from CY19/FY20 levels of c$20/t and c1.8x compared to the global average of $18, to broadly match the cost of capital pre-tax and depreciation.

Excessive optimism
So, what justifies SRCM’s stratospheric valuations? The answer most often is high growth and return ratios compared to peers. However, our analysis suggests SRCM’s growth has been tapering as the high base effect catches up. Also, the rise in valuations has coincided with a fall in ROCEs as SRCM continues to spend on growth despite weak demand. While the ROCEs are above peers, its PB is significantly ahead of peers. Our reverse DCF valuation cross-check points to excessive optimism built into all key valuation drivers. We therefore reiterate our Reduce rating with an unchanged TP of Rs 14,800.