Shree Cement

We reiterate our buy on the stock of Shree Cement at the current price of Rs 774 as there is potential for upside, given the stock’s discounted valuation and emerging strengths.

The stock is up 34 per cent from our earlier ‘Buy’ recommendation in September at Rs 576. The stock trades at a price-to-earnings ratio of just five times, at a sizeable discount to leading players such as ACC and Ultra Tech Cement (7-10 times).

A rising contribution from the company’s power division, improved cost control measures and the falling pet coke prices lend support to earnings prospects. Capacity additions (2.5 mtpa by end FY10) may also give a volume advantage, if strong trends in cement demand sustain.

The risks to prospects of the entire cement sector arise mainly from the addition of new capacities (37 mtpa estimated for FY10) and the likely fall in utilisation rates for players over the next year or two.

If this entire capacity materialises, the market would see a surplus of around 30 million tonne at a 6 per cent demand growth.

However, the recent trend in cement despatches, if sustained, could substantially reduce the expected surpluses.

With a cement capacity of 10 million tonnes and power generation capacity of 117 mega watts, Shree Cement appears to be well placed to capitalise on strong demand for cement and surplus power in its region. In the March 2009 quarter, 20 per cent of the company’s revenues were from power sales.
Power revenues Help

With realisations on surplus power rising and costs falling, the power segment matched the cement division’s contribution to profits during the quarter. Of the Rs 281 crore of profits before interest and tax in the segmental results, cement chipped in Rs 127 crore and power Rs 154 crore.

Revenues from power sales are expected to increase further with the company’s plan of adding another 85 mega watts of power by FY10. The company’s sales growth, at 21.7 per cent for the March quarter was helped by higher power sales, and volume additions which were backed by despatches growth (17.6 per cent for the quarter). Realisations for the company were more or less flat compared to last year.

The company’s cost cutting initiatives and also the falling pet coke prices have brought substantial relief from cost pressures, helping to expand operating profit margins for the quarter. Though Shree Cement’s power and fuel costs in the March 2009 quarter were higher by 28 per cent year-on-year, they saw a sequential decline of 12.6 per cent.
Investments to pay off

Shree Cement has outlined a capex of Rs 1,200 crore for FY10. Half of this would go towards setting up two grinding units, one each at Rajasthan and Uttarakhand which would increase the cement production capacity of the company by 2.5 million tonnes by end-March 2010.

Being a player in the high demand potential region of North, Shree Cement can expect these volume additions to turn to its favour given signs of a pick-up in demand.

While all India cement despatches for the March 2009 quarter were higher by 8.5 per cent year on year and by 11 per cent sequentially, the Northern region has seen a 16.8 per cent growth in consumption in this period. Another Rs 600 crore of capex will go towards building two captive power plants of 85 mega watts.

The company plans to fund 80 per cent of its estimated Rs 1,200 crore capex through internal accruals and the balance by debt. Given the company’s extremely comfortable interest cover (about 13 times for FY09), additional debt can be easily serviced without straining profitability.
Depreciation effect

Due to a changeover to the written down value method of charging depreciation (high in the initial periods of new machinery installation and lower as the useful life reduces), Shree Cement has been witnessing sharp fall in depreciation write-offs in recent quarters.

Lower depreciation and interest costs, even as margins expanded, contributed to a fourfold expansion in net profits for the March quarter. However even at the operating level, the company recorded a good 26 per cent growth (ACC and UltraTech reported a growth of 22 per cent and 8.6 per cent in PBIDT for March 2009 quarter).

Operating profit margins too have reported an expansion of 129 basis points year-on-year; on lower costs and revenues from the power division.