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S. Vaidya Nathan

AN INVESTMENT can be considered in the stock of Madras Cements, as its earnings card is likely to benefit from a nascent recovery in the southern markets. The enhanced institutional investor interest in the cement sector is also likely to improve the valuations of the stock; at about Rs 1,000, it trades at a price earnings multiple of about 15 times its likely per share earnings for FY-06. Buy with a one/two-year perspective, as there are risks that could, in the near term, cap the upside from the current levels. Any price weakness linked to broad market trends should be used to accumulate the stock.

This recommendation represents a change in our stance on the stock. We had suggested that investors book profits partially in the stock in June 2004 when it traded at Rs 660. We had also highlighted the need to re-enter the stock at lower levels, as it remains one of the superior options in the cement industry from a long-term perspective. As the stock rarely dipped below the price level at which our earlier recommendation was made, investors would not have had an opportunity to step up exposures. Indeed, they would have suffered an opportunity loss as the stock has in recent months traded in the Rs 900-1,000 range. Our recommendation was linked to supply running ahead of demand in the south, lack of growth in demand, low operating rates and the possibility of lingering pricing pressures. With an improvement in demand growth and price levels that are likely to be sustained, we believe that investors should ramp up their holdings in this stock. However, there are principal risks: A gap between demand and supply, which could act as a pressure point on prices; and low operating rates. So do higher fuel and transportation costs, which could impact profitability levels.

There has been a smart recovery in demand in the southern market last November on. The industry appears to have put behind it the protracted period of flat or declining growth. Even if the growth remains at 5-7 per cent levels, it would provide relief to the players who have had to suffer sluggish prices and operate their capacities at low levels. As for the latter, the worst may be over for Madras Cements.

The company has managed to increase volumes over the past few months and this trend is likely to continue. Given its proximity to its key markets in Tamil Nadu and Kerala, it is well-placed to gradually step up its capacity utilisation levels to take advantage of demand growth. It is, however, unlikely to scale up operating rates too rapidly as that could destabilise pricing levels.

A crucial aspect to the demand-supply equation would be the commissioning of new capacity of two million tonnes by Dalmia Cement, which is expected in July 2005. The effect of this new capacity may get fully reflected in the market dynamics only from FY-07. If demand growth continues to remain healthy, the ability of the market to absorb this additional capacity would be better than what was anticipated last June.

Dalmia Cement, too, can be expected to exercise discipline in bringing this new capacity to the market in phases, as it would also suffer if prices were to come under stress. An aggressive push for market share — on the lines of what ACC and Gujarat Ambuja did in Maharashtra a couple of years ago at the cost of substantially lower prices — appears unlikely.

As Madras Cements is set to commission a captive power facility, there is also the prospect of lower energy costs. Its operating efficiencies have been superior compared to its peers and its margins have been consistently bettered only by Gujarat Ambuja Cements and Shree Cement. This aspect, too, is likely to place it in a more comfortable position to tackle the imminent expansion in supplies in its key markets.

With no capacity expansion plans in the offing, Madras Cements is likely to cut its debt over the next couple of years as it enjoys healthy cash flows from operations. It has benefited from sourcing funds at fine rates and enjoyed steadily declining interest cost. This trend is likely to continue as it cuts its debt levels. The company would also be well-placed to pursue growth opportunities using debt and internal accruals.

It is, however, unlikely to pursue the acquisitions route to growth. We view this as a positive as it ensures that its profitability remain at high levels and provides a cushion even in difficult periods for the industry. The financing strategy has also ensured that the benefits of growth initiatives have accrued completely to shareholders over the years as it has expanded to a six-million tonne player; this is a strength that remains undiluted.

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