Sunday, May 09, 2010
Investors with an appetite for risk can consider buying the stock of Kajaria Ceramics, a leading tile manufacturer, trading at 14 times the trailing 12-month earnings.
An annualised growth of 22 per cent over the last five years against the industry's 15 per cent, extensive distribution network, focus on the retail segment, cost-savings following the switch to low-cost fuel and commissioning of domestic production of vitrified tiles that will improve margins, make a case for investing in the stock.
The risk in investment arises from the fact that the interest cover of the company stands at just 2.3 times. Though sales may grow at a fast pace with rising demand in the consumer market and revival in the realty segment, savings on interest front may not be possible.
There has been a repayment of Rs 70 crore of debt (of the total Rs 325 crore) during last year; however, this may be offset by additional borrowings to meet the working-capital requirements.
In FY-10, Kajaria Ceramics' net profit rose four-fold to Rs 35.85 crore, following lower interest costs, foreign exchange gains on import deals (Rs 4.39 crore) and higher sales (up 11 per cent). Nitco Tiles, the closest comparable to Kajaria Ceramics among the listed tile manufacturers, has not declared March 2010 quarter numbers, but reported losses in the June and December quarters.
The tiles business
Kajaria Ceramics has been in the business of tile manufacturing since 1988. From just one million square metre (msm) of tiles per annum, the company's capacity has increased to 23.4 million square metres now.
With a pan-India presence, the company also exports its products to 20 nations across the Europe, UAE and Australia. There only a few listed players in the tile industry; organised players have a 40 per cent share of the market.
The growing demand from the housing segment, new construction in the commercial space, the increasing disposable income of the people, favour the industry's growth. The government's imposition of anti-dumping duty last year on ceramic tiles from China has also given relief to domestic manufacturers. Tiles from China had at one stage threatened domestic manufacturer's prospects with their price advantage.
The key input material for the industry is clay (indigenous as well as imported) in addition to the soluble salts, abrasives, binding materials, etc.
Fuel costs work out to almost 30-35 per cent of the manufacturing expense. Margins at the operating level stand around 12-15 per cent for the industry and, at the net level, at 3-4 per cent. For FY-10, Kajaria Ceramics' managed higher operating profit margins at 16 per cent and net margins of 5 per cent.
Kajaria Ceramics' sales have grown at a 22 per cent CAGR over the last five years. The company has 6,000 dealers and sub-dealers across the country. In 2008-09, the company ramped up its retail market presence significantly to counter the slowdown in orders from the institutional segment.
The company now sells 70 per cent of its products to retail clients. However, with revival in the realty demand, the company is witnessing good order inflows from the big builders, most of whom are the company's regular customers. After a 30 per cent growth in 2008-09, Kajaria Ceramics' net sales reported an 11 per cent growth in 2009-10; partly weighed down by a high base. The company sold 25.28 msm of tiles last year, a 12 per cent growth over the previous year.
In February, Kajaria Ceramics began operations at its newly-built vitrified tile unit (2.4 msm) at Sikandarabad, UP, and produced 0.22 msm of vitrified tiles in the past two months. Until now the company had only been importing vitrified tiles. The company is setting up another six million square metre vitrified tile unit at a capex of Rs 125 crore at its Galipur unit in Rajasthan. This unit will commission production by November 2010.
Margins to improve
Local manufacture of vitrified tiles is expected to improve margins; manufacturing margins (at 20 per cent) are higher than trade margins (8-10 per cent).
However, import of vitrified tiles will not be completely discontinued. Kajaria Ceramics proposes to continue imports for the coastal market as freight costs may wipe out savings in margins if they try to move products from their factories in Rajasthan or UP to these regions. The company's margins would also improve on savings in fuel cost.
Kajaria Ceramics' Rajasthan unit (which contributes to 70 per cent of the company's production capacity), which was all along running on propane fuel, has switched to natural gas with GAIL having completed laying the pipeline for the gas supply.
The change in fuel will result in savings of around Rs 20 crore (18 per cent of the last year's fuel cost) every year as per the company's estimates. In FY-10, operating profit margins improved two percentage points (to 16 per cent).
At the net level, cost-related relief does not appear possible at least this year as depreciation and interest costs will only be higher following new plant installations and higher working capital needs that will be fed by debt. However, margin expansion at the operating level will help net profit margins too. Sales growth and cash flow that will follow are expected to give some respite to the company on the cash front. Following part-repayment of the outstanding debt during the last year, the company's debt-to-equity ratio has come down to 1.39 from 2.09 in the previous year.
Investors can consider picking up shares in steel producer, Bhushan Steel, which trades at Rs 1,570 or 9.4 times the trailing 12 months earnings. The company's aggressive expansion into integrated steel production is likely to lead to better margins and pricing power. This coupled with robust demand for cold-rolled steel variants from the automotive and consumer durables sector make for good odds on this bet paying off over the next two-three years. The company's multiple is at a discount to the steel sector, which trades at 15-16 times earnings.
Bhushan Steel imports hot-rolled steel coils from Tata Steel, SAIL, among other sources. They then re-roll these coils into cold-rolled coils, used mainly by the automotive and consumer durables segment.
The cold-rolled coils are further processed with various coatings, included galvanising (zinc coating), colour coating and so forth. With raw material costs being volatile and the consumers price-sensitive, intermediate players such as Bhushan Steel are left vulnerable to the steel price and consumption cycle. Downturns or spikes in one or both could leave them either with healthy margins or cringing from being squeezed for the last penny.
A move to ease this pressure is Bhushan Steel's transition into a steel producer with captive iron ore and coal mines. The company is in the process of setting up a five-million tonne per annum plant in Orissa to produce hot-rolled coils, a vital input. This would neatly complement their re-rolling facilities in Khopoli, Maharasthra and Sahibabad, UP, by ensuring timely raw material supply. This means incurring a higher fixed cost on operating mines and a steel plant even during downturns in the steel cycle. But integrated producers have less to fear from both the swings in the cycle and oligopoly-ridden raw material setup within the steel sector, than standalone producers.
The company's net sales have grown at 17 per cent annually between FY-05 and FY-09 and net profits at 29 per cent during the same period. Estimated FY-10 sales are likely to be up by 7-8 per cent while net profits may close to double compared to FY-09. The company is quite high on leverage which stood at 3.6:1 at the end of FY-09.
However, the company has seen some relief on debt, evident from the fact that interest cover improved from 3.22 times to 5.75 times for the first nine months of FY-10. Operating margins have been on the rise and peaked at 22 per cent for the first nine months of FY-10, double the average between FY-05 and FY-09. This is largely due to a favourable raw material cost scenario and buoyant demand from users. There is significant scope for upside in margins considering the company's foray into producing HR coils.
Bhushan Steel now processes over 600,000 tonnes of HRC into cold-rolled steel, with a capacity to process just over a million tonnes. It also produces rods, strips and billets. When the second phase of the Orissa plant becomes operational shortly (test runs are underway), it will produce just under two million tonnes of hot-rolled coils which should comfortably meet the in-house requirements.
Add to this mines, a captive power plant and another three-million tonnes of steel production that should become operational by FY-14, and the company appears well-positioned to capitalise on the expected growth in automobiles and consumer durables.
Another trump card is the fact that the land for the Orissa project has been secured, something which several major names are having immense trouble with in the mining belt.
Moves such as a technical tie-up with Sumitomo of Japan to produce auto-grade steel (a sought after competence) and the acquisition of the Australia-based Bowen Energy (high-quality coke) for raw material security are likely to aid margins in the long run. Also on the cards is a steel plant in West Bengal or Karnataka with Sumitomo holding a sizeable stake.
Automobiles and consumer durables, Bhushan's key users, proved quite resilient during the recent slowdown. Automobile sales have grown 30-40 per cent in the past 11 months. Same is the case with several consumer durable segments such as refrigerators and air conditioners.
The consumer durables IIP in Apr 2009-Feb 2010 period grew by 25 per cent over a year ago; this compares to a modest 4 per cent growth over the previous year. Both demographics and macro-indicators indicate a healthy doubling or tripling of automobiles and consumer durables over the next five years; however, the growth is likely to be lumpy.
Bhushan's phased transition into a fully integrated steel producer, if successful, holds the promise of pushing up operating profit margins north of 25 per cent if the price cycle remains firm.
But until the mines are operationalised, Bhushan will have to purchase iron ore and coking coal from volatile spot markets, where current forecasts are beginning to take extreme hues with prices expected to plunge if turbulence in Europe and a slowing Chinese economy pan out.
In such a scenario, India is expected to see steel prices plunge. Alternatively, if governments continue to play the white knight to fragile economies, mining majors may continue to wield pricing power. Steel players will then reap the benefits of volume-driven growth with profits on a leash.
Fresh exposure can be considered in the Housing Development Finance Corporation (HDFC) stock, as the company has witnessed strong growth in mortgage disbursements (27 per cent year-on-year) despite stiff competition.
It maintained its market share in a tough competitive environment (given the teaser rates offered by banks) and yet maintained strong spreads, thanks to fall in cost of funds and superior operating efficiency.
HDFC enjoys cost-income ratio as low as 7.9 per cent against 40-50 per cent for banking companies. HDFC's solid credit rating (AAA) also enables it to raise resources at low cost.
Also, it has decent capital adequacy of 14.6 per cent and superior asset quality numbers.
At the current market price of Rs 2,731, the stock trades at a price-to-consolidated FY-10 earnings of 24.8 times. HDFC's subsidiaries account for a chunk of the stock valuation. HDFC has an investment book of Rs 16,600 crore, with value unlocking opportunities in insurance business in addition to several profitable subsidiaries.
The fair value of all the subsidiaries (AMC, insurance) and investments works out to about Rs 1100 per HDFC share (not assuming any holding company discount).
If this is excluded from the HDFC stock price, the price-adjusted book value for the standalone business would be about 2.9 times.
With the Eleventh Plan projecting a 24.7 million unit shortfall in housing units, potential for market expansion for the home lender remains substantial.
The rising income levels of the individuals, increased focus by the developers on low-cost affordable housing and rising urbanisation, offer immense scope for housing finance.
Given this backdrop, HDFC as the market leader is expected to gain the most even as its focus has been on improving its profitability more than market share.
Incremental bank lending to housing was at Rs 22,000 crore for 2009-10. HDFC alone witnessed incremental lending in excess of Rs 12,500 (estimated) to the retail sector for this period.
The sanction-disbursement ratio of 82 per cent as of March 2010 for HDFC was high, thanks to its retail focus. For 2009-10, HDFC's loan book (adjusted for securitisation) grew by 16 per cent, while the scheduled commercial banks' housing loan portfolio grew by only 8.8 per cent year-on-year.
In addition to its good branch network of 279 outlets, HDFC also leverages on HDFC Bank's network of 1,725 branches for tapping clients and cross-selling its subsidiaries' financial products.
As of December 2009, 31 per cent of mortgages were routed from HDFC Bank. HDFC's low processing time has been its key edge over competition from banks.
Around two-thirds of HDFC's total loans are from retail investors. The average ticket size went up from Rs 11 lakh in 2007 to Rs 16.4 lakh for the nine months ended December 2009, indicating higher affordability of home loan borrowers.
HDFC's average loan-to-value of 68 per cent also provides it with some margin of safety.
The current gross NPA ratio stood at 0.79 per cent and the net NPA at 0.13 per cent. Asset quality improved 21 quarters in a row.
While borrowings from debentures continue to be a major source of funds, resources raised from financial institutions and retail deposit too are catching up.
In addition, HDFC also has other avenues such as securitisation to raise funds. As securitised housing loans are eligible to be categorised as priority lending, HDFC gets competitive spreads. HDFC has comfortable capital adequacy ratio of 14.6 per cent; further capitalisation is expected post-warrant conversion in two tranches beyond 2011.
The stand-alone net profit of HDFC grew at 22 per cent annually between 2005-10 while the consolidated earnings grew by 25 per cent.
Net profit was aided by strong loan book growth of 20 per cent in the last five years. The consolidated earnings grew by 40 per cent in FY 2010.
The strong profit number was supported by improved spreads of 2.31 per cent and low cost-income ratio. Cost-income ratio improved from 8.8 per cent to 7.9 per cent.
HDFC holds 23.7 per cent stake in HDFC Bank; 61 per cent in Gruh Finance; 72 per cent in the life insurance arm; 74 per cent in general insurance and 60 per cent in the mutual fund business.
The AMC business witnessed significant jump in profits during the current year; it posted Rs 208 crore profits against Rs 129 crore in the preceding year.
The life insurance subsidiary also contained losses to some extent for the year-ended March 2010, while general insurance continues to post losses.
HDFC's life insurance business is expected to unlock value as it plans to list next fiscal. The recent acquisition of Credila would diversify its loan book into the high-margin education loan business.
The imminent rise in interest rates may not be of much concern for HDFC in terms of interest rate risk, as 80 per cent of the assets and 82 per cent of liability, as of March 31, 2009, were on a floating basis.
This will enable HDFC to pass on interest hikes to customers. However, asset quality slippages cannot be ruled out.
With the low teaser rates gone and property prices rising, home buyers too may postpone their borrowings, limiting disbursement growth. Around one third of the total advances are for corporate projects, which are still not out of woods.
The priority lending sector status for housing, coupled with tax benefits, has made the sector lucrative.
However, any rollback in tax incentives to housing in the Direct Taxes Code poses a risk.
Investors with a medium-term horizon may buy the stock of construction contractor C&C Constructions, on the merit of its low valuations, operating efficiencies, comfortable order book position with shorter execution periods and wide geographical presence.
At Rs 229, the stock trades at a modest PE of 7.5 times trailing four-quarter earnings, lower than peers such as Valecha Engineering. Investors may accumulate the stock on declines linked to broad markets.
Roads and highways have long been the mainstay of the company, and this segment forms 52 per cent of the Rs 2,738-crore order book (as of March 2010). C&C has carved a reputation for timely execution in difficult terrains such as Bihar and Afghanistan.
In recent times, it has also moved to mitigate risks of sector concentration by increasing presence in higher margin railways (14 per cent of order book), commercial and industrial buildings (29 per cent of order book). It has begun to execute contracts in the water and sanitation segment and power transmission lines too.
The company is thus poised to increase order intake as spending on infrastructure and urban development grows. The order book stands at 3.7 times the sales of FY09 (July 2008 to June 2009) with an average execution period of 24 months, providing near-term earnings visibility.
C&C also undertakes contracts through joint ventures, allowing access to bigger projects and boosting own expertise. It has recently partnered Spain-based Isolux Corsan through which it will be able to execute projects in Asia and much of the Soviet bloc in segments such as oil & gas, power transmission, railways and roadways and bridges. C&C has a strategy of owning high-end equipment, with investment increasing over 60 per cent in FY09. Such investment ensures timely availability of critical equipment, besides operational efficiency. Operating margins are a healthy 24 per cent for the nine months ended March 2010, up from the 19 per cent in the same period the previous year, far superior to its peers. Net profit margins for the same period were at 4.7 per cent against 3.7 per cent last year on account of high depreciation warranted by machinery investment and interest costs on borrowing to fund projects and equipment. Such margin suppression may not persist in the long term as the company completes sourcing key equipment. Sales increased 33 per cent for the nine-month period ending March 2010, while net profits grew 67 per cent.