Cement your portfolio

One of the dilemmas of stock investing is that stocks that are acknowledged to have good prospects usually trade at high price to earning ratios.

One of the dilemmas of stock investing is that stocks that are acknowledged to have good prospects usually trade at high price to earning ratios PE. On the other hand,stocks that are available at attractive valuations belong to companies or sectors whose near- to medium-term prospects appear bleak. Investing in both types of stocks carries risks. If you buy a stock at a high valuation,you run the risk that at some point in future its earnings growth may flag,after which the stock price could get beaten down. On the other hand,if you buy a stock belonging to a troubled company or sector,the risks are whether its prospects will improve,and how long you will have to wait before the stock gets re-rated. The advantage of investing in the latter type of stocks,however,is that since you buy at a low valuation,your downside risk how much money you can lose gets limited.

The business

Grasim Industries has three major lines of business: cement,viscose staple fibre VSF,used in manufacturing textiles,and chemicals its sponge iron business was divested recently. In FY08,the cement division accounted for about 57.45 per cent of its revenue,the

VSF division for 29.24 per cent,chemicals for 4 per cent,and sponge iron for 9.27 per cent.

Strengths

Strong past performance. Between FY03 and FY08,Grasim Industries showed good growth: its income rose at a compounded average growth rate CAGR of 27 per cent from Rs 5,899.71 crore to Rs 20,055.81 crore. Over the same period,profit after tax PAT grew at a CAGR of 60 per cent from Rs 319.18 crore to Rs 3,346.21 crore. Another positive feature of its financials is its consistently high return on net worth RONW,which was always above 20 per cent during these five years.

Low valuation. Its current valuation of 8.77 12-month trailing PE is almost 35 per cent lower than its five-year average PE of 13.64 calculated using data at two-month intervals.

Quality management. The company belongs to the Aditya Birla Group which is well known for its quality of management and its global plans.

Market leader. Together with subsidiary Ultratech,Grasim enjoys leadership position in the cement industry it is 11th-largest globally. Moreover,Ultratech its subsidiary has a strong brand name that commands a premium in the market. Grasim is also the leading VSF producer in India with 24 per cent market share globally.

Weaknesses

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Commodity businesses. According to Ashish Kapur,chief executive officer of New Delhi-based Invest Shoppe,Both of Grasims main products are commodities that are subject to cyclical gyrations. As the company depends on exports in the VSF segment,the current global slowdown will have an impact on it. And its cement business is subject to government intervention whenever prices go up.

Current travails. The stock has been beaten down because both its two main divisions cement and VSF textiles belong to sectors that are currently in the doldrums. Demand within the cement sector has been hit hard by the slowdown in housing,infrastructure,and corporate capex plans. Between FY05 to FY08,demand for cement grew at a CAGR of 10 per cent. In FY09 it grew by 8.5 per cent,but in FY10 and FY11 growth is expected to falter further to 7-8 per cent.

More worrying is the over-capacity within the sector all major players have undertaken capacity additions in recent times that is expected to lead to a price decline. FY10 and FY11 prices are expected to be lower than those in FY08 amp; FY09. The over-capacity is expected to last for at least two-three years. VSF prices,too,are expected to decline. The realisation for VSF in FY08 was Rs 1,11,146 per tonne; in Q3FY09 it fell to Rs 1,05,000 per tonne; and in FY10 it is expected to plunge even further to Rs 95,000 per tonne.

Initiatives

The company is augmenting captive supply of pulp in order to keep input costs of VSF under control. It is now also venturing into value-added offerings it has started off by offering two brands of wipe that should help it improve its margins. Its in-house Ramp;D unit is working on more opportunities for making value-added offerings.

What happened in FY09

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During FY09 cement prices were firm and even went up marginally,so revenue kept growing,albeit only in single digits. But Grasims bottomline was affected due to increasing cost of power and fuel,and freight during the first three quarters of FY09. In Q4 the price of imported coal collapsed,and so did freight rates. The entire effect of this decline will be reflected in Q4FY09 and in the next few quarters,enabling the company to maintain its margins.

The future

In future the problem will be one of flat or negative demand and lower prices. According to Pawan Burde,analyst at Angel Broking,My estimate is that revenue growth will be -5.9 per cent due to lower prices of both cement and VSF. Besides,the company divested its sponge iron business at the start of the year,so that revenue will also not appear in FY10. Falling revenue will put pressure on the bottomline.

Should you buy?

In recent weeks the stock price has rallied by 25-30 per cent. According to Burde,it is now trading at a forward PE of 9.8 for FY10 and 10.3 for FY11 Kapurs estimates of forward PE are 10.1 and 11.2 respectively. Considering the downturn in the cement industry,the concern over VSF exports,and the decline in its prices,the current valuation is not attractive. There is further downside to this stock hereon, says Burde. He suggests buying whenever the stock declines. He further adds that investors with only a six-month horizon should stay away; only those with a two-and-a half to three-year horizon should buy the stock. Kapur is more bullish about its prospects. A trailing PE of 8.87 is very attractive for a company of Grasims size and competent management. The long-term prospects of the cement business are good,though the textile portion may act as a drag on its profitability. If you wish to buy the stock,buy a part now and the rest on dips, he suggests. The bottomline: this is a stock for patient investors only. u

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